Central Bank of Egypt
I. Portfolio Management
Choices
Prepared & Presented By:
Abdelhamid Mortagy
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Investment Philosophy
4000
• The value of $1invested
in the S&P 500 from
1926 to 2008 would have
grown around 4000 times
vs 100 times only if
invested in Bonds.
3500
3000
2500
S&P 500
2000
Bond
Market
1500
1000
500
0
1926
March 2014
Abdelhamid Mortagy
2008
Central Bank of Egypt
Considerations in Investment Philosophy
• Market Timing (TAA)
• Inefficiency
• Illiquidity
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Investment Management
There are THREE main decisions in IM:
1.
2.
3.
Active vs. Passive
Internal trading vs. External Managers
In-house selection team vs. Consultants
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Management: Decision Tree
Strategic Asset Allocation
Investment Management Activity
Active Management
Passive Management
Externally
Managed
Internally
Managed
Externally
Managed
External
Consultants
Internal
Advisory Team
External
Consultants
March 2014
Abdelhamid Mortagy
Internally
Managed
Internal
Advisory Team
Central Bank of Egypt
Active Management alpha drivers:
1.
2.
3.
4.
5.
6.
Market Inefficiency
Illiquidity
Leverage
Skill
Contrarian Thinking
Long term time horizon
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Active Management Value Proposition
1. Active Management can add value to a portfolio.
2. It requires an ability to identify external managers who can
generate future excess returns.
3. Exploring new investment strategies
4. Exploring new asset classes
5. Bringing new ideas at every stage of the investment
process
6. Provide training
7. Provide business contacts.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Internal Trading vs. External Managers
• . Diversification is a major benefit for the portfolio
Diversification limits the probability of extremely
negative outcomes.
March 2014
Abdelhamid Mortagy
External Portfolio Management:
Central Bank of Egypt
• The Activities of the External Managers Desk are as follows:
Activities
1. Mission and Governance
2. Asset Allocation
3. Risk Budget
4. External Managers selection process
5. Definition of Managers Guidelines
6. Legal Documentation
7. Compliance and Reporting
8. Risk Management
9. Portfolio Monitoring
10. Custodian Selection
11. Accounting and Back Office
• The level of complexity of these activities increases with the
complexity of the portfolio construction
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Cost/Benefit: Internal vs. External Managers
Cost/Benefit Analysis
Benefits of Using External Managers
Costs of Using External Managers
1. Intensive Investment Strategies
1. Difficult to control due to more risk
2. Best practice in the market
2. Requires significant experience in managing external
managers
3. Reduce staff turnover risk
3. No need for technical build up capability in selecting the
single investments
4. Minimizing infrastructure costs
4. Slows down the opportunity of implementing changes
in the portfolio
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
II. Active Management
Considerations
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
SAA for external managers
•
Strategic Asset Allocation (SAA): A portfolio of global assets that meets
a pre-specified investment objective (ALM)
•
Steps in deciding on the strategic asset allocation
1. Setting objectives and deciding on the acceptable amount of risk
2. Choosing eligible asset classes
3. Determining allocation to each asset class
4. Selecting benchmarks that reflect the performance of each asset
class
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Objectives and Horizon
• As a Central Bank our OBJECTIVE is:
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk Tolerance
– Translating concerns of decision makers
into quantifiable statistics.
– Risk tolerance should reflect an
institution’s ability to take risk and the
current operating environment.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Types of Portfolios
P1
P2
P3
Expected Return
3.85%
5%
2.65%
Expected Real
Return
1.35%
2.5%
0.35%
Standard
Deviation
1.81%
4.19%
1.62%
90% VaR
0%
-1%
0.70%
95% VaR
-1. %
-2.7%
0%
Prob (r<0)
10%
14%
6%
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Portfolio construction
• Most common approach employed by institutional investors and asset
managers to determine optimal portfolios is mean variance optimization
• Mean variance optimization is a procedure that helps an investor find the
portfolio that maximizes expected return for a given level of risk
• Key assumption: returns are normally distributed
• Inputs:
– Expected return of each asset class
– Standard deviation of each asset class
– Correlation of returns between asset classes
• Output:–The efficient frontier, i.e. the set of portfolios with the highest
expected return for a given level of risk
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Review of the SAA decision
• What are the factors driving an SAA review?
Internal factors: changes in objectives, liquidity situation and liability
structure could alter the risk-bearing capacity of the institution
External factors: changes in market conditions or the market
environment (e.g. level of yields) and changes in capital market outlook
could alter the risk and return profile of the policy portfolio
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Appropriate Benchmarks
What is a Benchmark ?
• An independent rate of return forming an objective test of the
effective implementation of an investment strategy.
