MSIM EDHEC Research Chair in Financial Engineering and Global Alternative Portfolios for Institutional Investors
By Lionel Martellini, PhD, Scientific Director of the EDHEC Risk and Asset Management Research Centre
Lionel Martellini
Most of modern asset pricing theory and portfolio selection analysis is based on so-called “fund separation theorems”, which in a nutshell advocate separate management of performance and risk control objectives. In the context of asset allocation decisions with liability constraints, it can be shown that the suitable expression of the fund separation theorem provides rational support for “liability-driven investment” (LDI) techniques that have recently been promoted by a number of investment banks and asset management firms. These solutions involve on the one hand the design of a customised liability-matching portfolio, the sole purpose of which is to hedge away as effectively as possible the impact of unexpected changes in risk factors affecting liability values (most notably interest rate and inflation risks), and on the other hand the design of a performance-seeking portfolio, the raison d’être of which is to provide investors with an optimal risk-return trade-off, without any constraints related to possible liability mismatch.
While the implementation of the liability-matching portfolio is relatively straightforward from a conceptual and technical standpoint, in particular when dedicated OTC derivatives such as inflation and interest rate swaps are available, the implementation of the performance-seeking portfolio requires further analysis, and standard practices based on security selection techniques in the presence of tight tracking error constraints with respect to commercial indices have been called into question. A new paradigm, known as core-satellite investing, has rapidly gained popularity amongst investors and consultants. This approach, which again can be regarded as a specific form of fund separation theorem, advocates on the one hand a focus on optimal management of factor exposures within a core portfolio so as to generate optimal access to rewarded risk factors, and on the other hand a focus on alpha generation within a satellite portfolio in an attempt to add skill-based performance benefits to further enhance the portfolio performance.
One outstanding question raised by this dual liability-driven investment and core-satellite portfolio construction approach is the introduction of alternative investment strategies and their impact on risk budgeting. The project for the first year of the Morgan Stanley Investment Management EDHEC research chair in Financial Engineering and Global Alternative Portfolios for Institutional Investors will involve Alternative Investments for Institutional Investors – Risk Budgeting Techniques in Asset Management and Asset-Liability Management
Alternative investment strategies such as hedge funds, commodities, real estate or private equity, can be particularly useful in both the core and the satellite components of the performance-seeking portfolio, where they can potentially bring beta and alpha benefits, respectively, but their impact on relative and absolute risk budgets has to be properly assessed. This first research project will focus on the design of dedicated financial engineering techniques aimed at allowing for sound management of risk budgets when alternative investment strategies are introduced into institutional investors’ portfolios. Our analysis will encompass the situation involving a leveraged investment in the liability-matching portfolio, in which case the natural benchmark for the performance-seeking portfolio is the funding rate, which in turn rationalises the introduction of absolute return strategies. We shall present both a static model for the management of these risk budgets through optimal allocation techniques, and a dynamic model, where risk constraints can be enforced though the introduction of dynamic allocation strategies.
Overall, particular attention will be given to the analysis of the formal relationship between risk management techniques used in asset management in the context of the performance-seeking portfolio design, and the standard risk indicators used in asset-liability management. Hence, we expect to show how implementing a sound portfolio construction process can induce a significant reduction in expected shortfall risk and/or the probability of severe surplus.
