solutions to a low nominal investment environment

Solutions to a Low Nominal Investment Environment

June 29, 2006

François Bourdon, FSA, FCIA, CFA, PRMVice President and Portfolio ManagerQuantitative Strategies and Financial Engineering

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1

2

3 Solutions

New Framework

Environment

Table of content

3

1Environment

Economy

Demography

Investments

Liabilities

4

Current Environment

ECONOMYInflation at 2%

Globalization

Potential WorldGDP at 3% - 4%

Lower riskpremium

Low NominalEnvironment

Risk shiftingto individuals

Securitization

World population shouldkeep increasing until 2050

Longevity isincreasing

DEMOGRAPHYBirth rate at 1%

LIABILITIESPension plan duration at 12Solvency ratio at 90%

INVESTMENTSYield curve at 4%Dividend yield at 2%Earnings yield at 5%

5

2New Framework

Investment Objectives

Minimum Risk

Risk Premiums

Value Added

6

Framework for Investment

LiabilitiesObjective

RequirementsRegulation

No RiskTolerance

RiskPremium

ValueAdded

Rl = Rf + β * (Rβ - Rf)+ α

Required ReturnsConstraints

MinimumRisk

SystematicRisk

SkillRisk

7

Typical Situation

Pension Plan for manufacturing company employees Assets : 2 billion, solvency ratio = 90%

Liabilities : nominal, inflation has a small impact

Life Insurance companyBook of business : 1 billion, T100 and T10, MCCSR = 225%

P&C Insurance companyBook of business : 1 billion, mainly car insurance

8

Illustration of typical investment

Value AddedRisk PremiumMinimum Risk

20 bps for T-Bills + 50 bps for Universe + 150 bps for TSX + 200 bps for MSCI W

5% T-Bills + 40% Universe + 30% TSX + 25% MSCI World

Scotia Capital Long Term Canada

PENSION PLANDuration = 12Actuarial assumption = 7%

Value AddedRisk PremiumMinimum Risk

20 bps for T-Bills + 50 bps for Universe + 150 bps for TSX + 200 bps for MSCI W

5% T-Bills + 40% Universe + 30% TSX + 25% MSCI World

Scotia Capital Long Term Canada

PENSION PLANDuration = 12Actuarial assumption = 7%

20 bps for Credit and Yield Curve

Credit riskReal estate

Cash Flow MatchLIFE INSURANCE (T100)Very long liabilitiesMCCSR = 225%

20 bps for Credit and Yield Curve

Credit riskReal estate

Cash Flow MatchLIFE INSURANCE (T100)Very long liabilitiesMCCSR = 225%

20 bps for T-Bills + 50 bps for Scotia Universe and Pref + 150 bps for TSX + 200 bps for MSCI World

20% Bills + 50% Scotia Universe + 15% Preferred + 10% TSX + 5% World

Cash Flow MatchP&C INSURANCE (CAR)Duration = 3Book accounting

20 bps for T-Bills + 50 bps for Scotia Universe and Pref + 150 bps for TSX + 200 bps for MSCI World

20% Bills + 50% Scotia Universe + 15% Preferred + 10% TSX + 5% World

Cash Flow MatchP&C INSURANCE (CAR)Duration = 3Book accounting

α+ β * (Rβ – Rf) +Rf=Rl α+ β * (Rβ – Rf) +Rf=Rl

9

Typical Approach

S&P TSX (active 150 bps)

30%

MSCI World (active 150 bps)

25%

Scotia Capital 91-day Treasury Bills

(active 20 bps)5%

Scotia Capital Universe

(active 50 bps)40%

PENSION PLAN

Scotia Capital Universe (active 50 bps)

50%

Nesbitt BurnsPreferred

(active 50 bps)15%

S&P TSX (active 150 bps)

10%

MSCI World(active 150 bps)

5%

Scotia Capital 91-day Treasury Bills(active 20 bps)

20%

P&C INSURANCE COMPANY

Bonds(active 20 bps)

