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					Liability Driven Investment
Chris Nichols, Standard Life Investments
February 2006
Agenda

• Background / Liability Driven Investment Process

• Hedging Strategies

• Dynamic Market Risk Allocation

• Risk Versus Liabilities

• Risk Monitoring




Taking only risk that is rewarded and managed
                                                     2
Market Background


Liability Driven
Investment Process




                     3
  Traditional pension fund asset management

                         ALM Study                       Manager Selection


           Scheme Actuary, Investment                Investment Consultants
                  Consultants


    • Liabilities                      Strategic      Investment
    • Risk Appetite                                                             Alpha
                                         asset       mandates for
                                                                              management
    • Long-term view                   allocation   each asset class
      of Asset returns




Timescale:               10-20 years                          1-3 years



  Disconnect between scheme objectives and asset management
                                                                                           4
 Results of Strategic Asset Allocation

                                                                  • Deficits caused by falling interest rates
140                                                                 and longevity increases
130
                                                                  • Investment mandates were related to
120
                                                                    markets not liabilities
110

100                                                               • So whilst investors beat the
                                                                    benchmark they failed against
 90
                                                                    requirements
 80




              Benchmark        Benchmark +1%   Liability Growth


  Source: Standard Life Investments




The status-quo for pension fund asset management is open to challenge
                                                                                                                5
 The focus of investment mandates

 Scheme                                                                     Strategic
Liabilities                                                                Benchmark




                                      Benchmark risk



                                                                        Tactical asset allocation Stock
                                                                                                Selection


   Risk budget                                0%                                   1.0%          1.5%
   Actual risk                               12.5%                                 1.0%          1.5%
   Target return   Long-term: Real return from asset class allocation              1.0%          2.0%
                   Short-term: ????




Traditional mandates do not manage all short-term risk
                                                                                                            6
 Impact of investment timescales

             Distribution of excess returns from equities over               • The excess return from equities over bonds
                    bonds as a function of time horizon                        has been 5% per annum over long periods
             25%

             20%                                                             • We would not expect it to be exactly 5%
             15%
                                                                               over 3 year intervals
             10%                                             Bounds
                                                                             • But how often has it been within 2% of this
Return (%)




                                                             Outer Deciles
             5%
                                                             Median            level over 3 year periods?
             0%

             -5%                                                             • Answer: less than 25% of the time
       -10%

       -15%                                                                  • The long run excess return expectation will
                   1 3 5 7 9 11 13 15 17 19 21 23 25 27 29                     be wrong in 75% of three year periods
                             Time Horizon (Years)



   Source: Standard Life Investments, Nov 2004




                                                                                                                             7
Impact of shorter timescales on return history

• As timescales reduce, risk and return expectations vary dramatically

                                                              10 years          3 years
                                                           Return   Risk    Return    Risk
                                                            pa       pa      pa        pa
UK equities                                                 11.1%   10.3%     8.7%    16.4%
UK bonds                                                     9.9%    4.2%     9.4%        6.2%
Overseas equities                                            9.5%    9.4%     6.8%    17.8%
Index-linked bonds                                           8.3%    2.8%     8.0%        4.9%
Property                                                     9.2%    3.7%     9.1%        7.7%
 Source: Datastream rolling returns, 31/12/86 – 31/12/04



• Shorter timescales have a significant impact on risk and return data
• True for all asset classes, not just equity



                                                                                                 8
Impact on traditional methodologies

                                     Bond Equity Efficient Frontier
                                Source Datastream: 31/12/1977-31/12/2004

                  15.0%

                  14.0%

                  13.0%
    Return (pa)




                                                                           100% equity

                  12.0%

                  11.0%

                  10.0%   100% bonds

                  9.0%
                      6.0%       8.0%    10.0%      12.0%      14.0%       16.0%         18.0%
                                                   Risk (pa)



    A traditional efficient frontier using all available data



                                                                                                 9
Impact on traditional methodologies

                        Bond Equity Efficient Frontier, Overlaid with Ranges for Bond
                            Equity Risk Return Points: 10 year rolling windows

                    20.0%
                                                                                Efficient Frontier
                    18.0%                                                       10 year rolling windows
                    16.0%
      Return (pa)




