The Art of Risk Management- Accessing Assets Efficiently
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This document discusses strategies for accessing different asset classes in order to obtain beta and alpha returns. It defines beta as market returns and alpha as returns generated through manager skill. It then provides examples of how to access various asset classes like equities, credit, and alternatives in order to obtain beta in a low-cost, passive manner or alpha in an active manner by removing investment constraints. The conclusions emphasize choosing investments that provide beta efficiently and cost-effectively, and only pursuing alpha if one believes in manager skill by giving managers flexibility in their mandates.
The Art of Risk Management- Accessing Assets Efficiently
- 1. A NEW DESTINATION FOR ASSET & LIABILITY MANAGEMENT 10th November 2008 The Art of Risk Management Accessing Asset Classes Efficiently
- 2. 2 Accessing Asset Classes Efficiently Contents Accessing Beta and Alpha 3 Accessing Beta Efficiently 5 Accessing Alpha Efficiently Alpha – Credit 8 Alpha – Equities 11 Alpha – Portable 13 Conclusions 15
- 3. Accessing Assets Efficiently Accessing Beta and Alpha 3
- 4. BETA ALPHA DEFINITION The return from the market The excess return generated by skill of an investment manager DRIVERS OF RETURNS Macroeconomic factors Managers’ unique decisions NO. OF SOURCES Relatively few Virtually unlimited CORRELATIONS Modest Low DISPERSION IN PERFORMANCE Relatively consistent performance Large dispersion on risk-adjusted basis AGGREGATE CHARACTERISTICS Positive sum game across asset classes Zero sum game across managers FORECAST RISK Low High FEES Can be accessed for low fees Usually accessed for higher fees Comparing Beta and Alpha Accessing Asset Classes Efficiently Accessing Assets Efficiently 4
- 6. Beta Accessing Asset Classes Efficiently Understanding Beta 6 Cash Derivatives Index Funds Equity Options Exchange Trade Funds (EFTs) Index Futures • Active Funds – wide range of active managers. • Part of return – also provides alpha; • Core and Satellite structures; • Relatively high charges. • Index Fund - a liquid, passive investment. • A portfolio constructed to match or track the components of a market index; • Available across equity and bond classes; • Provides broad market exposure, low operating expenses and low portfolio turnover. • Exchange Trade Funds (ETFs) - a liquid, passive investment.
- 7. Using Call Options Original Equity Allocation • Benefits from equity risk premium; • Exposed to equity beta volatility that may generate unwanted downside risk; • Large exposure to single source of return. Call Option Strategy • Use of long dated call options (e.g. 10 yr): • Captures equity premium, and; • Matches the long dated liabilities. Accessing Asset Classes Efficiently Using Call Options 7 Equity Option
- 8. Accessing Assets Efficiently Alpha - Credit 8
- 9. Shortening Credit Duration Sterling Spreads vs. Maturity (bps)Cumulative Default Probabilities on Maturity (20) 0 20 40 60 80 100 120 0 5 10 15 20 25 30 AA BBB A Source: Moody’s, Citigroup calculations. • Comparisons of spreads and default rates by tenor would suggest: • Shorten the corporate bond duration; • Lengthen duration through swaps or use of Supra/Sovereigns; • Diversify UK Gilt portfolio into alternative Supra/Sovereigns; • Consider diversifying into structured credit solutions. • Substantial risk savings can be achieved at limited or no cost to expected returns. 0% 2% 4% 6% 8% 10% 12% 14% 0 5 10 15 20 25 30 AA BBB A AAA Accessing Asset Classes Efficiently Shortening Credit Duration 9
- 10. Traditional (Cash) Assets • A wider selection of credit, not limited to financials and utilities. Alternative Assets • For example, an even wider selection of credit, i.e. loans. GiltsCorporate Bonds (5-10Yrs) Swaps Absolute Returns Short Term Short Term Long Term Long Term Accessing Asset Classes Efficiently Shortening Credit Duration 10
- 11. Accessing Assets Efficiently Alpha - Equities 11
- 12. Accessing Asset Classes Efficiently Removing Constraints 12 • Fund manager is better able to implement his negative views on individual stocks in addition to his favourable ones NB: In practice the percentages of 130/30 can vary according to the targeted market(s) Equity 130/30 Fund 1. Put 100% of the capital into an index such as a UK banking sector index 2. Then sell short 30% in the stocks expected to do worse than the market 3. Use the proceeds of selling short to go 30% long on stocks likely to beat the index 4. This strategy can add up to 2% of additional return whilst reducing volatility. • A fund manager can fully implement both positive and negative views on particular stocks Equity Long/Short Strategy 1. Borrow shares 2. Sell immediately 3. Place proceeds on deposit 4. Buy back when price corrects 5. Returns shares to lender
- 13. Accessing Assets Efficiently Alpha - Portable 13
- 14. Separating Two Sources of Return – Portable Alpha Portfolio Return Alpha = Beta Market Return Portable Alpha GBP Cash Short Beta e.g. using futures GBP Cash – + = Accessing Asset Classes Efficiently Portable Alpha • Investment returns in most asset classes can be attributed to “alpha” and “beta” components. • Beta returns are the reward delivered by exposure to an asset class, usually gained from taking passive market exposure. • Alpha is the return in excess of an appropriate benchmark that may be provided by active management; it is achieved by investment or manager skill. • Portable Alpha solutions allow the separation of these two sources of return. • Portable Alpha allows asset allocation returns – those which result from the market’s (beta*) – and the returns attributable to manager skill over and above market returns (alpha*) to be captured independently of each other. 14
- 15. Conclusions Accessing Asset Classes Efficiently Conclusions 15 • The market provides a wide range of instruments that can be used to access risk and return. • This choice provides Trustees with the opportunity to tailor their risk management policy to meet their scheme’s specific requirements. Two Key takeaways • If you choose to invest passively, i.e. seek Beta then: Invest Efficiently and Cost Effectively • If you believe in manager skill, and thus seek Alpha, do so by: Removing as many constraints as is consistent with your Risk Budget
- 16. Contacts Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415 dawid@redingtonpartners.com Robert Gardner | Partner Direct: +44 (0) 207 250 3416 robert.gardner@redingtonpartners.com Redington Partners LLP 13 -15 Mallow Street London EC1Y 8RD Telephone: +44 (0) 207 250 3331 www.redingtonpartners.com THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT Contacts Disclaimer Disclaimer For professional investors only. Not suitable for private customers. The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence . Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect. Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. 16