QMS Advisors - Liability Driven Investments and Portable Alpha Solutions

Liability Driven Investments &
Portable Alpha Solutions:
Efficient Deployment of Capital to Alpha
Sources

Q M S Advisors
. .
Av. C.-F. Ramuz, 85 | 1009, Pully | CH
This material does not constitute investment advice and should not be viewed as tel: 078 922 08 77 | 021 711 40 89
a current or past recommendation or a solicitation of an offer to buy or sell any e-mail: info@qmsadv.com
securities or to adopt any investment strategy. website: www.qmsadv.com

Liability Driven Investments And
Portable Alpha Capability
Efficient Deployment of Capital to Alpha Sources

This material does not constitute investment advice and should not be viewed as
a current or past recommendation or a solicitation of an offer to buy or sell any
securities or to adopt any investment strategy.

LDI And Portable Alpha Capability

Approach

To assist Private and Institutional clients’ in structuring
TARGET optimal investment solutions by making efficient use of
capital to meet the following criteria

Improve plans’ funded ratio
Maintain stable contribution levels
Improve return per unit of surplus risk
Reduce drawdown risks
Quasi-costless beta exposure results in lower overall fees:
achieving a higher uncorrelated alpha/fees ratio

Q.M.S Advisors Av. C.-F. Ramuz, 85 | 1009, Pully CH | tel: 078 922 08 77 | 021 711 40 89 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 2

Profiting From New Constraints Originating From
Regulatory Changes
Catalyst
A new focal point for pension plans: liabilities’ sensitivities to interest rates
• Minimization of asset-liability mismatches to reduce interest rate risks
• Altering pension funds’ liability profile to minimize surplus volatility
Alternative strategies as the new main generator of returns
Pension plan managers’ reduced opportunity set and the new alpha imperative
• Transferring out of equity market overexposure to uncorrelated alpha
strategies
• Increased allocation to uncorrelated alpha vehicles: a necessity to help
reaching funding ratio requirements
Efficient asset allocation combined with active liability management
Hedge interest rate risks and cash-flow mismatches
Constrain equity market beta to the pension plan manager’s utility function
Increase exposure to uncorrelated sources of alpha
Introduce assets with built-in inflation hedges

Page 3


Approach

Model the dynamics of plans’ assets and liabilities in a simulation framework
Introduce levered instruments to extend duration, enhance curve duration and
convexity hedges to
Minimize asset-liability tracking error
Maximize information ratio
Apply Portable Alpha principles to allow for a flexible and efficient use of capital to
diversify across all sources of uncorrelated alpha
Optimal utilization of Plans’ Risk Budget
Assess the impact of introducing alternative investments to Defined Benefit plans’
assets and its implications on expected risks and returns in surplus space
Introduction of bespoke baskets of Alternative Investments

Page 4


LDI Implementation
Duration lengthening strategies can provide enhanced returns
Benefits to be had by leveraging duration exposure (assets’ parallel and twist
duration)
7.4

Portfolio 3
7.3
Portfolio 2
7.2
Total Return (% )

Portfolio 1
7.1

7

6.9

6.8
Current Portfolio
6.7
5.3 5.4 5.5 5.6 5.7 5.8 5.9
Surplus Risk (%)
Cash based instruments do not provide an appropriate venue:
Lack of long term bonds to match liabilities of ultra long durations
Liquidity intensive Solution (sub-efficient use of capital)
Derivative instruments: the capital efficient solution to mitigating interest rate risks
For illustrative purposes only

Page 5


LDI Implementation – Interest Rate Futures
The price of interest rates futures contracts are negatively correlated to changes in
interest rates; buying an interest rate future contract increases a portfolio’s
sensitivity to interest rates, increasing the total portfolio’s duration
An efficient instrument for duration management
Liquidity (Depth of the futures market)
Cost Effectiveness (Low transaction costs)
Duration Management
Specification of a duration target (Duration of the Plan’s liabilities or index)
Offsetting or hedging the Pension Plan’s existing interest rate exposure
• Introduces basis risk (between the liability exposure and futures price)
To minimize basis risks, Q.M.S’ methodology aims at hedging the changes in both
the level and twist of the yield curve
Simultaneously hedging the price response to both level and twist scenarios or
“Two Bond Hedge”, to provide further accuracy to the hedging strategy.

