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Aspects of RiskRisk Management Within The Investment Portfolio
September 28, 2011
© 2011 Towers Watson. All rights reserved.
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Today’s Presenters
Jon Pliner, Investment Strategy Consultant
Mark Ruloff, Director of Asset Allocation
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Today’s Discussion
Opening Thoughts
Payout/Liability Hedging
Better Diversification
Risk Steering
Risk Pricing
Long-Termism Risk Return Concepts
Beyond Investment Policy
Closing Thoughts
4
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Opening Thoughts
Holistic
Many tools beyond diversification and liability hedging
Risk return management
5
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6
Standard Efficient Frontier
Illustrative EfficientFrontier
100%90%
80%70% 60%
50%40% 30% 20% 10% 0%
3%
4%
5%
6%
7%
8%
9%
12% 13% 14% 15% 16% 17% 18% 19%
Most Desirable
Efficient FrontierPoint Labels represent % fixed income
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Most Desirable
Asset/Liability Efficient Frontier
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Liability Hedging
8
Desirable
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Recent signs of slowing economic growth in the developed world have led to falling bond yields and a sharp sell off in equities
The USD has strengthened against many currencies, reinforcing it’s “safe haven” status
This in turn has led to rising uncertainty and increased market volatility, consistent with our “Bumpy Path with Slow Recovery” central scenario
An Eventful Couple of Months
9
Sources: Thomson, Towers Watson
Consumer confidence indicators
Fast(EM FX appreciation)
Slow(EM inf lation, DM def lation)
High(Fiscal stimulus,
high market liquidity)
Low(Fiscal austerity,
tight market liquidity)
Speed of global rebalancing(EM policy choices)
Public policy and financial conditions
(DM policy choices)
EM Overheating
Global growth slowdown
DM Deflation
High DM inflation
DM sovereign
debt crisis
Bumpy path with slow recovery
High DM
growth
EM: Emerging Markets DM: Developed Markets
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Despite low absolute yield levels, the long end of the curve implies a normalization of cash rates in line with our outlook for anaemic economic growth in the US and Europe
Though moderately unattractive versus cash, yield curves still support hedging long-term liabilities
Government Bonds
10
Bond Yield Curves (As of August 31, 2011)
Source: Bank of England, Deutsche Bundesbank, Federal Reserve, Bank of Japan
Asset allocation in volatile times. What now?
Global Markets OverviewGlobal Investment Committee, September 2011
In this issue
2The outlook for EM equities
4Summary of market views
5World markets statistics
6Notes
• Valuations of risky assets fell sharply in early August. In a “normal” business cycle current market levels (especially global equity markets) would look attractive, supported by a new global easing cycle in reaction to the current broad-based economic slowdown.
• However, the high debt levels and deleveraging needs in developed countries that are constraining governments and households and weakening conditions have important structural elements. This is not a “normal” cyclical/ liquidity environment and a sustainable solution for growth and jobs requires bothmoney printing on the monetary side and specific structural reforms (egpublic finance reform in Europe and housing reform in the US) on the fiscal side.
• Recent mediocre growth rates in the developed world and a necessary slowdown in over-capacity emerging economies have been an important driver of falls in risky assets. However, economic and financial outcomes remain highly dependent on policymakers and politicians, especially in the euro area. This will continue in the short-term, keeping investor sentiment fragile and market volatility high.
• When thinking about asset allocation it is important to balance perceptions of value against a forward-looking view of the macro risks. Our central outlook is still for policymakers to adopt a gradualist approach to addressing the headwinds undermining economic growth and jobs and avoiding the very bad economic and market outcomes. Nevertheless, there are still significantly more positive and more negative risk scenarios that are plausible based on policymakers boldly addressing the structural problems or failing to address sovereign, bank or household solvency concerns. Moreover, these policy actions are very difficult to predict accurately.
• While risky asset valuations are moderately attractive, we do think them sufficiently compelling to take an overweight position. Equally, the current relative pricing of bonds and equities does not support an underweight position in risky assets. We continue to recommend an aggregate neutral stance on risk.
• Within global equity markets, we have a regional overweight to Asian and broader emerging markets. Given the price declines this year, EM equities in general offer good value. Our favoured dividend discount approach suggests that equities are now discounting a long-term real earnings growth rate that is markedly lower than our view of trend growth. We expect EM equities to outperform DM with a three to five year view, although this is not without risk.
Three-Year Horizon
Asset Class View
Global Government BondsModerately Unattractive
Global Inflation-linked Bonds Neutral
Global Credit (Investment Grade) Neutral
Global EquitiesModerately Attractive
CommoditiesModerately Attractive
Figure 01. Our current viewsModest opportunities due to recent moves, relative to cash
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Diversified Portfolio: Risk/Return Buckets
11
Typical portfolio Well diversified portfolio
Source of returns as a percentage of total return
The typical portfolio includes some diversification….
