ACTEX Learning Learn Today. Lead Tomorrow.

ACTEX Study Manual for Retirement Benefits & Investment Management Fall 2017 Edition

Anna Wong, ASA, MBA

ACTEX Study Manual for Retirement Benefits & Investment Risk Management Fall 2017 Edition

Anna Wong, ASA, MBA

ACTEX Learning New Hartford, Connecticut ACTEX Learning Learn Today. Lead Tomorrow.

Actuarial & Resource Materials Since 1972

Copyright © 2017, ACTEX Learning, a division of SRBooks Inc.

ISBN: 978-1-63588-055-7

Printed in the United States of America.

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TABLE OF CONTENTS

Retirement Plan Investment And Risk Management Exam – Fall 2017

Instructional Objective 1

Litterman, Modern Ch. 2 1 Ch. 17 5 Ch. 21-24 7 Ch. 27 (pp. 501-505 only) 24 Ch. 28 (pp. 516-520 only) 26

McGill, Fundamentals of Private Pensions, McGill, 9th Edition Ch. 26 – Ch.28 28

Morneau Shepell Handbook of Canadian Pension and Benefit Plans, 16th edition, Ch. 7 35

RPIRM-102-13: Equities in DB Plans – Is the Traditional 60/40 Mix a Dinosaur? 42

RPIRM-103-15: Fiduciary Liability Issues for Selection of Investments 44

RPIRM-104-15: Maginn and Tuttle, Managing Investment Portfolios, Third Edition Chapter 12 through Section 5 only 50

RPIRM-107-13: Reflections on the Efficient Market Hypotheses: 30 Years Later 62

RPIRM-108-13: Introduction and Overview of Retirement Plan Investments 63

RPIRM-132-14: CAPSA, Guideline No. 6, Pension Plan Prudent Investment Practices Guideline ` 67

RPIRM-133-14: CAPSA, Guideline No. 7, Pension Plan Funding Policy Guideline 69

RPIRM-142-17: Morningstar Target-Date Fund Landscape, 2016, pp. 1-9 and 13-28 only 71

RPIRM-143-17: How to Address Due Diligence Concerns From Sponsors 77

RPIRM-144-17: Patient Capital, Private Opportunity: The Benefits and Challenges of Illiquid Alternatives 80

RPIRM-145-17: An Introduction to Infrastructure as an Asset Class 83

Instructional Objective 2

RPIRM-110-13: Plan Sponsor Guide to Liability –Driven Investing 1

RPIRM-111-13: Mind the Gap: Using Derivatives Overlays to Pension Duration 2

RPIRM-112-13: Asset/Liability Modeling and Asset Allocation for Pension Plans 7

RPIRM-114-13: Top 10 Myths about Liability-Driven Investing 18

RPIRM-115-13: Asset/Liability Management in the Public Sector 20

RPIRM-116-13: and Actuarial Practice 23

RPIRM-136-15: Longevity Risk Management: New Tools for Defined Benefit Pension Plans, Coughlan, Institutional Investor Journals, Fall 2013 31

RPIRM-138-16: FSCO’S IGN 001 – Buy in Annuities for Defined Benefit Plans 35

RPIRM-139-16: FSCO’s IGN 002 – Prudent Investment Practices for Derivatives 37

RPIRM-140-16: OSFI’s Policy Advisory #2014-002- Longevity Insurance and Longevity Swaps 42

RPIRM-146-17: The Pension Risk Transfer Market at $260 Billion 46

RPIRM-147-17: Charting the Course: A Framework To Evaluate Pension De-Risking Strategies 48

RPIRM-148-17: Key Rate Durations: Measures of Interest Rate 59

RPIRM-149-17: Practical De-Risking Solutions: Asset Duration and 68

RPIRM-150-17: De-risking in a Low Interest Rate Environment 70

Can Pensions Be Valued as Marketed Securities, Bader, Pension Section News, June, 2009 71

Instructional Objective 3

RPIRM-120-13: The Case Against Stock in Public Pension Plans 1

RPIRM-121-13: The Case for Stock in Pension Funds 8

RPIRM-122-13: Guaranteed Trouble: The Economic Effects of the Pension Benefit Guaranty Corporation 11

RPIRM-123-13: Risk Management and Public Plan Retirement Systems (appendix background only) 13

RPIRM-124-13: Bader and Gold’s Rebuttal to The Case for Stock in Pension Funds 21

RPIRM-125-13 :The Pension Bomb 22

RPIRM-126-13: Funding Regulations and Risk Sharing, pp. 15-24 23

RPIRM-127-13: Retirement Benefits, Economics and Accounting: Moral and Frail Benefit Designs 25

RPIRM-128-13: The Impact of the Financial Crisis on Defined Benefit Plans and the Need for Counter-Cyclical Funding Regulations, excluding appendices 29

RPIRM-135-17: CAPSA Guideline No.4 Pension Plan Governance Guidelines and Self-Assessment Questionnaire 30

