towers watson: portfolio development and implementation in uncertain times

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Portfolio Development and Implementation in Uncertain Times

June 28, 2011

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Discussion

Economic and Market Uncertainty

Portfolio Positioning in Uncertain Times

Role of Valuations

Impact on Liability-Driven Investing


Shorter View

2010 2015

Scenario Probability Positives Negatives

Bumpy ride to recovery

Global slowdown

High inflation

Deflation (‘indebted’)

Debt crisis (‘indebted’)

High growth (‘indebted’)

Growth rate

Time


Shorter View

2010 2015

Scenario Probability Positives Negatives

40% Commodities

20%

15% Credit

10%

10%

5% Equities

Sove

reign

bon

ds

Growth rate

Time

Commodities

Credit

Equities

Sove

reign

bon

ds


Global slowdown

High inflation





Loose fiscal policy

Tight fiscal policy

Loose monetary policy Tight monetary

policy

“Indebted markets”

Loose fiscal policy

Tight fiscal policy

Loose monetary policy Tight monetary

policy

“Indebted markets”

Politics (Policy) Will Matter Greatly

“Growth markets”

Exchange rate

Rebalancing

vs


Longer View

2015 2025

• Capitalism reinventing itself• Jobs being recycled into new areas• Confidence returning

• Caught in a debt / liquidity trap• Western financial system crisis-prone• Wealth and power shifting East

Sovereign nominal bonds

Equities, credit, commodities

Sovereign nominal bondsEquities, credit, commodities(?)

Growth rate

Time

Policies favored growth

Debt more powerful than policies


Investment Framework

7

Stage 1: Investment Strategy Development

Stage 2: Portfolio Construction

Stage 3: Risk Budgeting

Manager selection and monitoring of strategy

Liability-matching

Investment grade bonds

Return-seeking

Domestic

Asset Allocation Supporting Objectives

Non-U.S.ABS/MBS

CorporateTreasury

Non-U.S.

Alternatives

High yield

Bank loans

Convertibles

Equities Non-investment grade bonds

Hedge FOF

Private real estate

Private equity


What makes a good return driver?

8

Return driver Easy to access Reliable Attractive distribution

Capacity Governance Macro consistent High IR Positive skew Correlation

ERP - -

Credit

Illiquidity

Insurance

Term -

Inflation

Currency

Skill * -

* Assumes skilled managers are picked across multiple asset classes with a low correlation between their alphas.


TWIS Return-Driver Framework

9

hgAsset Classes Equity Credit Illiquidity Insurance Term Inflation Currency SkillDeveloped market equityAlternative creditAlternative betas

ReinsuranceCommoditiesVolatility arbitrage

Emerging WealthEmerging market equitiesEmerging market debtEmerging market currency

Hedge fundsIlliquid assets

Core global propertyCore InfrastructurePrivate market funds

BondsCorporate bondsNominal government bonds (AAA)Inflation-linked gov't bonds (AAA)

Risk Premia


Valuations Matter – Our Current Views

10

Three-Year HorizonAsset Class View

Global Government Bonds Neutral

Global Inflation-linked Bonds Neutral

Global Credit (Investment Grade) Neutral

Global Equities Neutral

Commodities Neutral

Asset class- Few clear dislocations in major global markets relative to cash

Return Drivers- Few clear dislocations in major global markets relative to cash


Portfolio Construction: Return-seeking portfolio considerations

11

Unconstrained

Long-Horizon Iliquid

Portfolio

All Assets

Client portfolio dependent on: Time horizon Opportunities re annuitization Cashflows

Long-Horizon Liquid

Portfolio

Government Debt and Cash-Like

InstrumentPriv

ate

Equi

ty

Prop

erty

Infr

astr

uctu

re

Rei

nsur

ance

Illiq

uid

Hed

ge F

unds

Emer

ging

Mar

ket C

urre

ncy

Hig

h Yi

eld

EM E

quity

Dev

elop

ed E

quity

Liqu

id H

edge

Fun

ds

Loan

s

EM D

ebt

IG C

redi

t

LT G

ov D

eb


KEY: positive, very positive, = broadly neutral, negative, very negative

Fast(EM FX appreciation)

Slow(EM inf lation, DM def lation)

High(Fiscal stimulus,

high market liquidity)

Low(Fiscal austerity,

tight market liquidity)

