Foundations of Asset Management: A Practitioner s Perspective

Transcription

1 Foundations of Asset Management: A Practitioner s Perspective October 2013 Robert C. Merton, PhD School of Management Distinguished Professor of Finance, MIT Sloan School of Management Resident Scientist, Dimensional Holdings Inc. Dimensional Fund Advisors Pte. Ltd. holds a capital markets services license for fund management serving accredited and institutional investors under the Singapore Securities and Futures Act. For institutional use and for informational purposes only. Not for use with the public. Robert Merton is an Advisory Board member of Dimensional SmartNest LLC, an affiliate of Dimensional SmartNest (US) LLC, which is an investment advisor registered with the US Securities and Exchange Commission. This document is for distribution in the People's Republic of China (excluding Hong Kong, Macau and Taiwan for the purpose of this document only, the PRC ) only to the specific investors that are expressly authorized under relevant laws and regulations of the PRC to buy and sell securities and other financial instruments or products in foreign exchange in the following circumstances which do not constitute a public invitation to offer, or a public offer or a public sale of the same or the provision of securities investment consulting or advisor services within the PRC, and should not be deemed public under relevant laws and regulations of the PRC: (i) no public media or other means of public distribution or announcement will be used within the PRC in connection with the delivery or distribution of this document; (ii) each of the above-described PRC domestic investors who receives this document is advised that redistributing or sending this document, in any way, to any third party (other than to its authorized advisers, counsels and/or representatives), or discussing any information contained herein with any third party (other than with its authorized advisers, counsels and/or representatives), by such qualified domestic investors is prohibited; and (iii) this document further does not constitute any securities or investment advice to citizens of the PRC, or nationals with permanent residence in the PRC, or to any corporation, partnership, or other entity incorporated or established in the PRC. Potential investors resident in the PRC are responsible for obtaining all relevant approvals from the government authorities of the PRC, including but not limited to the State Administration of Foreign Exchange.

2 Agenda Goal-based approach to investment management: setting the correct objective function Investment management process Only three primary ways to manage risk: diversification, hedging, and insuring Market portfolio: foundation of the optimal combination of risky assets (OCRA) Failure of the Capital Asset Pricing Model (CAPM) implies alpha exists relative to the passive market portfolio benchmark Sources of alpha: seeking to create superior performance over the market portfolio Potential sources of superior and sustainable investment performance Traditional alpha seeking versus financial services alpha seeking Traditional alpha seeking versus dimensional alpha seeking Functions served by asset management institutions as part of the financial ecosystem Innovation to help pursue comparative advantage in investment management 2

3 Goal-Based Approach to Investment Management A Solution-Focused Perspective Determination of the appropriate objective function for the portfolio before optimization Example: Liability-driven investing with the goal of repaying targeted liabilities according to a schedule, as in a defined-benefit pension fund. Example: A managed DC product where the goal is inflation-protected retirement income for life adequate to sustain the late-in-work-life standard of living. Example: Goal is four years of tuition and housing at a university within a selected classification beginning when each child is 18 years old. Example: Sovereign wealth fund goal derived from its role in an integrated A/L management perspective on meeting the overall economic goals set for the sovereign. 3

4 Functions of Sovereign Wealth Funds Although the management of sovereign wealth funds, currency reserves, and sovereign debt policy can be decentralized, the objective function from which the optimal policies for each are derived should reflect an integrated, comprehensive asset/liability management perspective on overall country risk exposures. The principal functions of the sovereign wealth fund are to facilitate a) the execution of intergenerational transfers and other intertemporal savings and b) efficient risk diversification and risk modulation for the country. The sovereign fund should generate the highest expected return for the risk taken. In effect, it should maximize its franchise value, subject to performing its principal functions. This can be done if it has the capability to generate alpha through superior investment skills of security selection and market timing. It can be done by performing financial services for which it has a competitive advantage, earning an above-competitive profit margin, based on its comparative advantages in credit-standing, long-horizon, lack of liquidity needs, reputational capital, and sponsorship value. 4