RPIRM-141-16: Chapter 9 of Recreating Sustainable Retirement: Resilience, Solvency and Tail Risk 34

Corporate Pension Risk Management and Corporate SOA August 2015 39

Adequate Funding for a Pension Plan, Sze, Pension Forum 46

“Pension Funds: Company Manager’s View”, SOA, June 2003, Exlely & Mehta 48

Pension Actuary’s Guide to Financial Economics; Pension Arbitrage Example Worksheet 53

______Objective 1 – 1

MODERN INVESTMENT MANAGEMENT (LITTERMAN)

CH 2 - THE INSIGHTS OF MODERN THEORY

I. THE ADVERT OF FINANICAL ECONOMICS (FE)

1. Axiom: More risk, more return 2. Risk a) quantifies the probability and size of loss. A loss => postponed/ no consumption b) Loss is a random event c) may generate loss => impact net worth => reduce risk appetite in the future => limited future growth, and reduced risk appetite d) is a scarce resource 3. A Investment process helps investor prepare for assuming risks 4. Investors have limited risk appetite => needed to budget it wisely a) Goal: max return per unit of risk (Micro-economics) i) => same utility per dollar spent on every purchase ii) => same return per unit of portfolio risk iii) If (return/risk)A > (return/risk)B, then invest (return/risk)A and drive down (return/risk)A until they equalize 5. Basics a) E(T) = E(T1) + E(T2) +... + E(Tn), linear relationship b) Return can be compounded c) Var(X + Y) = Var(X) + Var(Y) – 2Cov(X,Y), risk holds non-linear relationship i) Play around the correlation term to lower the risk through diversification d) Diversification can either i) Increase the return given the same level of risk ii) Or decrease the overall portfolio risk e) Loosely speaking, assets roughly independent, risk compounds ~ sqrt (Time), while expected returns is linear over time i) Assume 0.01% of risk generates 0.02% of return per day. ii) Take 0.01% risk a day over a long term (e.g. 1 yr) => sqrt(252 trading days * 0.01%) ~ 16%/yr =>252 days *0.02% ~ 5% return/yr iii) However, take 16% in ONE day, generates 0.02%*16 = 0.32% of (simple proportion), this is the math for long term investors 6. a) Insight – through the size, control the expected return of targeted asset in relation to the impact on the risk of the total portfolio b) Hard to quality return and variance (historical/ forward-looking definition, etc) c) Focus on the correlation among assets, how one value move up and down relate to others d) Avoid concentration of risk => diversification => look at overall risk profile! i) Quantify how much a risk budget that an investment should consume e) An application. A business owner sells his business, obtain proceeds, and park in money market fund for a long time before making further decision

______ACTEX Learning Retirement Benefits & Investment Risk Management ______2 – Objective 1

i) Bad idea – too much wealth in unproductive fund (negative real return after tax) too long ii) better fully diversify the proceeds and earn a better return f) Process of helping your client i) Identify risk tolerance ii) Experience reveals that the client’s risk appetite swings from the extreme risky (business) to virtually riskless (money market fund), clients go to either extreme, seldom in between. Avoid this situation. g) A good investment decision and a good investment outcome do not necessarily have a cause-and-effect relationship. A good outcome is due to luck in short term. h) Risk management framework i) Identify the sources of risk ii) Deploy risk effectively max Ri, Ri =(return i / unit of portfolio risk), i = ith assets. How to measure risk? Many definitions, e.g., volatility, mean-absolute deviation, etc... iii) Find out your risk tolerance => fix the risk you accept, then max return. If risk budget isn’t fixed, you can always increase return by adding risks. iv) Adjust the size, then improve returns, control the risk v) Building blocks - diversifier – asset relatively independent of others, risky by itself, little risk to the overall portfolio vi) People ask how to invest?? Proper thinking should be measuring and monitoring the universe of assets, how much to invest to improve return and reduce overall risk. vii) Good stuff are => add less risk to the portfolio => use up less risk budget => buy more! (Heuristic meaning of the mathematics of the portfolio theory) i) Process of optimizing portfolio i) Identify all assets in your universe ii) Determine portfolio risk tolerance, fix risk budget iii) Recall, Ri =(return i / unit of portfolio risk), i = ith assets. iv) Buy and sell asset such that R1 = R2 = R3 = ... Rn, n = nth assets! v) Domestic / International example vi) Buy and sell such that R(domestic) = R(international). If R(domestic) > R(international), then short R(international), buy R(domestic) until the equation holds, and vice versa. vii) Apply the two-asset scenario to n-asset scenario

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 3

MODERN INVESTMENT MANAGEMENT (LITTERMAN)

CH 2 - THE INSIGHTS OF MODERN PORTFOLIO THEORY

(QUANTITATIVE QUESTIONS)

