Every basis point counts: using a modified total-return approach, insurers can maximize returns from a fixed-income portfolio.Key Points * The first step in optimizing a portfolio is to complete a strategic asset allocation Strategic Asset Allocation A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation. Notes: At the inception of the portfolio, a "base policy mix" is established based on expected returns. . * One way for insurers to achieve potentially higher returns, without impacting overall portfolio risk, is to increase active fixed-income risk. * Successful active fixed-income investing requires a risk-budgeting framework that effectively combines a broad investment opportunity set, investor skill and diversification Diversification A risk management technique that mixes a wide variety of investments within a portfolio. It is designed to minimize the impact of any one security on overall portfolio performance. Notes: Diversification is possibly the greatest way to reduce the risk. benefits. Today's fixed-income environment is challenging for insurers. With low yields and tight spreads, insurers have begun contemplating an investment strategy that includes both passive and active management of their portfolios. This modified total-return approach may be the most efficient way for insurers to generate meaningful returns. By focusing on both yield and total-return strategies, a modified total-return approach enables insurers to make every basis point count in their fixed-income portfolios. Strategic Asset Allocation The first step in optimizing a portfolio is to complete a strategic asset allocation. There are many frameworks available to perform this exercise, such as proprietary risk-budgeting systems, value at risk, enterprise risk management and dynamic financial analysis, but the basic requirements are to consider a variety of potential market risks, in the form of benchmark portfolios, that meet the return objectives and the risk tolerance Risk Tolerance The degree of uncertainty that an investor can handle in regards to a negative change in the value of their portfolio. Notes: An investor's risk tolerance varies according to age, income requirements, financial goals, etc. of the insurer An individual or company who, through a contractual agreement, undertakes to compensate specified losses, liability, or damages incurred by another individual. An insurer is frequently an insurance company and is also known as an underwriter. , all within the specific company's constraints CONSTRAINTS - A language for solving constraints using value inference. ["CONSTRAINTS: A Language for Expressing Almost-Hierarchical Descriptions", G.J. Sussman et al, Artif Intell 14(1):1-39 (Aug 1980)]. . (See "Strategic Asset Allocation" on page 88.) It is important for the insurance company to use a process that makes it feel comfortable, and allows it to get important constituents comfortable, with the long-term asset Long-term assets or noncurrent assets are those assets usually in service over one year such as lands and buildings, plants and equipment, and long-term investments. These often receive favorable tax treatment over current assets. allocation The apportionment or designation of an item for a specific purpose or to a particular place. In the law of trusts, the allocation of cash dividends earned by a stock that makes up the principal of a trust for a beneficiary usually means that the dividends will be treated as . [ILLUSTRATION OMITTED] The required inputs are fairly straightforward. Insurance companies should: * Set expectations about the risk, return and correlations of various investment strategies. * Determine how various investment strategies fit into its specific circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or . * Determine which metrics metrics Managed care A popular term for standards by which the quality of a product, service, or outcome of a particular form of Pt management is evaluated. See TQM. are most important to its unique circumstances. The output of the strategic asset allocation is not a precise recommendation, but rather, a range of potential investment strategies with different risk/return profiles. Portfolio strategy advice should be based on basic principles of modern financial economics. Although we do not believe that capital markets are in equilibrium equilibrium, state of balance. When a body or a system is in equilibrium, there is no net tendency to change. In mechanics, equilibrium has to do with the forces acting on a body. , we do believe that thoughtful portfolio advice should use equilibrium as a starting point Noun 1. starting point - earliest limiting point terminus a quo commencement, get-go, offset, outset, showtime, starting time, beginning, start, kickoff, first - the time at which something is supposed to begin; "they got an early start"; "she knew from the . In our view, deviations from equilibrium expected returns Expected Return The average of a probability distribution of possible returns, calculated by using the following formula: do exist, and should be reflected in investment strategy. However, these deviations should be justified both empirically and in terms of the underlying financial economics. Our approach to finding equilibrium returns is to rely on basic principles of asset pricing. In an ideal world, this exercise would focus solely on economic decision making, with 100% of an insurer's asset portfolios marked-to-market Marked-to-market An arrangement whereby the profits or losses on a futures contract are settled each day. . The company should focus on optimizing its asset returns regardless of whether the returns came from income or capital appreciation. However, it would be naive naive - Untutored in the perversities of some particular program or system; one who still tries to do things in an intuitive way, rather than the right way (in really good designs these coincide, but most designs aren't "really good" in the appropriate sense). to ignore the implications of accounting-based metrics, such as recurring re·cur intr.v. re·curred, re·cur·ring, re·curs 1. To happen, come up, or show up again or repeatedly. 