Real estate

LIFE INSURANCE

10

3Solutions

Pension Plan

Life Insurance

Property and Casualty Insurance

11

Solutions

Risk Intolerance World


Risk Premium World

Risk Premium World

Value Added World

12


Objective

Identify lowest risk investment characteristics

Determine the impact of low risk portfolio on expected results

Look for tools to reduce risk

13

Impact of this strategy on expected return of assets should be insignificant

Strategies to get closer to minimum risk

Pension Plan Case (D=12)Increase duration

20%0%20-year duration fund

25%25%MSCI World

30%30%S&P TSX

25%40%Scotia Capital Universe

0%5%T-Bills

ProposedCurrentAssets

Effect = increase of 3.1 years in duration

14

Impact of this strategy on profitability and pricing could be significant


Life Insurance Company Case Expected Cash Flow Match

± 0.02year

± 0.15year

Key rate duration

± 0.02year

± 0.25 year

Duration


Effect = Insulation from interest rates

15

Liability Swap :

Pay CDOR + 80 bpsReceive Return on Cash Flow Matched Portfolio

Impact of this strategy depends on ability to beat CDOR + 80 bps

May need to dynamize T-Bill assets to meet CDOR + 80bps


P&C Insurance Company CaseLiability Swap

xoLiability Swap

5%5%MSCI World

10%10%S&P TSX

15%15%Preferreds

0%50%Scotia Capital Universe

70%20%T-Bills


Effect = Better match, clear positions

16

Risk Premium World (β World)

Objective

Determine optimal mix of directional positions

Tools to improve risk premium capture

New asset classes

Better performing benchmarks

Tactical risk allocation

17

Strategies to better exploit risk premium (new asset classes)

Improved sources of risk premium and better complementarities

Comparative operating advantageNatural resources exploration

DemographyReal estate

Risk premiumEmerging debt and equity

Liquidity premiumPrivate equity

StabilityInfrastructure

Relative yield curveInternational bonds

Corporate healthHigh yield bonds

Relative economic performanceCurrencies

ProductivitySmall cap

Demand and growth of economyCommodities

Demand and global instabilityPrecious Metals

Low level and negative correlationVolatility

18

Strategies to better exploit new asset classes

100MVolatility

100MAsian Currencies

200MInternational Bonds

150MEmerging Market Equities

150MCommodities

100MPrecious Metals

100MSmall Capitalisation

400M500MMSCI World

300M600MS&P TSX

400M800MScotia Capital Universe

100M T-Bills

ProposedCurrentAssets ($2 billion)

Pension Plan Case

Effect = greater diversification of drivers of return

CURRENT EXPECTED CONTRIBUTION

MSCI World0.75%

S&P TSX0.90%

T-Bills0.00%

Scotia Capital Universe0.10%

PROPOSED EXPECTED CONTRIBUTION

MSCIWorld

S&P/TSX


T-Bills0.00%

Volatility0.05%

Small Capitalization

0.20%

Precious Metals0.20%

Commodities0.30%

Emerging Market Equities0.30%

International Bonds

Asian Currencies0.15%

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Zero-coupon bond (5 years to maturity) emerging market debt + equity small cap equities global equities gold calls 2009 commodity calls 2009 asian currencies high yield debt international bonds volatility futures

DIRECTIONAL NOTE


25M0Directional note

50M50MHydro One 2034

50M50MPower 2033

50M50MLoblaw 2032

50M50MEnbridge 2030

50M55MGTAA 2030

50M55MBell 2029

50M55MGaz Met 2027

50M55MTD 2025

50M55MTranscan 2022

25M25MReal estate

ProposedCurrentAssets (1 billion)


Real Estate0,25%

Credit1,00%

New classes0,00%


Real Estate0,25%

Credit0,95%

New classes0,10%

PROPOSED EXPECTED CONTRIBUTION

Life Insurance Company Case

20


50MHigh Yield Bonds

50MInternational Bonds (hedged)

50MInfrastructure

50MReal Estate

50M50MMSCI World

50M100MS&P/TSX

100M150MPreferreds

450M500MScotia Capital Universe

150M200M T-Bills

ProposedCurrentAssets ($2 billion)



P&C Insurance Company Case

MSCI World0.15%

T-Bills0.00% Scotia Capital

Universe0.13%

Preferreds0.15%

S&P TSX0.30%

PROPOSED EXPECTED CONTRIBUTIONHigh Yield Bonds

0.13%

International Bonds (hedged)