I. LITTERMAN, CH02

1. Imagine you view a portfolio frontier, you either max the return given a fixed level of risk, or min the portfolio risk given a fixed level of return. 2. Two-asset case (domestic index, international index) 3. Let d and f = weights of domestic and international index funds respectively 4. ρ = correlation between domestic and international index 5. Mathematics 2 2 2 2 1/2 a) Portfolio risk (d, f) = (d *σ d + f *σ d + 2*d*f*σd*σf*ρ) ……(1) b) Marginal contribution to portfolio risk of domestic equities i) Δd(δ) = ( Risk (d + δ, f) – Risk (d,f) ) / δ …… (2) c) Similarly, i) Δf(δ) = ( Risk (d, f + δ) – Risk (d,f) ) / δ …… (3) d) Goal: decide 10% of portfolio risk (fix the risk budget), then max the expected return i σi Expected excess return i Total Return d 15% 5.5% 10.5% f 16% 5.0% 10.0% Cash 0% 0.0% 5.0% e) ρ = 0.7, domestic and international correlates! f) Goal: make sure (ed / Δd) = (ef / Δf), …..(*), if imbalance, short low and buy high to equalize g) Initially, 100% domestic index, now, we need to optimize the total portfolio h) Since the goal is 10% risk, and we have 100% domestic fund, we need to sell some domestic fund, because σd=15% > 10% (our target) i) Intuitively, 2/3 to domestic, 1/3 to cash, => 10% portfolio risk, can we do better? j) Differentiate (1) w.r.t. d and f, we get 2 i) Δd = d*σ d + f*σd*σf*ρ / Risk (d,f) ……(4) 2 ii) Δf = f*σ f + d*σd*σf*ρ / Risk (d,f) ……(5) k) When f = 0, => no international equity 2 2 1/2 i) (4)  Δd = ( d*σ d ) / (d*σ d ) = σd = 0.15 2 2 1/2 ii) (5)  Δf = ( d*σd * σf * ρ ) / (d *σ d ) = ρ * σd = 0.104 l) Suppose the portfolio has infinitely many unit, ν, and you want to sell one unit of domestic equity, i.e. δ = -1, i) The portfolio risk is decreased by Risk(d + δ, f) – Risk(d, f) = 0.15*δ = -0.15 ii) To maintain (*) in equilibrium, the investor must purchase (Δd/Δf) = 0.15/0.104 = 1.442 unit of international index m) 1.442 unit of international index increases the expected return by (1.442)*(0.5) = 0.7215, selling one unit of domestic index reduce the expected return by (1)*(5.5%) = -5.5%. In summary, the net increase in return is 0.01715. The benefit is clear, and the investor should short domestic fund until (*) holds

______ACTEX Learning Retirement Benefits & Investment Risk Management ______4 – Objective 1

6. Hurdle rate, the indifferent rate of return on international index, an implied view of the portfolio a) Trick: define the expected excess return, not expected return b) Considering: 1.442*ef +(-1)*(0.055) = 0 => ef = 3.8% c) Implication: If expected return on international equity < 3.8% => won’t consider 7. Short domestic and long international until (*) holds equilibrium. Purchase an asset A if the expected excess return on A > the hurdle rate, and short if the expected excess return on A < the hurdle rate. 8. Case 2 9. 3-asset example: the new asset = commodity, (σ2 = 25%; ρ with domestic = ρ with international = -0.25) -0.25 is good, because it can reduce portfolio risk, commodity is a good diversifier. 10. Applying the same analysis, optimal weight of commodity = 10% to min the portfolio. 11. Holding fixed weights in all other assets, there is a risk-minimizing position for each asset. Weights greater than that risk-minimizing position reflects your positive implied views; weights less than that risk-minimizing position reflect bearish views. 12. If you optimize your portfolio, look for assets that produce positive expected excess return, and that are uncorrelated with the portfolio. Inclusion of these assets is beneficial. 13. Case 3 a) Suppose an asset that has some correlation with the existing portfolio => there is a non-zero risk-minimizing position => any position between zero and that risk- minimizing position is an opportunity for investors. 14. By modern portfolio theory, shop for assets that have negative or low correlation of the portfolio, and that has an expected excess return, identify a risk-minimizing position, inclusion of it is usually beneficial.