                    14.0%
                    12.0%
                    10.0%
                    8.0%
                    6.0%
                        0.0%    5.0%     10.0%          15.0%   20.0%   25.0%
                                                 Risk (pa)

    Source: Datastream 31/12/1977 - 31/12/2004


    The „area of possibility‟ for a traditional efficient frontier, using 10
    year rolling data windows

                                                                                                          10
Impact on traditional methodologies

                                   Bond Equity Efficient Frontier, Overlaid with Ranges for Bond
                                    Equity Risk Return Points: 3 and 10 year rolling windows

                          30.0%
                                                                                        Efficient Frontier
                          25.0%
                                                                                        10 year rolling windows
                          20.0%
                                                                                        3 year rolling windows
            Return (pa)




                          15.0%

                          10.0%

                           5.0%

                           0.0%

                           -5.0%

                          -10.0%
                                0.0%       5.0%     10.0%       15.0%   20.0%   25.0%
                                                        Risk (pa)


           Source: Datastream 31/12/1977 - 31/12/2004

• The „area of possibility‟ for a 3 year rolling data windows
• The efficient frontier breaks down on these timescales

                                                                                                                  11
Conclusions for portfolio design

• Short-term measurements forces investors to be concerned with short-
  term portfolio returns, relative to the liabilities

• Long-term historic return data has little correlation with short-term return
  data

• Traditional methodologies of return optimisation and risk diversification
  using historical data fall apart on a short-term view

• A good solution will therefore ensure

    • that all market risk is optimally managed in relation to the liabilities

    • that risk monitoring and controls relate to the key risks


        Informed investment view of short-term returns from different
                       areas of market risk required
                                                                                 12
Liability driven process

  Scheme Specific Funding Objective                           Manager Selection


  Scheme Actuary, Investment Consultants                      Investment Consultants



                                                                                       Beta
  Liabilities                   Investment
                                                               Investment              management
                                 objective
  Risk Appetite
                                Risk budget                   mandates
  Funding Objective                                                                    Alpha
                                Alpha strategy                                        management




Timescale:                                        3-5 years



Continuum established between liabilities and assets
                                                                                                    13
LDI Solution Spectrum
                Risk Elimination                                       Risk Management


                                                                         Comfort Zone




             MATCHING                             HEDGING                            MITIGATING

Rationale   • Full matching impossible due   • Shares features of traditional        • Management processes altered
              to longevity risk                methodologies – within comfort zone     from traditional methodologies
                                             • Natural first step towards a full     • Likely to involve prolonged buyer
                                               liability driven approach               education process



            • Immunisation funds             • Duration / Cashflow Matching          • Dynamic Market Risk Allocation
Approach                                     • Inflation Overlay                       (DMRA)
                                                                                     • RPI+ and libor+ strategies




                                                                                                                           14
         Pragmatism v‟s Perfection

                  Tracking error versus uncertain cashflows
 A measure of total investment and non-investment risks in liability benchmark
                                                                                                            •   Possible to devise an investment
                                                                                                                solution that aims to match out a set of
                                                                                                                projected liabilities

                                                                                                            •   As well as expensive, it is
                                                                                                                unnecessary and impractical

                                                                                                            •   Where non-investment risks are
                                                                                                                included it is not possible to produce
                                                                                                                an asset management strategy that
                                                                                                                takes away all risk



Source: Watson Wyatt Ltd (LIABILITY DRIVEN BENCHMARKS FOR UK DEFINED BENEFIT PENSION SCHEMES, 21 June 05)




 Avoid an over-engineered solution
                                                                                                                                                           15
“Modified Duration” = Interest rate sensitivity

                                                    • Changes in interest rates are amplified in their effect
                                                      on Assets and Liabilities
High                                                      •   Asset and Liability values often change by different
                                                              amounts making funding volatile
                  Scheme deficit
               increases if interest                • The rate at which the value changes is measurable
                    rates fall
                                                      and called “Modified Duration”

£                                                   • It is very important to manage the overall modified
                                          Value of   duration risk versus the liabilities
                                       Scheme Assets
                                                        •   Much greater impact than performance versus a
                                                            standard bond benchmark
                          Value of Pension
Low                           Liabilities           • There are investment strategies to limit the difference
                                                      between Asset and Liability movements
       Low                                   High         •   These strategies reduce the volatility of a scheme‟s
                Interest Rates                                funding rate