Page 6


LDI – Interest Rate Risk Immunization
Mitigating interest rate risks by
extending duration can allow for a EXAMPLE OF AN INTEREST Duration Full Liability
Risk Contribution -
more efficient use of the plan’s RATE RISK MITIGATION
Current Portfolio
Extension Driven Solution
STRATEGY Example Example
tracking error budget
Reallocation to uncorrelated Net Interest Rate Risk 66.2% 58.6% 0.0%
strategies with high expected Risk from Investment Policy 31.8% 39.0% 92.1%
Unhedgeable Liability Risk 2.0% 2.4% 7.9%
information ratios can help the Surplus Risk 14.0% 13.3% 10.8%
plan meet its objective Expected Return -1.0% -1.0% -0.6%

Risk Contribution - Current Portfolio Duration Extension
Duration Extension Full Liability Driven Solution

39.0%
39.0%
31.8%
7.9%

92.1%
66.2% Duration Gap: 0
2.0% 58.6%
58.6% 2.4%
2.4%

Net Interest Rate Risk Net Interest Rate Risk
Net Interest Rate Risk Net Interest Rate Risk
Risk from Investment Policy Risk from Investment Policy
Risk from Investment Policy Risk from Investment Policy
Unhedgeable Liability Risk Unhedgeable Liability Risk
Unhedgeable Liability Risk Unhedgeable Liability Risk

Duration Gap: 9.1 Duration Gap: 7.9 Duration Gap: 0

Page 7

Derivatives Overlay Program

CASH-BASED APPROACH OVERLAY-BASED APPROACH
Liability hedging: futures or swap
overlay strategy
The swap portfolio is managed as a
passive fund with the objective of tracking
Asset-liability and the liabilities via a portfolio of interest rate
asset management futures or swaps and inflation linked swaps
have to be
accommodated in
Asset management: active alpha
one process
generation
• typically achieved
through mix of high The manager can implement active
grade credit / strategies to their full extent
government bonds
The fund can be invested in asset classes
• Subject to limitations that are independent of the liabilities,
of cash market therefore providing better diversification
and increased investment opportunities

Overall risk adjusted return is improved

Page 8

Optimal Allocation of Active Risk

Defining the Optimal Active Risk Exposure
18% 100%

16% Total Required Risk 90%
(LHS)
14% 80%
Total Required Risk (%)

Equity Allocation (%)
70%
12%
60%
10%
Optimal Equity Allocation 50%
8% (RHS)
40%
6%
30%
4% 20%
Optimal Active Risk (LHS)
2% 10%

0% 0%
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
Active Risk Information Ratio
Required Total Risk (LHS) Optimal Active Risk (LHS)
Optimal Equity Allocation (RHS) Return / Risk

OPTIMAL ACTIVE RISK ALLOCATION:
Equity Market Beta and Total Active Risk Exposure As a Function of Active Risk Information Ratio

Page 9

Optimal Allocation of Active Risk

Portable Alpha Implementation: Optimal Allocation Of Active Risk

Transport alpha efficiently to virtually any asset class or market

Market Returns Alpha/ Skill Returns
Portfolio Returns =
= Benchmark Returns Value Added

Synthetic strategies allow for flexible and efficient use of capital when porting alpha

Long Index
Futures (= b) Fixed Incom e
Return on Index Total Absolute Return
Return 40% Strategy
Current + Alpha (= a + b) Long
on 10%
Long Alpha
Port- Portfoli
Index
Strategies (= a) Futures
folio o (= a + 20%
Beta + Overlay Managers
Rf) Equity 10%
Futures Return on 40%
Collateral (Rf) Collateral (Rf)

Improving portfolio efficiency by making optimal use of capital to increase active risk
For illustrative purposes only.
These materials do not contain any recommendation to buy or sell or a solicitation of an offer to buy or sell any securities or investment services. Q.M.S Advisors provides no determination of suitability or assurances or guarantees regarding the performance of any
investment or investment strategy. You are responsible for conducting your own independent investigation and analysis, taking into account your particular circumstances, before deciding upon a particular investment or investment strategy. Investments in certain
asset classes, including hedge funds, carry significant additional risks that you should consider prior to investment. You accept complete responsibility for any investment decisions you may make as a result of your use of this material.

Page 10

Formulation of Client-Specific Alpha Solutions:
Spectrum of Potential Sources of Alpha
Downward sloping strategies offer negative correlation to traditional 60/40 portfolios
Assessing the simultaneity of extreme values (tail dependencies)
Evaluating assets’ cyclicality and shifts in correlations
Dedicated a t e d S h o r t B ia s
D e d ic Short Bias ManagedM a n a g e d FFixed e s
Futures u t u r Income Arbitrage c o m e Ar b it r a g e
F ix e d In Multi-Strategy M u lt i- S t r a t e g y
Convertible Arbitrage
Informationo n
I n fo r m a ti
-0.17 -0 . 1 7 0.49 0.49 1.85 1.85 2.07 2.07
1.81
Ratio o
R a ti
4

25 4

4
2 3
10
20

2

F ix e d In c o m e A rbitrag e retu rn s (% )

C o n v e rtib le A rb itra ge re tu rn s (% )
D ed ic ated S h ort B ias returns (% )

2
15 0
M an a ge d F utu re s re turns (% )