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 5

MODERN INVESTMENT MANAGEMENT (LITTERMAN) CH 17. RISK MONITORING & PERFORMANCE MEASUREMENT

I. 3 LEGS OF FINANCIAL CONTROL

1. Risk Plan (5 guideposts) a) Set expected return and volatility (VaR and tracking error) goals i) Scenario analysis to identify factors of failure b) Define points of success and failure (ROE / RORC) i) Risk capital – defined with VaR methods c) Show how risk capital will be deplored to meet objectives i) Define min. acceptable RORC for each allocation ii) Explore correlations to ensure ROE and variability acceptable d) Set “Bright Line” defining events that inflict serious damage from disappointing ones i) Indentify which one needs insurance coverage e) Identify critical internal and external dependences (in good and bad environ.) i) Describe response nature if dependences breakdown 2. Risk Budget (asset allocation) – Quantify risk plan a) Aggregate expectation of each allocation – consistent with organization’s obj. and tolerances b) Management must define time horizon of risk budget and for RORC measurement c) Example: Investment portfolio impact on earnings volatility on reported earnings i) From business and risk plan, identify acceptable RORC and ROE over different time frames ii) Determine appropriate weights for each investment class iii) Simulation and sensitivity testing iv) Ensure appropriate individual and aggregate risk level as per planning v) Ensure acceptable volatility around expected return vi) For each significant downside scenario, devise contingency steps bring logical and measured response 3. Risk Monitoring – Principal concern if investment activities are behaving as expected

II. INDEPENDENT RISK MANAGEMENT UNITS

1. Objectives a) Gathers, monitors, analyze and distribute risk data to right people at right time i) Develop (a) disciplined process and framework to identify and address risk topics; (b) risk data inventory; (c) risk measurement and tool ii) Promote (a) risk culture and internal control environment; (b) transparency of risk info. iii) Set and implement risk agenda; Identify trend before becomes a big problem iv) Catalyst for comprehensive discussion of risk-related matters v) Should not manager risk (responsibility of individual portfolio manager)

______ACTEX Learning Retirement Benefits & Investment Risk Management ______6 – Objective 1

2. Permit users to be conclusive a) If forecasted tracking error consistent with target? i) Compare Forecast tracking error with tracking error budget for reasonableness ii) Policy to set the magnitude of variance from target as unusual b) If risk capital spent in the expected themes for each portfolio? i) If not in line, may indicate style drift by individual manager ii) Monitor risk decompositions of acceptable active weights and marginal contribution to risk at stock, industry, sector and country level c) If risk forecasting model is behaving as expected (explore tracking error stresses) i) Techniques - Simulation (short fall: observed history only gives 1 set of realized outcomes) / Monte Carlo simulation (more robust) 3. Quantifying Illiquidity Concerns a) Dramatic change in Liquidity profile during hard times b) Some illiquid situations (e.g. 144A securities, position concentration) can coincide with unanticipated capital redemption - Risk often apparent only if large stresses are assumed 4. Monitoring - Ensure all counterparties meet credit policy criteria

III. PERFORMANCE MEASUREMENT – TOOLS AND THEORY

1. Objectives a) Determine if manger generates i) Consistent excess risk-adjusted performance over benchmark ii) Superior risk-adjusted performance over peer iii) Sufficient return for risk assumed (cost/benefit) b) Identify such manager 2. Why use multiple Performance measurement tool a) Most comprehensive measurement - Risk has many human dimensions b) For very different results from different tools, risk profession to apply judgment 3. Improve meaningfulness of Performance Measurement Tools a) Must supplement tools with i) Clear articulation of management philosophy from individual manager ii) Routine position and style monitoring process (early warning system) b) Tools: Attribution of returns / Sharpe and Information ratios / Alpha vs. benchmark and peers

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 7

MODERN INVESTMENT MANAGEMENT (LITTERMAN) CHAPTER 21&22 An Approach to Manager Selection

I. CH21: SUMMARY

1. Consider you are a big pension fund, and you delegate your money to other investment companies. How do you select the right companies to work hard for you? 2. Definition: alike = shared the same believes, same philosophy! a) Alike (pension trustee) attracts alike (investment companies) to work for the same goal (money)! 3. Use a system (don’t believe people, little discretion) to deliver strong performance systematically. A system (an actuarial control cycle), a) leads to self-improvement process, expanded knowledge, etc. b) impacts the structure, culture, work flow, investment tools, and recruiting of investment companies 4. Shared culture a) develops a spider network among pension trustees and investment companies b) selects and retains the top performers c) promotes meritocracy, fees for performance, not fees for consulting

II. THE IMPORTANCE OF INVESTMENT PHILOSOPHY

1. No. 1 priority, because “alike attracts alike” 2. Identify (trustees) investment philosophy that is sound, tested, and coherent, and use it to select alike (managers) who work for your portfolio! 3. Best managers beat peers because of creating portfolio alpha return 4. Manager-selection process has 4 areas a) Goals b) Structures c) Tools d) Processes 5. Manager-selection process = a system = can yield a high-quality process over time

III. ASSET-MANAGEMENT APPROACH

1. View each manager as an investable asset, apply the following process to select managers, instead of performing traditional due diligence a) Universe determination i) Decide what can/can’t be invested (from investment policy) b) Idea generation i) Quantitative screens ii) Industry sources (conference, publications, referrals) c) Analysis of securities i) Quantitative (past performance) ii) Fundamentals (management discussions, industry, business analysis)

