Feb 27, 2011

Gold: Risk or Rescue?

For those of you who are still doubting...we live in a crazy world....

The Dutch Central Bank (DNB) has ordered (by court !) the glass-workers pension fund (SPVG) to decrease its 13% Gold allocation to less than 3% within two months.

DNB and Court arguments in short:
  1. An investment of 13% is not in line with the Prudent Person Rule, which includes the principle that: assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.

  2. Gold is a commodity and holding 13%  is classified as 'overweight' in comparison to the 2.7% average that Dutch pension funds have invested in commodities.

  3. 15% allocation in Gold is a 'concentration risk' that could lead to a coverage shortage if the gold price imploded (volatility of Gold is relatively large).

At first, it seems unbelievable that important decisions, with substantial financial impact  - even in Court - are not based on financial facts, but on 'general principles' and the way the market 'used to do it'.

A decision based on an argument that refers to 'the average pension fund,' would more or less imply that pension funds would not be allowed to base their investment strategy on their own specific situation or a changing market outlook. Pension Fund Boards appear to be  'captured' by the market and a Supervisor who obviously has a hard time to develop 'own standards'....

Secondly, DNB actually takes over the investment responsibility of the pension Board. One could wander if DNB is (sufficiently) aware of the possibility that it can be hold financially responsible for the effect of a negative outcome if it turns out in the near future that SPVG has suffered a substantial financial loss, caused by this DNB-designation.

Is Gold really a risk?....  or a rescue?

Checking the facts.... 
Let's just check if DNB's and Court's arguments are valid.....

Yearly Return
We start by comparing the yearly returns of Gold, the S&P-500 Index and '10-Y Treasury Bonds' over the period 1971-2010.

To make Bonds risk-comparable with Gold and the S&P-500 Index, the yearly average Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in a specific year are valued, and sold at the average interest rate one year later (approximation).

Here is the result:

To bring some sense and order into this chart, we calculate the 'Moving Compound Annual Growth Rate' (MCAGR).
We start in 2010 and calculate the  compound average yearly return backwards moving up (year by year) to 1971. This is the result:

Now, this looks better... and a bit surprising as well!!! On the long term Gold (μ=9.2%) and the S&P-500 (μ=10.2%) are tending to a rough 9-10% yearly return......  A little bit Surprising is that Bonds (μ=7.6%) get along very well with their big risky brothers...
Take your time to 'absorb' the impact of this chart.....

Next, we take a look at Risk. We define Risk at first as the Standard Deviation (SD). We directly cut trough to the 'Moving Risk' (Moving SD).
We might conclude here that during recent years there was an increase of risk with regard to the S&P-500 (the 'red' crisis 'Mount K2' is clearly visible). Note that also for a longer period, i.c. the last 30 years, the S&P-500 Risk is substantial higher than the Risk of Gold and much higher than the Risk of Bonds. Only looking at a period of 40 years, Gold shows 'optical' up as more risky (SD=σ=25.8%) than the two other asset categories, Bonds (SD=σ=6.9%) and S&P-500 (SD=σ=18.1%).

However this way of presenting Risk is strongly discussable. Another view of Risk that comes closer to what we naturally 'perceive' as Risk, is to define Risk as only as the Downside Standard Deviation (look up : Sortino ratio ), where all positive yearly returns are eliminated (DSD) or set to zero (DSDZ).....
Let's have a look:
Now, these charts give us a quite a different sight on Risk-reality....
It shows that -on the long term -  not Gold (DSD=Dσ=7.5%) is the riskiest asset, but the S&P-500 (DSD=Dσ=10.6%). Bonds (DSD=Dσ=0.5%), as aspected, have the least volatility and are therefore less risky.

Perhaps the Risk of Bonds is a bit underestimated (very few observations) by the DSD-method (excluding positive yearly returns). In this case the downside deviation of yearly Bond-returns, replacing positive returns by zero, which generates a standard deviation of 3.2%, gives a better indication of a more likely standard deviation on the long run.

