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2018 | Book

Hedging Potential Liabilities of Foreign Reserves Through Asset Allocation Read chapter Read first chapter

Advances in the Practice of Public Investment Management

Portfolio Modelling, Performance Attribution and Governance

Editors: Narayan Bulusu, Dr. Joachim Coche, Alejandro Reveiz, Francisco Rivadeneyra, Prof. Vahe Sahakyan, Dr. Ghislain Yanou

Publisher: Springer International Publishing

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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About this book

This book covers the latest advances in the theory and practice of public investment management. It includes the most up-to-date developments in the implementation of public asset management – including multiple contributions on portfolio allocation in varying interest-rate and credit-risk environments. Other highlights include implementation, performance attribution and governance issues surrounding reserves management, portfolio construction techniques appropriate for public investors and an in-depth discussion of the challenges to achieving international diversification.

Table of Contents

Frontmatter

Foreign Reserves Management Strategies: Implementation, Performance and Governance

Frontmatter
Chapter 1. Hedging Potential Liabilities of Foreign Reserves Through Asset Allocation
Abstract
One of the most important objectives of holding foreign reserves is to cope with a balance of payments crisis. The liquidity required during periods of crisis defines the potential liabilities of a foreign reserves portfolio. This chapter proposes an asset allocation approach that takes into account a country’s foreign liabilities and its volatility. A reserve adequacy measure allows an estimation of the liabilities. The portfolio is divided into two tranches: an asset-liability tranche and a long-term investment tranche. For the asset-liability tranche, benchmark construction attempts to hedge the liabilities of foreign reserves. For the long-term investment tranche, asset-only optimization allows the construction of a portfolio with the objective of maximizing returns. We propose a framework for Colombia but that is applicable to any other country.
Daniel E. Diaz, Julián David García-Pulgarín, Cristian Porras, Marco Ruíz
Chapter 2. Setting the Appropriate Mix Between Active and Passive Management in the Investment Tranche of a Foreign Reserves Portfolio
Abstract
Among the crucial questions a central bank faces when establishing an investment tranche of a foreign reserves portfolio are (1) should the investment tranche be subject to active management? (2) If it should, what is the appropriate mix of active risk and benchmark risk that maximizes the achievement of foreign reserves objectives? This chapter aims to overview the first question by reviewing the sources of alpha suggested by Merton (Foundations of asset management goal-based investing the next trend. MIT Finance Forum, MIT Sloan, 2014) and defining their relevance in a central bank’s foreign reserves context. The second question is answered by suggesting that maximizing the expected value of the logarithm of wealth (Kelly criterion) is superior to other approaches such as that pioneered by Treynor and Black (Journal of Business 66–86, 1973) in selecting the portfolio mix between active and passive.
Daniel Vela Barón
Chapter 3. A New Fixed-Income Fund Performance Attribution Model: An Application to ECB Reserve Management
Abstract
We present a novel framework to attribute the excess returns obtained by fixed-income portfolio managers to typical active strategies: (1) duration, (2) curve, (3) spread, and (4) security selection. We apply this model to the group of reserve managers in charge of investing the European Central Bank’s (ECB) official reserves in US dollars, worth around USD43 billion, in the period 2006–2010. We find that, among the performance layers, the spread contribution seems the most relevant; curve and duration bets, with some exceptions, have provided small value addition. Our analysis supports the view that portfolio managers adopt diversified investment styles. This may also explain the non-negligible excess returns of the aggregate reserve portfolio, averaging 10 basis points on an annual basis, net of transaction costs.
Francesco Potente, Antonio Scalia
Chapter 4. Sovereign Wealth Fund Investment Performance, Strategic Asset Allocation, and Funding Withdrawal Rules
Abstract
We examine the relationship between sovereign wealth funds’ (SWFs) investment performance and funding withdrawal rules. The heterogeneity of the underlying policy purposes in establishing SWFs and their legal organizations and governance structures, including the operational and investment management arrangements, determine to a large degree their performance. Recent macroeconomic difficulties in commodity-based SWF owner countries demonstrate the need for strong SWF operational frameworks and management to avoid a fiscal gap-filling function that would inevitably result in compromises in SWF investment performance. Our analysis indicates that over the past decade, several savings and pension funds that adopt robust governance structures and operational frameworks, as well as support diverse strategic asset allocations (SAAs), have performed better than stabilization, strategic, and other reserve investment funds.
Michael G. Papaioannou, Bayasgalan Rentsendorj

