towers watson: portfolio development and implementation in uncertain times
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© 2010 Towers Watson. All rights reserved.
Portfolio Development and Implementation in Uncertain Times
June 28, 2011
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Discussion
Economic and Market Uncertainty
Portfolio Positioning in Uncertain Times
Role of Valuations
Impact on Liability-Driven Investing
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Shorter View
2010 2015
Scenario Probability Positives Negatives
Bumpy ride to recovery
Global slowdown
High inflation
Deflation (‘indebted’)
Debt crisis (‘indebted’)
High growth (‘indebted’)
Growth rate
Time
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Shorter View
2010 2015
Scenario Probability Positives Negatives
40% Commodities
20%
15% Credit
10%
10%
5% Equities
Sove
reign
bon
ds
Growth rate
Time
Commodities
Credit
Equities
Sove
reign
bon
ds
Bumpy ride to recovery
Global slowdown
High inflation
Deflation (‘indebted’)
Debt crisis (‘indebted’)
High growth (‘indebted’)
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Loose fiscal policy
Tight fiscal policy
Loose monetary policy Tight monetary
policy
“Indebted markets”
Loose fiscal policy
Tight fiscal policy
Loose monetary policy Tight monetary
policy
“Indebted markets”
Politics (Policy) Will Matter Greatly
“Growth markets”
Exchange rate
Rebalancing
vs
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Longer View
2015 2025
• Capitalism reinventing itself• Jobs being recycled into new areas• Confidence returning
• Caught in a debt / liquidity trap• Western financial system crisis-prone• Wealth and power shifting East
Sovereign nominal bonds
Equities, credit, commodities
Sovereign nominal bondsEquities, credit, commodities(?)
Growth rate
Time
Policies favored growth
Debt more powerful than policies
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Investment Framework
7
Stage 1: Investment Strategy Development
Stage 2: Portfolio Construction
Stage 3: Risk Budgeting
Manager selection and monitoring of strategy
Liability-matching
Investment grade bonds
Return-seeking
Domestic
Asset Allocation Supporting Objectives
Non-U.S.ABS/MBS
CorporateTreasury
Non-U.S.
Alternatives
High yield
Bank loans
Convertibles
Equities Non-investment grade bonds
Hedge FOF
Private real estate
Private equity
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
What makes a good return driver?
8
Return driver Easy to access Reliable Attractive distribution
Capacity Governance Macro consistent High IR Positive skew Correlation
ERP - -
Credit
Illiquidity
Insurance
Term -
Inflation
Currency
Skill * -
* Assumes skilled managers are picked across multiple asset classes with a low correlation between their alphas.
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
TWIS Return-Driver Framework
9
hgAsset Classes Equity Credit Illiquidity Insurance Term Inflation Currency SkillDeveloped market equityAlternative creditAlternative betas
ReinsuranceCommoditiesVolatility arbitrage
Emerging WealthEmerging market equitiesEmerging market debtEmerging market currency
Hedge fundsIlliquid assets
Core global propertyCore InfrastructurePrivate market funds
BondsCorporate bondsNominal government bonds (AAA)Inflation-linked gov't bonds (AAA)
Risk Premia
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Valuations Matter – Our Current Views
10
Three-Year HorizonAsset Class View
Global Government Bonds Neutral
Global Inflation-linked Bonds Neutral
Global Credit (Investment Grade) Neutral
Global Equities Neutral
Commodities Neutral
Asset class- Few clear dislocations in major global markets relative to cash
Return Drivers- Few clear dislocations in major global markets relative to cash
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Portfolio Construction: Return-seeking portfolio considerations
11
Unconstrained
Long-Horizon Iliquid
Portfolio
All Assets
Client portfolio dependent on: Time horizon Opportunities re annuitization Cashflows
Long-Horizon Liquid
Portfolio
Government Debt and Cash-Like
InstrumentPriv
ate
Equi
ty
Prop
erty
Infr
astr
uctu
re
Rei
nsur
ance
Illiq
uid
Hed
ge F
unds
Emer
ging
Mar
ket C
urre
ncy
Hig
h Yi
eld
EM E
quity
Dev
elop
ed E
quity
Liqu
id H
edge
Fun
ds
Loan
s
EM D
ebt
IG C
redi
t
LT G
ov D
eb
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
KEY: positive, very positive, = broadly neutral, negative, very negative
Fast(EM FX appreciation)
Slow(EM inf lation, DM def lation)
High(Fiscal stimulus,
high market liquidity)
Low(Fiscal austerity,
tight market liquidity)
Speed of global rebalancing(EM policy choices)
Public policy and financial conditions
(DM policy choices)
EM: Emerging MarketsDM: Developed Markets
