STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS

333II1 – International Asset Allocation

Structures 1

STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS

Global investment industry

Participants:

Investors

Investment Managers

Brokers

Consultants and Advisers

Custodians

INTERNATIONAL FINANCIAL INVESTMENT


Structures 2

Investors

Private investors

Individuals or small groups of individuals (eg. represented by a family trust).

Can have high “net-worth”.

In Europe and in the USA there are over 2 million individuals with assets over 1 milion $ (in Asia over 1.5 milion such individuals).



Structures 3

Institutional investors

a) Pension funds

Committed to long-term investments

Most assets in pension funds are concentrated in the USA, Japan and the UK.

Different pension system models in various countries (in continental Europe, for instance, pensions are administered by the government).



Structures 4

b) Endowments and Foundations

Invest contributions made to charitable and educational institutions (eg. Nobel Foundation).

c) Insurance Companies

Most important – life insurance companies.

Collect premiums on life insurance, which are invested until claims are paid.



Structures 5

Investment Managers

Very diverse group form the point of view of the role they play (depending on the places where they work).

Usually work in the asset management departments in banks or in companies specializing solely in asset management.

Charge a fee for their services as well as the share of the generated profits for the client.



Structures 6

Brokers

Act as agents for buyers and sellers who charge the commission for their services.

Two types of brokers:

inter-dealer brokers – work with specialist market makers

client (or agency) brokers – deal on behalf of institutional or retail clients



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Independent consultants advise: pension funds, insurance companies, endowments and other foundations.

Custodians

Keep the securities deposited by the investors.

Highly complex procedure due to the national differences in taxation, trading and settlement processes.



Structures 9

Any international asset allocation decision involves thorough and continuous research, management and control.



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1. INVESTMENT PHILOSOPHY AND STRATEGY

Investment managers should decide on:

(a) Passive or active investment strategy

(b) Top-Down or Bottom Up portfolio construction

(c) Global or specialised asset management

(d) Quantitative or subjective investment analysis.



Structures 11

Passive investment strategy

Reproduces a market capitalisation-weighted index of all international securities markets.

The model for equity funds may be the Morgan Stanley Capital International or the FT international indices.

The model for fixed income funds is usually the Salomon Brothers international bond index.



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The main assumptions of the passive approach is that

(a) a well diversified international portfolio is efficient in a risk-reward framework, and

(b) there is zero forecasting ability.



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Well-diversified domestic portfolios tend to track the domestic market index

but international portfolios do not necessarily track the international market index.

International efficiency of world market portfolios has not been empirically proven yet.



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A special type of passive strategy is indexation.

The objective of indexation is to replicate an existing or a manufactured market index.

Large pension funds having already indexed their domestic assets are moving towards indexing their international assets.



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One of the problems with structuring international index funds is how to weight each country’s presence to the index.

A market capitalisation country weight ignores cross holding of shares.

A GDP country weight seems a more sensible approach but it is costly to be implemented and requires portfolio rebalancing each time a new GDP figure is published.



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A second problem with structuring international index funds is to decide whether the fund should be hedged for currency risk or not.

This is despite of empirical studies having shown that the contribution of currency risk to the total risk of a fund is insignificant.



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A final problem with structuring international index funds is to measure its performance after allowing for bonds and cash investments in a variety of currencies.

The advantage of a passive strategy is that is less costly than an active one and less demanding in terms of research, management and control.



Structures 18

Active investment strategy

Active management aims for higher-return higher risk performance.

Managers attempt to time markets and currency switching between them so that to take advantage of low intramarket correlations.

Approach requires high-quality management skills and above-average ability at forecasting markets and currencies.



Structures 19

The lack of systematic investment structure and the concentration in a small number of markets and currencies can lead to increased portfolio risk.

Forecasting is never easy and entails high commissions and costs.



Structures 20

Top-Down portfolio construction

Research department focuses on country and currency analysis.

Approach is usually broken into three parts, in the following order:

Strategic asset allocation: Decide on the proportion of equity, bonds, cash etc. in the total portfolio.