Asset Allocation and Interest Rate & Credit Risk Environment

Frontmatter
Chapter 5. A Macro-Based Process for Actively Managing Sovereign Bond Exposures
Abstract
We propose a macro-based yield-curve model for actively managing sovereign bond portfolios. Based on inflation and gross domestic product (GDP) growth expectations and an assumption of the central bank’s policy response function, we project the evolution of the sovereign yield curve. To address constraints on the lower bound of policy rates, we apply the concept of a shadow short rate that is unconstrained by the lower bound. The properties of the model are illustrated for the US, German, UK, and Japanese bond markets. We show that this approach—for naïve assumptions on the evolution of macro variables—has statically significant excess return predictability. Excess return predictability improves with improvements in the quality of inflation and GDP growth expectations.
Jacob Bjorheim, Joachim Coche, Alex Joia, Vahe Sahakyan
Chapter 6. Carry On?
Abstract
We analyse whether portfolios of high-carry developed market government bonds provide better risk-adjusted returns compared to low-carry portfolios and a measure of broad market returns. Carry-based portfolio strategies are assessed in three settings: (1) cross-market for specific maturities, (2) cross-curve for specific markets, and (3) cross-market and cross-curve. Our results show that carry can provide a meaningful predictive signal, but with a varying degree of power and with dependence on the selected sample period. Generally, we observe evidence for time-varying compensation for risks related to carry strategies, and more specifically, that carry strategies appear to underperform in periods of broadly rising interest rates. Overall, our verdict on carry is a little more nuanced than results found in recent studies.
Joachim Coche, Mark Knezevic, Vahe Sahakyan
Chapter 7. Short-Term Drivers of Sovereign CDS Spreads
Abstract
This chapter presents large-scale estimated models, one for each country, representing factors driving changes in credit default swap (CDS) spreads of 35 sovereigns. I estimate the models and test their robustness using data from July 2005 to July 2016. The set of eligible explanatory variables comprises indicators of the state of the global economy and of the domestic economic conditions, and proxies for risk premia. I find that not only the S&P 500 variable is pervasive across the countries, but also that the estimated S&P 500 coefficients are higher in magnitude for emerging markets than developed countries.
Marcelo Yoshio Takami
Chapter 8. Long-Term Expected Credit Spreads and Excess Returns
Abstract
We estimate long-term expected credit spreads and excess returns for multiple US corporate bond ratings and maturities and extend the findings of Giesecke et al. (Journal of Financial Economics, 102(2), 233–250, 2011). We develop a risk-neutral valuation model and correct the credit spreads for the well-known “credit spread puzzle”. We calibrate the model on data from 1919 to 2014, which is much longer than used in most other papers analyzing expected credit spreads and excess returns. Our model-implied expected credit spread term structures are in line with the results in the literature.
Erik Hennink