…but equities still dominate returns (and risk)
In building a diversified portfolio, it is therefore important to think about sources of return and risk, rather than asset allocation
Term risk premium
Credit risk premium
Equity risk premium
Equity risk premium
Insurance risk premium
Skill risk premium
Inflation risk premium
Term risk premium
Credit risk premium
Inflation risk premium
Skill risk premium
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Alternative beta
Treasuries and cash
Corporate bonds
Developed equities
Private markets
Emerging wealth
Traditional Unconstrained
Treasuries and cash
Corporate bonds
Developed equities
Private markets
Emerging wealth
Source: Towers Watson
Hedge funds
Alternative beta
Alternative credit
12
Sample DB Pension Fund
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A sharp sell off leaves equities moderately attractive, albeit with significant downside risks given the large macro risks the economy faces
Emerging equities look attractive to developed equities given recent performance and long term outlook for growth
Equities
13
Most markets look attractive based on simple valuation metrics
Sources: Bloomberg LP, Towers Watson
Markets have failed to rally significantly from the August lows
Sources: Bloomberg LP, Towers Watson
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20%FI (LGC)30%FI (LGC)
40%FI (LGC)
50%FI (LGC)
2%
4%
6%
8%
10%
12%
14%16%
18%
20%22%24% 26%
30%
2%
4%6%
8%
10%
12%
14%
16%
18%
20%22%24%
26%28%30%
$200
$210
$220
$230
$320 $330 $340 $350 $360 $370 $380
Combined: PV of Cumulative Contribution + TL Deficit ($M)95th Percentile
Asset/Liability Frontier Year 2019
28%
Sample Analysis of Dynamic Asset Allocation: Cumulative Contributions plus Deficits
Com
bin
ed:
PV
of
Cum
ulat
ive
Con
trib
utio
n +
TL
Def
icit
($M
)50
th P
erce
ntile
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Risk Steering
Dynamic Asset Allocation Separating funded status trigger into interest rates, returns, and contributions
In declining markets
Enterprise Risk Management Compare investment portfolio options with core operations
Consideration of investments compared to core business risks Sponsor Beta
Commodities
Inflation
Cash contributions
15
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0
100
200
300
400
500
600
700
800
-27
%
-23
%
-19
%
-15
%
-11
%
-7%
-3%
1%
5%
9%
13
%
17
%
21
%
25
%
29
%
33
%
37
%
41
%
45
%
49
%
53
%
57
%
61
%
65
%
69
%
73
%
Amount
Fre
qu
en
cy
65% Fixed Income - no Collar 65% Fixed Income with Collar
16
5th %
ile – no Collar
5th %
ile – Collar
25th %
ile – both
50th %
ile – both
75th %ile – Collar
75th %ile – no Collar
95th %ile – Collar
95th %ile – no Collar
16
Collared vs. Uncollared Domestic Equities: Annual Return
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Approach is often to obtain the appropriate hedge for a certain risk exposure at the cheapest possible price
However, markets are complex and we expect negative swap spreads to continue to persist in the near-term
We outlined rationale for our view in a note to clients earlier this year
Development of Liability Hedging Elements
17
Sources: BarCap, Towers Watson
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Risk Pricing
Puts, calls, and collars
Swaps, Swaptions, and Swaption collars
Generally would be a loss of value if done always and passively
Requires good governance to know when to use and how to implement
Could depend on connection with enterprise risks Put on swaption to avoid “unbearable” situation, like breaking of bond
covenants
18
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Long-Termism Risk/Return Concepts in Model Portfolio
Risk framework Risk return framework
Risk return management, not just measurement
Long-term risk return management framework
Risk scenarios
Theme investing
Extreme risks
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Sustainability
20
Sustainable Investing
Social and Environmental
Goals
Return Goals
Risk Management
Goals
Universal Owner
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Beyond Investment Policy
PensionRisk
Effective at managing active liability risk profile and long-term
plan cost
Effective at managing short-term plan cost and volatility
Effective at managing long-term plan cost and volatility
Effective only for short-term issues
BENEFIT STRATEGY
FUNDING STRATEGY
ASSUMPTIONS & METHODS
INVESTMENTSTRATEGY
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Holistic
Many tools beyond diversification and liability hedging
Risk return management
22
Closing Thoughts
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2323
Questions
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Disclaimer
The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.
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Contact Details
Jon Pliner
335 Madison Avenue, New York, NY 10017-4605 212-309-3811 [email protected]
Mark Ruloff
901 N. Glebe Road, Arlington, VA 22203 703.258.8058 [email protected]