Measuring the impact of interest rate movements
                                                                                                                     16
Duration Mismatch Example

•   Assume scheme liabilities are valued using the AA bond yield

•   Scheme assets invested in FTSE UK Gilts All Stocks

•   Current AA bond yield is 5%
     • Present Value (PV) of liabilities = £100m = Asset Value



•   If yield falls by 1%:
     • PV of liabilities rises to £115m

     • Value of scheme assets rise to £107m

     • Result = Deficit of £8m




                                                                   17
Traditional bond fund options

• Government bond portfolios
    •   Gilt fund                             duration 7.6
    •   Long bond fund                        duration 13.4
    •   IL bond fund                          duration 12.0
    •   Overseas bond fund                    duration 5.9

• Corporate bond portfolios
    • Corporate bond fund                     duration 7.7
    • Long corporate bond fund                duration 10.8

• Government and corporate bond portfolio
    • UK Fixed Interest fund                  duration 7.7




Benchmarks may bear little resemblance to scheme liabilities
                                                               18
To whom does this matter most?

• Companies where the scheme liabilities are large relative to
  shareholder funds / the size of the parent company


• Where the liabilities are longer dated than in this example


• Where a substantial proportion of scheme assets are
  invested in other asset classes that are insensitive to interest
  rates
       • Investing 50% in equities for example would mean the scheme
         assets would only respond half as much to an interest rate change

       • The impact could be nearer 15% of the fund


                                                                             19
   Example Liability vs Benchmark Cashflows

             Liabilities

             Benchmark




                           Benchmark   Liabilities




Source: CreditDelta, UBS
                                                     20
   Risk Analysis

          Benchmark




      Benchmark vs Liabilities




   • Risk is decomposed into interest rate and spread risk
   • Desire to remove interest rate curve risk

Source: CreditDelta, UBS
                                                             21
   Sensitivity to Swap Curve Changes
  • LDD1 at given tenor point indicates change in value for +1bp shift in rate




                                     Indicates liabilities are longer duration



Source: CreditDelta, UBS
                                                                                 22
   Calculating the Required Swap Hedge
  • Assume purchase of swaps with 5, 10 and 30yr maturity
  • Calculate nominals required to hedge LDD1 mismatch




   • Cost of each swap is (spread from Mid) * magnitude of LDD1
   • At 1bp spread, cost of swaps is £209,770
   • Cost represents 6.5bps of total fund




Source: CreditDelta, UBS
                                                                  23
   Sensitivity to Swap Curve Changes

  • LDD1s are matched at selected tenor points




                                 Only small mismatches remain


Source: CreditDelta, UBS
                                                                24
   Risk Analysis

            Benchmark




            vs Liabilities




   • Interest rate risk becomes small with swaps
   • Tracking error drops from 2.8% to 1.5%
Source: CreditDelta, UBS
                                                   25
Duration Products

• Custom swap overlay is available to seg funds
    • Collateral management
    • Legal requirements

• Pooled Fund Alternatives:
    • Bucketed Funds
    • Actuarially priced pooled funds

• Share the objective of giving duration

• Differences:
    • Legal structure
    • Credit spread
    • Active management




                                                  26
     Liability Replicating Portfolio
14,000,000




12,000,000




10,000,000




 8,000,000

                                                                                                                               BENCHM ARK
 6,000,000                                                                                                                                                         % of category   % of total

 4,000,000
                                                                                                                               INDEX-LINKED GILTS                                   50.00%
                                                                                                                               2.5% index-linked Treasury 2016       22.50%         11.25%
                                                                                                                               2.5% index-linked Treasury 2024       22.50%         11.25%
 2,000,000
                                                                                                                               4.125% index-linked Treasury 2030     20.00%         10.00%
                                                                                                                               2% index-linked Treasury 2035         17.50%          8.75%
        0
             2005   2010     2015     2020   2025    2030       2035    2040      2045     2050      2055      2060     2065
                                                                                                                               1.25% index-linked Treasury 2055      17.50%          8.75%
                      Fixed Increases (0%)      RPI Increases          LPI subject to 5%          LPI subject to 2.5%
                                                                                                                               ZERO COUPON LPI SWAPS                                30.00%
                                                                                                                                    5 year                           10.00%          3.00%
                                                                                                                                    10 year                          10.00%          3.00%
                                                                                                                                    15 year                          20.00%          6.00%
                                                                                                                                    20 year                          20.00%          6.00%
                                                                                                                                    25 year                          20.00%          6.00%
                                                                                                                                    30 year                          20.00%          6.00%

