The Credit Conundrum- Strategic Asset Allocation

26th March 2009

The Credit Conundrum

Session 1: Strategic asset allocation

Agenda

Strategic Asset Allocation

Agenda

2

Context


• Importance

• History

Current Markets

• Impact

• Strategy vs Tactics

Governance

Why Credit?


Trustee Governance

Investment Strategy

Portfolio Strategy

Monitoring

ALM Analysis

Set Goals / Objectives

Implementation

Trustee Governance

• Strategic asset allocation form a key part of the Investment and Portfolio Strategy

• Setting goals and objectives of the stakeholders is an absolute pre-requisite

3


Relative Importance

Investment Strategy

Portfolio Strategy

Monitoring

ALM Analysis


Implementation

Relative Importance

• Historically insufficient focus on goals and objectives of the key stakeholders and overall investment strategy

• Necessary inputs to an effective Portfolio Strategy and in particular a Strategic Asset Allocation

• But what do they really mean...

4


Destination “Fully Funded” – Flight Plan

Minimum Funding Level

Cone of Uncertainty

Cone of Uncertainty

FRS 17/IAS 19

BUYOUT S75

5


Understanding the Players

6

Fuel Efficiency

Common Objectives • Shut down un(der) rewarded

risks • Optimise portfolio

performance

• Funding level • Value at Risk

• Contribution volatility • IAS19 Expected Return

• Solve for risk • Set risk budget using 3 lenses • Build consensus • Implement hedging strategy • Seek to optimise risk adjusted return

(Fuel Efficiency) • Be proactive in changing market

conditions • Apply regular risk monitoring and

risk management

Redington Approach

Risk Return

Virtuous Circle

Trustees Sponsor


Trustee Time Spent

Investment Strategy

Portfolio Strategy


Implementation

Trustee Time Spent

• Significant time spent on manager structures and selection

• Monitoring focused on manager performance versus benchmark

• Until recently not enough time spent on

• Volatility and impact of liabilities

• Monitoring funding vs objectives

• Sponsor covenant

Monitoring

ALM Analysis

7

Importance of Asset Allocation – Academic Research


Importance of Asset Allocation

Study 1 /2 Study 3 Study 4

Authors Brinson, Hood & Beebower / Brinson, Singer & Beebower

Ibbotson & Kaplan Drobetz & Kohler

Publisher and Date Financial Analyst Journal (1986/1991)

Financial Analyst Journal (2000)

Universities of Basel and St Gallen (2002)

Data Used

91 Large US Balanced Pension Funds 1974 –1983 / 82 Large US Balanced Pension Funds 1977-1987

58 US Balanced Pension Funds 1993 –1997 and 94 US Balanced Mutual Funds 1987 –199

51 German and Swiss Balanced Mutual Funds 1995 –2001

Fin

din

gs

% of the Variability of Portfolio Return over Time Explained by Strategic Asset Allocation

94% / 92% Pension Funds 88.0% * Mutual Funds 81.4%

83%

% of the of Total Long-Term Portfolio Return Explained by Strategic Asset Allocation

112% / 101% Pension Funds 99% * Mutual Funds 104%

134%

Source: Evercore Pan-Asset Capital Management Limited

8

A Brief History – Who is Responsible?


A Brief History

9

Balanced Mandates – Delegation to manager

Core Satellite – More active management of satellite

Growth vs Matching Assets

Diversification – Wider range of options

Liability Driven Investment (LDI)

Global Tactical Asset Allocation (GTAA) – Back to delegation?


Impact of Recent Market Changes

10

Equity Indices rebased – Returns

• Since the beginning of 2008, World Equity markets have produced very poor performance:

• FTSE ALL Share TR: -40% • S&P 500: -50% • Eurostoxx 50: -56% • Nikkei 225: -53% • Pacific ex Japan: -39%

Equity Indices rebased - Volatility

• The volatility of world equities has increased to unprecedented levels.

• FTSE ALL Share TR: +19% • S&P 500: +27% • Eurostoxx 50: +24% • Nikkei 225: +27% • Pacific ex Japan: +15%

Market Changes

World Equities – High Negative Returns/High Volatility

11

Market Changes – World Equities

Do future expectation of the equity risk premium provide adequate reward for the higher volatility?

Source: Bloomberg

Source: Bloomberg

12

Market Changes

Historical Credit Spreads

Source: Bloomberg / Barclays Capital Redington

Market Changes – Credit Spread

Is credit spread just reward for corporate risk? What about an illiquidity premium?

13

Market Changes

Asset Performance

Market Changes – 12-Month Rolling Asset Performance

Source: Bloomberg / Barclays Capital Redington

• Most growth assets correlated?

• Matching-like assets uncorrelated to growth assets ?

Is diversification working?

14

Market Changes

Gilts yield vs. Swaps

Swap spreads

• Nominal swap spread widening has been concentrated in the longer tenors (beyond 10 years)

Index-linked gilts & swaps

• Index-linked gilt yields remain well above rates on equivalent real rate swaps

Market Changes – Gilts Yield vs. Swaps

Market anomalies persist. Opportunities for real money investors?

Source: Bloomberg Source: Bloomberg

Governance Structure

Scheme Governance Structure

Delegates from Sponsor

Risk/Finance

Delegates from Investment

Manager

Experienced LDI Manager

Trustees

Investment Sub-Committee

/Working Party

Redington Partners

Redington Investment Consultants

15


Effective Governance Process

• When do tactics take over?

• Transition – Implementation and execution

• Monitoring – Progress and adapting to changes

Where on the Spectrum


Where on the Spectrum

Lower Return, Lower Risk

Higher Return, Higher Risk

Matching Assets

Growth Assets

Credit Credit

In 2009 • Credit has Growth characteristics. • ...as well as maintaining its matching characteristics

16

Economy & Finance

The Credit Conundrum- Strategic Asset Allocation