______ACTEX Learning Retirement Benefits & Investment Risk Management ______8 – Objective 1

iii) “Triangulation” (cross check your targeted managers with competitors, suppliers, customers, other sources) d) Ranking i) Debating which manager to hire, fire, retain ii) Developing a process for including/ excluding managers e) Portfolio construction i) Size ii) % of investment relative to overall portfolio risk and return iii) Add advanced risk management techniques f) Monitoring i) Report to the management ii) Perform “triangulation” iii) Monitoring risk exposure and structure

IV. UNIVERSE DETERMINATION AND SCREENING (SECTION III, A&B)

1. Employ a massive database to select the best managers out of >10,000 2. As a starting point, identify your preferred style of manager with information inside the database a) Consider metrics, knowledge, intangible considerations, consistency, risk-adjusted performance, downside risk analysis, finer-style analysis 3. Two key benchmarks for best managers a) Superior risk-adjusted performance b) Over a full market cycle, consistent results compared to the benchmarks 4. Mindful of survival bias and quantitative pitfalls a) Remove bad managers known to you beforehand b) The investment house, which hired best managers, should be on the list c) The house, which lost best managers, should be removed d) Best managers, placed in a wrong reporting structure, may leave, so be mindful of that 5. Focus on observable, objective performance and risks taken to achieve the returns

V. FUNDAMENTAL ANALYSIS (SECTION III, C)

1. Key is people, understand managers through meetings 2. Avoid sales people, who sell strength, and hide weakness of managers 3. Ask same set of questions to everyone (the management such as CEO, IT, CFO, CIO and EEs such as money managers, new hires, traders) a) Consistency matter! b) A good firm i) Everyone gives consistent answer, they share the same philosophy ii) Has motivated, accomplished EE, who knows their roles and career path c) A bad firm i) Everyone gives inconsistent answer, => politics, bad internal communication ii) EE short-sighted, don’t know big picture of the firm 4. Look for small nuances, which tells a lot

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 9

5. Goal is to cross check the corporate culture, structures, process

VI. TRIANGULATION (SECTION III, F)

1. Cross-check the consistent performance from other sources a) Competitors i) Competitors, being biased, know their competitors very well, may tell “secret” info. b) Clients i) a list of reference from the targeted managers may be biased ii) New clients must have more insights why to choose them iii) Terminated clients may have useful info why left iv) Seasoned professional give unique perspectives v) Look for consistency from all sources c) Supplier of information i) Brokers “sell” information to investment managers ii) Sell-side people put appropriate weight to each conversation iii) If the managers use sell-side info, they can tell you the source and you cross- check, if little reference, big problem. iv) If the managers don’t use sell-side info => own research => know the company very well, if don’t know, big problem... see the consistency here?

VII. QUANTIATIVE ANALYSIS (SECTION III, D1)

1. Quantitative methods – a systematic framework 2. Two indicators for every manager a) Current snapshot b) Historical overview 3. Obtain monthly return, full monthly holding since inception a) Analyze risk taken and styles in the past 4. 4 perspectives on managers a) What angles? i) Stand-alone ii) Comparative basis iii) Current snapshot iv) Past performance b) Recommended tests i) Returns-based attribution to sector/ style/ etc... ii) Factor attribution of returns iii) Factor attribution of risks iv) Returns-based analysis (correlation, style, draw-down analysis, upside/downside capture) c) Look for the consistency of alpha return, identify what drivers are, any change in the drivers? d) Question investment managers to see if they understand the drivers and risks taken and why failed!

______ACTEX Learning Retirement Benefits & Investment Risk Management ______10 – Objective 1

VIII. INVESTMENT DECISION MAKING (SECTION III, D2)

1. Being a trustee, before delegating your money a) Out of massive info, identify all issues, determine future risks of managers b) Look for future excessive alpha returns c) Get a full picture and pinpoint strength and weakness of investment managers d) When making final decisions, consider to: i) Apply quantitative rating to all aspects of a firm ii) Invite professionals in making decisions iii) Debate with the professional on each manager iv) Standardize rating across all asset classes, all categories of investment managers e) Evaluate the investment process of your managers i) Is the investment process sensible? ii) Idea generation iii) Quality of research iv) Effective communication with stakeholders v) Consistency in approach vi) Sell discipline f) Each reviewer rate managers independently, and debate the overall rating

IX. CH22: PORTFOLIO CONSTRUCTION PROCESS (SECTION III, E)

1. Goal – how to transform an investment theory into practice 2. When delegating money, use a control cycle a) Develop risk budget b) Quantitative monitoring of returns, volatility, correlations c) Fire, hire, retain managers, loop the process 3. Pitfall – want to diversify, but may create . E.g. Give $ to person A and B for diversification, but A and B buy asset C, too much concentration, be mindful! 4. Well-designed plan, sound theoretical background, and being practical are key to successful implementation