5 Integrated A/L Mgt: Government Risk Balance Sheet Determining the Objective Function for a Sovereign Wealth Fund Assets $ Bn Present Value of Incomes from: ### TAXES ### Income % Assets % Customs 1.1 ### Excise & GST % Motor Vehicles % Others-Tax Liabilities $ Bn Present Value of Non Discretionary Expenses on: SOCIAL DEVELOPMENT SECURITY & EXTERNAL RELATIONS ECONOMIC DEVELOPMENT GOVERNMENT ADMINISTRATION 70.7 ### FEES % Sales of Goods 4.9 1% Rental % All other Fees % SEIGNORAGE TBD 0% Balances of: INVESTMENTS Pension Fund ### Wealth Fund Balances of: MONETARY BASE GOVERNMENT DEBT OUTSTANDING Foreign Currency Local Currency PENSION LIABILITIES Contingent Claims (Implicit Guarantees) GUARANTEES TO BANKS AND NON-BANKS GUARANTEES ON RETIREMENT INCOME GUARANTEES ON SOCIAL WELFARE TBD TBD TBD TBD TBD TBD TBD CASH % INFRASTRUCTURE TBD General Balance (Economic Assets in excess of Economic Liabil TBD Government-owned Enterprises TBD TBD CURRENCY RESERVES REAL ESTATE TBD OTHER ASSETS 6.0 ### TOTAL TRUE Note: Economic Balance Sheet integrates central bank. TOTAL For illustrative purposes only. 5

6 Integrated Risk Balance Sheet Approach to Asset Allocation Determining the Objective Function for a University Endowment Assets Tuition: Undergraduate Tuition: Executive Education Endowment Alumni Gifts Grants Sponsored Research Publishing Real Estate: Commercial Real Estate: Residential Patents Liabilities Salaries: Tenure Faculty Financial Aid Energy Forward Tuition Contracts Other Liabilities Net Worth 6

7 Domain of Investment Management Stages of Production Process for a Given Investment Goal Passive Benchmark Market Portfolio Efficient Diversification Active Asset-Class Allocation Macro Sector Market Timing Non-CAPM Equilibrium Super Efficient Max Sharpe Ratio Portfolio of Risky Assets (Optimal Combination of Risky Assets) Optimal Mean-Variance Portfolio Combine with State-Variable Hedging Portfolios Alter Shape of Returns on Underlying Optimal Portfolio Structured Efficient Form of Returns to Client Superior Performing Micro Aggregate Excess-Return Portfolio Alpha Engines Components of Max- Sharpe-Ratio Risky Assets-Only Portfolio Diversification Risk Modulation Riskless Asset Portfolio Risk Modulation through Hedging or Leveraging Risky Portfolio Constrained Asset Holdings OCRA Market Timing Active Management (Derivative Securities Non-Linear Payoffs) Tailor payoffs to specific goal Risk Modulation with Insurance or nonlinear leverage Pre-programmed dynamic trading Building Block State-Contingent Securities to create specialized payout patterns Expropriation efficient Regulatory efficient Liquidity tradeoff Transaction cost efficient 7

8 Transform Shape of Payoffs from Investing in the Optimal Portfolio: Derivatives 8

9 Traditional Active Management Designed to Enhance Portfolio Performance Asset-Class Allocation: Macro-Sector Market Timing Long-Short combinations to change fractional allocations from Benchmark Weights ASSET CLASS BENCHMARK WEIGHT LONG (SHORT) INCREMENTAL REVISED WEIGHT Small-Cap Equity 5% +5% 10% Mid-Cap Equity 10% 0% 10% Large-Cap Equity 30% (10%) 20% Emerging Market Equity 15% (5%) 10% Domestic Fixed-Income 30% 5% 35% Real Estate 10% 5% 15% 100% 0% 100% Micro Excess Return Portfolio: Security Selection: Alpha Engines Engine #1 U.S. Risk Arbitrage Hedge Fund Engine #2 Technical Analysis of Equities Fund Engine #3 Fundamental Analysis of Equities Fund Engine #4 Foreign Currency Forecast Fund Engine #5 Private Equity Fund Engine #N Mortgage-back Security Relative Value Fund Security Analysis Technical Analysis Proprietary derivative-security Pricing Models Super-Performing Micro Aggregate Excess-Return Portfolio Optimal Weighting 9

10 Passive Market Portfolio Foundation for the Optimal Combination of Risky Assets Total Portfolio Risk-Return Portfolio Component Risk-Return S = Sharpe Ratio 10

