Reference Portfolio Research Articles

Comment on “Public Pension Fund Management: Best Practice and International Experience”

Rozanov (2015) tries to answer the question of what are the important issues for improving pension fund management? I think that important issues are related to pension design, pension governance, investment management, and collaboration strategies. Rozanov focuses on a little bit of pension design, but is mainly devoted to pension governance and investment management. Rozanov's investigation succeeds quite well because his coverage of pension governance issues and investment management is well documented and well selected from the main stream of the pension management revolution over the past 20 years. I would like to focus on his proposals for the Japanese Government Pension Investment Fund (GPIF) because as the deputy chairman of the GPIF's investment committee I am responsible for designing the reform plan for the GPIF now and in the future. Rozanov proposes two steps: first, applying the 12 principles of best practices and investment philosophy framework summarized in Table 1 to evaluate the current state of affairs at the GPIF, and second demonstrating a long-term vision that Japan's reformers can bring to GPIF. His recommendations are similar to my suggestions to the GPIF and the Japanese government. Mission clarity with full stakeholder commitment A highly competent investment function with clear responsibilities and accountability Appropriate resourcing of each element in the investment process and governance chain Strong and effective leadership at the board level (chairman) and the executive (chief executive officer) Clear and meritocratic procedures for nominating, selecting, and evaluating board members Effective compensation practices An investment philosophy rooted in strong beliefs and enjoying fund-wide support A clear and shared understanding of the institution's comparative advantages and limitations A risk budget aligned to fund goals and incorporating an integrated view of “alpha” and “beta” Utilizing flexible decision-making systems that function in real time Effective use of external managers via clear mandates, aligned goals, and rigorous evaluation Developing a learning culture focused on change and innovation Rozanov recommends the Canada model for three reasons: compelling risk-adjusted, net of cost, long-term returns on a large asset base; classic pension fund liability profiles; and the importance of investments in domestic markets. I agree with his recommendation because of these three points. Rozanov also shows five important characteristics of Canada model: operational autonomy and board independence; a high degree of delegation and investment management flexibility; direct investment by internal teams in less liquid, private market assets; the opportunity cost model and reference portfolio; and leadership in innovation. His points are also right. Rozanov also suggests starting first with Norway model, mainly a traditional asset portfolio, then moving to the Yale/Australia Future Fund model, a well-diversified portfolio with a small number of investment staff, and finally moving to the Canada model with a well-diversified portfolio, a large number of staff and strong internal investment capabilities. This suggestion might be right, but I would like to suggest a path that is a little bit different from the one that Rozanov suggests. The most important first steps by the GPIF would be the separation of the oversight and execution functions, and the establishment of an independent and expert board of trustees. If we can establish a board of trustees independent from the government, everything will change dramatically. As Rozanov (2015) correctly points out, “the fund's investment style and strategy its governance budget: all else being equal, institutions that can bring in trustees with higher levels of expertise, more time to spend on governance, and a stronger commitment to work collegiately to a common goal should be better positioned to run more sophisticated and more effective investment programmes.” Governance issues matter a lot. Rozanov also correctly points out that the size and the quality of leadership will be important for better pension governance budgets. Finally, Keith Ambachtsheer, who is my mentor with respect to pension governance and who was the chief advisor to the reform commission of the Ontario State Teachers' Pension Plan in 1990, pointed out that the most important issue of pension governance is the establishment of an independent and expert board of director.

Application of multifactorial market-timing models to assess risk and effectiveness of equity-linked insurance funds in Poland

Traditionally, models developed by Treynor and Mazuy (T-M) and also by Henriksson-Merton (H-M), which are called market-timing models, are applied to assess effectiveness of investment funds. The objective of the presented study is an application of the T-M and H-M models and their T-M-FF and H-M-FF modifications with additional Fama-French factors to assess effectiveness and risk of equity insurance connected with unit-linked insurance. Estimation and verification of the models for the subject group of equity funds were performed and the significance of the impact of particular factors on returns on reference portfolios was discussed.

