Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 9
Capital Market Expectations and Asset Allocation
Greg Vaughan

This Week

Maginn, Tuttle et al Managing Investment Portfolios

Chapter 5. Prescribed reading as follows:
Sections 1; 2.1-2.3 ; 3.1 ; 4.1-4.3 ; 5 ; 6.6; 7.1-7.3; 9.1-9.4; 10
Group N to cover 2.3, 3.1, and 4.1
Group L/O to cover Grinold et al A Supply Model of the
Equity Premium and also Dimson Rethinking the Equity
Risk Premium
Group M to cover Section 10 of Maginn and Tuttle, and
Perold and Sharpe Dynamic Strategies for Asset
Allocation

Capital Market Expectations (1)

Capital Market Expectations will shape the asset allocation
alternatives to be investigated in asset-liability studies
They are also important in quantifying risks (SRM)
Asset return models should be calibrated for consistency
with capital market expectations
Asset models will also be used to predict liability valuation
bases in some instances (Defined Benefit Superannuation)
Capital Market Expectations underpinned by financial/
economic structure are more likely to be realistic and
consistent

Expected Equity Returns - Equilibrium

The CAPM framework suggests a simple model for
expected equity returns:
E( R M ) = R f + ERP

If the bond market and the equity market were in

equilibrium, and ERP was constant we might simply add a
historical average ERP to the current bond yield
But what if the bond market is distorted?
Does the ERP vary over time with perceived risk? If so,
how do current risks compare to history?
Interpreting market history may not be straightforward
Is Australia different from the rest of the world?

Expected Equity Returns Market History (1)

The reference work for the global equity risk premium is by
Dimson, Staunton and Marsh, first published in 2000, and
updated annually
Includes data across 19 countries from 1900
Inevitably many data issues but hopefully averaged out
Previously ERP estimates dominated by US analysis, but
the US has done better than most markets
About 0.5% has been added by an expansion of price
multiples (lowering of dividend yield)
This suggests an element of pleasant surprise which
would not be expected in the future.

Geometric Average Real Equity Returns

1960-2014

Source: Credit Suisse Global Investment Returns Sourcebook 2015

Geometric Average Equity Risk Premium over

Bonds 1960-2014

Source: Credit Suisse Global Investment Returns Sourcebook 2015

Equity Return Volatility 1900-2014

(excluding very high inflation markets)

Source: Credit Suisse Global Investment Returns Sourcebook 2015

Current bond yields and inflation expectations

give rise to different equity return expectations

Current real bond yields are circa 0.5% compared to 3.0% historically
Note geometric averages have been converted to arithmetic for above

Expected Equity Returns Market Implied (1)

An alternative to the equilibrium ERP approach is to determine
the return expectation implied by current market prices
Recall the DDM

D
P=
kg
So

D
k = +g
P
Currently numbers are approximately k = 5% + 3% = 8%

Expected Equity Returns Market Implied (2)

Although the DDM can be problematic at the stock level, it is
useful for considering market return expectations
The dividend yield of the market is observable so we just need
to do something sensible about growth expectation
There are two classic approaches
Using a stock analog, we can consider the earnings retention,
and return on retained equity of the market (g=b x ROE)
Alternatively from a macro perspective we can base growth on
the performance of the economy
We wont always get the same result

Expected Equity Returns Market Implied (3)

g = b x ROE
We can observe the average dividend payout of the market
The estimate of ROE is somewhat arbitrary, but might be
inferred by market average P/E and P/B
The figures below infer growth of circa 3-3.5% for Australia
compared to 6% for global equities

Source: MSCI, August 2015

Australian versus global equity return

expectations
Using these figures we might estimate Australian equity return
expectation as circa 8.3% (5% + 0.28x11.9%)
The corresponding global equity estimate would be 8.7%
(2.6% + 0.53x11.5) in this case very close
This arithmetic concerns global equity returns before currency
translation
Global equity allocations tend to be only partly hedged
Hedged overseas assets pick up any interest rate differential
Unhedged assets should in theory pick up inflation differential

Expected Equity Returns Market Implied (4)

g = GDP NI (nominal economic growth less new investment)
The profit share of GDP should be reasonably constant
So corporate profits should grow in line with nominal GDP
The asset base for corporate profits is expanded by new
capital raising so adjustment is necessary
Capital raisings on the ASX consist of IPOs and secondary
capital raisings by companies already listed
The appropriate adjustment to growth with this approach
corresponds to secondary raisings as a % of market cap
This figure is typically 2-3%
With nominal GDP of circa 5-5.5%, that implies growth of circa
3%.