– Starting point for portfolio construction
– Yardstick for measuring and attributing the success of active or passive
management
– Pre-requisite for effective risk control
What makes an Appropriate Benchmark?
• Reflect the institution’s long-term risk return profile, embodied in the
SAA
• Expressing the appropriate SAA through selecting the right BM
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Benchmark Process
Key Inputs
Investment Objectives
Risk Tolerance
Strategy Asset
Allocation
Capital Market Assumptions
March 2014
Abdelhamid Mortagy
Investment
Benchmarks
Central Bank of Egypt
From SAA to Benchmarks
• Meeting the SAA requirements
– Currency Composition
– Eligible Asset Composition
– Target Duration
– Eligible Maturity Range
– Liquidity Requirement
• Setting Benchmark Rebalancing Rules (MONTHLY)
• Other Considerations in constructing the benchmark
– Source of the benchmark (BARCLAYS)
– Choice of the providers (ML)
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Source of the Benchmark
• A benchmark may take any of the following
forms:
– A well recognized published index
– A tailored composite of indexes
– A peer group of similar funds or
managers
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Characteristics of a Good Benchmark
1. Transparent (names and weights of securities)
2. Investible (investible securities)
3. Measurable (returns )
4. Appropriate (represents the manager’s style
5. Specified in advance (evaluation)
6. Availability of historical data and index characteristics
7. Coverage
8. Documentation
9. Data Access
10. Relationship Management
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
III. Portfolio Construction
principles
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Understand The Benchmark
• The benchmark is the output of the asset allocation
process and is an input in the portfolio
construction and manager selection process.
• An analysis of the selected benchmark is useful to
understand:
– types of risks
– types of skills
– possible replication
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Understand The Benchmark
•
Understand its risk components of the BM. Different
asset classes, potentially included in your benchmark,
have different risk/return profiles.
•
The required managers’ skills set is a function of your
benchmark
•
Exploring passive investment alternatives will allow:
 A fair evaluation of managers returns
 The implementation of structures
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Understand The Benchmark
Understanding how the benchmark can be passively replicated is important for:
• evaluate the performance of the active managers
• explore the possibility of specific investment alternatives
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Database Search
• Finding the best managers for you?
• Building an internal database is the starting point of the
portfolio construction and manager selection process
– Search the available information
– Select and clean the data
– Keep the database updated
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Database Search
• The internal database construction is an ongoing
activity necessary for:
• Monitoring the portfolio:
• Evaluate existing and potential new managers:
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Portfolio Profile
•
•
What type of managers are we going to select?
Different alternatives:
1.
2.
3.
•
•
•
Active managers
Combination of specialized active managers
Portable alpha strategies
evaluate against the benchmark
evaluate against one of the benchmarks sub components (
area, sectors, etc..)
combine both the qualitative and the quantitative
evaluation in your decision making
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Portfolio Profile
•
Flexibility in the guidelines, increases the probability of
achieving better risk adjusted returns
•
specific legal documentation can be required to access certain
instruments or markets ( Dodd-Franc and EMIR)
•
broader due diligence
•
Detailed guidelines are important in limiting downside
potential
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Portfolio Profile
• Including a greater number of managers in the portfolio should result
in a lower volatility of the overall excess returns
• Increasing the number of managers also reduces the probability of
achieving very high excess returns
DON’T PUT ALL YOUR EGGS IN ONE BASKET
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Conclusion
1.
2.
3.
4.
5.
Understanding the benchmark
Database search
Portfolio composition
Flexibility in the guidelines
Optimal diversification
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
IV. Key Risk/Return Indicators
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Indicators Overview
Quantitative analysis:
• provides a framework for evaluation and
comparison of a large set of managers
• most efficient method to screen out managers that
do not meet investor’s minimum requirements
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Indicators Overview
• Risk-adjusted Performance
Risk-adjusted performance indicators evaluate the manager’s ability to
generate excess return, taking into account risk exposure as well.
• Consistency
The goal of consistency indicators is to demonstrate the degree to which
managers have stable and sustained performance combined with low
volatility.
• Downside Risk
Downside risk exposure metrics evaluate the manager’s ability to
protect the investment against losses.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk-adjusted Performance
•
•
•
•
Alpha
Information Ratio
Sharpe Ratio
Sortino Ratio
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk-adjusted Performance
• Alpha: A measure of the active return on investment. It
assesses an active manager’s performance and is
calculated as the return in excess of a benchmark index.
March 2014
Abdelhamid Mortagy
Risk-adjusted Performance
Central Bank of Egypt
• Information Ratio:
– The ratio of the excess return of a portfolio to its tracking
error
– Measures active return per unit of risk.
