CP1 - Chapter 16

[Darragh Kelly]

Hi,

I have a couple of questions on chapter 16 of CP1 notes.

Section 2 - Tactical Asset Allocation (page 5)
In relation to factors to be considered before making a tactical asset switch, there are a couple that confuse me:
- the problems of switching a large porfolio of assets (such as shifting market prices). Does this mean if the switch takes too long market prices change and by the time you make the switch the profit/return you were going to make has gone?
- Selling asset at bad time
- the switch taking a long time
What exactly do these points mean?

A partial solution to this problem is to use derivatives to gain the required exposure immediately and then to conduct a gradual sale of the porfolio. Institutions do this technique in practice. Does this mean you hedge the price of the assets with derivatives that your are switching from so you can take your time switching assets and not lose out on the gains?

Section 4 - Porfolio construction and benchmarking (page 8)

Strategic risk reflects both the risk of the matched benchmark relative to the liabilities and the risk taken by the strategic benchmark relative to the matched benchmark. Just struggling to get my head around this and relate it the the original statement: The strategic risk (or policy) risk of a fund is the risk of poor performance of the strategic benchmark relative to the value of the liabilities.

Thanks in advance,

Darragh

 

[James Nunn]

Hi Darragh

Section 2 – Tactical Asset Allocation (page 5)

The ‘shifting market prices’ problem you mention is due to it being more difficult to sell large amounts of an asset than small amounts. There will be less buyers willing (even between them) to buy large than small amounts. To enable the sale to happen, the price may need to fall to make large trade attractive enough to buyers, resulting in a decrease in profit, or even a loss, for the seller. Put another way, a big increase in supply (trying to sell a large amount of assets) and no change to demand will result in a fall in price.

Selling at a bad time can be thought of as selling when prices are low in this context, decreasing returns/profits. The switch may take too long if the investor waits until prices increase before selling – for example, this would be the case if the investor needs cash to cover imminent liability outgo and so needs the sale to happen soon.

Another reason for a sale being needed urgently could be that the investor’s liability profile has changed, and the assets therefore need to change to maintain a match to the liabilities – so that the risk of the value of assets falling relative to the value of liabilities does not increase. Derivatives could be used to effectively change the investment portfolio straight away (by changing its exposure) so that it matches the new liability profile. This then means that the switch of other non-derivative assets taking a long time (if waiting for a better price is preferred for example) is less of a problem and the derivative positions can be discarded gradually over time as the other assets are sold so other matching assets can be bought.

Section 4 - Portfolio construction and benchmarking (page 8)

An investor will set a long-term strategic benchmark position. Even if this is the position that best matches liabilities (the ‘matched benchmark’), there will still be a mis-match risk for many liabilities. For example, liabilities depending on now long people live (annuities) or when they die (life insurance protection products like whole of life policies) cannot be matched perfectly because of the uncertain term/timing of liability outgo due to the link with lifetime.

If this strategic position is not the ‘matched benchmark’, there will a greater mismatching risk – that the value of assets could more easily fall relative to the value of liabilities.

Those are the two risks mentioned in the ‘Strategic risk reflects both ...’ statement. Both of these risks together are the drivers of mismatch or poor performance of assets invested in line with the strategic benchmark relative to the value of liabilities.


Hopeful the above helps make things clearer.

 

[Darragh Kelly]

Hi James,

Firstly thank you for providing a clear and detailed response, I appricate that.

Section 2 – Tactical Asset Allocation (page 5)
Regarding Section 2, that's very clear now thanks. Just had one last point regarding the derivatives used to change the investment porfolio straight away. So basically in simple terms if the liability paid out a sum of money every 5 years in the past, but now will pay regular monthly cashflows, we need to switch our assets, as our assets right now payout cash amounts every 5 years to match the original liability. We want to sell this on the market and buy an asset that pays out monthly cashflows (ie to match new liability profile). To protect ourselves we may have bought a derivative that will payout monthly cashflows for say 3 years of the same amount as new liability profile. This will allow us to wait for a better price on the original asset that we can then sell and buy an asset that matches our new liability profile?

Section 4 - Portfolio construction and benchmarking (page 8)
Ah ok so basically strategic risk is the risk of mismatching (ie assets will not match the liabilities perfectly, which is never possibly in reality) and then also the risk that the assets you've choose to best match the liabilities perform even worse then anticipated? For eaxmple the porfolio of assets choose maybe like in the text, 90% equities and 10% bonds to achieve high long term returns (even though 80% equities and 20% bond are a better match to the liabilities?), which is risky as your further mistmatching?

Thanks,

Darragh

 

[James Nunn]

Hi Darragh

No problem - glad my answers helped. Some answers to the two further things you raised are below:

1. Tactical asset allocation (derivatives):

Yes - that's broadly the idea. So in your scenario, there may be a derivative that could be invested in that would allow annual income to be exchanged for monthly income - the party with the liability you mention could use this to swap the annual proceeds (eg income/redemption proceeds) they get from the current assets in return for monthly payments (from the derivative counterparty in return for the annual payments).

More generally, particularly if we have longer term liabilities where there may be little or no immediate outgo required, we will wish to match assets with liabilities so that their market values move in the same way (to reduce the risk of the value of assets falling relative to the value of liabilities in particular). We can use derivatives to do this as they would change the exposure / investment characteristics of the fund, when added, so that its value moves in a way that better matches liability value movements. If this matching is achieved (temporarily at least) using derivatives, there's less pressure to make an immediate change to other assets held to achieve this.

2. Portfolio construction and benchmarking:

Yes - I agree. Strategic risk includes both the mismatch risk that can't be avoided (due to any uncertainty in timing or amount of liabilities that can't be matched for example) and any avoidable/deliberate mismatch between assets and liabilities when setting the strategic benchmark.

Hopefully that helps.