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18 September 2003
Joeri van AlphenLodewijk van Pol
Modelling Active Management
AFIR 2003, Maastricht
2
Agenda
Introduction
The model
Example
Application to manager structure
Conclusion
3
Absolute versus relative risk
Efficiënte Grenslijn
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
5.25
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5
Standaarddeviatie
Gem
iddel
d reë
el ren
dem
ent
Quarterly PerformanceRelative to Benchmark
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
III1996
I1997
III I1998
III I1999
III I2000
III I2001
Added Value Rolling three year added value Added value target
4
Active return matters
An additional 1% return saves an average pension fund about 6% contribution of payroll
In a low return environment, additional return from active management becomes more important
5
Model
Active return normally distributed with expectation and standard deviation TE
Portfolio return Rp = Rb +
Portfolio risk: standard deviation of benchmark (b ) tracking error (TE) correlation between Rb and
2,
2 ***2 TETE bbbp
6
Impact of TE and correlation on portfolio standard deviation
Impact of TE and correlation
18%
19%
20%
21%
22%
23%
24%
25%
26%
0% 1% 2% 3% 4% 5% 6%
TE
Sta
ndar
d d
evia
tion o
f act
ive
port
folio
Cor = 0.75
Cor = 0.50
Cor = 0.25
Cor = 0.00
Cor =-0.25
7
Some real-life examples
Standard Deviation European Equities of Managers versus Benchmark
0%
5%
10%
15%
20%
25%
30%
Benchmark 20.3% 20.3% 20.5% 20.5% 20.1% 20.6%
Portefeuille 22.5% 21.3% 21.6% 23.1% 21.1% 25.7%
TE 5.5% 6.0% 3.7% 4.5% 3.1% 8.6%
Cor 28.1% 2.3% 20.7% 49.2% 22.8% 46.3%
1 2 3 4 5 6
Portfolio
8
Two “active” asset mixes
Example 1 (IR = 0.5) Example 2 (IR = 0.25)
Bonds(50%)
Equities(50%)
Bonds(50%)
Equities(50%)
Alpha 0.5% 2% 0.25% 1%
Trackingerror
1% 4% 1% 4%
Correlationof alpha andbenchmark
0 0.5 0 0.5
9
Two “active” asset mixes compared with 50/50-benchmark and 40/60-mix
Efficient frontier
50/50, IR=0,5
50/50, IR=0,25
50/50 40/60
2.00
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
5.25
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5
Standard deviation (%)
Ave
rage
rea
l ret
urn
(%)
10
Two “active” asset mixes compared with 50/50-benchmark and 40/60-mix
Efficient frontier
50/50, IR=0,5
50/50, IR=0,25
50/50
40/60
3.75
3.85
3.95
4.05
4.15
4.25
4.35
4.45
4.55
4.65
4.75
3.5 3.6 3.7 3.8 3.9 4.0 4.1 4.2 4.3 4.4 4.5
Standard deviation (%)
Ave
rage
real
ret
urn
(%
)
More efficient manager structure
11
What is manager structuring?
How can the strategic investment allocation best be implemented taking into account the efficiency of markets, the capabilities of investment managers and the costs of investment management?
12
The Investment processPension funds
Follow upSearch & selectionImplementationALM study
ISSUES TO CONSIDERSERIES OF DECISIONS PRE-DEFINED CRITERIA USEDFOR SELECTION /REVIEW
ISSUES TO CONSIDER
financial strength•Nature of Fund's liabilities and
•Legislative issues, Accounting
•The risk tolerances of sponsoring organisation
•Specific Issues of relevance tothe Fiduciaries
• Transition Management
• Investment guidelines• Statement of Investment
Policy
• Custody
•Active versus passive investment management
•Specialist or balanced mandates
•Multiple versus single manager structures
•Organizational criteria•(stability, commitment)
•Process related criteria•(research, risk management)
•Product related criteria•(performance, fees)
Determine Investment Objective / Set Asset Allocation Strategy
Determine Investment Management Structure
Review / AppointInvestment Manager(s)
Implement & Document Changes
• Monitoring & Evaluation
13
Why is it important?
ALM study Implementation
Risk Benchmark +
Return Benchmark +/- (?)
Costs = zero! +
Implementation affects Assumptions of the ALM study
Manager structuring is focussed on controlling this process
Possibly to enhance return and diversify risk
14
Concepts & Approach
Three basic questions
Active versus passive investment management
Balanced versus specialist investment management
Multi versus single investment management
15
Active versus passive Investment ManagementThree issues
(in)Efficiency of markets
Potential of positive alpha and information ratio
Need to reduce risk
Costs
Transaction costs
Management fees
Diversification
Low correlation of Alpha with benchmark
Volatility of (active) portfolio is not sum of passive + TE
16
Active versus passive: a variety of degrees of activity
TABEL: VARYING DEGREES OF ACTIVE MANAGEMENT
Outperformance target (alpha) and risk budget (tracking error)
(Global) equities (Euro) fixed incomeType ofmanagement
Alpha Tracking Error Alpha Tracking Error
Passive 0% 0% 0% 0%
Index enhanced 0,5% - 1,0% 0,5% - 1,5% < 0,25% 0,5%
Light active 1,0% -2,0% 2,0% - 4,0% 0,25% 0,5% - 1,0%
Active 2,0% - 3,0% 4,0% - 6,0% 0,5% - 1,0% 1,0% - 2,0%
Agressive active 2,0% - 4,0% >> 6,0% 1,0% - 2,0% 2,0% – 3,0%
17
Active versus passive Investment ManagementTransaction costs: equities
Transaction costs Equities
Large Cap
0
20
40
60
80
100
120
US /NorthAmerica
Euro Japan EM Markets
Ba
sis
po
ints
maximum
average
minimum
18
Active versus passive Investment Management Management fees: global equities
Active management feesGlobal Equities (active)
0,0
20,0
40,0
60,0
80,0
0 - < 50 50-100 100-200 200-500 500-1000
Assets under management (euro ml)
Basis
po
ints
Minimum
Average
Maximum
19
Balanced versus specialist Investment ManagementPros and cons of specialization
+/+ of specialization
Select capability out of larger universe
Diversity of Investment styles
Greater flexibility in appointment
-/- of specialization
Higher fees
More complex communication
TAA will require additional solutions >> consistency problem
Extra costs for Monitoring & Evaluation, appointment
20
Summary & Conclusions
Manager structuring has impact on ALM assumptions
All pension funds have to decide on:
Active versus passive
Balanced versus specialist
Multiple versus single
Modeling and quantification is possible, but…
Make careful assumptions!
In active equity investment management, style diversification appears attractive