– Very helpful in comparing managers with different returns
and different risk levels.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk-adjusted Performance
• Sharpe Ratio
– A measure of the manager excess return over the riskfree rate per unit of risk.
– It is calculated as the manager’s return minus the riskfree rate, divided by the absolute standard deviation of
the portfolio.
– Used to characterize how well the return of an asset
compensates the investor for the risk taken.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk-adjusted Performance
• Sortino Ratio
– The ratio of excess return to downside tracking error. It is designed
to differentiate between ‘good’ and ‘bad’ volatility.
– Provides a risk-adjusted measure of portfolio performance without
penalizing it for upward price changes.
– Helpful when volatility is not symmetrical.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Consistency
•
•
•
•
Tracking Error
Hit Ratio
Absolute Range
Longest Outperformance
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Consistency
Tracking Error
• A measure of how closely a portfolio follows the index to
which it is benchmarked. It is calculated as the standard
deviation of the difference between the portfolio and index
returns.
• It is also called active risk as it measures the variability in
alpha.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Consistency
Hit Ratio
• The percentage of time a manager outperformed the
benchmark historically.
Hit Ratio
Alpha
Goldman PIMCO
52%
31%
0.05%
0.16%
Which Manager do you prefer?
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Consistency
Absolute Range:
– The absolute difference between max monthly loss and max
monthly gain. A measure of return dispersion.
– It gives an indication of the magnitude, but not of the direction of
the move.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Consistency
Longest Outperformance
Maximum number of consecutive months with positive excess return.
Longest Outperformance
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
•
•
•
•
•
•
Downside Tracking Error
Average Loss
Maximum Loss
Longest Underperformance
Maximum Drawdown
Longest Recovery Period
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Tracking Error
Downside Tracking Error
– Standard deviation of excess returns below the average excess
return. A measure of downside volatility.
– If returns are symmetric, it is proportional to total tracking error.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
Average Loss
The average of negative excess returns over the entire specified timeperiod.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
Maximum Loss
• The most negative excess return over a specified time-period.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
Longest Underperformance
Can you see the longest underperformance period?
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
Maximum Drawdown
– The largest cumulative loss from peak to trough over a period of time.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Downside Risk
Longest Recovery Period:
The longest period (e.g. months) it took a manager to recover a loss.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Summary
• Evaluate a manager against your investment
objectives.
• Comparison among managers.
• Consistency or downside risk protection.
• Give an insight into the manager’s track record.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
V. Qualitative Due Diligence
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
General Guiding Principles
• Due Diligence is an ART:
– Do not fall in LOVE with:
• The manager
• The performance
• The strategy
• Stick to the PROCESS.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
General Guiding Principles
You need to be:
•
•
•
•
•
•
An Investment Professional
A Risk Manager
A Lawyer
An Auditor / Forensic Accountant
Management Consultant
Psychologist
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
General Guiding Principles
Meet with everyone that could add value:
•
•
•
•
•
•
Portfolio Manager
Strategists
Risk Manager
Back Office Staff
Business Client Service
Traders and Front Desk
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Due Diligence Approach
Business and Organization
Risk Management Process
Business
Portfolio
Staff
Risk
Factors
Risk
Monitoring
Measures
Infrastructure
Investment Process
Experience
+ Edge
Operational Due Diligence
Sources of Risk
& Return
Trading
Market
Manage Themes Trades
r
Opportunity
set
March 2014
Idea Generation
Portfolio
Portfolio
Construction
P&L
Cash
Portfolio
NAV
Trading
Abdelhamid Mortagy
Pricing
Action
Central Bank of Egypt
Due Diligence Approach
• Examine firm processes
• Consistency with manager statements
• Consistency with other processes
• Consistency across time
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Business & Organization
Examples of General Business Risks:
•
•
•
•
•
•
Corporate culture versus investment team culture
Future business plans and your product
Products of the firm and your product
Growth rate of assets under management
Compensation structure versus market
Unstructured business decision making process
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Business & Organization
Staff (RED FLAG) :
•
•
•
•
High turnover rate
High DeMotivation
Lack of cooperation between the team
Running the business is lead by Portfolio Managers
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Business & Organization
Infrastructure (RED FLAG) :
•
•
•
•
No front –back office system
No automated pricing source system
No disaster recovery plan
No portfolio management system
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Investment Strategy
Experience
+ Edge
Market
Opportunity
set
March 2014
Manager
Sources of Risk
& Return
Themes
Trades
Idea Generation
Abdelhamid Mortagy
Portfolio
Construction
Portfolio
Trading
P&L
Central Bank of Egypt
Investment Strategy
1.Opportunity Set :
Ask the manager what is the best environment for his strategy
2. Manager Edge:
Manager’s style of managing risks is an edge.
