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DGAM's Portable Alpha Power Point File

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					Portable Alpha: What it is
and how it can be applied
to Insurance Companies'
    Surplus Portfolios

     by Pierre Laroche
      Senior Director
   Financial Engineering

  for The 2006 Stochastic
   Modeling Symposium
 and Investment Seminar,
   Toronto, April 4 2006
1. Desjardins
Global Asset Management

2. What is Portable Alpha?

3. PA, Portfolio Volatility
and Tracking Error

4. Discussion

5. An Example
1. Desjardins Global
   Asset Management (DeGAM)

    DeGAM is Mouvement Desjardins' main portfolio
    management subsidiary.


    CAD 41 Bn under management:

      CAD 14,5 Bn Fixed Income
      CAD 11,5 Bn Repo
      CAD   9 Bn Multi-Management – Retail
      CAD   5 Bn Funds of Hedge Funds
      CAD 1 Bn Multi-Management – Institutional
      (Conventional & Quantitative)

3
2. What is Portable Alpha?




      Sample: 125 US Defined Benefits Pension Plans
      Source: JP Morgan Chase, 2005


4
2. What is Portable Alpha?
"Portable Alpha refers to the process of separating the alpha
from the beta and then applying it to other portfolios"
(Kung and Pohlman (2004))

To well understand PA, let's define it as a portfolio enhancement
strategy:
                           rE  rB  r A
rP = excess returns (i.e. returns in excess of the risk-free interest
rate) of the enhanced portfolio (E), the base portfolio (B) and the
(external) active management mandates (A) that constitute the
enhancement sources

and where:
                                       N j ,t 0
    r A   j 1w j  r A, j
                                                          N

                                                         w
              N
                                wj                             j   0
                                       VB ,t 0           j 1


5
2. What is Portable Alpha?



Since actively managed portfolios are usually benched against
an index portfolio, we can write:

                     r A , j  a ji  b j  rI , j   e j

We then have:       VA  r A  rI  a  rI  ( b  1)  e

And since:            ( rI , e )  0

Then:                                                        
                     TE   (VA )  ( b  1)2   2 ( rI )   2 ( e )

6
2. What is Portable Alpha?

Many classical hedge fund strategies carry a mix of alpha and
beta. Sometimes, the beta component is quite proheminent.

For example, most Fixed Income Arbitrage hedge funds use a
mix of the three following strategies:

     Buying illiquid securities and/or with more credit risk
     and selling more liquid securities and/or with less credit
     risk.
     Riding the interest rate curve ("positive carry" positions).
     Selling interest rate volatility.


This combination of these three pure beta bets has a circa 0.8
correlation with Tremont's Fixed Income Arbitrage Hedge Fund
Index!
7
3. PA, Portfolio Volatility
    and Tracking Error
Important issue: Active portfolio management creates
tracking error… does that raise the enhanced portfolio's
absolute risk (i.e. volatility)? Answer: usually not.

We know that:                    2 ( e )   2 ( r A )  b 2   2 ( rI )

Hence:                                                 
                               TE 2   2 ( r A )   2 ( rI )  ( 1  2b )    
Since TE must be non-negative, this last equation requires that:
                                2 ( rA )
                           .               2b  1
                                ( rI )
                                 2




So that if    ( rA )   ( rI )         then                 b 1

8
3. PA, Portfolio Volatility
    and Tracking Error

    We tested the model over the Jan. 1996 – Dec. 2005
    observation period for 269 managers:

    40 TSE Composite            103 SP500
    78 MS EAFE                  48 MS Emerging markets

    The main results were:

      The median value added is quite small
      The best value added are found for the tougher markets
       (EAFE and Emerging Markets)
      Most b are less than 1.0
      The managed portfolios' volatility is equal to that of their
       benchmark index
      The model is quite well validated by data

9
4. Discussion: PMIT



 The main benefits arising from PMIT's (portable-) alpha
 and beta separation are:

       The portfolio manager can stick to her strategic asset
       allocation target (in the pure beta –indexed - portfolio)

       There is no need for modifying the management
       structure

       It simplifies the portfolio performance attribution

       It allows a simpler risk budgeting



10
4. Discussion: Challenges
Applying PMIT has several challenges:

     The investment policy may have to be modified, especially
     regarding the funding decision (financing the pure alpha bets)

     The investment constraints (particularly regarding credit risk
     limits, leverage and duration) may be harder to define and
     monitor

     The risk involved may not be well understood (e.g. tracking
     error) nor measurable with enough precision (e.g. liquidity
     risk and transparency issues)

     The identification of reliable external managers with above-
     average alpha investment skills is not an easy task and may
     be costly

     The best alpha markets are often "difficult" markets
11
4. Discussion: Modelling


Stochastic Modeling Issues:

     Expected added value, volatility and tracking error are
      sufficient : no need to take care of the managed
      portfolios' correlations. Benefit: lower dimension of the
      correlation matrix/Cholesky Factorization problem.


