Chapter 24 - Valn of asset classes & portfolios

[fischer]

Hi again!
Notional portfolios

I am not able to understand the use of a notional portfolio!!
It does not influence the investment strategy - then why would a company want to do it?

It is not affected by the actual portfolio structure - then what use can it be to a company?

In the example on page 16, the assessed value can be written as

0.75*MVall*DVeq/MVeq + 0.25*MVall*DVbond/MVbond
Q01 Does this ratio tell me anything (is it actually supposed to tell me anything?)

Q02 First line (non-core reading) on page 15 says ".... is a form of discounted cashflow valuation...." and
Last 3 lines (core reading) on page 15 says ".... removes problem of having to estimate future cashflows on each individual asset...."
Are these two statements contradicting each other or is the key each individual asset?

Q03 If total MV of all assets (eq and bonds) = £1m and
Actual split = 60% and 40% => 600,000 and 400,000 and
Notional split = 75% and 25% => 750,000 and 250,000
Then could I do the following:
1. Use some software to project the future value of an equity investment of 750,000 and then discount it back (using suitable interest rate) to present time to give me the DV for equity.
2. Use some software to project the future value of a bond investment of 250,000 and then discount it back (using suitable interest rate) to present time to give me the DV for bonds.
3. Add 1 and 2 to get the value of the notional portfolio.

Any help would be much appreciated.

 

[didster]

Basically the notional value attempts to value the theoretical "best" portfolio to match the liabilities. The investment mananger can deviate from this strategy but does so in order to gain higher returns.

If you were to adopt a "risk free strategy" then you would switch all your assets in line with the notional portfolio. It thus gives a objective value to compare with the liabilities.

It is usually a discounted cash flow value on the notional benchmark (although i suppose other values eg market values can be used).

The key is it doesn't depend on the actual assets held. You dont need to value ABC shares and XYZ bonds specifically, but rather a general average for the asset type.

 

[Anna Bishop]

Fischer, have you tried looking at the CA1 thread - FAQ? It's the second thread on the list. It contains an alternative approach to looking at notional portfolio valuations and, in particular, helps to explain the calculation in the notes.

The history of NPVs relates to defined benefit pension schemes. Prior to moves towards more market-related approaches to valuations, the assets of a DB scheme used to be valued (for an ongoing funding valuation) using a NPV. Liabilities were valued using a long-term, stable discount rate and a consistent method was required for the assets. The notional portfolio valuation approach was also designed to save time and effort and to avoid influencing the investment managers. A benchmark asset allocation was determined, eg 30% bonds, 70% equities. This was designed to reflect the "long-term" investment strategy of the scheme. And then, within each class, a representative asset was valued using a discounted cashflow approach and a discount rate consistent with that used for the liabilities. The detail of the actual assets held could be ignored. The rationale for this was that a long-term, stable valuation was required, not one that fluctuated wildly every time the market value of a particular asset changed or a tactical switch was made.

Whilst it had its merits, the NPV method was criticised for its lack of realism. The value you would actually get if the assets of the scheme had to be realised would not be the NPV value! Also, accounting standards and regulation changed and required a more market-based approach to be adopted and hence the NPV saw its demise.

However, I've still heard that the method is sometimes used in both life and pensions' contexts as a "rough and ready" calculation. And who knows, there may be countries, other than the UK, where the method is still in force.

Anna