2. To return to one's attention or memory. 3. To return in thought or discourse. investment income and realized gains Realized Gain A gain resulting from selling an asset at a price higher than the original purchase price. Notes: There may be tax consequences for a realized profit. and losses, and the importance of those metrics to external constituents, within the scope of this analysis. This may lead insurers to focus on short-term Short-term Any investments with a maturity of one year or less. short-term 1. Of or relating to a gain or loss on the value of an asset that has been held less than a specified period of time. financial statement results at the expense of creating long-term Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. economic value. Regardless of the ultimate decision criteria, we believe it is imperative for insurers to understand the true economic trade-offs. These various options are then filtered through the: * Company's risk management philosophy, and * The eyes of important external constituents. These combined filters help an insurance company determine how to focus its investment strategy to meet the company's overall strategic goals. The insurer can now focus on implementation. One of the most important outcomes of the strategic asset allocation process is the creation of benchmarks for different asset classes, representing the types of risk the insurer wants to take in its portfolio. For short-duration property companies, it may be a short, high-quality bond benchmark. For life and annuity annuity: see insurance. annuity Payment made at a fixed interval. A common example is the payment received by retirees from their pension plan. There are two main classes of annuities: annuities certain and contingent annuities. companies, it may be a longer duration, low credit quality, higher yielding benchmark. These benchmarks are now used to judge the performance of the team managing the portfolio. Moving From Passive (Beta) To Active (Alpha) One way for insurers to achieve potentially higher returns, without impacting overall portfolio risk, is to increase active fixed-income risk. What is active risk? First, active risk is taking portfolio positions that are different from the benchmark. Second, active risk is changing those positions as market conditions and portfolio-manager views merit. One example of active risk is to position the portfolio based on one's view of the direction of interest rates. For example, if an insurer owned a 5-year Treasury note during 2005, it would have received coupon income of 3.61%, but its bonds would have experienced a decline in value of 2.55%. While the insurer can argue the "ability and intent" to hold the bond to maturity, and therefore not realize that 2.55% price decline, the total return of holding that bond was approximately 1%. Now let's let's Contraction of let us. assume that the insurer sold the 5-year note on Dec. 31, 2004, and purchased 3-month T-bills. If it held those T-bills through the year, the income from the T-bills would have been approximately 50 basis points below the 5-year note strategy. However, there would have been no loss of principal value, providing a total return of 3%, or 2% higher than the total return of holding the T-note. Additionally, the insurer could have reversed the trade at year-end 2005, selling the T-bills and buying the 5-year notes, with a new book yield of 4.31%. While we are not advocating aggressively moving between T-bills and notes or bonds for an insurance portfolio, we do believe that some active management, within book yield and gain/loss constraints, can add value to the insurer--either higher investment income, greater book value per share, or both. (See "Yields on 3-Month T-Bill and 5-Year Treasury Note" below.) Level of Target Risk Once the insurer determines that it is willing to take active risk (deviate from the benchmark), it should determine how much active risk it is willing to take. Since the selection of the benchmark is measured, in part, by the risk (volatility) of the benchmark, the insurer also should measure the potential deviation DEVIATION, insurance, contracts. A voluntary departure, without necessity, or any reasonable cause, from the regular and usual course of the voyage insured. 2. from the benchmark in a similar fashion. We believe the appropriate measure for active risk is tracking error, which measures the expected standard deviation In statistics, the average amount a number varies from the average number in a series of numbers. (statistics) standard deviation - (SD) A measure of the range of values in a set of numbers. of the excess returns and also measures the actual deviations. Since every set of benchmarks and guidelines guidelines, n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. has an implicit tracking error associated with it, it is important for insurers to explicitly quantify Quantify - A performance analysis tool from Pure Software. that tracking error. TRACKING ERROR: The annualized annualized Of or relating to a variable that has been mathematically converted to a yearly rate. Inflation and interest rates are generally annualized since it is on this basis that these two variables are ordinarily stated and compared. standard deviation of a portfolio's monthly returns relative to a benchmark (usually the representative index). Tracking error is a measure of the extent to which a portfolio's historical returns did not resemble