X. SIZE OF THE MONEY

1. Largest determinant 2. Large size can use separate accounts 3. Separate account a) Can allow customized investment policy, e.g. restriction on regional exposure, ethical investing, tracking error i) A tool to fudge up/down risk, not available for small investors b) Expensive to administer c) Not standardized => implementation risk 4. Comingled funds a) Single-manager mutual funds i) A vehicle to invest in smaller asset class, achieve diversification ii) Mindful of concentration risk

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 11

iii) Need monitoring b) Multi-manager portfolio = fund-of-funds, investment managers, who know the industry very well, delegate $ to other investment managers => diversification c) Affordable to small investors, because it spread the transaction cost a larger capital base 5. Economies of scales => lower fees a) Sources of fees i) Investment mgmt – direct cost ii) Custody iii) Transaction costs – brokers iv) Admin – salary for CFO, legal, CPA, etc... v) Firing, hiring, and retaining managers => re-balancing => costly b) Use of transition managers can reduce cost 6. The size impacts the level of portfolio risks, two sources a) Benchmark risk b) Active management risk i) Small plans have to use alternative vehicle (comingled funds) to improve risk- adjusted returns (more return, more diversification, affordable method) ii) Because of fiduciary role, small plans use costly separate accounts, => over- allocate capital to hit fee break point => concentrated risks => little diversification iii) Active managers try to beat the benchmark by 3% iv) Develop a risk budget, max return per unit of active risk 7. Large plan can invest directly in real-estate, junk bonds, hedge funds, etc. a) Have resources to diversify b) Problem is to find enough qualified managers c) Typical largest plan asset mix: (5% junk bonds, 5% real estate, 5 to 10% small cap, 5% emerging equities, etc) d) Recognize each investment manager has capacity i) So, 10 billion needs 2 to 3 junk bond managers, etc... ii) When hiring more managers, [trustee] balance diversification of active management risk, the risk of hiring bad managers, and increasing fees due to more managers iii) By hiring more managers, reduce correlation of alpha return to low level e) Monitor risk-budgeted tracking error (alpha return) f) Active managers make alpha return because of taking additional risks, but [trustee] must avoid concentration of risks (a conflicting goal: trustee want to make more money and to avoid concentration risk)

XI. ASSET ALLOCATION DRIFT AND COMPLETION MANAGEMENT

1. Unintentional asset allocation risk (UAAR) – you plan to invest 60% in equity, but it ends up more than what you expect. 2. Drift occurs when the portfolio value moves away from the strategic benchmark due to differences in asset class returns and the fact that fixed benchmark weights reset at the end of each month

______ACTEX Learning Retirement Benefits & Investment Risk Management ______12 – Objective 1

a) E.g. (60% equity), equity outperforms bond by 4%, new allocation will be 60.9% in equity, assuming no re-balancing, 0.9% produces 0.19% unintentional tracking error b) 0.19% unintentional tracking error  0.17% extra portfolio volatility => ruin the whole risk budget, need to do it again c) Drift is correlated with the benchmark risk d) The more frequent the portfolio re-balancing, the less magnitude the UAAR e) If not re-balance, average annual return would be -0.05% in LT i) The average masked the loss in the crisis! Considering overweighting in equity in LTCM blow-up of 1998, it would magnify the loss! f) Active management causes larger drift risk 3. Sources of UAAR a) Drift risk b) Cash holding c) Currency deviation d) Change in the composition of the benchmark 4. How to min UAAR a) Completion manager i) Coordinate overall asset allocation ii) Job duty to min. UAAR iii) Use of frequently trades financial derivatives, availability determine success

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 13

MODERN INVESTMENT MANAGEMENT (LITTERMAN) CH 23. EQUITY PORTFOLIO MANAGEMENT (EPM)

I. OVERVIEW

1. Evolution a) Originated from Benjamin Graham and David Dodd b) Enriched by modern portfolio theory, CAPM c) Computer getting cheaper d) => average investors are getting sophisticated e) => more difficult to exploit pricing errors f) => Competition get stiffer => encourage use of “alternative strategies” g) => more biased, unfamiliar, wrong data in a flawed strategy than in the past 2. How to identify flawed strategies? a) Focus on LT, avoid narrow rankings of ST performance 3. Two major approach to EPM a) Traditional approach i) Forecast (µ, σ, ρ, trading costs) ii) Max expected risk-adjusted return, net of trading costs iii) Trade stocks efficiently iv) Feedback – evaluate results and improve process b) Quantitative approach c) Need to ensure consistency (ST activities supported by ST methodology) d) Success should be back by sound theories, cross-reference multiple info sources, empirical studies

II. TRADITIONAL AND QUANTITATIVE APPROACHES

1. Think a unique and innovative investment process to beat your peers 2. Both share common platform a) Sound economic reasoning b) Use data to identify return drivers c) Use judgment to relate return drivers to stock-picking d) Performance being appraised over time 3. Difference – how they perform these steps Traditional Quantitative Methods Subjectively access stocks, C-level Employ statistics to unveil return factors interviews, study disclosures, statements, do objectively business analysis, financial metrics, stock prices Pros Coping with data error, structural change Fixed cost for building models, low marginal (M&A, etc) cost for analyzing one more firm => larger pool to pick stocks, can unravel neglected stocks to improve returns, allow back-cast analysis to understand how stocks behaved in recession