Speed of global rebalancing(EM policy choices)

Public policy and financial conditions

(DM policy choices)

EM: Emerging MarketsDM: Developed Markets

EM Overheating

Global growth slowdown

DM Deflation

High DM inflation

DM sovereign

debt crisisBumpy ride

to recovery

High DM

growth

Consideration of these scenarios should form a qualitative overlay to

the outcomes from the risk-budgeting analysis

12

Bumpy ride Growth slowdown DM deflation High DM

inflation High DM growth Sovereign default EM crisis

Probability 40% 20% 15% 10% 15%

Nominal Bonds (developed market) =

Inflation linked bonds = =

Global Equities

EM Wealth

Alternative Credit =

Inv. Grade Credit =

Insurance = = = = = = =

Spending the Risk Budget: Economic scenario analysis


Alternative beta

Treasuries and cash

DB Pension Fund

Corporate bonds

Developed equities

Private marketsEmerging wealth

Traditional Unconstrained

Treasuries and cash

Corporate bonds

Developed equities

Private markets

Emerging wealth

Source: Towers Watson

Hedge fundsAlternative beta

Alternative credit


Higher-Risk Fund Asset Structure

Unconstrained

Source: Towers Watson

Sustainability

Higher-risk fund

Developed equities

Hedge funds

Alternative beta

Alternative credit

Private markets

Emerging wealth

Treasuries and cash

Corporate bonds

Developed equities

Private markets

Emerging wealth

Hedge fundsAlternative beta

Alternative credit

Cash


Portfolio Construction: Return-Seeking

15

Typical RSA

Developed Equity

Alternative Credit

Insurance

Emerging Wealth

Hedge Funds

Private Markets

Bonds

Extreme Risk Hedges

Liquidity

Low Fee Liquidity Constrained Unconstrained


16

Impact of Uncertainty on Liability-Driven Investing

60%

65%

70%

75%

80%

85%

90%

95%

100%

105%

Funded Status


17

Don’t Forget about Risk Management: Left-Tail Risks


TW and the market expect interest rates to rise

This chart shows the market’s and our expectations for future cash interest rates (ie forward rates). Please note that our expectations are focused around a long-term yield level for Treasurys (and swaps) of 4% pa.

Both we and the market expect cash interest rates to rise over the next few years as monetary policy normalizes.

18

Source: Towers Watson as at 3 May 2011

Assessing the value of Treasurys relative to cash

Treasury forward cash rates

0.0

1.0

2.0

3.0

4.0

5.0

6.0

0 5 10 15 20 25 30

Yiel

d (%

pa)

Term

Market forward Treasury cash rate

TW expected Treasury cash rate

Interest rates expected to

increase from current low

levels

Market expectation above 5%

Our assumption below market expectation


19

“Rates are low, don’t you know?”

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

90 92 94 96 98 00 02 04 06 08 10Pe

rcen

t (%)

Expected change in family income (next 12 months), median response

Smoothed series (moving average)

High unemployment puts strong pressure on US wages in the short term

Source: University of Michigan, Towers Watson

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

00 01 02 03 04 05 06 07 08 09 10 11

US core inflation UK core inflation

Euroland core inflation Japan core inflation

% yoy

G4 core inflation (CPI excluding the volatile energy and food prices) modestly rising

Source: Bloomberg LP


“Rates are low, don’t you know?”

2010 2015

Scenario Probability Progression To Goal

5%

15%

40%

20%

10%

10%


Global slowdown

High inflation




Growth rate

Time

Low probabillty/modest upside

High probabillty/greater downside


2121

Liability Hedging Portfolio Construction

Representative Cash Flow Distribution - 70% Fixed Income

Representative Cash Flow Distribution - 30% Fixed Income

0%

10%

20%

30%

40%

0-5 6-10 11-20 21-30 30+

Government Credit Liabilities

0%

10%

20%

30%

40%

0-5 6-10 11-20 21-30 30+

Government Credit Liabilities


Decide how to factor in your views on the markets and risks

Review your portfolio structure

Be alert to investment opportunities arising

Understand and manage left tail risk

So, what now?


Contact Details

Chris DeMeo 335 Madison Avenue, New York, NY 10017-4605 212-309-3845 [email protected]

Matt Stroud 335 Madison Avenue, New York, NY 10017-4605 212-309-3835 [email protected]

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