Why Gold? 
Although these simple calculations already put the DNB conclusions in a different light, let's get to the main point that should be addressed in defending why Gold should be a substantial part of any Pension Fund portfolio:
 Gold Reduces VaR

In a 2010 (october) publication the World Gold Council published a document called Gold: Hedging Against Tail Risk. This interesting report concludes:
  1. Gold is first and foremost a consistent portfolio diversifier
  2. Gold effectively helps to manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances such tail-risk events (VaR).
Following this excellent WGC report, let's test the balancing and risk-reducing  power of Gold by analyzing (classical) Risk (SD) in combining Gold with different allocations (0% up to 100%)  in an asset mix with Bonds, respectively investments in S&P-500 stocks.

This chart clearly shows that Gold has the power to reduce the S&P-500 Risk (SD) from18.1% to 13,3% with an optimal asset location mix of  approximately 60% S&P-500 and 40% Gold. 

In case of Bonds the Risk (SD) is reduced from 6.9%  to 4.8% with an optimal mix of 80% Bonds and 20% Gold.

Asset Liability Model (ALM)
In practice it is necessary to optimize, by means of an adequate ALM study, the  allocation mix of stocks, Bonds and Gold. Just as a 'quick & dirty' excercise, let's take a look at the next asset-combination scenarios, based on data over the period 1971-2010:
Just some head line observations:
  • From scenario M1 it becomes clear that even a 100% Bond scenario is't free from Risk. So diversification with other assets is a must.
  • Looking at M2-M5 we find that the optimal mix, defined as the mix that best maximizes Return (Compound Annual Growth Rate)  and Sharpe Ratio (at a Risk free rate of 3% or 4%) and minimizes Risk (Standard deviation), is something something in the order of: 70% Bonds, 15% stock and 15% Gold.
  • Scenarios M6-M8 and M9-M11 take todays most common (but strongly discussable!) practice as a starting point. Most pension funds have allocated around 50% or 40% to Bonds and 50% or 60% in more risky asset categories (stocks, etc.). It's clear that even in this situation Risk can be reduced and Return can be optimized, if Stocks are exchanged to Gold with a maximum allocation of 20% or 30%.

Although this 'rule of thumb exercise' on this website provides some basic insights, please keep in mind that finding the optimal mix is work for professionals (actuaries).

A serious ALM Study is always necessary and should not only take into account a broad range of diversified asset categories, but should also focus and optimize on:
  • The impact of the liabilities (duration) and coverage ratio volatility
  • The Timing: Mean values and Standard Deviations are great, but the expected return highly depends on the actual moment of  investment or divestment in the market.
  • Future expectations. In the current market situation (2011) the risk of interest rates going up and therefore Bond market value going strongly down, isn't hypothetical. Secondly, the stock market has been pumped up by trillions of 'investments' (?) in the US economy. Once this crisis-aid definitely stops, the question is if these 'cement investments' will be strong enough to keep stocks up. Personally I fear the worst...
    Not to mention a scenario with declining stock rates in combination with increasing interest rates and inflation......
    Who said the life of an actuary was easy???

We may conclude that:
  • Investing in Gold up to a 10% to 15% allocation, reduces the Risk of a portfolio consisting of Bonds and S&P-500 Stocks substantially. 
  • Gold is less Risky than investing in S&P-500 Stocks

Therefore the 'not with facts' underpinned intervention of DNB looks - to put it euphemistically -  at least strongly discussable....

A wise and modest underpinned allocation of Gold is no Risk, it's a Rescue!

Related Links:
- Spreadsheet with Data used in this Blog
- Prudent person Rule
- IPE: Dutch regulator orders pension scheme to dump gold
- Downside Risk:Sortino ratio
- Dutch Central Bank Orders Pension Fund To Sell Its Gold
- Pension Fund Benchmarking 
- Strategic Risk Managment and Risk Monitoring for Pension Funds

Bonus: Gold, Hedging against Tail Risk Video

Feb 22, 2011

Pension Fund Weigh House

Investment Benchmarking of Pension Funds has been made extremely difficult.

