LDI based Private Wealth Management 2 – Risk Budgeting

The present article is the extension of the first such article named: LDI based Private Wealth Management - Introduction

Overall, it is not the performance of a particular fund nor that of a given asset class that will be the determining factor in the ability to meet a private investor’s expectations. The success or failure of meeting the investor’s long- term objectives is dependent on an LDI exercise that aims to determine the proper strategic asset allocation as a function of the investor’s specific objectives, constraints, and time horizon. In other words, the decisive factor will be the ability to design an asset allocation solution that is a function of the particular risks to which the investor is exposed, as opposed to the market as a whole.

Hence, a five-year zero-coupon Treasury bond will not be a perfectly safe investment for a private investor interested in a real estate acquisition five years in the future. The actual liability-hedging asset in theis example would be a correlating perhaps liquid and tradable Real Estate asset like a REIT. More generally, an investor whose objective is related to the acquisition of property would accept low and even negative returns in situations where Real Estate prices significantly decrease, but would not be satisfied with relatively high returns if such returns were not sufficient to meet a dramatic increase in real estate prices. In such circumstances, a long-term investment in stocks and bonds, which are weakly correlated with Real Estate, would not be the right investment solution. In a pension context, absolute return performance, often perceived as a natural choice in the context of Private Wealth Management (PWM), would not be satisfactory for a private investor facing long-term inflation risk, where the concern is capital preservation in real, as opposed to nominal, terms. In other words, the main benefit of the ALM approach is the predominant focus on assets with the highest possible correlation against the liabilities they are set to fund.

It is typically understood that high risk aversion levels leads to a predominant investment in the liability-hedging portfolio, which in turn implies low extreme funding risk (zero risk in complete market case), as well as low expected performance and therefore high necessary contributions. On the other hand, low risk aversion levels lead to a predominant investment in the performance-seeking portfolio, which implies high funding risk as well as higher expected performance, and hence lower contributions.

ALM in private wealth management

As mentioned above, proximity to clients is often seen as the reason for the existence of private wealth management. A private wealth manager’s ability to offer tailored services to meet the particular needs of his or her clients is crucial. When it comes to tailoring an investment strategy that addresses client-specific concerns, it is only natural to make sure that the client’s risk preferences as well as his spending objectives are taken into account. In fact, these spending objectives are his liabilities. 

Standard asset management approaches in private wealth management, would only be relevant in the performance-seeking portfolio, whose objective is to maximise the Sharpe ratio and which does not depend on client- specific objectives. A client’s liability hedging portfolio, however, depends on the nature of his liabilities. Again, in the absence of formal liabilities, any spending objectives can, in this framework, be seen as investor liabilities.

In fact, private clients often have the same problem as pension funds and institutional investors: setting up an investment strategy that provides enough cash when specific financial obligations fall due, but without excessive sacrificing of potential returns. As institutional investors are well versed in ALM, it should be easy to put their expertise to work meeting the challenges of private banking. The idea is simple: by analogy with the ALM techniques for pension funds, investor could create liability-matching portfolios to achieve an optimal trade-off between high returns and matching of future obligations.

By explicitly making individual liabilities a part of the asset allocation decision, it is possible to construct superior portfolios, since portfolios that may be optimal from an asset-management perspective are usually not optimal when liabilities are taken into account.

Traditionally most pension plans maintain a relatively constant asset allocation and risk budgets are neither sensitive to market cycles or, more importantly, not related to funding ratios. Hence, roughly the same amount of investment risk is taken (as a percentage of the assets) during times of overfunding as underfunding. To improve investment outcomes, investor should define a clearly identified goal and directly link it?to the investment policy. This is accomplished with a risk-budgeting process that adjusts between liability-matching and risk-seeking portfolios based on funding level. Naturally, the impact of funding status on the risk budget and, specifically, changes in the funding status over time is tied to how the pension plan’s objective is formulated, and its significance depends on the plan. The dynamic risk-budgeting process should dynamically reassesses whether the existing investment portfolio is desired given the new circumstances, and most importantly the?new funding ratio.