0.03%

Infrastructure0.25%

Real Estate0.25%

T-Bills0.00%


Preferreds0.10%

S&P TSX0.15%

MSCI World0.15%

21

Strategies to better exploit risk premium (better benchmarks)

Improved characteristics of risk premium

Popular benchmarks generally reflectMinimum quality (benchmark inclusion)

Availability (capitalization-weighted for equities, issue size for bonds)

Better benchmarks shouldShow persistency in excess returns

Favor better company and industry characteristics for stocks

Favor better demand characteristics for bonds

22

Strategies to exploit better benchmarks

Pension Plan

Reduced volatility in country exposure MSCI World (GDP)MSCI World

No changeS&P TSXS&P TSX

No changeScotia Capital UniverseScotia Capital Universe

No changeScotia Capital 91-dayScotia Capital 91-day

ReasoningProposedCurrent

0

5

10

15

20

Dec-69 Dec-79 Dec-89 Dec-99

M SCI World M SCI World (gdp-weighted)

23

Strategies to exploit better benchmarks

P&C Insurance Company

Reduced volatility in country exposure MSCI World (GDP)MSCI World

No changeS&P TSXS&P TSX

No changeNesbitt Burns PreferredNesbitt Burns Preferred

Same duration, more carry and creditScotia Capital Short + Scotia Capital CorpScotia Capital 91-day + Scotia Capital Universe

ReasoningProposedCurrent

0.8

3.2

5.6

Dec-85 Dec-90 Dec-95 Dec-00 Dec-05

30% Bills - 70% Universe 40% Short Term - 60% Corp

24

Strategies to better exploit risk premium (tactical risk allocation)

Tailored distribution of expected results

Popular approach is to set long-term policy and live with results unless no longer bearable

Better approach may be to allocate risk dynamically according toenvironment and evolution of market value

For risk averse investors with short horizon, it may mean to cut risk when results are negative and increase risk when results are positive

For less risk averse investors with very long horizon, it may mean to increase risk when and where losses have been the greatest

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% of years with a return below 6%: 51.5 % vs 71.2%

% ofobservations

Simulated Annual Returns Distribution

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

80%

0,00% 1,00% 2,00% 3,00% 4,00% 5,00% 6,00% 7,00%

Current Portfolio

Solution

Annual Return (%)

Strategies to exploit tactical risk allocation

P&C Insurance CompanyAbsolute returnNo capital loss on a 1-year horizon

Mar

ket V

alue

0 Time

Safety cushion

Immunization value

Minimum value

1 year

Mar

ket V

alue

0 Time

Safety cushion

Immunization value

Minimum value

1 year

1 year

Mar

ket V

alue

0 Time

Increase % of morevolatile assets

Decrease % of lessvolatile assets

Reduction

Increase

Reduction

Initial amount

Scenario 1 (I3)

Scenario 2 (without I3)

Safety Cushion

Scenario 2 (I3)

Immunization – 100%in money market

1 year

Mar

ket V

alue

0 Time

Increase % of morevolatile assets

Decrease % of lessvolatile assets

Reduction

Increase

Reduction

Initial amount

Scenario 1 (I3)

Scenario 2 (without I3)

Safety Cushion

Scenario 2 (I3)

Immunization – 100%in money market

Simulated Annual Returns Distribution

0%

5%

10%

15%

20%

25%

-5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00%

Current Portfolio

Solution

Maximum annual potential loss: -1.2% vs -3.9%1

% ofobservations

% or years with a negative return: 1.1% vs 5.4%

Annual Return (%)

26

Value Added World (α World)

Objective

Determine optimal mix of talent

Energize less productive assets

Tools to improve value added capture

Pure alpha strategies

Diversified alpha strategies

Alpha transfer and risk management

27

Pure Alpha Strategies

Pension PlanLooking to energize less productive assetsInvests previous T-Bills exposure in Alpha Strategy

Period from March 1st, 2005 to March 31, 2006Source: Fiera Capital

Fiera Capital North American MarketNeutral Pooled Fund (US$)