M u lti-S tra teg y retu rn s (% )
5 1

10
0 0
-2
0
5 -1

-4 -2
-2
0
-5
-3
-6 -4
-5
-4
-10
-10
-8 -5
-6

-10 -8 -6 -4 -2 0 2 4 6 8 -10 -8 -6 -4 -2 0 2 4 6 8 -8 -6 -4 -2 0 2 4 6 -8 -6 -4 -2 0 2 4 6 -10 -5 0 5 10
60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%)

Global Macro Equity Market Neutral Emerging Markets Event Driven Long/Short Equity
Information
1.34 3.44 0.45 2.01 1.18
Ratio
20 6
4
25
20
15 4
20
3
2
10 15
10
E quity M ark et N eutral returns (% )

E m erging M ark ets returns (% )

0

Long/S hort E quity returns (% )
10
G lobal M ac ro returns (% )

E v ent D riv en returns (% )
2
5
-2
5
0
0 -4
1 0

-6 -5
-5 -10
0
-8 -10
-10
-20 -10 -15
-1
-15
-12 -20

-20 -30 -25
-2 -14

-10 -8 -6 -4 -2 0 2 4 6 8 -8 -6 -4 -2 0 2 4 6 -8 -6 -4 -2 0 2 4 6 -10 -8 -6 -4 -2 0 2 4 6 8 -10 -5 0 5 10
60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%) 60/40 portfolio returns (%)

Source: Credit Suisse First Boston/Tremont. Return calculations based on unadjusted CSFB/Tremont historical returns from Apr 1994 to May 2005. Bivariate return distributions modeled as mixture of multivariate Normal distributions.

Page 11

Formulation of Client-Specific Alpha Solutions:
Optimal Combination of Uncorrelated Sources of Alpha
Seek alpha managers with little or no beta Hypothetical Backtested Performance Analysis
exposure:
Evaluate each strategy’s potential exposure
to systematic risks and market cycles 8.0%
R2 = 0.0053
Include all explicit and implicit costs inherent

Current Portfolio in Asset-Liability space
6.0%
to alpha extraction
4.0%
Analyze interactions among alpha managers:
Define the origin of returns and risk for each 2.0%

source of alpha 0.0%
Identify risk and return relationships in -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%
-2.0%
different market cycles
Allocate active risk across uncorrelated sources of -4.0%

return for optimal diversification: -6.0%
The less dependent or correlated the assets,
-8.0%
the more the potential gains from
CS' Optimal Model Alpha Solution*
diversification.
Addition of uncorrelated assets results in a
reduction of portfolio-level volatility, thus
enhancing risk-adjusted returns

Page 12

Enhancing Portfolio Returns In A Risk Controlled
Framework By Introducing Uncorrelated Alpha
Efficient Redeployment Of Liquidity In Uncorrelated Active Risk

Historical Returns: Asset–Liability space Historical Risks: Asset–Liability space
4.0% 3.73% 6.1% 6.03%

Historical Portfolio Standard Deviation (%)
3.5% 3.35%
6.0% 5.98%
Historical Portfolio Returns (%)

2.98%
3.0%
2.61% 5.94%
6.0%
2.5% 2.24%
5.91%
2.0% 1.87% 5.9%
5.88%
1.50% 5.85%
1.5%
1.13% 5.9% 5.84% 5.83% 5.84%
5.83% 5.83%
1.0% 0.77%
5.8%
0.5% 0.40%
0.03%
0.0% 5.8%

30% of Fixed

60% of Fixed

90% of Fixed
ported to CS'

ported to CS'

ported to CS'

ported to CS'
0% of Fixed
notional ported

notional ported

notional ported

notional ported
30% of Fixed

60% of Fixed

90% of Fixed
to CS' Alpha

to CS' Alpha

to CS' Alpha

to CS' Alpha
0% of Fixed

Strategy

Strategy

Strategy

Strategy
notional

notional

notional

notional
Income

Income

Income

Income
Alpha

Alpha

Alpha

Alpha
Strategy

Strategy

Strategy

Strategy
Income

Income

Income

Income


Page 13

Defining An Optimal Uncorrelated Alpha Risk Exposure
To Reach Pension’s Risk Budget And Return Target
Efficient Redeployment Of Liquidity In Uncorrelated Active Risk

Porting alpha to traditional beta exposure Equity Exposure Risk-Return Frontier: Asset–Liability space
ensures additional diversification at the 4.0%
portfolio level, without significantly altering the
3.5%
original risk profile

Historical Returns (% )
The less dependent or correlated the 3.0%
assets, the more the potential gains from 2.5%
diversification
2.0%
Porting alpha drastically improves the
portfolio’s return per unit of risk 1.5%
Optimal allocation of active risk in surplus 1.0%
space : Addition of uncorrelated assets
0.5%
results in a reduction of portfolio-level
volatility, thus enhancing risk-adjusted 0.0%
returns 5.80% 5.85% 5.90% 5.95% 6.00% 6.05%
Historical Standard Deviation (%)

Page 14

QMS Advisors - Liability Driven Investments and Portable Alpha Solutions

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