11 Failure of CAPM Implies Alpha Exists for Market Portfolio Benchmark Sources of Alpha: Traditional Alpha, Financial Services Alpha, Dimensional Alpha Possible Reasons for CAPM Failure I. Empirical Deviations from CAPM Black, Jensen and Scholes (1972); Fama and MacBeth (1973); Fama/French (1992) II. III. IV. Market Information Inefficiency: Traditional Alpha Market Frictions: Affected by Technology, Institutions, and Regulation Institutional rigidities from regulation or charter/prospectus restrictions/requirements Taxes and accounting rules Leverage inefficiency; borrowing constraints Short-sale restrictions and cost Stock loan limitation and tracking requirements Other Dimensions of Risk besides Market Beta Hedging roles for securities in addition to diversification Uncertainty about the future investment opportunity set; i.e., changing interest rates, volatility and Sharpe ratio risks Uncertainty about human capital labor income Uncertainty about inflation and the menu of possible consumption goods in the future Uncertainty about relative prices of consumption goods; Uncertainty about liquidity Uncertainty about mortality and longevity V. More-Complete Equilibrium Asset Pricing Models: Multiple Betas and Risk Dimensions with Risk Premiums Where is the (theoretical) multiple-regression coefficient from regressing the return on security j on the returns on the m dimension portfolios, E1,...,Em Intertemporal Capital Asset Pricing Model (Merton 1973,1975) Arbitrage-Pricing Theory Asset Pricing Model (Ross 1976) Consumption-based Capital Asset Pricing Model (Breeden 1979) Fama/French 3- or 4-Factor Model (reduced-form model) 11

12 Traditional Alpha vs. Financial Services Alpha Traditional Alpha Seeking Depends on being faster, smarter, better models or better information inputs Is it sustainable? Is it scalable? Kenneth French, The Cost of Active Investing, Journal of Finance (August 2008) Compares the fees, expenses, and trading costs society pays to invest in the US stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980 to 2006, finds that investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society's capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980 to 2006 period if he switched to a passive market portfolio. Non-economic costs and benefits Financial Services Alpha: Financial Intermediation of Institutional Rigidities & Market Frictions Depends critically on being lightly regulated, with highly skilled professionals who can identify which rigidities are binding; diagnose which security prices are impacted by the rigidities; devise an efficient trading strategy to provide the other side of the trade to alleviate the impact of the rigidity on affected institutions; and earn an intermediation fee in the form of the excess return on the strategy. Other helpful but not essential advantages: strong credit-standing, long-horizon, flexible liquidity needs, large pool of assets, reputational capital, and sponsorship value. Is it sustainable? Is it scalable? Hedge funds have a comparative advantage vs. traditional intermediaries that define their functional purpose in the financial ecosystem. 12

13 Strategic Analysis of Financial Services Functions Served by Institutions Assessing and Pursuing Comparative Advantage of the Institution What are the functions served by the institution within the financial ecosystem? What are the comparative advantages of the institution? Have technological, regulatory, or market conditions changes created new opportunities for the institution s comparative advantages? Have technological, regulatory, or market conditions changes caused the institution to have a comparative disadvantage in performing any of its current financial functions in the future? How best can the institution implement its comparative advantages and exit from its comparative disadvantages to improve its performance? 13

14 Traditional Alpha vs. Dimensional Alpha In the CAPM equilibrium, the market portfolio is the OCRA for mean-variance investors, and those investors hold the same risky portfolio of assets. However, in more complete equilibrium models, investors use securities to hedge other dimensions of risk in addition to the overall market risk. So in general, investors will not hold the same proportions of risky assets, and thus the market portfolio will not be mean-variance efficient [aka OCRA], and the CAPM will fail. The existence of alphas relative to the passive market benchmark is entirely consistent with perfect-market and efficient-market conditions, and these alphas are long-run sustainable because these are risks that, on balance, investors are willing to pay a risk premium to avoid. While theoretical structural models suggest the potential identity of these other dimensions of risk, the search for these dimensions with alphas has been largely empirical, resulting in reduced-form models with surrogate dimensions and factors, rather than the actual structural ones. Well-known examples of factors that appear to have significant alphas over long time periods and across geopolitical borders are size of company [small large], ratio of book-tomarket value [high low], ratio of profits-to-market value, and possibly liquidity [low high]. Alphas from identified dimensions of risk with risk premiums are called dimensional alphas. 14