                                                                                                                               ZERO COUPON FIXED INTEREST SWAPS                     20.00%
                                                                                                                                    5 year                     15.00%                3.00%
                                                                                                                                    10 year                    15.00%                3.00%
                                                                                                                                    15 year                    15.00%                3.00%
                                                                                                                                    20 year                    20.00%                4.00%
                                                                                                                                    25 year                    20.00%                4.00%
                                                                                                                                    30 year                    15.00%                3.00%


     Manage market risk against the liabilities
                                                                                                                                                                                                27
Mapping the solution to the mandate
                       Benchmark + 75bps                                                                                              Benchmark + 75bps + fees



                     Liability Replicating Portfolio                                                                              Swap LIBOR to Liability Replicating Portfolio

                                                  ILG Gilts                                                                                      Inflation swaps

                                          ZC LPI Swaps                                                                                             LPI Swaps

                                            ZC IR Swaps                                                                                      Plain Vanilla IR Swaps

                                                                                                                                                                                        Netting off
                                                                                                                                                       +                               of positions
                                                                                                                                         LIBOR + 90bps gross

                                   Scheme Liabilities
3,500,000




                                                                               Pensions: increasing at lpi
3,000,000

                                                                               Pensions: increasing at 0%
                                                                                                                                       Swap Asset Benchmark to LIBOR
                                                                               Lump sums
2,500,000




2,000,000
                                                                                                                                                       +
1,500,000                                                                                                                                      Investment Assets

1,000,000
                                                                                                                             50% ILG (>5 year index)     50% ML, £, Non-gilt, Ex AAA
 500,000
                                                                                                                              Alpha Target + 60 bps         Alpha Target +80 bps
                                                                                                                                                            Beta Target +40 bps
       0
            07 09 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79




                                                                                                                                                                                                      28
LDI Solution Spectrum
                Risk Elimination                                       Risk Management


                                                                         Comfort Zone




             MATCHING                             HEDGING                            MITIGATING

Rationale   • Full matching impossible due   • Shares features of traditional        • Management processes altered
              to longevity risk                methodologies – within comfort zone     from traditional methodologies
                                             • Natural first step towards a full     • Likely to involve prolonged buyer
                                               liability driven approach               education process



            • Immunisation funds             • Duration / Cashflow Matching          • Dynamic Market Risk Allocation
Approach                                     • Inflation Overlay                       (DMRA)
                                                                                     • RPI+ and libor+ strategies




                                                                                                                           29
Dynamic Market Risk Allocation (DMRA)
• Increasing focus on avoiding short-term asset/liability mismatch

• Market risk is the principle contributor of risk relative to the liabilities

• Logical movement from static to dynamic market risk positions

• Standard Life Investments‟ solution:
    • Dynamic management of market risk based on three year view
    • Active views on all areas of market risk,
    • Optimal portfolios created to meet individual client requirements




 Risk budget optimally deployed at all times

                                                                                 30
 The „new balanced‟ approach

                                               Investment time horizon

                                    1d -1m            1m – 1y           1y-10y       10y-50y        • Is it plausible?
                                    Traders        Fund Managers        DMRA        WP funds etc
 Active
 participants
                                                                         -                       • Has it made money?
 Source of                       Pairs trading     Earnings upgrades     Value        Economics
 added value                   Convert arbitrage    Recovery stocks    Funds Flow    Demographics   • Is it theoretically proven?
Source: Standard Life Investments




   • Fund managers and traders look to add value over short time scales
                •       Numerous active participants limit opportunities to add value over short term time horizons

   • DMRA is about exploiting medium term opportunities
                •       3 to 5 year time horizon

   • Look to take as many diverse views as possible to exploit benchmark risk
   • Strategies to provide downside protection versus liabilities