Portfolio Construction

Frontmatter
Chapter 9. Regime Identification for Sovereign Bond Portfolio Construction
Abstract
Traditional asset allocation algorithms do not typically incorporate regime-specific information to construct optimal portfolios. In this chapter, we introduce a state-dependent investment strategy based on a set of indicators that we believe are useful in identifying economic and financial regimes and apply it to a universe consisting of four of the most important and liquid developed government bond markets: the United States, the United Kingdom, Germany, and Japan. The results show that portfolios optimised across regimes have properties markedly different from those optimised using conventional asset allocation approaches. The findings may indicate that the regime-optimised allocations are exposed to an additional risk factor that, when priced, could give rise to an expected excess return over standard mean-variance portfolios.
Santiago Alberico, Joachim Coche, Vahe Sahakyan, Omar Zulaica
Chapter 10. Benchmark-Relative and Absolute-Return Are the Same Thing: Conditions Apply
Abstract
Recent market turmoil and the prospect of higher interest rates will have reminded many investors of the benefits of an absolute-return investment strategy, which aims to avoid losses when markets turn down. Some, however, are constrained by investment guidelines that force them to use a market benchmark. This chapter sets out a framework for relating absolute-return and benchmark-relative portfolio construction and demonstrates that, under certain conditions, these two very different strategies can actually result in identical portfolios. This is of particular use for public institutional investors who must stick to a benchmark-relative approach for governance reasons, but would like to have the capital protection in bear markets that an absolute-return strategy seeks to provide.
Robert Scott
Chapter 11. Factors and Sectors in Asset Allocation: Stronger Together?
Abstract
This chapter compares and contrasts factor investing and sector investing and then seeks a compromise by optimally exploiting the advantages of both styles. Our results show that sector investing is effective for reducing risk through diversification, while factor investing is better for capturing risk premia and so pushing up returns. This suggests that there is room for potentially fruitful combinations of the two styles. Presumably, by combining factors and sectors, investors would benefit both from the diversification potential of the former and the risk premia of the latter. The tests reveal that composite strategies are particularly attractive; they confirm that sector investing helps reduce risks during crisis periods, while factor investing can boost returns during quiet times.
Marie Brière, Ariane Szafarz

Asset Classes for Public Investors

Frontmatter
Chapter 12. The Impact of Benchmark Investing by Institutional Investors on International Capital Allocations
Abstract
We analyze how the use of well-known benchmark indexes affects both international portfolios and the investment of mutual funds across countries. Extending the analysis in Raddatz et al. (Journal of International Economics 413–430, 2017), we illustrate the different channels through which benchmarks affect international capital allocations. Redefinitions of benchmarks directly impact capital flows through the reallocations in the fund weights. Moreover, there is a direct relation between benchmark weights and how funds react to inflows and redemptions. Because the sensitivity of country flows to fund flows is mediated by the benchmark weight, the use of benchmarks can generate amplification and contagion effects across countries. We show algebraically the presence of these direct, sensitivity, amplification, and contagion effects; describe them through various examples derived from the data; and quantify their importance.
Claudio Raddatz, Sergio L. Schmukler, Tomás Williams
Chapter 13. Equity Markets Integration and Active Portfolio Management
Abstract
This chapter’s goal is to present an argument to support long-term portfolio deviations from the benchmark in equity portfolios to enhance risk-adjusted returns, in the face of financial integration. Diversification opportunities are identified by selecting the least co-integrated equity market indices by country (regionally) and by industry (globally) using co-integration tests. Then, portfolios are constructed by altering the weights of the least co-integrated countries or industries vis-à-vis the benchmarks. Finally, those portfolios’ performance is compared to MSCI indices benchmarks to illustrate the benefits of diversification due to absence of co-integration, as they exhibit improved risk-return characteristics. Further research is suggested to deepen the reasoning behind the patterns of co-integration, as well as implementation of the technique by active equity managers due to liquidity considerations.
Gabriel Petre, Olga Sulla, Daniel Vela Barón
Chapter 14. Government Bond Clienteles and Yields
Abstract
We document the effects of investor preferences for bonds with particular characteristics on their yields. Using a unique security-level dataset on institutional investors’ monthly holdings of Government of Canada bonds, we study the relationship between the net purchases of investors with different investment mandates and bond yield changes. We find considerable heterogeneity in the impact of net purchases and yield changes, depending both on the type of investor and on the duration of the bond. This provides support for the notion that different segments of the bond maturity spectrum are “inhabited” by particular types of investors and that their investment mandates partly determine the nature of the interaction between their purchases and yields.
Jianjian Jin, Francisco Rivadeneyra, Jesús Sierra
Backmatter
Metadata
Title
Advances in the Practice of Public Investment Management
Editors
Narayan Bulusu
Dr. Joachim Coche
Alejandro Reveiz
Francisco Rivadeneyra
Prof. Vahe Sahakyan
Dr. Ghislain Yanou
Copyright Year
2018
Electronic ISBN
978-3-319-90245-6
Print ISBN
978-3-319-90244-9
DOI
https://doi.org/10.1007/978-3-319-90245-6