International market exposure: Decide on the proportion of domestic/international market exposure.

Tactical asset allocation: select individual securities to satisfy this allocation.



Structures 21

Important questions

In strategic asset allocation:

1) Which global benchmarks should be used?

2) What should be the weights? Market capitalization or GDP-related weights?

3) Should the investments be protected against currency risk? If yes – then should there be a full or partial hedging?



Structures 22

In tactical asset allocation:

1) How often should the individual securities be adjusted (transaction costs!) – monthly, weekly, …..?

2) Which criteria should be used for judging if the assets are over- or underpriced?

3) Should strict rules be applied or are the deviations allowed?

4) How should this process be adjusted given the impact of company related news?



Structures 23

Bottom-Up portfolio construction

Research department specialises by worldwide industry sectors.

Approach usually used in international equity portfolios.

Start from selecting the best securities (irrespective of nationality or currency origin) within the best performing market sector.

Built a portfolio with high-performing shares.



Structures 24

The product of this approach is a portfolio with a market and currency allocation, which is a random result of the securities selected.

Manager is more concerned with risk exposure in various sectors than with either market or currency risk exposure.



Structures 25

Global or specialised asset management

Global asset management manages all assets of a customer and determines both the asset allocation and the selection of each security for the portfolio.

Specialised asset management manages specific investment areas, such as Japanese stocks or gold and gold-linked investments, and leaves the asset allocation for the portfolio to the customer himself.

Sensible solution for the small investors only.



Structures 26

Quantitative or subjective investment analysis

A quantitative investment process includes:

Econometric or technical forecasting models of markets and currencies;

International asset allocation optimisers;

Dividend-discount models, betas, durations or option valuation models;

Risk management models; and

Performance and risk analysis.



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A subjective investment analysis requires high-quality management skills and above-average ability at collecting, analysing and interpreting information on markets and currencies.



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2. STRUCTURING THE ASSET ALLOCATION PROCESS.

Once the investment philosophy and strategy have been decided, the asset allocation process is structured as follows:

(a) Research and analyse the market

(b) Find the optimal asset allocation

(c) Construct the portfolio

(d) Constantly monitor the performance and control the portfolio’s risk.



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Research and Market Analysis

The major responsibility of the research department is to provide forecasts on currencies, interest rates and national stock indexes.

Research and market analysis is performed using large international databases, which contain both price histories and information on economic statistics, markets and individual securities.



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Asset Allocation Optimisation and Portfolio Construction

To achieve the highest performance for a given level of risk a dynamic optimisation model may used.

Optimisation models usually use quadratic programming and involve the development of efficient frontiers.

Irrespective of the degree of their sophistication, optimisation models have been developed based on the Markowitz mean-variance framework.

More sophisticated ones allow for a number of linear and non-linear constraints.



Structures 31

Performance and Risk Control

The final step in the investment process is to monitor the performance and risk of individual portfolios.

A way to monitor the effectiveness of the international money manager is to compare the total return of the fund over a specified period and the breakdown of return in terms of capital gains, currency fluctuation and income, with the targets decided on the strategic planning.



Structures 32

Additional information may involve:

Performance analysis in terms of asset allocation, market timing and individual stock selection.

Provision of evidence of unusual expertise in a particular market.

Assessment of attaining the risk diversification objective.

Degree of investment strategy’s aggression.



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Summary

Global investment industry:

Investors

Private

Institutional (pension funds, endowments & foundations, insurance companies)

Investment Managers

Brokers


Custodians



Structures 35

The structure of the international investment process depends on the following decisions:

(a) Passive or active investment strategy

(b) Top-Down or Bottom Up portfolio construction

(c) Global or specialised asset management

(d) Quantitative or subjective investment analysis.



Structures 36

Once these decisions have been taken, structuring the asset allocation process involves:

1.Research and market analysis;

2.Asset allocation optimisation;

3.Portfolio construction; and finally

4.Performance and risk control.


STRUCTURING OF THE INTERNATIONAL ASSET ALLOCATION PROCESS

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