        Exploiting an uncrowded area
                                                                                                                                    31
  Evidence for Opportunities at Longer Timescales
                                                                 Box Plot: 1-Year Equivalent Volatility of UK Equity Market
                                                      Total Real Return Data: 1900 - 2002, Source BZW Equity Gilt Study
                                                                 Comparison with 40 random shuffled BZW data surrogates
                                             0.34



                                             0.30
              1 Year Equivalent Volatility




                                             0.26



                                             0.22



                                             0.18



                                             0.14


                                                                                                                                                      Non-Outlier Max
                                             0.10                                                                                                     Non-Outlier Min
                                                                                                                                                      75%
                                                                                                                                                      25%
                                             0.06                                                                                                     Median
                                                    bzw          sur     bzw          sur   bzw          sur   bzw          sur   bzw           sur
                                                          y _1                 y _2               y _4               y _8               y _16

                                                                         Non-overlapping return runs of length n



Source: Standard Life Investments

                                                                                                                                                                        32
  Evidence in individual stock returns
                                                                           Box Plot: 1-Month Equivalent Volatility of Shell Stock
                                                                     Total Return Data 31/12/69 - 30/11/04, Source DataStream
                                                                      Comparison with 40 random shuffled Shell data surrogates
                                              0. 11




                                              0. 10
              1 Month Equivalent Volatility




                                              0. 09




                                              0. 08




                                              0. 07




                                              0. 06


                                                                                                                                                                                    Non-Outlier Max
                                              0. 05                                                                                                                                 Non-Outlier Min
                                                                                                                                                                                    75%
                                                                                                                                                                                    25%
                                              0. 04
                                                      S H E L(R I ) s ur   S H E L(R I ) s ur   S H E L(R I ) s ur   S H E L(R I ) s ur   S H E L(R I ) s ur   S H E L(R I ) s ur
                                                                                                                                                                                    Median
                                                              m _1                 m _2                 m _4                 m _8                m _16                m _32

                                                                                    Non-overlapping return runs of length n



Source: Standard Life Investments

                                                                                                                                                                                                      33
Areas of market risk

• Market risk positions can be very broadly based
• Not just an equity bond call
• The risks that should be brought to bear include
    •   FX risk
    •   Duration risk
    •   Credit risk
    •   Equity market risk – including regional and sector views
    •   Property market risk
    •   Commodities
    •   Volatility
    •   Optionality




  Play the right team at the right time

                                                                   34
Example of Efficient Risk Deployment
                                                             Risk Return Options
                                  8
                                                                                                                  Equity
                                  7

                                  6
 Return relative to Liabiliites




                                                    DMRA
                                  5                                                      Current

                                                           LMC               50:50
                                  4

                                  3                         70:30

                                  2

                                  1           Corporate Bonds


                                  0
                                      0   2   4        6            8        10        12          14   16   18            20
                                                                 Risk relative to Liabilities


                                                                                                                                35
Measuring Risk v‟s Liabilities

• Ex-ante analysis:
    • Must allow for liabilities
    • Overcome shortcomings of historic data


• Ex-post analysis:
    • tracking error in absolute and relative terms:
        • volatility of returns of asset pool
        • volatility of relative returns
    • V-masks




Risk monitoring and control must relate to the key risks versus liabilities
                                                                              36
         Measures of variation and association
                                Source Datastream: 31/01/1995 – 31/12/2004

                 15.0%                                                                                                                                                    30%


                 10.0%                                                                                                                                                    25%


                  5.0%                                                                                                                                                    20%
Monthly Return




                                                                                                                                                              Frequency
                  0.0%                                                                                                                                                    15%


                  -5.0%                                                                                                                                                   10%


                 -10.0%                                                                                                                                                   5%


                 -15.0%                                                                                                                                                   0%




                                                                                                                                                                                                                                      %

                                                                                                                                                                                                                                            %
                            5             6             7             8             9             0             1             2             3             4




                                                                                                                                                                            8%

                                                                                                                                                                            6%

                                                                                                                                                                            4%

                                                                                                                                                                            2%

                                                                                                                                                                            0%




                                                                                                                                                                                                         0%

                                                                                                                                                                                                              2%

                                                                                                                                                                                                                   4%

                                                                                                                                                                                                                          6%

                                                                                                                                                                                                                               8%
                                                                                                                                                                                   %