those of the benchmark, In its simplest form, tracking error helps an insurer set expectations regarding its potential performance. If the tracking error target is set at 100 basis points, the insurer can expect to have, under normal market conditions, the worst-case return of the benchmark, less 100 basis points. On the other hand, the insurer also should expect annual returns not to exceed the benchmark plus 100 basis points. It is the active manager's job to consistently generate returns above the benchmark by taking active risk. Maximizing Returns at Any Target Risk Once an insurer establishes the maximum amount of tracking error available from its guidelines and from the marketplace, it should determine the ultimate amount of tracking error it is willing to take, and, as importantly, the excess return it expects to generate by taking that risk. The success of this process is ultimately determined by thoughtfully combining three basic elements: 1. Broad opportunity set. In the fixed-income markets, there are thousands of securities for investors to evaluate, trade and incorporate into a portfolio. Likewise, there are many diverse active strategies, such as interest rate, country, currency and sectors, that can be employed. The range of risks is as diverse as the range of strategies. These risks vary in both size and correlation to one another and they can be employed simultaneously for optimal performance. One way to think about active risks is to group them into "top down" and "bottom up" categories. (See "Top Down and Bottom Up Risks" above.) With top down risks, also called "macro" risks, the manager imparts a broad view. For example, a duration view may be "rates will rise," or a cross-sector view may be "corporates are cheap." Bottom up risks reflect securities that the sector specialist feels provide the most potential return versus the universe of bonds available. [ILLUSTRATION OMITTED] The risks available within a mandate are a function of both guideline guideline Medtalk A series of recommendations by a body of experts in a particular discipline. See Cancer screening guidelines, Cardiac profile guidelines, Gatekeeper guidelines, Harvard guidelines, Transfusion guidelines. flexibility and market opportunity. For certain strategies, the market affords the insurer meaningful opportunity to take risk. Duration and yield curve risk, for instance, are plentiful plen·ti·ful adj. 1. Existing in great quantity or ample supply. 2. Providing or producing an abundance: a plentiful harvest. . The deviation from the benchmark can be quite high, but is usually constrained con·strain tr.v. con·strained, con·strain·ing, con·strains 1. To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at force. 2. by the allowable duration band in the guidelines. Other risks are not as plentiful, due to the fact that there may be a reasonably high correlation in spread movements within certain sectors (for example, the government/agency strategy). Although investment guidelines may allow for unlimited item selection risk, the risk available from the marketplace is not large. Therefore, insurers have to judge how market and self-imposed constraints affect their risk-taking abilities. 2. Historical evidence of manager skill. While it is great to be able to quantify the level of risk-taking opportunities available, an insurer should deviate from its strategic benchmark only if it feels it has the skill to capitalize on Cap´i`tal`ize on` v. t. 1. To turn (an opportunity) to one's advantage; to take advantage of (a situation); to profit from; as, to capitalize on an opponent's mistakes s>. these opportunities. There are several ways to judge skill in a fixed-income manager. We find it most useful to look at the historical information ratio. INFORMATION RATIO: The excess return of the portfolio divided by the tracking error. It measures excess return per unit of risk that is due solely to the specific risks associated with the securities of the portfolio. A higher number is better. While it is important to know the skill at the overall portfolio level, managers should also know their skill set at each individual sub-strategy. Before employing a specific active management strategy, an insurer, or its investment manager, should provide some (quantifiable Quantifiable Can be expressed as a number. The results of quantifiable psychological tests can be translated into numerical values, or scores. Mentioned in: Psychological Tests , based on performance attribution at·tri·bu·tion n. 1. The act of attributing, especially the act of establishing a particular person as the creator of a work of art. 2. ) estimate of its historic ability to add value from employing the strategy. 3. Diversification benefits. Lastly, we believe there are diversification benefits from combining different sources of active risk. If an insurer possesses skill in several areas, and if those skills are uncorrelated (for example, the ability to pick the highest performing corporate bonds has no correlation with the ability to pick the future direction of interest rates), employing multiple strategies should improve the expected risk-adjusted returns Risk-Adjusted Return A measure of how much risk a fund or portfolio takes on to earn its returns, usually expressed as a number or a rating. Notes: This is often represented by the Sharpe Ratio. The more return per unit of risk, the better. . "Combining Passive and Active Strategies," below, shows a graphic representation of combining different strategies. The return from passive exposure to the strategic benchmark is the market, or beta, component of return. Here we focus on the alpha components--how to add value across a number of different strategies. For more yield-focused clients, you can think of some of these opportunities as "yield alpha." Notice that the discs representing each active strategy are different sizes, as each strategy's contribution to portfolio risk and total return has a different weight. Intuitively, you should place a larger weight on strategies with higher information ratios and favorable fa·vor·a·ble adj. 1. Advantageous; helpful: favorable winds. 