Expected Equity Returns Market Implied (5)

Reconciling (b x ROE) and (GDP NI)
If earnings retention is high there will be less need for
secondary capital raising
Hence a high retention market will tend to have a low New
Investment adjustment
For example in the US, the NI adjustment might even be
negative because share buybacks are common
These buybacks are funded by very high earnings retention (in
excess of 60%)

Expected Equity Returns Market Implied (6)

Basing return expectations on market implied returns is OK if
the market valuation is reasonably neutral
In that case the ERP based estimates are likely to be
reasonably consistent with market implied returns
But if the market valuation is expensive the market implied
return will be depressed so as to validate that price level
It may then be necessary to factor in a correction to market
pricing

Expected Equity Returns Market Implied (6)

D
P
E(R) = + GDP NI +
P
E
Based on Grinold-Kroner (2002)
If market multiples are extended or depressed expected
returns might reflect a reversion to equilibrium pricing
P/E s can revert to normal by movement in the E, rather than
the P
When earnings are depressed the market P/E may be high in
anticipation of an earnings recovery. In that instance prices
may be underpinned by earnings growth and not recede.
So the market multiple adjustment should be applied carefully

The market cycle leads the business cycle

The market cycle is more ahead of the business cycle at the peak than the trough
The market cycle transpires in phases, often starting abruptly

Current P/Es are normal (more or less)

But our dividend yields are elevated by

historically high payout ratios

Log-normal returns
If expectations are framed as simple expected nominal returns
(m) and volatility (s) these need to be translated if the lognormal distribution is being used:
= log

1+ m

! s $
&
" 1+m %

1+ #

2*
'
2
) ! s $,
&,
= log)1+ #
)( " 1+m % ,+

You cant just log the expected return and volatility!

Covariance
In bear markets and at times of heightened volatility
correlations across global equity markets tend to increase
This compromises the benefits of diversification
Regime switching models can allow for this effect directly
Global equity returns translated to $A have a market
component and a currency component
Australian equity correlation with the market component is
positive, but with the currency component is negative

Equity Returns Over Time

The P/E of the market tends to exhibit some stationarity
Exceptionally high and low P/Es tend to revert
The structure of equity prices over time is a stationary multiple
applied to earnings moving around a trend
This is different to a random walk as implied by the
assumption of log-normal i.i.d returns
Over a short-horizon (eg 1 year) not a significant issue
However over longer horizons (5-10 years) ignorance of this
dynamic may overestimate equity risk

How would we model this?

Australian Bank Bill and Bond Yields
12
10
Spread

Bank Bills

Yield %

8
6
4
2
0
-2
Jun-1994

Jun-1999

Jun-2004

Jun-2009

Jun-2014

Bond return distribution depends on yield level

Yield Curve Modeling (1)

Bond returns, especially when yields are low, are not well
described by log-normal i.i.d
They are a function of yield level and yield change (and the
duration of the portfolio)
But yields are not a random walk
They are anchored by inflation expectations
Inflation expectations have been very stable in the era of
effective inflation targeting by central banks
However there have also been major distortions in bond
markets over recent years due to eccentric monetary policy
(ie quantitative easing)
Ideally we want to model the yield curve through time

Yield Curve Modeling (2)