______ACTEX Learning Retirement Benefits & Investment Risk Management ______14 – Objective 1

Cons Subjective, selective perception, hindsight Specification errors, over-fitting, corrected by bias, stereotyping, over-confidence, costly well-structured, disciplined research process; to implement, impossible to analyze entire garbage data can ruin the model; can’t handle industry, no backcast analysis to nail down structural change (M&A, bankruptcy, etc), return drivers, Position Concentrated, large bets Highly diversified, avoid a situation where one company can make or break the strategy Depth Know fewer companies completely, can Broad understanding of everything. By smell wrong data and info diversification, small bets to add modest return Regime Good to handle regime shift, identify when Computer help you consider all factors before Shift back-cast inapplicable making decisions Signal Because of deeper knowledge, can identify Quant usually back-tests signals before using unique data sources and info to make them, need to re-calibrate the model to ensure decisions consistent weighting for various signals Risk mgmt Well-equipped to do quantitative risk management Qualitative Many valuable info is hard to quantify, e.g. Hard to capture qualitative factors factors Management departure, vision, new tech on profitability Cost Expensive for each analysis High set-up cost, low marginal cost for new company

III. FORECASTING RETURNS, VOLATILITY, CORRELATION, TRANSACTION COSTS

1. Most important, high quality forecast 2. Forecasting returns a) Identify return drivers and signals i) Reflect fundamentals, sound economic principles, get ideas from Wall Street analysis, financial statement analysis, finance and accounting journal, study the price anomalies from a list of papers (tbl 23.2) ii) Portfolio managers need to “back-test” your unique investment strategies to reflect your style. iii) Identify reliable factors to reflect your investment style, and diversification covers your bottom if one of your signals fail b) Test the effectiveness of each signal i) Make sure data are available and free of errors, Spot outliers and other funny characteristics to detect data error, need to transform data to improve the data symmetry ii) Uni-variate signal – single signal can predict the outcome iii) Multi-variate signal – single signal only works if other variables function iv) Evaluate signal by quintiles, regression analysis, R2 c) Need to simulate empirical return study, impose constraints i) Mindful of “innovative strategies”,  excessive trading  which could not pass standard back-test. ii) Constraints are things that can’t be captured in the math model, e.g. Diversification, consistency, etc…

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 15

d) Assign weights of each signal in a model i) Assign more weights to stable, consistent low-risk signals that enhance diversification, reduce transaction, reduce costs ii) Invest in signals that change slowly => incur less transaction costs e) Calibrate forecasting model with market to produce a reasonable expectation i) The investment algorithm  max expected return. What if expected return wrong => max forecasting errors. ii) Check reasonableness of expected return by examining inconsistent correlations among stocks iii) Black-Litterman model is designed to ensure consistency in forecasting, which matches people’s view on the market. 3. Forecasting Risks a) Risk: variance of returns, and covariance of returns among stocks, use variance- i) Highly computational => use factor risk model to reduce # of calculations ii) Attribute risks to few reasons, industry, size, leverages, etc. b) Let A: all parameters that forecast returns, B: all parameters that forecast volatility c) A is a subset of B, why? The risk model monitor all risks in an investment strategy, including the favorable exposure, and unfavorable areas to be avoid d) If B is a subset of A, it would underestimate the volatility, and leads to an inefficient frontier e) Frequency of data, use of high-frequency data (daily observations) produce accurate estimates 4. Forecasting Transaction Costs a) Catch: realized returns (not expected) less transaction costs i) Transaction costs can eat up alpha returns b) Good if forecast close to actual c) Encourage patient trading and use of alternative trading mechanism d) Explicit costs i) Commission, ticket charges ii) Small portion, not dependent on # of shares traded iii) Easy to forecast, info publicly available, e) Implicit costs i) E.g. Inventory cost  large  compensate for dealer who assumes market risks ii) Hard to forecast, information incomplete  private deals between i-bank and clients f) Methods i) Tick-by-tick approach ii) Lee and Radhakrishna (2000) iii) Log all your transactions, review your transaction costs, and compare with your peers of the same style, then forecast iv) Implementation shortfall, constraints (contemporaneous sector returns) g) Investment style affects trading costs h) Drivers for transaction costs i) Order size, ii) Average trading volume

______ACTEX Learning Retirement Benefits & Investment Risk Management ______16 – Objective 1

iii) Market capitalization iv) Stock price volatility v) Stock price level i) By fig 23.1, i) trading large cap cheaper than small cap, given same liquidity ii) cost proportion to size iii) small cap  thinly traded  illiquid  expensive

