Also ….
• provide source of government funding • providቤተ መጻሕፍቲ ባይዱ finance for specific government investment projects or to further government policy • develop capital markets
Efficient frontier
5% B
Mean Rate of Return
4% C 3% A
2%
1%
0 0 1% 2% 3% 4% 5% 6% 7%
Variance of Return
However this approach is simplistic
• returns are not normally distributed and variance is not the only measure of risk • the returns, variances and correlations are not known, and may change over time • does not have regard to the liabilities
Purpose of investment
• allow liabilities to be met as they fall due
– liquidity – matching
• aim to produce good return to minimise cost of benefits (or increase benefit levels) • control risks - diversification • provide security for members’ benefits • stabilise contribution rate
Classical asset allocation theory
• • • • • • optimisation of risk and return (Markowitz) there is a wide spectrum of possible portfolios rational investors select strategy on frontier… …to maximise return for given level of risk… …or to minimise risk for given level of return combine portfolio with risk-free assets to reflect acceptable level of risk • assumes asset returns are known and normally distributed
General principles
• • • • • assets should be appropriate to the liabilities diversification is needed to reduce risk… …between asset classes and within classes trade-off of risk and return correlations of risks and returns
Nature of liabilities
• identify the liabilities to which the investments relate • amount and timing • nominal or related to inflation • currency • degree of uncertainty in amount and timing • possible embedded options
STRATEGIC ASSET ALLOCATION
James Thompson Government Actuary’s Department United Kingdom
What is strategic asset allocation?
The efficient optimisation of investment allocation to major asset classes of investment in order: - to meet the overall investment objectives of the institution and - to achieve an acceptable balance between risk and return
Liabilities
• investments aim to allow the liabilities to be met • some more uncertain than others • promise to pensions or other cash benefits in future • promise to provide non-cash benefits such as healthcare • contingent liabilities, including catastrophe and fluctuation reserves
As opposed to tactical investment selection
• Tactical investment selection is the choice of individual investments in line with the chosen strategy • Both strategic and tactical decisions are important • But the strategy will often be the more significant determinant of performance