Just ask your Pension Fund's actuary whether your Pension Fund has achieved a 'market conform investment performance'... For sure you'll get a dazzling multiform and relative answer. It's all about 'market indexes' (stock and bond indexes), risk appetites, asset mixes, derivatives, uncertainty and lots of other interesting complex stuff that underpins the fact that the final answer to this simple question is nuanced, complex and relative.

A simple question
Ahead of all this growing complexity and 'levels of detail', a first key question has to be answered by every Pension Fund:

Was it worth setting up a complex multi fund investment plan instead of simply investing in 10-Years Government (Treasury) Bonds over an arbitrary period of (at least) the last 10 years?

Even this simple question, will probably not lead to a simply answer from your fund's investment manager or actuary.

Pension Fund Weigh House Help
This is where the help of the 'Pension Fund Weigh House' comes in...

Just look up the yearly return over the last ten years in your Pension Fund's annual report. Next, do the test at 'Pension Fund Weigh House'  (PFWH) and see for yourself whether your Pension Fund has  performed better than the simple benchmark: 10-Y Bonds.

Did your Pension Fund perform better than Bonds? (the compound mean over the last 10 years) Congratulations!
Was it worth the risk? Well..., just look at the Risk (Standard Deviation) or - even better - the Sharpe Ratio at different levels of possible 'Risk Free Rates' to find out. The Higher the Sharpe Ratio, the more it was worth to take the risk.

Market Value
To compare Bonds 'fair' with Market Value based Pension Fund performance, the yearly Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in January of a specific year are valued, and sold at the interest rate one year later.

Do it yourself
The standard example as presented on PFWH concerns the performance of the Dutch pension fund ABP, the third largest pension fund of the world. Answer the key question 'Was it worth?' for ABP for yourself.

ABP (Pfd-R) Performance 2001-2010

Go to PFWH and change the numbers and 'heads' in the application to fit the numbers of your own (pension) fund or change both columns (Bonds & PFD-R) to compare two pension funds .
Compare your pension fund to either  '10-Y Euro Government Bonds', '10-Y US Treasury Bonds' or the 'S&P 500 Index'.

From now on you may answer this extremely difficult question "How did my pension fund perform?" yourself in a  5 minute weigh house test.

Have (professional) fun!

Feb 9, 2011

Dutch Pension Muppet Show

There's a lot of fuzz about the performance of the largest (€ 246 billion assets) Dutch Pension Funds ABP and the somewhat smaller (€ 91 billion) PFZW (former PGGM). According the Dutch television program Zembla and Bureau Bosch Asset Consultants, Dutch pension funds would have consistently underperformed.

ABP commented: "The yearly return of 7.1% on average since 1993 is much higher than returns on government bonds would have been and is in part thanks to our equity investments."

PFZW overshoots ABP wit the comment: "PFZW's calculations show a return of 8.4% on average during the past 20 years which is much higher than the 10-year Dutch government bonds of 5.3% on average during the same period."

Great statements, but who's right?

Performance Test
Let's quickly "do the proof" by comparing (benchmarking) the 'modest' yearly performance of ABP with the yearly performance of 10 year Government Euro Bond Yield Benchmark as provided by the ECB.

Both pension funds are not limited to  the Dutch market, therefore  performance is not related to Dutch Government Bonds, but to 10-Y Euro Government Bonds.

As the yearly performance of ABP in a particular year is in fact a kind of 'compound performance' of the years before, it's more realistic to relate ABP's (yearly) performance to the 10-years moving average of 10-Y Euro Bonds.  

What becomes clear from is that ABP's volatility overshadows the 10-year Bond's volatility by far. As a consequence ABP's out-performance should be significant.

Let's test this by looking at the YTD (Year To Date) performance of ABP on the long run:

The average performance of ABP 1993-2010 indeed turns out exactly 7.1% as published, but hardly outperforms the 10-year Euro Bonds Moving average of 6.8%.