Application of Multifactorial Market-timing Models to Assess Risk and Effectiveness of Equity-Linked Insurance Funds in Poland

Abstract Traditionally, models developed by Treynor and Mazuy (T-M) and also by Henriksson-Merton (H-M), which are called market-timing models, are applied to assess effectiveness of investment funds. The objective of the presented study is an application of the T-M and H-M models and their T-M-FF and H-M-FF modifications with additional Fama-French factors to assess effectiveness and risk of equity insurance connected with unit-linked insurance. Estimation and verification of the models for the subject group of equity funds were performed and the significance of the impact of particular factors on returns on reference portfolios was discussed.

Outperforming markets: IC and the long-term performance of Japanese IPOs

This article studies the effects of disclosure practices of Japanese IPO prospectuses on long-term stock performance and bid–ask spread, as a proxy for cost of capital, after a company is admitted to the stock exchange. A disclosure index methodology is applied to 120 IPO prospectuses from 2003. Intellectual capital information leads to significantly better long-term performance against a reference portfolio, and is thus important to the capital market. Further, superior disclosure of IC reduces bid–ask spread in the long-term, indicating that such disclosures are important in an IPO setting. Analysts and investors can attain higher long-term returns by understanding IC.

A model based on Copula Theory for sustainable and social responsible investments

In this paper, a model is proposed that allows us to obtain a portfolio made up of sustainable and socially responsible (SR) investment funds. This portfolio tracks the one that investors might have chosen if they had not taken into account social, ethical and ecological (SEE) issues in their investment decisions. Therefore, in the first stage, reference portfolio exclusively made up of conventional funds is obtained. For the construction of the conventional portfolio the Prospect Theory has been used: net profits as the financial objective and error function as the utility function. In the second stage, a portfolio consisting exclusively of SR-funds is built. To do so, the reference portfolio is used as an ideal point, with the objectives of the SR-investor being the relative wealth with respect to the reference portfolio and the SEE quality of the portfolio. The relative wealth will be manipulated by a downside-risk measure, the Conditional Value at Risk (CVaR), and the periodic values of the portfolio. The second objective is the SR Quality of the portfolio, taking into account the personal values of a particular investor. This is built using Fuzzy Set Theory tools. We are faced with a multi-objective problem which is solved by using Goal Programming methodology. The estimation of both conventional and SR markets has been carried out by a semi-parametric approach by using the Copula Theory for modeling the dependence structure of the assets’ returns. The approach has been applied to a set of 38 conventional and 12 ethical funds domiciled in Spain.

Pricing equity linked annuities under regime-switching generalized gamma process

We propose a model for valuing equity linked annuity (ELA) products under a generalized gamma model with a Markov-switching compensator. We suppose that the market interest rate and all the parameters of the underlying reference portfolio switch over time according to the state of an economy, which is modelled by a continuous-time Markov chain. The model considered here can provide market practitioners with flexibility in modelling the dynamics of the reference portfolio. We price the ELA by pricing its embedded options, for which we employ the regime-switching version of Esscher transform to determine the pricing kernel. A system of coupled partial-differential-integral equations satisfied by the embedded option prices is derived. Simulation results of the model have been presented and discussed

Mathematical reserves in insurance with equity fund versus a real value of a reference portfolio

Mathematical reserves in insurance with equity fund versus a real value of a reference portfolio

Book Review. What Really Matters when Evaluating teachers? Lessons from Successful Education Systems

Book Review. What Really Matters when Evaluating teachers? Lessons from Successful Education Systems

Portfolio Optimization in the Financial Market with Correlated Returns Under Constraints, Transaction Costs and Different Rates for Borrowing and Lending

In this work, we consider the optimal portfolio selection problem under hard constraints on trading amounts, transaction costs and different rates for borrowing and lending when the dynamics of the risky asset returns are governed by a discrete-time approximation of the Markov-modulated geometric Brownian motion. The states of Markov chain are interpreted as the states of an economy. The problem is stated as a dynamic tracking problem of a reference portfolio with desired return. Our approach is tested on a set of a real data from Russian Stock Exchange MICEX.

