Modelling Active Management
AFIR 2003, Maastricht
Joeri van Alphen
Lodewijk van Pol
18 September 2003
Agenda
 Introduction
 The model
 Example
 Application to manager structure
 Conclusion
2
Absolute versus relative risk
Efficiënte Grenslijn
5.25
5.00
Gemiddeld reëel rendement
4.75
4.50
4.25
4.00
3.75
3.50
3.25
3.00
Quarterly Performance
Relative to Benchmark
2.75
2.50
2.25
8.0%
2.00
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
6.0%
Standaarddeviatie
4.0%
2.0%
0.0%
III
-2.0% 1996
I
1997
III
I
1998
III
I
1999
III
I
2000
III
I
2001
-4.0%
Added Value
Rolling three year added value
Added value target
3
Active return matters
 An additional 1% return saves an average pension fund
about 6% contribution of payroll
 In a low return environment, additional return from active
management becomes more important
4
Model
 Active return normally distributed with expectation  and
standard deviation TE
 Portfolio return Rp = Rb + 
 Portfolio risk:
 p   b 2  2 * b * TE *  b ,  TE 2
 standard deviation of benchmark (b )
 tracking error (TE)
 correlation between Rb and 
5
Impact of TE and correlation on portfolio standard deviation
Standard deviation of active portfolio
Impact of TE and correlation
26%
25%
24%
Cor = 0.75
23%
Cor = 0.50
22%
Cor = 0.25
Cor = 0.00
21%
Cor = -0.25
20%
19%
18%
0%
1%
2%
3%
4%
5%
6%
TE
6
Some real-life examples
Standard Deviation European Equities of M anagers
versus Benchmark
30%
25%
20%
15%
10%
5%
0%
1
2
3
4
5
6
Benchm ark
20.3%
20.3%
20.5%
20.5%
20.1%
20.6%
Portefeuille
Portfolio
22.5%
21.3%
21.6%
23.1%
21.1%
25.7%
TE
5.5%
6.0%
3.7%
4.5%
3.1%
8.6%
Cor
28.1%
2.3%
20.7%
49.2%
22.8%
46.3%
7
Two “active” asset mixes
Alpha
Tracking
error
Correlation
of alpha and
benchmark
Example 1 (IR = 0.5)
Example 2 (IR = 0.25)
Bonds
(50%)
Equities
(50%)
Bonds
(50%)
Equities
(50%)
0.5%
2%
0.25%
1%
1%
4%
1%
4%
0
0.5
0
0.5
8
Two “active” asset mixes compared with 50/50-benchmark and
40/60-mix
Efficient frontier
5.25
5.00
4.75
50/50, IR= 0,5
Average real return (% )
4.50
4.25
50/50, IR= 0,25
4.00
50/50
3.75
40/60
3.50
3.25
3.00
2.75
2.50
2.25
2.00
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
Standard deviation (% )
9
Two “active” asset mixes compared with 50/50-benchmark and
40/60-mix
Efficient frontier
4.75
50/50, IR= 0,5
Average real return (% )
4.65
4.55
More efficient
manager structure
4.45
4.35
4.25
4.15
4.05
40/60
50/50, IR= 0,25
3.95
3.85
50/50
3.75
3.5
3.6
3.7
3.8
3.9
4.0
4.1
4.2
4.3
4.4
4.5
Standard deviation (% )
10
What is manager structuring?
How can the strategic investment allocation best be implemented
taking into account the efficiency of markets, the capabilities of
investment managers and the costs of investment management?
11
The Investment process
Pension funds
ALM study
Implementation
Determine Investment
Objective / Set Asset
Allocation Strategy
Determine Investment
Management Structure
ISSUES TO CONSIDER
SERIES OF DECISIONS
Search & selection
Review / Appoint
Investment
Manager(s)
PRE-DEFINED CRITERIA USED
FOR SELECTION /REVIEW
•Nature of Fund's liabilities and
financial strength
• Active versus passive
investment management
• Organizational criteria
• (stability, commitment)
•Legislative issues,
Accounting
• Specialist or balanced
mandates
• Process related criteria
• (research, risk management)
•The risk tolerances of
sponsoring organisation
• Multiple versus single
manager structures
•Specific Issues of relevance to
the Fiduciaries
• Product related criteria
• (performance, fees)
Follow up
Implement & Document
Changes
ISSUES TO CONSIDER
• Investment guidelines
• Statement of Investment Policy
• Transition Management
• Custody
• Monitoring & Evaluation
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Why is it important?
ALM study
Implementation
 Risk
Benchmark
+
 Return
Benchmark
+/- (?)
 Costs
= zero!
+
 Implementation affects Assumptions of the ALM study
 Manager structuring is focussed on controlling this process
 Possibly to enhance return and diversify risk
13
Concepts & Approach
Three basic questions
 Active versus passive investment management
 Balanced versus specialist investment management
 Multi versus single investment management
14
Active versus passive Investment Management
Three issues
 (in)Efficiency of markets
 Potential of positive alpha and information ratio
 Need to reduce risk
 Costs
 Transaction costs
 Management fees
 Diversification
 Low correlation of Alpha with benchmark
 Volatility of (active) portfolio is not sum of passive + TE
15
Active versus passive: a variety of degrees of activity
TABEL: VARYING DEGREES OF ACTIVE MANAGEMENT
Outperformance target (alpha) and risk budget (tracking error)
Type of
management
(Global) equities
(Euro) fixed income
Alpha
Tracking Error
Alpha
Tracking Error
Passive
0%
0%
0%
0%
Index enhanced
0,5%- 1,0%
0,5%- 1,5%
< 0,25%
0,5%
Light active
1,0%-2,0%
2,0%- 4,0%
0,25%
0,5%- 1,0%
Active
2,0%- 3,0%
4,0%- 6,0%
0,5%- 1,0%
1,0%- 2,0%
Agressive active
2,0%- 4,0%
> > 6,0%
1,0%- 2,0%
2,0%– 3,0%
16
Active versus passive Investment Management
Transaction costs: equities
Transaction costs
Equities
Large Cap
120
Basispoints
100
80
maximum
60
average
40
minimum
20
0
US /North
America
Euro
Japan
EM Markets
17
Active versus passive Investment Management
Management fees: global equities
Active management fees
Global Equities (active)
Basispoints
80,0
60,0
Minimum
40,0
Average
Maximum
20,0
0,0
0 - < 50
50-100
100-200
200-500 500-1000
Assets under management (euro ml)
18
Balanced versus specialist Investment Management
Pros and cons of specialization
+/+ of specialization
-/- of specialization
 Select capability out of larger
 Higher fees
universe
 Diversity of Investment styles
 Greater flexibility in appointment
 More complex communication
 TAA will require additional
solutions >> consistency problem
 Extra costs for Monitoring &
Evaluation, appointment
19
Summary & Conclusions
 Manager structuring has impact on ALM assumptions
 All pension funds have to decide on:
 Active versus passive
 Balanced versus specialist
 Multiple versus single
 Modeling and quantification is possible, but…
 Make careful assumptions!
 In active equity investment management, style
diversification appears attractive
20