As an example, lets say a investors objective is to have future liabilities fully funded in 10 years, while minimizing contributions required both over the 10-year period and prospectively beyond this point. At time zero, the plan constructs an optimal portfolio to achieve this goal without relying on future contributions. Because the investor recognizes that a funding ratio is a relative measure of assets versus liabilities, he seeks to close the funding gap by targeting a liability- plus rate of return. In the example this equals an annual required rate in excess of the drift rate of liabilities of 3%.(see illustration).

To keep things simple we will assume a prudent Liability Hedging Portfolio, with immunizing duration of liabilities, can generate a return roughly in line with the drift rate of liabilities, this require 60% of the plan’s capital has to be allocated to the Performance Seeking Portfolio.

End of year one

Suppose that after one year, the plan experiences an increase in the value of the Performance Seeking Portfolio, and also a 1.5% rise in long-term interest rates (and hence the liability discount rate. The liability hedging portfolio is duration hedged, and will moved in tandem with the liabilities, where as the increase in the value of the Performance Seeking Portfolio, has improved the funding ration, and hence decreased the future required target return to 2% for the remaining nine years to the target horizon.

Description: isk budgeting

So far, apart from clarifying the objective and linking the initial policy to achieving this goal, there is little difference between this approach and a traditional liability-driven investment policy. But now, one year into the investment plan, the new dynamic risk-budgeting process cuts in and formally re-assesses whether the existing investment portfolio is appropriate given the new circumstances, and most importantly the new funding ratio.

The key focus is where investor is in relation to his objective. Assuming that the previously set objective still holds, the question is whether the current risk budget is still correct, or the proportion between the more risky Performance Seeking Portfolio and Liability Hedging Portfolio need adjustment.

Note that, unless the view on the prospective returns from different asset classes and investment opportunities has changed, investor does not need to change the composition of the performance Seeking Portfolio, but merely need to change the amount of capital allocated to it. (I will return with an article on the use of ETP’s absolute return PSP). In any case the Liability Hedging Portfolio need calibration, since one year has passed and the implied duration of future liabilities has also changed.

A natural consequence is a strong reduction in the range of uncertainty, as the risk budget has been reduced relative to the liabilities. This action may seem fairly obvious, but unfortunately that it is NOT what is generally observed in practice, the normal situation is that a plan would rebalance back to the previous target strategic asset allocation (SAA); that is, it would keep the risk budget constant as a percentage of assets, without reappraising whether this SAA is still as appropriate as when it was first conceived. Because the funding ratio changes continuously, the risk budgeting algorithm directs the plan to reassess the risk budget. Keeping the original goal in mind and redoing the analysis suggests a target return of liabilities +2.5% for the remaining eight-year horizon

End of year two

Now consider how this risk budgeting would impact the plan’s response in a down year. In year two, we assume markets retrench somewhat, and Performance Seeking Portfolio is down while long-term interest rates also fall by 0.5%.

Description: iskbudgeting 2

The impact on the plan is as follows: The liability hedge neutralizes the gain in value of the liabilities, while the equities in the plan lose in value. Because the funding ratio has changed, the risk budget is re-assess. Keeping the original goal in mind and redoing the analysis suggests a target return of liabilities +2.5% for the remaining eight-year horizon. Again If the plan’s views have not altered, it should reallocate the portfolio to target this new level of return.

To conclude; With a clear focus on splitting assets into a Liability Hedging Portfolio constructed with assets that correlates with liabilities, and an independent Performance Seeking Portfolio, and letting the allocation between each be a function of funding surplus, the risk budgeting process can significantly reduce the amount of contribution needed, while increasing the probability of fully funding the future liabilities. Further one can argue that such practise is a more sustainable skillset, instead of seeking to improve asset returns on through various selection strategies. Consider going to the Cranberger Asset Allocation & Risk Management Group for further insight and discussion around different assets classes suitability a Liability Hedge.

 

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