The large homogeneous portfolio approximation with a two-factor Gaussian copula and random recovery rate

In this paper we consider the large homogeneous portfolio (LHP) approximation with a two-factor Gaussian copula and random recovery rate. In addition, we assume that the earlier the default occurs, the less the asset recovers; in other words, random recovery rate and individual default times have a positive rank correlation. Under the LHP assumption, the conditional cumulative loss of the reference portfolio is approximated by the product of loss given default and conditional default probability. In order to derive semi-analytic formulas for the loss distribution and the expected tranche loss, we use a Gaussian two-factor model and assume that the recovery rate depends on one systematic factor. In addition, we consider stochastic correlation for a better fit to credit default swap index tranches. The derived semi-analytic formula only involves integration with respect to the standard normal density and can be computed by Gauss–Hermite quadrature. Numerical tests show that the two-factor model with stochastic correlation and random recovery fits iTraxx tranche premiums better than other correlation or recovery assumptions under the Gaussian LHP framework. We also apply our model to credit risk assessment such as value-at-risk of the loss distribution.

Asset correlation in residential mortgage-backed security reference portfolios

This paper contributes to the literature about estimating asset correlation in two ways. First, we compare the performance of different estimation approaches in a simulation study. By doing so, we provide knowledge about the behavior of the applied estimators, which is an important precondition for the interpretation and robustness of the estimation results. Second, we present a novel data set from which to estimate asset correlation: the loss data of residential mortgage backed security (RMBS) deals. Our data set is largely made up of the most toxic RMBS deals that sparked the subprime crisis. Contrary to the widely held view, our analysis reveals that asset correlation in the subprime market is surprisingly low (roughly 6%). By giving an intuitive and straightforward explanation for these low values, we provide valuable insight into the mechanism and evolution of the subprime crisis in general, and into the risk characteristics of a credit portfolio in particular.

Modeling Life Expectancy at Birth for Multi-Population: A Cointegration Approach

The continuous improvements in mortality rates and life expectancy from the last century have been giving particular attention from academics, life insurers, financial engineers and pension planners, particularly in developped countries. Mortality-linked securities such as longevity bonds (EIB & BNP as well as Swiss Re bonds), survivor swaps or mortality forward (q-forward) have appeared recently in the industry to help operators hegding such risks. A classical survivor bond has been proposed in literature with coupons payment linked to life time of the last survivor in insurance reference portfolio. It appears therefore to be crucial to improve the accuracy of future life expectancy. In this paper, we investigate time varying dependency associated with common trends which drive regional life expectancy within Canada. We aim to compare the three main models appeared recently in literature such as Autoregressive Integrated Moving Average (ARIMA), Vector Autoregressive model (VAR) and Vector Error Correction Model (VECM), to analyse the common factors that have determined a progressive shift of life expectancy in six Canadian regions. The latter shows better performance over VAR and ARIMA in terms of backtesting and its ability to capture the dynamics of common life expectancy. Findings from these analysis are useful for local insurers and demographers in their goal to project life expectancy improvements and also to forecast future trends.

A recursive formula for a participating contract embedding a surrender option under regime-switching model with jump risks: Evidence from stock indices

This study proposes a recursive formula to value a surrenderable participating contract. To capture the dynamics of stock returns over expansion–recession cycles and the occurrence of catastrophic events, we assume the rate of return of the reference portfolio would follow a regime-switching model with jump risks. Our empirical results show that compared to the Black–Scholes model and the regime-switching model, the regime-switching model with jump risks can better explain the dynamics of the S&P 500 stock index. In addition, we give a recursive formula of a participating contract embedding a surrender option under a regime-switching model with jump risks. Sensitivity analysis shows that the changes of parameters of the regime-switching model with jump risks did influence participating contract premiums. The differences between valuations under the Black–Scholes model, the regime-switching model and the regime-switching model with jump risks suggest that it is critical to apply an appropriate model to value precisely a participating contract.

Substitution Costs in Managed Synthetic CDOs

Managed synthetic CDOs permit the dynamic substitution of credits in the reference portfolio. The expectation of investors in is that a skilled manager should be able to identify deteriorating credits before they experience a credit event and should therefore be able to remove the credit from the portfolio at a lower cost than the loss due to a credit event. This ability to substitute credits has a cost and in this paper we explain the source of this cost and calculate it across a wide range of CDO deal scenarios using a Gaussian copula correlation model. In deals where the cost is transformed into a change in subordination, we show that in it is possible to estimate this change without use of a correlation model. We also describe an extension of Vasicek's portfolio model that allows us to improve upon this estimate. We also incorporate the effect of transaction costs into the substitution cost and calculate their size across a range of CDO parameters. Our aim is to enhance transparency around the cost of substitutions.