                                                                                                                                                                                         %

                                                                                                                                                                                               %

                                                                                                                                                                                                     %
                          99            99            99            99            99            00            00            00            00            00




                                                                                                                                                                                                                                    10

                                                                                                                                                                                                                                          12
                                                                                                                                                                                 -8

                                                                                                                                                                                       -6

                                                                                                                                                                                             -4

                                                                                                                                                                                                   -2
                                                                                                                                                                          -1

                                                                                                                                                                          -1

                                                                                                                                                                          -1

                                                                                                                                                                          -1

                                                                                                                                                                          -1
                    c   -1        c   -1        c   -1        c   -1        c   -1        c   -2        c   -2        c   -2        c   -2        c   -2
                  De            De            De            De            De            De            De            De            De            De
                                                                                                                                                                                                         Monthly Return




                   • General characteristics of individual time series can often be easily observed from graphs.

                   • Harder to determine the relationship, if any, between relative variations of two or more series.

                   • Related measures of Correlation and Covariance are used to quantify this behaviour.




                                                                                                                                                                                                                                                37
  Interpreting correlation
                        World Equites ex UK vs S&P Comp
                                                                      • A scatter plot helps illustrate correlation
                                         15%
                                                                      • The example shows monthly returns on two
                                         10%                            indices plotted against one another. The
                CorXY=0.96
                                                                        proximity to a „regression line‟ through the data
                                          5%
                                                                        shows there is strong, positive, correlation
                                                                        between the two indices
                                          0%
-20%        -15%       -10%        -5%          0%   5%   10%   15%
                                          -5%                         • A positively sloping line indicates positive
                                                                        correlation – returns on the assets move
                                         -10%                           together
                                         -15%
                                                                      • A negatively sloping line means negative
                                         -20%                           correlation – asset returns move in opposite
                                                                        directions
       Source Datastream: 31/01/1995 – 31/12/2004
                                                                      • The extreme cases of CorXY =1 and CorXY = -1
                                                                        (perfect correlation) occur only if all points lie on
                                                                        a straight line

                                                                      • If CorXY = 0, the assets returns are uncorrelated




                                                                                                                                38
Covariance Matrix

• When there are many variables, the co-variation between
  all possible pairs can be conveniently represented in a
  Covariance Matrix. E.g for 3 variables:
• Same format used for correlations. Elements along the
  leading diagonal are unity.

• Example:
  Mean:                  7.82%      9.20%    -4.37%         5.88%      8.02%         9.49%       7.95%     10.73%     5.36%
  Standard Dev:         13.84%     17.88%    21.73%        17.04%      5.38%         7.59%       4.32%      1.38%     0.35%
  Correlation coeffs:
                    FT All Share   S&P       Topix     World ex UK   IL Gilts    Long Gilts    UK Corp    Property    Cash
  FT All Share              1.00
  S&P                       0.82      1.00
  Topix                     0.47      0.48      1.00
  World ex UK               0.87      0.96      0.64          1.00
  IL Gilts                  0.11      0.09      0.11          0.12        1.00
  Long Gilts               -0.04      0.02     -0.02          0.00        0.69          1.00
  UK Corp                   0.01     -0.01     -0.05         -0.01        0.64          0.88       1.00
  Property                  0.02     -0.06      0.05         -0.01        0.08          0.04      -0.04        1.00
  Cash                      0.13      0.18     -0.10          0.10        0.21          0.27       0.22       -0.10     1.00




                                                                                                                               39
Calculating Ex-Ante Tracking Error
• Tracking error is the standard deviation of the difference in returns between a portfolio and a
  benchmark. It is calculated as
  where Cov is the covariance matrix and B is the vector of bets away from a neutral
  benchmark position (i.e. the difference in percentage weight, for each asset class, between
  the portfolio and the benchmark). The sum of bets across all asset classes is 0.

• Extension to TE versus liabilities is achieved by treating liabilities, represented by a
  replicating portfolio, as a separate asset class. Covariance is calculated in the usual way.
  Weights are then against a neutral position, with the liability weight taken as –100%.