15 Relation Between Illiquidity Risk Factor and Hedge Fund Returns, A Case Study Exploring a Potential New Dimension of Risk Performance Attribution between Traditional Alpha and Dimensional Alpha STRATEGY ALPHA W/O LIQ. T-STAT ALPHA ALPHA WITH LIQ. T-STAT ALPHA Convertible Arbitrage 7.23% % 1.58 Dedicated Short -1.27% % 0.98 Emerging Markets 12.48% % 2.21 Equity Market Neutral 6.07% % 1.44 Event Driven 8.65% % 1.61 Fixed Income Arbitrage 9.47% % 2.07 Global Macro 10.98% % 1.08 Long/Short Equity 10.07% % 0.78 Managed Futures 4.10% % 1.82 Multi-Strategy 7.39% % 1.53 References: Chacko, G., S. Das, and R. Fang (2012): "An Index-Based Measure of Liquidity," Working Paper, Santa Clara University. Chacko, G., C.L. Evans (2012): "Liquidity Risk in Corporate Bond Markets," Working Paper, Santa Clara University. Past performance is no guarantee of future results. 15

16 Cumulative Returns Liquidity-Event Risk Portfolio Liquidity Premium Fund Net Asset Value Time References: Chacko, G., S. Das, and R. Fang (2012): "An Index-Based Measure of Liquidity," Working Paper, Santa Clara University. Chacko, G., C.L. Evans (2012): "Liquidity Risk in Corporate Bond Markets," Working Paper, Santa Clara University. Past performance is no guarantee of future results. 16

17 Innovation and Investment Management Efficient Implementation of Comparative Advantage Financial contracting technology permits the separation of risk-exposure selection and management from physical investment choices, capital expenditure plans, ownership, and governance of assets. Risk exposures can be radically changed without capital flows or investment. Investment management solutions should take full advantage of this technology in pursuing the client s objectives. Innovations in asset management and financial technology offer the prospect for achieving more efficient risk-return frontier risk allocations while addressing other goals. Innovation in using an integrated risk balance sheet approach to tailor asset allocation designed to provide a superior client performance. 17

18 Separating Risk Exposures from Cash Investments, Governance, and Liquidity Pursuing Both Comparative Advantage and Efficient Diversification Cash Holding Private Equity Portfolio Swap Contract Illiquid Cash Fund Portfolio Return = Public Equity Index + α + E Public Equity Index Counterparties LIBOR Fund Return = LIBOR + a + e Cash Holding Fixed Income Portfolio Swap Contract Diversified Fund Portfolio Return = Public Bond Index Bond Index Counterparties World Market Fund Return = World Market + a + e Cash Holding Local XYZ Portfolio Swap Contract Diversified Fund Portfolio Return = World XYZ World XYZ Counterparties World Market Fund Return = World Market 18

19 References Black, F., M. Jensen, and M. Scholes (1972), The Capital Asset Pricing Model: Some Empirical Tests, in M. Jensen, ed. Studies in the Theory of Capital Markets, Praeger. Breeden, D.T. ( 1979), An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities, Journal of Financial Economics, September. Chacko, G., S. Das, and R. Fang (2012), An Index-Based Measure of Liquidity, Working Paper, Santa Clara University. Chacko, G., and C.L. Evans (2012), Liquidity Risk in Corporate Bond Markets, Working Paper, Santa Clara University. Fama, E.F. and K. French (1992), The Cross-section of Expected Stock Returns, Journal of Finance, June. Fama, E F. and J. MacBeth (1973), Risk, Return, and Equilibrium: Empirical Tests, The Journal of Political Economy, May-June. Lo, A. (2001), Risk Management for Hedge Funds, Financial Analysts Journal, Nov-Dec. Merton, R.C. (1973), Intertemporal Capital Asset Pricing Model, Econometrica, September [Ch. 15 in CTF]. Merton, R.C. (1975), The Theory of Finance from the Perspective of Continuous Time, Journal of Financial & Quantitative Analysis, November. Merton, R.C. (1992), Continuous-Time Finance, [CTF], Blackwell, Revised edition. Ross, S.A, (1976), The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory. 19

20 Important Disclosure This presentation is strictly for information purposes only and shall not be used for any other purposes. All information in this presentation is given in good faith and without any warranty and is not intended to provide professional, investment or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this presentation, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional does not accept any responsibility and cannot be held liable for any person s use of or reliance on the information and opinions contained herein. 20