Measuring fund style, performance and activity: a new style-profiling approach

We construct new measures of fund style, performance and activity from linear combinations of off-the-shelf stock-market indices. A fund's benchmark portfolio is a linear combination of two or more reference portfolios that in a least-squares sense most closely approximates the fund's portfolio. The resulting linear combination scalar is itself a measure of fund style and the distance between a fund and its benchmark is a measure of fund activity. Our approach has a number of advantages over existing characteristic-matching methods. We illustrate our approach using a data set of US institutional funds.

Mean–variance optimal portfolios in the presence of a benchmark with applications to fraud detection

We first study mean–variance efficient portfolios when there are no trading constraints and show that optimal strategies perform poorly in bear markets. We then assume that investors use a stochastic benchmark (linked to the market) as a reference portfolio. We derive mean–variance efficient portfolios when investors aim to achieve a given correlation (or a given dependence structure) with this benchmark. We also provide upper bounds on Sharpe ratios and show how these bounds can be useful for fraud detection. For example, it is shown that under some conditions it is not possible for investment funds to display a negative correlation with the financial market and to have a positive Sharpe ratio. All the results are illustrated in a Black–Scholes market.

Anatomy of ABS CDO: Why Do ABS CDOs Exist?

This paper investigates the ABS CDOs (Asset-Backed Security Collateralized Debt Obligations) market between 2005 and 2007 and answers the question of why ABS CDOs exist. The dataset used in this paper contains 516 ABS CDOs, 4,023 CDO tranches, and 79,724 securities used as the collateral of ABS CDOs. Using detailed collateral information on ABS CDOs, I find that there is a large re-securitization rate distinction between AAA- and non AAA-rated tranches. Less than 1% of AAA-rated subprime MBS tranches were used as collateral for cash flow ABS CDOs. In contrast, more than half of non AAA-rated subprime tranches were re-securitized through cash flow CDO.I also show that the reference portfolio of synthetic CDOs consists to a large degree of BBB rated subprime mortgage backed securities. As a notional amount, $94 billion out of $172 billion, which was the total collateral amount of synthetic CDOs, was comprised of BBB-rated subprime MBS tranches. It is evident that the synthetic CDO market deteriorated due to short demand in the housing sector, but there is no evidence that the cash flow ABS CDO market deteriorated between 2005 and 2007.

Contagion models a la carte: which one to choose?

We propose a copula contagion mixture model for correlated default times. The model includes the well-known factor, copula, and contagion models as its special cases. The key advantage of such a model is that we can study the interaction of different models and their pricing impact. Specifically, we model the default times of the underlying names in a reference portfolio to follow contagion intensity processes with exponential decay coupled with a copula dependence structure. We also model the default time of the counterparty and its dependence structure with the reference portfolio. Numerical tests show that correlation and contagion have an enormous joint impact on the rates of CDO tranches and the corresponding credit value adjustments are extremely high to compensate for the wrong-way risk.

Can habit formation under complete market integration explain the cross-section of international equity risk premia?

In this article, we analyse whether the prominent habit formation model of Campbell and Cochrane (1999) can explain the cross-section of the G7 equity risk premia when formulated under the assumption of complete capital market integration. We test the conditional covariance representation of the model using a combined GARCH and GMM approach in the spirit of Bali (2008) and find that in comparison to the CAPM and the standard power utility CCAPM the habit model has superior explanatory power. It explains more than 90% of the cross-sectional variation in risk premia. Overall, our findings suggest that global consumption-based recession indicators and not returns of reference portfolios are key risk factors driving equity risk premia.

Discrete dynamic model of portfolio optimization with risk and risk-free assets

This paper considers a discrete dynamic model of profit optimization with risk-free and risk assets. Optimal control strategy is defined by quadratic functional, minimization of which aims at three objectives: tracking of reference portfolio, minimization of investment at each step and maximization of the final income. The mathematical model is a linear‐quadratic discrete optimal control problem with control restrictions. By using the approaches proposed in the paper [1] and [2], we deduce necessary Pontryagin-type optimality conditions to obtain a closed form solution for the optimal control via conjugate variables. It enables us to reduce the boundary value problem to a finite system of linear algebraic equations. Mathematics Subject Classification: 65K10, 90C39, 49L20, 49N05