 TE = 5.01%



                                                                                                    40
     Overcoming the historic data problem
                                Strategic Investment Group                                                     Inputs:
                                                  Euan Munro                                                           •    Core & custom data pack
                                           Head of Strategic Solutions
                                                   Chairman
                                                                                                                       •    Asset class desk experts
                                Dr Julian Coutts                  Sarah Smart
                            Head of Quantitative Risk
                                (Advisory role)
                                                               Investment Director
                                                                   (Secretary)
                                                                                                                       •    Quant input
      Keith Skeoch               Lance Phillips                 Neil Matheson        Andrew Sutherland
     Chief Executive        Head of Overseas Equities         VP and Economist       Investment Director
Standard Life Investments                                    Standard Life Canada       Fixed Interest
                                                                                                               For each view the SIG produces:
                                                                                                                       •    Return expectations
                                                                                                                       •    Upside and downside expectations
                                                         Central  Upside   Downside Standard
                    Asset Class                          Return   Return    Return   Deviation                         •    Conviction
                                                        Estimate Estimate Estimate Estimate
   UK Equity
   Global Equity
                                                            10.0%
                                                            12.0%
                                                                     18.0%
                                                                     20.0%
                                                                               -3.0%
                                                                               -5.0%
                                                                                          8.2%
                                                                                          9.8%
                                                                                                                       •    Correlation
   Property                                                  6.0%     8.0%     -6.0%      5.5%
   Credit                                                    4.6%     5.0%      3.6%      0.5%
   Japanese Government Bonds (hedged)                        6.5%    10.0%      3.0%      2.7%
   Global Index Linked Bonds (hedged)
   Cash
                                                             4.0%
                                                             4.0%
                                                                      6.0%
                                                                      4.0%
                                                                                1.0%
                                                                                4.0%
                                                                                          2.0%
                                                                                          0.0%
                                                                                                               Directly driving portfolio construction &
                                                                         + Conviction                          risk monitoring
  Source: Standard Life Investments


Historic Risk                                                            Expected Risk
                                                                                                            Client
                                                                                                                           V - Masks
                                                                                                           Portfolio
Historic Correlation

                                                                                                                                                               41
                         Ex-Post Risk / Monitoring

                         1.10                                                                 Use V-masks for return
                                                                                              generating processes:
                         1.05

                                                                                              “Is the current experience
Cumulative Value Added




                         1.00                                                                 plausible, within the context of
                                                                                              our original opinion of the risk
                         0.95                                                                 and return inherent in this
                                                                                              particular position”
                         0.90
                                                                Monthly Cumulative Return
                                                                Upper and Lower Boundary
                         0.85



                         0.80
                            Nov-00   May-01   Nov-01   May-02   Nov-02    May-03     Nov-03




                         Confidence we will not overrun the budget
                                                                                                                                 42
Maths of the generalised V Mask

• Excess value is proposed to be R(T) = N(μT, σ2T)
• “Funnel of Doubt”
    •   Expected value R(T) = exp(μT)
    •   UB(T) = exp{μT + 1.65*σT1/2} etc
• Now turn “funnel of doubt” backwards…
• To end up at Actual(T) on the above return process, the expected value should
  have come from
    •   R(t) = Actual(T)*exp{- μ(T-t)}
    •   UB(t) = Actual(T)*exp{- [μ(T-t) + 1.65 *σ(T-t)1/2]}

• Interpret this as…

“To have ended up here, with the proposed return process, we should have come
  from inside the (backwards) “funnel of doubt”. If the trajectory actually falls
  outside the UB, then the process actually operating was NOT that proposed, to
  UB level of certainty (1.65 = 95% certainty.)”

THE LINE’S OUTSIDE, THE STORY IS WRONG, SO REVIEW IT…


                                                                                    43
                               DMRA V-Mask Monitor: Stop Losses in Practice
                                                          UK Equity                                                                                            Global Equity                                                                                                                 UK Credit

                            1.1000                                                                                                1.1000                                                                                                     1.1000


                            1.0500                                                                                                1.0500                                                                                                     1.0500




                                                                                                                                                                                                                 Cu mulative Valu e Added
Cumulative Value Added




                                                                                                        Cumulative Value Added
                            1.0000                                                                                                1.0000                                                                                                     1.0000


                            0.9500                                                                                                0.9500                                                                                                     0.9500