Bonds (Scotia Capital Universe) 0.07

Canadian Equities (S&P/TSX) -0.30

U.S. Equities (S&P 500, $CA) -0.13

Technology Equities (NASDAQ, $CA) -0.11

Fiera Capital North American MarketNeutral Pooled Fund (US$)

Bonds (Scotia Capital Universe) 0.07

Canadian Equities (S&P/TSX) -0.30

U.S. Equities (S&P 500, $CA) -0.13

Technology Equities (NASDAQ, $CA) -0.11

Source: Fiera Capital

March 1st, 2005 to March 31, 2006

Beta (S&P/TSX) -0.18

Alpha (S&P/TSX) 24.55%

Sharpe Ratio 3.21

Maximum Drawdown -0.08%

Fiera Capital North American Market Neutral Pooled Fund (US $)

-0.06 -0.07-0.01 -0.03

-0.08 -0.05-0.12

-0.25

-0.04

0.000.000.010.030.02

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

2005-02 (end ofmonth)

2005-03 2005-04 2005-05 2005-06 2005-07 2005-08 2005-09 2005-10 2005-11 2005-12 2006-01 2006-02 2006-03

Estimated beta in relation to the S&P/TSX index

Market risk (beta)

Net (%)

0.1

TOTAL 79.5% -77.7% 1.8

0.2

0.1

4.1

-0.5

-1.9

-0.1

-0.2

-0.4

0.4

Long ShortPosition

-25.0 -15.0 -5.0 5.0 15.0 25.0

Utilities

Telecommunications

Technology

Financials

Health care

Consumer staples

Consumer discretion.

Industrials

Materials

Energy

Industry exposure*

28

Diversified Alpha Strategies

Life Insurance CompanySignificant portion in Short-Term AssetsCurrent value-added objective of20 bps Replaces Short-Term Assets (2.5%) byDiversified Fund of Alpha to targetextra 20 bps

Measurement of actual positionsDiversificationComplementarity

Maximum lossDownside behaviourNon-directional

Speed of executionStabilityLiquidity

Continuous reviewPotential of strategyInvestment process

Risk allocation and guidelinesInformation ratioHistorical results

Risk ManagementAllocation Inclusion Criteria

Canadian Fixed IncomeGlobal Fixed IncomeCurrenciesNorth American Market NeutralActive S&P500 hedged to neutralActive EAFE hedged to neutralVolatility Arbitrage

Strategies:

10%Volatility:

T-Bills or other bench + 8%Return objective:

Fund of Alpha

Effect = increase potential without changing profile of assets

RISK ALLOCATION

North American Market Neutral

US Equities

InternationalEquities

Volatility

Canadian Fixed Income

Global Bonds

TacticalCurrencies

29

Alpha Transfer and Risk Management

P&C Insurance CompanyHas a significant portion in Canadian equities (10%)

Wants to reduce his Canadian equities and be less influenced by direction of stock markets

Use 20% T-Bills as collateral to :Short S&P TSX 60 futures (10%)Invest in Diversified Fund of Alpha (10%)Collateral sufficient to support short S&P/TSX

Applies maximum loss on Fund of Alpha

Benefits from value added potential

Liquidity of large positionsDefers taxes

Manages basis risk between actual equities and futures

Eliminates directional Canadian equity exposure

Risk managementCharacteristics of new strategy

Effect = increase potential and respond to desired profile while managing tax situation

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Putting it all together Things to do

Recognition of minimum risk portfolioHow do the liabilities behaveWhat are the objectivesWhat are the constraints

Determination of the desirable amount of risk willing to take

What is the tolerable range of deviation from minimum risk

Establishment of the most attractive risk premiumsWhat is the best β mixShould we be tactical with β mix

Identification of the most attractive value added approachesHow should α be combined

Analysis of the best combination of risk premiums and value added approachesWhat are the most appropriate tools for implementationHow should monitoring and risk management be conducted

31

Considerations for implementation

Knowledge

Risk Management

Transparency

Liquidity

Completeness

32

Conclusion

Difficult Environment

Triangular Approach Minimum Risk

Risk Premium

Value Added

Current Strategies can be improvedFlexibility

Clarity

Specificity

Better solutions

solutions to a low nominal investment environment

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