     Statistical challenges:

       Short observation periods and style drifts (homogegeity of the
        sampled returns)

       Fundamental hypothesis may not be met (estimation and
         model risks)


12
4. Discussion:
   Multi-Management

There are many reasons to allocate external active
management mandates to at least a dozen of different
firms:


      Average value added does not diminish and becomes more
      stable

      Portfolio volatility diminishes


      Tracking error diminishes a lot


      Information ratio rises substantially



13
4. Discussion:
   Multi-Management

                                                                  Value Added
                   0.03000
                                                                                                                  Average
                                                                                                                  Median
                   0.02500                                                                                        Simul 3
                                                                                                                  Simul 5
                                                                                                                  Simul 7
                                                                                                                  Simul 8
                   0.02000                                                                                        Simul 12
                                                                                                                  Simul 14
                                                                                                                  Simul 19
                   0.01500                                                                                        Simul 25
                                                                                                                  Simul 26
                                                                                                                  Simul 27
                                                                                                                  Simul 30
                   0.01000                                                                                        Simul 35
                                                                                                                  Simul 36
     Value added




                                                                                                                  Simul 38
                                                                                                                  Simul 42
                   0.00500                                                                                        Simul 43
                                                                                                                  Simul 46
                                                                                                                  Simul 47
                   0.00000                                                                                        Simul 50


                   -0.00500


                   -0.01000   1   2   3   4   5   6   7   8   9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30


                   -0.01500


                   -0.02000
                                                                       Number of portfolios
14
4. Discussion:
   Multi-Management

                                                                       Portfolio Volatility
                            0.18000
                                                                                                                          Average
                                                                                                                          Median
                            0.17500                                                                                       Simul 3
                                                                                                                          Simul 5
                                                                                                                          Simul 7
                            0.17000                                                                                       Simul 8
                                                                                                                          Simul 12
                                                                                                                          Simul 14
                                                                                                                          Simul 19
                            0.16500                                                                                       Simul 25
                                                                                                                          Simul 26
                                                                                                                          Simul 27
     Portfolio volatility




                            0.16000                                                                                       Simul 30
                                                                                                                          Simul 35
                                                                                                                          Simul 36
                            0.15500                                                                                       Simul 38
                                                                                                                          Simul 42
                                                                                                                          Simul 43
                                                                                                                          Simul 46
                            0.15000                                                                                       Simul 47
                                                                                                                          Simul 50

                            0.14500


                            0.14000


                            0.13500


                            0.13000
                                      1   2   3   4   5   6   7   8   9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

                                                                               Number of portfolios
15
4. Discussion:
   Multi-Management

                                                                   Tracking Error
                      0.08000
                                                                                                                    Average
                                                                                                                    Median
                                                                                                                    Simul 3
                      0.07000                                                                                       Simul 5
                                                                                                                    Simul 7
                                                                                                                    Simul 8
                                                                                                                    Simul 12
                                                                                                                    Simul 14
                      0.06000                                                                                       Simul 19
                                                                                                                    Simul 25
                                                                                                                    Simul 26
                                                                                                                    Simul 27
                                                                                                                    Simul 30
     Tracking error




                      0.05000                                                                                       Simul 35
                                                                                                                    Simul 36
                                                                                                                    Simul 38
                                                                                                                    Simul 42
                                                                                                                    Simul 43
                      0.04000                                                                                       Simul 46
                                                                                                                    Simul 47
                                                                                                                    Simul 50

                      0.03000



                      0.02000



                      0.01000
                                1   2   3   4   5   6   7   8   9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

                                                                         Number of portfolios
16
4. Discussion:
   Multi-Management

                                                     Information Ratio

                         0.60000




                         0.40000




                         0.20000
     Information ratio




                         0.00000




                         -0.20000
                                    1
                                    2
                                        3
                                        4
                                            5
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                                                                                        25
                                                                                        26
                                                                                             27
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                                                                                                  30
                         -0.40000


                                                                                             Average
                                                                                             Median
                         -0.60000                                                            Simul 3
                                                                                             Simul 5
                                                           Number of portfolios              Simul 7
                                                                                             Simul 8
                                                                                             Simul 12
17                                                                                           Simul 14
                                                                                             Simul 19
                                                                                             Simul 25
5. Application to Insurance
   Companies' Surplus Portfolio
Important Makeover:

     Active Management
     New Asset Classes (Emerging Markets Bonds, Real Return
      Bonds, Insurance-Linked Bonds, Commodities, etc.)
     Some Asset Classes Removed (i.e. "transformed")
     Overlays (fully financed) –vs- lowering Money Market
      Allocation (… and lowering the duration of the other fixed
      income allocations)

Main Challenges:

     Investment Committee's Good Understanding of the Rationale
     Additional Risks and MCCSR Concerns

18
Question Period

      

				
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