EM Overheating
Global growth slowdown
DM Deflation
High DM inflation
DM sovereign
debt crisisBumpy ride
to recovery
High DM
growth
Consideration of these scenarios should form a qualitative overlay to
the outcomes from the risk-budgeting analysis
12
Bumpy ride Growth slowdown DM deflation High DM
inflation High DM growth Sovereign default EM crisis
Probability 40% 20% 15% 10% 15%
Nominal Bonds (developed market) =
Inflation linked bonds = =
Global Equities
EM Wealth
Alternative Credit =
Inv. Grade Credit =
Insurance = = = = = = =
Spending the Risk Budget: Economic scenario analysis
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Alternative beta
Treasuries and cash
DB Pension Fund
Corporate bonds
Developed equities
Private marketsEmerging wealth
Traditional Unconstrained
Treasuries and cash
Corporate bonds
Developed equities
Private markets
Emerging wealth
Source: Towers Watson
Hedge fundsAlternative beta
Alternative credit
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Higher-Risk Fund Asset Structure
Unconstrained
Source: Towers Watson
Sustainability
Higher-risk fund
Developed equities
Hedge funds
Alternative beta
Alternative credit
Private markets
Emerging wealth
Treasuries and cash
Corporate bonds
Developed equities
Private markets
Emerging wealth
Hedge fundsAlternative beta
Alternative credit
Cash
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Portfolio Construction: Return-Seeking
15
Typical RSA
Developed Equity
Alternative Credit
Insurance
Emerging Wealth
Hedge Funds
Private Markets
Bonds
Extreme Risk Hedges
Liquidity
Low Fee Liquidity Constrained Unconstrained
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
16
Impact of Uncertainty on Liability-Driven Investing
60%
65%
70%
75%
80%
85%
90%
95%
100%
105%
Funded Status
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
17
Don’t Forget about Risk Management: Left-Tail Risks
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
TW and the market expect interest rates to rise
This chart shows the market’s and our expectations for future cash interest rates (ie forward rates). Please note that our expectations are focused around a long-term yield level for Treasurys (and swaps) of 4% pa.
Both we and the market expect cash interest rates to rise over the next few years as monetary policy normalizes.
18
Source: Towers Watson as at 3 May 2011
Assessing the value of Treasurys relative to cash
Treasury forward cash rates
0.0
1.0
2.0
3.0
4.0
5.0
6.0
0 5 10 15 20 25 30
Yiel
d (%
pa)
Term
Market forward Treasury cash rate
TW expected Treasury cash rate
Interest rates expected to
increase from current low
levels
Market expectation above 5%
Our assumption below market expectation
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
19
“Rates are low, don’t you know?”
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
90 92 94 96 98 00 02 04 06 08 10Pe
rcen
t (%)
Expected change in family income (next 12 months), median response
Smoothed series (moving average)
High unemployment puts strong pressure on US wages in the short term
Source: University of Michigan, Towers Watson
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
00 01 02 03 04 05 06 07 08 09 10 11
US core inflation UK core inflation
Euroland core inflation Japan core inflation
% yoy
G4 core inflation (CPI excluding the volatile energy and food prices) modestly rising
Source: Bloomberg LP
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
“Rates are low, don’t you know?”
2010 2015
Scenario Probability Progression To Goal
5%
15%
40%
20%
10%
10%
Bumpy ride to recovery
Global slowdown
High inflation
Deflation (‘indebted’)
Debt crisis (‘indebted’)
High growth (‘indebted’)
Growth rate
Time
Low probabillty/modest upside
High probabillty/greater downside
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
2121
Liability Hedging Portfolio Construction
Representative Cash Flow Distribution - 70% Fixed Income
Representative Cash Flow Distribution - 30% Fixed Income
0%
10%
20%
30%
40%
0-5 6-10 11-20 21-30 30+
Government Credit Liabilities
0%
10%
20%
30%
40%
0-5 6-10 11-20 21-30 30+
Government Credit Liabilities
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Decide how to factor in your views on the markets and risks
Review your portfolio structure
Be alert to investment opportunities arising
Understand and manage left tail risk
So, what now?
towerswatson.com© 2011 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Contact Details
Chris DeMeo 335 Madison Avenue, New York, NY 10017-4605 212-309-3845 christopher.demeo@towerswatson.com
Matt Stroud 335 Madison Avenue, New York, NY 10017-4605 212-309-3835 matthew.stroud@towerswatson.com
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