The Nelson-Siegel model

" 1 %
" 1
%

e
e
'' + c t $$
yt ( ) = l t + s t $$
e ''
# &
#
&
is the yield on a zero coupon bond at time t with
years to maturity
l t corresponds to the level of the curve at time t
s t corresponds to the slope of the curve at time t
c t corresponds to curvature at time t
is a constant, set at 0.7173 when , maturity, is
measured in years (or 0.0609 for months)

y ( )
t

Yield Curve Modelling (3)

The Nelson-Siegel curve has several convenient
properties:

As maturity tends to infinity the yield tends to a constant, l t

As maturity tends to zero the yield tends to l t + s t
Implied forward rates are always positive
It is parsimonious but flexible
The evolution of the yield curve through time can be
described by the time series behavior of level, slope and
curvature parameters

Yield Curve Modelling (4)

First-order vector autoregression

(f

) (f

= A

t1

Where

!
#
=#
t
#
#
"

curve

l
s
c

t
t
t

$
&
&
&
&
%

!
#
#
t = ##
#
#
"

noise

l
t
s
t
c
t

$
&
&
&
&
&
&
%

!
#
#
=#
#
#
#
"

$
&
&
&
&
&
&
%

Mean or
equilibrium

!
#
A =#
#
#
"

a
a
a

11
21
31

a
a
a

12
22
32

a
a
a

13
23
33

Yield curve
dynamics

$
&
&
&
&
%

Yield Curve Modelling (5)

The specification of the equilibrium curve is a judgement
call in the current environment
Over the last twenty years inflation targeting by the RBA
and other central banks has been effective
Pre-GFC bond yields averaged around 5.5% in current era
against an inflation target of 2-3%
How soon will we return to that regime, or has there been a
structural shift (eg reduction in trend growth) ?
Bond returns may be impacted by the gradual reversion to
a higher yield curve level
For example a 50bp lift each year over 3-4 years will
reduce returns by circa 2% below the yield (currently 3%)

Yield Curve Modeling (6)

Broader Linkages
The Nelson-Siegel framework can be applied to the global
environment whereby local yield curve parameters are
related to global bond yield curve parameters
For example if global bond yields shifted abruptly then that
should have a direct impact on Australian yields
Broader economic variables including inflation, output gap
etc can augment the vector autoregression

Currency (1)
Over the short term currency movements are unpredictable
However over the medium term (5-10 yrs) the concept of
equilibrium value (eg Purchasing Power Parity) is a popular
anchor of currency expecations
Currently Australias PPP is estimated at circa US$0.65 by
the OECD (2014)
Tests of currency stationarity are inconclusive there is no
strong reversion tendency back to PPP
Currency movements are less predictable, even in the
medium term, than they may seem

RBA model of real exchange rate based on

terms of trade and interest rate differentials

Note the width of the deviation band and the duration of significant deviations

Currency (2)
Sovereign bond yields differ due to sovereign risk
premiums (real yield component) and inflation expectations
These differences will carry across to equity market
expectations (R = Bond Yield + ERP)
Inflation differentials in theory will drive medium term
currency adjustment (eg if Australias inflation is higher than
the global average then the $A will tend to weaken)
Generally avoid blending currency forecasts with market
forecasts (eg global equities) other than to recognise
inflation differentials
Eg If the local currency equity expectation is 7% for global
equities, and Australia inflation is 1% higher then the $A
translated return expectation might be 8%

Australian Economic History and Inflation

The Australian economy has experienced a number of distinct phases post
WW2
High inflation at the time of the Korean war (high wool price, terms of
trade boost, increased demand) falling back until the early 1960s
recession
A low inflation Long Boom from early 1960s to the early 1970s
Extreme inflation in the mid 1970s due to oil prices and local wage
increases
Recurrent stagflation from mid 1970s to late 1980s with persistent high
inflation and sluggish growth
A low inflation environment since the recession of the early 1990s
The structure of the economy has evolved significantly over this period.
How relevant is economic history?

Over this period modeling inflation looks easy

AR(1).

Australian Inflation Experience 1950-2013

35

Up until 1990

30

1991 onwards

Frequency

25
20
15
10
5
0
2.5%

5.0%

7.5%
10.0%
12.5%
Annual Inflation Rate

15.0%

17.5%

Low and stable inflation is a relatively recent phenomenon. Why?