0.3% '18-years out-performance' (OP-18) for such a high volatility is strongly discussable. The long term out-performance 1994-2010 (OP-17) was 0.0%. The out-performances of shorter periods (OP-[18-x]) are not stable and strongly swap from positive to negative.

Benchmarking Pension funds performance with Euro Bonds 0f 20 years or longer would be even more adequate and in line with the duration of pension fund's liabilities. Taken into account that 20 year Bonds on average score a 0.25% à 1.00% higher return than 10 year Bonds, it can be concluded that Dutch pension funds on average do not out-perform Government Bonds. Not to mention the influence of the yearly investment-costs of at least 0.2% on the returns.....

Pension Fund PFZW
Pension Fund PFZW is completely lost on their non-transparent and backwards changing performance of 8.4% over the last 20 years.
From their annual (inconsistent) accounts it can be concluded that their 2001-2010 performance came down to 4,8%. This performance is exactly the same as the performance op ABP in that period and underperforms the moving average 10-years Euro Bonds with 0.7% !!!

It's clear that pension funds don't convince in the outperformance of Government Bonds and that the pension industry is in desperate need for an impartial benchmark with regard to out or underperformance of Bonds.

The comments from ABP and PFZW, Boenders and Cocken are like 'shooting from the hip' and must be qualified as highly unprofessional.

Dutch pension fund members are watching an extra edition of the Muppet show. Who's gonna stop this pension media madness and bring some order in the pension room?

Related Links and Sources:

- Source: 10 year Government Euro Bond Yield Benchmark
- 'grave miscalculations' in Zembla (Boender aand Kocken
- Watch: Zembla 
- Download: Spreadsheet with calculations as presented
- IPE: Heavyweights ABP, PFZW come out swinging against Zembla
- Bloomberg: 10-year, - -  30-year performance Gv. Bonds

Feb 6, 2011

Solvency II: Standard or Internal Model?

Solvency II is entering the critical phase.Time is running out!

But...., as a wise proverb states:

"When The Actuaries Get Tough,
The Tough get Actuaries"

However, the market for actuarial resources is limited and Solvency II Actuaries that  combine strategic and technical knowledge with 'common sense' are like  white ravens.

In the case of Solvency II, actuaries and models are moving forward in a particular way.

Standard Model
Originally, the 'standard model' was foreseen as a simple model for small and mid-size insurers (apart from very small insurers that were excluded). Big insurers, with more developed actuarial models, larger scale and more resources, were expected to work out a more sophisticated 'internal model'.

As the Solvency II Time Pressure Cooker gets up steam, things start turning.

Small and mid-size insurers found out that the 'standard model' was highly inefficient and the wrong instrument to steer adequately on risk management and to determine adequate solvency levels in their company.

Just because of their limited size and product selection, small and mid-size insurers often already have a well tuned risk management system in place and implemented throughout the organization. The manager, actuary (being the risk manager as well) and CFO of such companies therefore have enough time to develop a formal Solvency II 'internal model' that could be easily implemented throughout their organization.

Internal Model
Quit the opposite happens in the world of big insurers.

Big insurers coordinated Solvency II at Holding level and started to challenge their business-units around 2009 to develop and implement Solvency II programs on basis of an 'internal model'.

Collecting homework at the Holding in 2010, it became clear that a lot of technical issues in the models were still unclear. Moreover, models were not integrated (= condition)  in the business and counting up several 'internal models' showed up several consolidated inconsistencies. 

The complexity of developing a consistent risk model turned out to strong. Some big insurers are now considering to fall back on the 'standard model' (or partial model) before it's too late: the shortest errors are the best.

Looking back it's not surprising that big insurers need more time to operationalize a fine tuned risk model. It took specialist Munich Re 10 years to implement an internal model.

This development is also an indication that some big insurers are strongly over-sized. In order to keep up with the speed of the market, big insurers have to be split up into a manageable and market-fit size.

Related Links:

- Surviving Solvency II (2010)
- The influence of Solvency II on an insurer’s strategic policy
- White Ravens and Black Swans (Math Fun)