IV. CONSTRUCTING PORTFOLIOS

1. Specify investment goals, 3 areas a) Identify benchmarks i) Help you decide passive v. active management ii) Active management  overweighting to sectors you think attractive, and underweighting unattractive iii) If active management  higher risk  higher tracking errors (tracks the deviation from the benchmarks) iv) Tracking error = of the portfolio’s active return v) Active return = difference between portfolio return and that of the benchmark vi) (IR) = active return / tracking error, meaning the return per unit of risk vii) IR help compare strategies with different active risk levels viii) Efficient portfolio = max return for a target level of risk => highest IR ix) An efficient portfolio = marginal contribution to expected return proportional to marginal contribution to risk b) Set risk/return target c) Determine maximum holdings in any single asset 2. Both rule-based approach and formal – obtain efficient portfolio 3. Rule-based approach a) Stratified sampling i) Ranks stocks within buckets formed on the basis of a few key risk factors such as sector and size (by Fundamental Analysis) ii) Heavy exposure to highest-ranked stocks within each bucket iii) Keep the total weight in each bucket close to that benchmark iv) It ignores concentration risk, transaction costs, investment objectives, constraints, no quantitative measures of risk v) Application: How to beat TSX? Identify benchmark, i.e. TSX  apply fundamental analysis  findings: e.g. don’t buy Nortel  Win  beat the index! You won’t apply fundamental analysis to every company, it’s too costly! 4. Formal portfolio optimization a) Quantitative measurement of risks, transaction costs, constraints b) Use algorithm to max return for a given level of risk c) Min uncompensated sources of risks, including sector and style biases d) Vulnerable to input parameters, i.e. forecasting variables. If garbage in, garbage out!

______ACTEX Learning Retirement Benefits & Investment Risk Management ______Objective 1 – 17

e) Use in-house model, CORE U.S. models by Litterman to outperform stratified approach, (You may not be able to buy somebody’s proprietary capital!)

Comparison Stratified Optimization Tracking error (Risks) Difficult to compute Automatically produce Expected alpha return Lower Higher (more efficient) Expected IR Lower Higher (more efficient) Risk budget used by top Higher Lower (well diversified) 10 stocks Percent of risk from return Lower Higher (algorithm factors generates more returns from risk factors) Portfolio (rel. to Higher, e.g. 1.03 Lower, e.g. 1.01 (min benchmark) unintended risks, closely track the benchmark) Risk-adjusted returns Returns less compensated Returns more by risks compensated by risks Transaction cost Can’t guarantee the Minimize the cost lowest Constraints, guidelines, Can’t guarantee to comply Guaranteed to comply E.g. Cap on industry, market beta, size, etc. How algorithm works? Rank within a bucket, and Pick those with highest overweight the highest forecasted alpha return, ranking greatest underestimates of risks or transaction costs Check and balance Need to examine carefully any outliers, indeed, those returns are forecasted numbers (phantom numbers), but you invest real money. Need to re-calibrate the Black-Litterman model to ensure consistency of your market view and the forecasted numbers. Ease of implementation Easy, all are rule-based, You need financial everyone can make it engineers! Will i-Bank sell you their most recent in-house models? Think!

V. TRADING

1. Balancing between frequent and infrequent trading is an art, and is a key to success.

______ACTEX Learning Retirement Benefits & Investment Risk Management ______18 – Objective 1

Frequent trading Infrequent trading Adv. Min. lost alpha and price Larger opportunity costs, uncertainty due to delay ST execution price risk Disadv. Big market impact Reduce market impact

2. Use algorithms to optimize # of trades a) Trade aggressively for liquid stocks, or a large effect on portfolio risk, and patiently for illiquid stocks, or stocks with less impact on portfolio risk b) Can handle petty cash reserves for all accounts c) Can handle LT, and ST investment strategies. If LT  trade patiently, if ST e.g. Capture good earnings tomorrow,  trade quickly d) Easily adapt to all price patterns of individual stocks 3. Define aggressive and infrequent trading for traders to follow

VI. EVALUATING RESULTS AND UPDATING THE PROCESS

1. Compare actual results to expected results 2. A quality control tool, and a source of new improvement 3. Good system if a) How much it over- or under-perform b) Gain/ (loss) by sources 4. Compare perceived risk and realized risk, use Bloomberg traffic light communication platform a) If realized risk within expected => green => no action b) If realized risk a bit beyond expected => amber light => close monitoring c) If realized risk far beyond expected => red => action i) Why? We get enough risks from our intended sources 5. For trading cost, if exceed the benchmark, action 6. When triggers fine-tuning the process? a) Size b) Persistency c) Back testing the new refinement i) Simulate historical return ii) Did the new refinement make a difference in the simulated environment? d) Need to identify sources of gain/ (loss), the study gives you new hints

VII. SUMMARY

1. Forecasting 2. Portfolio construction 3. Trading 4. Monitoring 5. Back-test new strategies

______ACTEX Learning Retirement Benefits & Investment Risk Management