The 1980s deregulation and the modern

economy
The structure of the economy changed in three important ways
The floating of the dollar (1983). Global financial markets became a
discipline on domestic economic policies
Relaxation of capital flows so businesses and banks could freely borrow
and invest overseas. Some L plate accidents in the late 1980s.
Recommitment to tariff reduction/elimination. Imported goods became
cheaper and import price competition became constant. Local costs of
production improved with cheaper inputs. Global inflation trends became
more relevant to domestic inflation.
With these changes the management of the economy has been
transformed. Prior inflation experience would have been different under this
framework. A more flexible labour market has also been very important.

Terms of trade and inflation

A rise in the terms of trade, other things being equal, can cause an
inflationary demand surge through higher domestic incomes
However the Australian dollar tends to move sympathetically to the
terms of trade creating an offsetting deflationary effect. This mechanism
was not available prior to the currency float of 1983.
Hence the 1950s inflation spike
Terms of trade/currency impact on inflation depends on whether the
currency overcompensates or does not move enough
Over time a floating currency should ameliorate the inflation
disturbance of the terms of trade in a commodity based economy

Monetary policy and inflation (1)

Inflation integrity matters with a floating currency and a small open
economy
Rampant demand can quickly create a current account deficit as
imports rise faster than exports
In the Balance of Payments a Current Account Deficit must be
balanced by a Capital Account Surplus (equity or debt inflows)
If a current account deficit is offset by sharply increasing foreign debt,
global financial markets may lose confidence in the currency
A currency crisis is a hard landing option, better avoided
The Reserve Bank is therefore focused on targeting inflation and
dampening demand when necessary with higher interest rates
Controlled inflation supports stable growth

Monetary policy and inflation (2)

The inflation targeting framework has been highly effective over the
past twenty years false confidence?
Inflation expectations have been well anchored since the early 1990s
recession
But inflation has not been challenged by significant supply side shocks
(eg energy prices or food prices) over that period
With demand driven inflation the objectives of the RBA in regard to
prices and output are aligned
With a supply side shock (eg energy prices), inflation may increase, but
output may be weak so monetary policy is conflicted
It is tempting to understate inflation risk by extrapolating past success
at inflation targeting

Strategic Asset Allocation

The conventional approach is to resolve a Strategic Asset
Allocation (SAA) for a fund based on its liability profile
(ALM) or risk definition (AO)
The SAA implemented passively, as far as possible, can be
an important performance benchmark
Actual asset allocation may differ due to market drift or
deliberate asset allocation deviations from the SAA
Investment governance should be explicit about
permissible ranges around the SAA

APRAs requirements under SPS-530

18. An RSE licensee must, when determining an appropriate
level of diversification for each investment strategy:
a) identify the risk factors, and sources of return with
which the risk factors are associated;
b) where the strategy includes multiple assets and/or
classes, identify how sources of returns are expected
to interact, the variability in these interactions and the
impact of these interactions on the overall
diversification of the strategy in different market
conditions;

APRAs requirements under SPS-530

By investment risk factors, APRA refers to equity risk
premium, credit spreads, maturity premium,
macroeconomic risk, illiquidity etc
The idea is that various asset classes will be exposed to
several of these factors (eg leveraged infrastructure may
be exposed to all of these)
This factor perspective will lead to a better understanding
of risk and return than traditional asset class allocation
This ambition not followed through in SPG-530
But still a good way to think about diversification

Dynamic and Tactical Asset Allocation (DAA, TAA)

Superannuation funds over recent years have increasingly
indulged Dynamic Asset Allocation (DAA)
This is meant to adjust for short and medium term views
that differ from long-term views on which SAA is based
To make this activity respectful it is vaguely differentiated
from Tactical Asset Allocation which is more fidgety
Where an RSE licensee also employs tactical asset
allocation, APRA expects an RSE licensee would be able to
demonstrate clearly the differences between dynamic and
short-term tactical asset allocation decisions where both
are used SPG-530

