
STRATEGIC ASSET ALLOCATION James Thompson Government Actuary’s Department United Kingdom
What is strategic asset allocation? The efficient optimisation of investment allocation to major asset classes of investment in order: - to meet the overall investment objectives of the institution and - to achieve an acceptable balance between risk and return
As opposed to tactical investment selection • Tactical investment selection is the choice of individual investments in line with the chosen strategy • Both strategic and tactical decisions are important • But the strategy will often be the more significant determinant of performance
Purpose of investment • allow liabilities to be met as they fall due • liquidity • matching • aim to produce good return to minimise cost of benefits (or increase benefit levels) • control risks - diversification • provide security for members’ benefits • stabilise contribution rate
Also …. • provide source of government funding • provide finance for specific government investment projects or to further government policy • develop capital markets
General principles • assets should be appropriate to the liabilities • diversification is needed to reduce risk… • …between asset classes and within classes • trade-off of risk and return • correlations of risks and returns
Classical asset allocation theory • optimisation of risk and return (Markowitz) • there is a wide spectrum of possible portfolios • rational investors select strategy on frontier… • …to maximise return for given level of risk… • …or to minimise risk for given level of return • combine portfolio with risk-free assets to reflect acceptable level of risk • assumes asset returns are known and normally distributed
Efficient frontier 5% 4% 3% 2% 1% 0 B A C Mean Rate of Return 0 1% 2% 3% 4% 5% 6% 7% Variance of Return
However this approach is simplistic • returns are not normally distributed and variance is not the only measure of risk • the returns, variances and correlations are not known, and may change over time • does not have regard to the liabilities
Liabilities • investments aim to allow the liabilities to be met • some more uncertain than others • promise to pensions or other cash benefits in future • promise to provide non-cash benefits such as healthcare • contingent liabilities, including catastrophe and fluctuation reserves
Nature of liabilities • identify the liabilities to which the investments relate • amount and timing • nominal or related to inflation • currency • degree of uncertainty in amount and timing • possible embedded options
Possible investments • depends on market • government bonds • corporate bonds • index-linked bonds • bank deposits • equity shares • real estate • derivatives
Also … • mortgage loans • government projects • works of art • precious metals • commodities
Nature of investments • amount and timing of cashflows • nominal or linked to inflation • marketability/liquidity • volatility of value • default risk
Other factors • diversification • accountability mechanism • political interference • social security legislation • impact on stakeholders • regulation • expertise • expenses
Matching the assets and liabilities • matching involves investing in instruments whose value will behave in a similar way to the value of the liabilities in varying financial conditions • if absolute matching, no future changes in conditions would affect the ability to meet the liabilities • in practice, matching will never be absolute • matching may be low risk, but may be expensive if the matching assets have low returns
Example of matching • there may be a liability to pay pensions, increasing in line with prices, to an existing group of pensioners • the pensions in effect represent a stream of payments linked to prices over the next 30 years or so • index-linked government bonds also represent a stream payments linked to prices • hence matching could be achieved by investing in a portfolio of index-linked bonds whose duration was similar to that of the pensions
Example of matching • in practice, the position may be much more complicated than this • liabilities will also relate to current workers and their benefits may therefore depend on wage as well as price inflation • the scheme may be only partially funded raising the question of which liabilities are funded and can be matched • future contributions might be regarded offsetting future payments but this adds further uncertainty
Asset-liability modelling • determine the measure to be controlled by the investment policy, e.g. the funding level (assets as a percentage of liabilities) or contribution rate • stochastically project liabilities and assets • many different investment models and parameters which will produce differing results • compare results from different strategic asset allocations
Funding level after 15 years 4 3.5 3 90% 75% 50% 25% 10% Upper Decile 2.5 2 Upper Quartile Ratio of Assets to Liabilities 1.5 Median 1 Lower Quartile Lower Decile 0.5 0 A B C D Portfolio
Suitability of asset classes • Cash and short-term deposits • usually low risk and low return • useful for liquidity (e.g. for a working balance and fluctuation reserves) • not generally appropriate for longer duration liabilities except as a short-term tactical measure
Suitability of asset classes • Government bonds • a variety of terms means they are often useful as matches for certain liabilities • longer-term bonds can be vulnerable to high inflation and therefore index-linked bonds may be preferred if liabilities are inflation linked • may be relatively marketable, although this will depend on the country concerned • generally low risk and low return
Suitability of asset classes • Corporate bonds • similar to government bonds but less secure (and consequently higher return) • risk will vary according to the issuer and may change during the course of the investment • market for corporate bonds usually less broad and less liquid than that for government bonds • will be affected by wider economic sentiment and may therefore have depressed values at precisely the time they are needed (e.g. in a recession)
Suitability of asset classes • Equities • more risk and higher expected returns than bonds • historically have produced considerably higher returns than bonds • returns should be linked to future economic fortunes of the country • however, the value of equities can vary very widely in the short and long-term • high levels of equity investment may lead to issues of government control and indirect nationalisation • market in equities may be limited or non-existent in some countries
Suitability of asset classes • Foreign investment • useful in order to diversify • can take advantage of investments not available in the domestic market • may introduce currency mis-matches which can be mitigated by suitable hedging • central banks may be concerned over possible adverse currency flows • tax may be levied in foreign countries
Suitability of asset classes • Real estate • some features of bonds and equities • generally illiquid and expenses of managing such investments can be high • investment in domestic property (houses) may be sensitive and prone to political interference
Benchmarking • set a benchmark against which to measure performance • benchmark might be a low risk matching portfolio… • …or perhaps an index or combination thereof • effect of deviating from the benchmark can be measured • is the extra return worth the risk?