2. Encouraging; propitious: a favorable diagnosis. 3. diversification benefits. Putting It All Together A broad investment opportunity set, investor skill and diversification benefits are necessary ingredients, but do not alone guarantee successful active fixed-income investing. A risk-budgeting framework that effectively combines these elements also is required. Individual skilled decision makers need to know how much risk to take. The risk budget communicates quantitatively the amount of risk-taking allowable within each top down and bottom up strategy. An example of a risk budget that could be employed in an insurance company portfolio is shown in "Using Active Risk Most Efficiently" above. The column marked "Constraint Constraint A restriction on the natural degrees of freedom of a system. If n and m are the numbers of the natural and actual degrees of freedom, the difference n - m is the number of constraints. " indicates a maximum tracking error by strategy, which often reflects a constraint externally imposed by the investment mandate. The "Optimized Target" shows the amount of risk that could be assigned as·sign tr.v. as·signed, as·sign·ing, as·signs 1. To set apart for a particular purpose; designate: assigned a day for the inspection. 2. to each strategy to best balance investment skill, diversification benefit and potential return within an overall level of risk. For instance, the guidelines may allow for 50 basis points of tracking error in the duration positioning of the portfolio. However, since the strategy has less demonstrable de·mon·stra·ble adj. 1. Capable of being demonstrated or proved: demonstrable truths. 2. Obvious or apparent: demonstrable lies. skill than some others (as quantified by the lower information ratio), the insurer may not want to use all the active risk allowed in the guidelines. By allocating active risk to many different fixed-income areas of expertise, insurers may be able to diversify diversify To acquire a variety of assets that do not tend to change in value at the same time. To diversify a securities portfolio is to purchase different types of securities in different companies in unrelated industries. overall risk, and expect higher risk-adjusted returns. The beauty of the risk budgeting process is that it allows insurers and their portfolio managers to have a quantitative conversation about the risk/return trade-offs of different investment constraints. Road Map for Implementation We believe that a simple seven-step process can help insurers create more optimal risk-adjusted portfolios. This process was first outlined in Chapter 24 of Modern Investment Management--An Equilibrium Approach, a book by Bob Litterman and a number of Goldman Sachs The Goldman Sachs Group, Inc., or simply Goldman Sachs (NYSE: GS) is one of the world's largest global investment banks. Goldman Sachs was founded in 1869, and is headquartered in the Lower Manhattan area of New York City at 85 Broad Street. Asset Management investment professionals. Jonathan Beinner, chief investment officer and co-head of global fixed income and money markets at Goldman Sachs Asset Management, authored the chapter. The steps are as follows: 1. Determine the appropriate strategic benchmark. 2. Determine the investment constraints. 3. Determine which active strategies you wish to (can) employ. 4. Determine the maximum risk (tracking error) by strategy. 5. Determine skill level in each strategy as well as the correlation with other strategies. 6. Determine the overall portfolio target risk (the amount of risk you want to take). 7. Based on skill in each strategy and correlations between strategies, use the overall target risk and return to determine the optimal amount of risk to allocate To reserve a resource such as memory or disk. See memory allocation. to each strategy. Only then can an insurer feel it has made every basis point count. Contributor John Gauthier is managing director, head of insurance fixed-income portfolio management, for Goldman Sachs Asset Management. He can be reached at john.gauthier@gs.com.
Yields on 3-Month T -Bill and 5-Year Treasury Note
Year-end Year-end Year-end
2004 2004 2005
Bond Price Bond Yield Bond price
3-Month T-Bill 100 2.21% 100.00
5-Year Treasury 100 3.61% 97.45
2005 Average Year-end
Price 2005 Book 2005
Change Yield Bond Yield
3-Month T-Bill 0.00% 3.10% 3.99%
5-Year Treasury -2.55% 3.61% 4.31%
Source: Bloomberg
Using Active Risk Most Efficiently
Active Risk Mix
Typical
Guideline
Information Constraint
Active Strategy Ratio (Basis Points)
Duration/Yield Curve 0.25 50
Country Exposure 0.50 25
Sector Rotation 0.40 40
Security Selection:
Government/Agency 0.50 10
Mortgage-Backed/Asset-Backed 0.80 25
Securities
Corporate Credit 0.60 30
High Yield 0.60 10
Emerging Market Debt 0.80 10
Sum of Standalone Active Risks
Less Diversification Benefit
Total Active Fixed-Income Tracking
Error (annualized)
Target Gross Excess Return
(annualized)
Active Risk Information Ratio
Optimized
Target
Active Strategy Basis Points
Duration/Yield Curve 45
Country Exposure 25
Sector Rotation 39
Security Selection:
Government/Agency 10
Mortgage-Backed/Asset-Backed 25
Securities
Corporate Credit 30
High Yield 10
Emerging Market Debt 10
Sum of Standalone Active Risks 192
Less Diversification Benefit -92
Total Active Fixed-Income Tracking 100
Error (annualized)
Target Gross Excess Return 90
(annualized)
Active Risk Information Ratio 0.9
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