                            0.9000                                                                                                0.9000                                                                                                     0.9000
                                                                      Daily Cumulative Return                                                                                  Daily Cumulative Return                                                                                                            Daily Cumulative Return
                                                                      Lower Boundary                                                                                           Lower Boundary                                                                                                                     Lower Boundary
                            0.8500                                                                                                0.8500                                                                                                     0.8500
                                                                      Upper Boundary                                                                                           Upper Boundary                                                                                                                     Upper Boundary

                            0.8000                                                                                                0.8000                                                                                                     0.8000




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                                                              Date                                                                                                    Date                                                                                                                             Date




                                                         JGB Hedged                                                                                  Global Index Linked Bonds Hedged

                            1.1000                                                                                                1.1000

                            1.0500                                                                                                1.0500
  Cumulative Value Added




                                                                                                        Cumulative Value Added




                            1.0000                                                                                                1.0000


                            0.9500                                                                                                0.9500


                            0.9000                                                                                                0.9000
                                                                      Daily Cumulative Return                                                                                  Daily Cumulative Return
                                                                      Lower Boundary                                                                                           Lower Boundary
                            0.8500                                                                                                0.8500
                                                                      Upper Boundary                                                                                           Upper Boundary

                            0.8000                                                                                                0.8000
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                                                              Date                                                                                                    Date


                         Source: Standard Life Investments

                                                                                                                                                                                                                                                                                                                                                             44
Benefits of taking a dynamic approach
• Broadens the investment universe
    • Examines the return potential of all areas of market risk


• Targets asymmetric return expectations
    • Positioning in the range informs those to harness and those to avoid


• Flexing the position to respond to specific circumstances
    • Taking a contrarian view on an asymmetric position can protect in downside
      scenarios – implied volatility for example


• Responsive to the Investor‟s risk appetite
    • Adjusting the hedging strategy depending on the Sponsor‟s ability to make
      additional contributions



 Investment expertise guided by quantitative discipline

                                                                                   45
Example: Long volatility

                       • Strategy:
                           • hold out of the money calls to
                             access desired additional equity
                             exposure and exposure to implied
                             volatility
                       • Rationale:
                           • Asymmetric return expectation:
                               • implied volatility currently right at
                                 the bottom of its range
                               • expect it can go a lot higher but
                                 not much lower
                           • rise in dynamic hedging means
                             there are many institutions that will
                             be forced traders if there is a big
                             move in any direction
Source: Bloomberg


                                                                         46
.. portable alpha strategies, which is another way of referring to LDI. Global
                                                                                                ..liability-driven investing, which seeks to match more closely the
                                          Investor Magazine, 08/05
                                                                                                        returns generated by a pension fund’s assets with its
                                                                                                                    commitments. Financial News, 02/01/06
 Liability Driven Investing is
    a risk preference based    ‘liability-driven investing’ (matching liability
 approach which can be used growth to the extent possible), Watson Wyatt,
   to complement or totally                          Canada
                                                                                                         'liability-driven investment strategies', which involves
  replace current strategies.
       Finance IQ Conference, 04/06
                                                                                                      swapping the income which they will receive from their
                                                LDI is about establishing a transparent link           long-dated bonds with instruments which better match
                                               between liabilities and assets and minimising                                     their liabilities. The Observer, 22/01/06
                                                  uncompensated risks. Hugh Cutler, Pensions
                                                                     Management, 01/04/05




                                                                                                 LDI relates to the practice of using investment tools such as derivatives
  Liability-driven investing focuses on managing a plan’s liability risk while                   to help funds meet their payouts to investors even though markets may
      providing multiple sources of excess return. Jane Tisdale, SsgA, 17/10/05                                  be volatile. The Standard (Hong Kong), 21/12/04




                                      ‚LDI … the process whereby an investment strategy is set with explicit reference to a specific
                                                              set of liabilities.‛ Mercer Investment Consulting
What is LDI?
• A range of strategies and novel processes

• That are evolving in response to the problems pension schemes are facing
    • Mark – to market
    • Visibility in accounts


• Making optimum use of available risk budgets
    • Specifically, avoiding unmanaged and unrewarded risk


• Employing those closest to the market to

• Perform against liabilities

• Over timescales that are now appropriate


                                                                             48

				
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Description: Market Risk Monitoring document sample