STRATEGIC ASSET ALLOCATION

James ThompsonGovernment 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

C

B

A

Variance of Return

Me

an

Rat

e o

f Ret

urn

0 1% 2% 3% 4% 5% 6% 7%

5%

4%

3%

2%

1%

0

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

Behaviour of matched portfolio

0

20

40

60

80

100

120

140

160

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Interest rate

Valu

e o

f assets

an

d lia

bilit

ies

Pension liabilty

Bond value

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

Lower DecileLower Quartile

Median

Upper Quartile

Upper Decile

0

0.5

1

1.5

2

2.5

3

3.5

4

A B C D

Portfolio

Rat

io o

f A

sset

s to

Lia

bili

ties

90%

75%

50%25%10%

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?