1. STRATEGIC ASSET ALLOCATION
James Thompson
Government Actuary’s Department
United Kingdom

2. What is strategic asset allocation?
The efficient optimisation of investment allocation to major asset classes of investment in order:
- to meet the overall investment objectives of the institution and
- to achieve an acceptable balance between risk and return

3. As opposed to tactical investment selection
Tactical investment selection is the choice of individual investments in line with the chosen strategy
Both strategic and tactical decisions are important
But the strategy will often be the more significant determinant of performance

4. Purpose of investment allow liabilities to be met as they fall due
liquidity
matching
aim to produce good return to minimise cost of benefits (or increase benefit levels)
control risks - diversification
provide security for members’ benefits
stabilise contribution rate

5. Also …. provide source of government funding
provide finance for specific government investment projects or to further government policy
develop capital markets

6. General principles assets should be appropriate to the liabilities
diversification is needed to reduce risk…
…between asset classes and within classes
trade-off of risk and return
correlations of risks and returns

7. Classical asset allocation theory
optimisation of risk and return (Markowitz)
there is a wide spectrum of possible portfolios
rational investors select strategy on frontier…
…to maximise return for given level of risk…
…or to minimise risk for given level of return
combine portfolio with risk-free assets to reflect acceptable level of risk
assumes asset returns are known and normally distributed

8. Efficient frontier Mean Rate of Return Variance of Return 5% B 4% 3%2% 1% B A C
Mean Rate of Return
0 1% 2% % % % % %
Variance of Return

9. However this approach is simplistic
returns are not normally distributed and variance is not the only measure of risk
the returns, variances and correlations are not known, and may change over time
does not have regard to the liabilities

10. Liabilities investments aim to allow the liabilities to be met
some more uncertain than others
promise to pensions or other cash benefits in future
promise to provide non-cash benefits such as healthcare
contingent liabilities, including catastrophe and fluctuation reserves

11. Nature of liabilities
identify the liabilities to which the investments relate
amount and timing
nominal or related to inflation
currency
degree of uncertainty in amount and timing
possible embedded options

12. Possible investments depends on market government bonds
corporate bonds
index-linked bonds
bank deposits
equity shares
real estate
derivatives

13. Also … mortgage loans government projects works of art precious metals
commodities

14. Nature of investments amount and timing of cashflows
nominal or linked to inflation
marketability/liquidity
volatility of value
default risk

15. Other factors diversification accountability mechanism
political interference
social security legislation
impact on stakeholders
regulation
expertise
expenses

16. Matching the assets and liabilities
matching involves investing in instruments whose value will behave in a similar way to the value of the liabilities in varying financial conditions
if absolute matching, no future changes in conditions would affect the ability to meet the liabilities
in practice, matching will never be absolute
matching may be low risk, but may be expensive if the matching assets have low returns

17. Example of matching
there may be a liability to pay pensions, increasing in line with prices, to an existing group of pensioners
the pensions in effect represent a stream of payments linked to prices over the next 30 years or so
index-linked government bonds also represent a stream payments linked to prices
hence matching could be achieved by investing in a portfolio of index-linked bonds whose duration was similar to that of the pensions

18. Behaviour of matched portfolio

19. Example of matching
in practice, the position may be much more complicated than this
liabilities will also relate to current workers and their benefits may therefore depend on wage as well as price inflation
the scheme may be only partially funded raising the question of which liabilities are funded and can be matched
future contributions might be regarded offsetting future payments but this adds further uncertainty

20. Asset-liability modelling
determine the measure to be controlled by the investment policy, e.g. the funding level (assets as a percentage of liabilities) or contribution rate
stochastically project liabilities and assets
many different investment models and parameters which will produce differing results
compare results from different strategic asset allocations

21. Funding level after 15 years4
3.5 3
90%
75%
50%
25%
10%
Upper Decile
2.5
Ratio of Assets to Liabilities 2
Upper Quartile
1.5
Median 1
Lower Quartile
Lower Decile
0.5 A B C D
Portfolio

22. Suitability of asset classes
Cash and short-term deposits
usually low risk and low return
useful for liquidity (e.g. for a working balance and fluctuation reserves)
not generally appropriate for longer duration liabilities except as a short-term tactical measure

23. Suitability of asset classes
Government bonds
a variety of terms means they are often useful as matches for certain liabilities
longer-term bonds can be vulnerable to high inflation and therefore index-linked bonds may be preferred if liabilities are inflation linked
may be relatively marketable, although this will depend on the country concerned
generally low risk and low return

24. Suitability of asset classes
Corporate bonds
similar to government bonds but less secure (and consequently higher return)
risk will vary according to the issuer and may change during the course of the investment
market for corporate bonds usually less broad and less liquid than that for government bonds
will be affected by wider economic sentiment and may therefore have depressed values at precisely the time they are needed (e.g. in a recession)

25. Suitability of asset classes
Equities
more risk and higher expected returns than bonds
historically have produced considerably higher returns than bonds
returns should be linked to future economic fortunes of the country
however, the value of equities can vary very widely in the short and long-term
high levels of equity investment may lead to issues of government control and indirect nationalisation
market in equities may be limited or non-existent in some countries

26. Suitability of asset classes
Foreign investment
useful in order to diversify
can take advantage of investments not available in the domestic market
may introduce currency mis-matches which can be mitigated by suitable hedging
central banks may be concerned over possible adverse currency flows
tax may be levied in foreign countries

27. Suitability of asset classes
Real estate
some features of bonds and equities
generally illiquid and expenses of managing such investments can be high
investment in domestic property (houses) may be sensitive and prone to political interference

28. Benchmarking set a benchmark against which to measure performance
benchmark might be a low risk matching portfolio…
…or perhaps an index or combination thereof
effect of deviating from the benchmark can be measured
is the extra return worth the risk?