3. Investment Process & Idea Generation:
Understand the process & examine how trades are being structured.
4. Portfolio Construction:
Check historical portfolios & Understand the risks in the concentrated
positions and sectors.
5. Trading:
Is there a separation between PM and trader? How does the trader
the rest of the team? Any Chinese walls?
interact with
6. Sources of Risks and Returns:
Understand all the sources of risks and their allocation in the different
territories and sectors.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Major types of risks
•
•
•
•
•
•
•
Liquidity Risk
FX Risk
Basis Risk
Concentration Risk
Credit Risk
Counterparty Risk
Interest Rate Risk
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
VI. Investment Guidelines
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Benchmark and Return Objective
Define risk/return preference:
•
•
•
•
Investment objective
Used Benchmark
Excess return target.
Tracking error limit.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Eligible Instruments
Define flexibility:
•
•
•
•
•
•
•
•
Govi
Agencies
CP
Municipal
Supras
Corps
MM Funds
Derivatives
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Portfolio Risks
Define credit preference:
•
•
•
•
•
•
•
•
•
Credit quality
Credit Concentration
Duration Risk
Currency Risk
Credit Risk
Liquidity Risk
Diversification Criteria
Asset Exposure
Counterparty Exposure
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
VII. Management Fees
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Road Map
• Performance Fees vs. Flat Fees
• Fees in the Alternative Asset Classes
• Factors in Fee Negotiations
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Performance Fees vs. Flat Fees
•
Standard Flat Fee based on AuM:
$
First 15 Mio
Next 20 Mio
Next 25 Mio
Next 30 Mio
Next 35 Mio
Thereafter
BP
50
40
30
20
10
5
How much would you pay for a portfolio of $ 100 million AuM?
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Factors in Fee Negotiations
• The name recognition of the plan sponsor
• The larger the size of the mandate
• The smaller size of the money manager.
• The shorter the track record of the money manager
• The worst the track record of the money manager.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
VIII. Monitoring External
Managers
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Keep asking these questions
•How is the portfolio doing?
•How are the managers in the portfolio doing?
•What to do with an out/under-performing manager?
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
How is the manager doing?
Analysis required for answering this question:
• Quantitative:
–
–
–
–
Return & risk
Return & risk attribution
Ranking
Service level and Relationship
• Qualitative:
–
–
–
–
Business risk
Key person risk
Market exposure
Some red flags: aggressive pursuit of AUM, change of ownership
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Return & Risk vs. Expectation
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Return Attribution
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Risk Attribution
• Risk attribution can be used together with return
attribution to evaluate a manager’s skill and
efficiency in generating excess return.
• To analyze Risk Attribution go back to the
Quantitative Analysis section and start creating
your map.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Manager Ranking
1.Alpha ranking
2. IR ranking
Alpha Attribution Ranking: measures the active
return on investment from different alpha sources. It
assesses an active manager’s performance and is
calculated as the return in excess of the benchmark
index.
Information Ratio Ranking: measures excess return
of the portfolio to its tracking error. It measures active
return per unit of risk.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Qualitative Issues
• Business risk
• Trading style change
• Key person risk
• Market exposure
• Some red flags:
– Aggressive accumulation of AUM
– AUM exceeds capacity of a certain strategy
– Change of ownership
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
IX. Governance
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Outline
• Principles of Good Governance
• Delegation of Authority and Accountability for decisions
• Governance
• Policy making is key to managing external managers
• IMA
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Principles of Good Governance
• Clear delegation of authority
• Informed policy making
• Oversight based on quantitative and qualitative
performance indicators.
• Internal controls
• Transparency
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Governance
• Governance is the process of exercising fiduciary duties
• Central Bank of Egypt is responsible for setting the benchmark, the risk
budget for active management and the investment guidelines specifying
the types of strategies and limits the external managers are allowed to
invest.
• Asset managers are agents who invest based on delegated authority and
instructions
– Benchmark performance is the responsibility of the CBE
– Portfolio performance relative to the benchmark is the
responsibility of the external manager.
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
Policy making is key
RMU
Board
Proposes SAA strategies with
different risk/return profiles
Endorses SAA
Proposes benchmarks
Endorses benchmark
Propose risk allocation vs Passive
Endorses risk allocation
Reviews SAA
March 2014
Abdelhamid Mortagy
Central Bank of Egypt
IMA
1. The Investment Management Agreement
specifies the legal rights and obligations of
each party and defines the objective of the
mandate
2. The benchmark.
3. The risk budget or tracking error target and
limits on investment strategies relative to the
benchmark.
4. Custodian of the assets
5. Fees.
March 2014
Abdelhamid Mortagy