Is Tactical Asset Allocation (including DAA)

successful?
Blake, Lehmann, Timmermann (1999) Asset Allocation Dynamics and
Pension Fund Performance Journal of Business Vol 72, Issue 4
9 years of monthly data (1986-94) for 306 UK pension funds across 8
asset classes
Concentrated funds management industry with top 5 fund managers
accounting for 80%
For over 75% of pension funds tactical asset allocation detracted from
performance
The evidence suggests the rewards to dynamic/tactical asset allocation
are questionable.
However its easy to demonstrate enthusiastic tactical asset allocation
adds significantly to active risk.

Setting Strategic Asset Allocation

Mean-Variance Optimisation (MVO) is an asset only
concept but relevant in Asset Only contexts such as
superannuation investment options
MVO is based on a simplified asset return model
Extremely sensitive to expected return assumptions
Black-Litterman, previously discussed, is a substantial
improvement
Simulation approaches can use more sophisticated asset
return models

Setting Strategic Asset Allocation (2)

Strategic Asset Allocation Constraints
Nature of liabilities and funding
Risk tolerance
Investment horizon (ie long or short term)
Income versus capital preference
Tax (how are income and capital taxed)
Liquidity
Regulations (is borrowing allowed?)

Setting Strategic Asset Allocation (3)

Defining asset classes
Assets within an asset class should be homogenous
Asset classes should be mutually exclusive
Asset classes should be diversifying (ie imperfectly
correlated)
Asset classes should span investment opportunities
Asset classes should be practically liquid
Are Alternatives, including infrastructure, private equity, and
hedge funds, an asset class?

Setting Strategic Asset Allocation (4)

Asset/Liability Modeling simulates assets and liabilities
Where liability valuation is based on bond yields, the
modeling of yields needs to be realistic
The variable of interest changes from asset return to
surplus of assets over liabilities (eg Assets/PBO)
Assets that hedge liabilities in this context (eg bonds)
become risk free, so optimal portfolios are reshaped
Variables examined will include risk of funding shortfall,
volatility of surplus, variability of contributions

The importance of asset allocation

Most of the volatility of portfolio returns over time is due to asset
allocation, rather than security selection
For this reason investment options for superannuation funds (eg
growth, diversified, balanced, conservative) are differentiated by
strategic asset allocations
However in practice there is much interest in whether performance is
better than a passive implementation of the strategic asset allocation
A similar question is Why did Fund XYZ underperform the median of
other funds last year? (eg comparing funds diversified options)
The varying significance of asset allocation in answering these
questions is different to its role in calibrating portfolio return volatility
The importance of Strategic Asset Allocation, WB ,is often falsely quoted
as justification for Dynamic/Tactical Asset Allocation (WP-WB)

Australian Super pre-mixed investment options

Managing asset allocation around the Strategic

Asset Allocation (1)
Perold and Sharpe, Dynamic Strategies for Asset Allocation, FAJ Jan-Feb
1988
How to respond as market movements change the asset allocation
Constant mix rebalancing (CMR) sells the outperforming asset class and
buys the underperforming asset class
CMR is effective, and enhances performance, when markets oscillate
without trend
Usually operates after a threshold of drift is breached
However if an asset class trends (equities in a bull market) CRM will
underperform buy and hold

Managing asset allocation around the Strategic

Asset Allocation (2)
An alternative to CMR is Constant Proportion Portfolio Insurance (CPPI)
With CPPI the proportion in risk assets is a function of how far assets
have appreciated above a floor value (eg risk free accumulation)
A CPPI strategy sells risk assets as they fall and buys risk assets as they
rise
A CPPI will outperform buy and hold if markets trend strongly, but will
underperform if markets oscillate without trend.

Constant Mix Rebalancing

After the break

Maginn, Tuttle et al Managing Investment Portfolios

Chapter 5. pp 286-295 (Group P)
Ahlgrim et al Modelling Financial Scenarios Sections 1-3

56