Pensions industry must use academia’s knowledge to create more imaginative solutions to global pensions crisis, argues Lionel Martellini. By Lionel Martellini. From asset management to risk-and-asset management”. Lionel Martellini has been Scientific Director and Director of Edhec Risk and Asset Management Research Centre since March

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Top Pension Funds Given overall pressure on funding rates and falling asset markets, looks set to be a year where good governance and adaptability to external events will be crucial.

Applying economics models to understand politics is like trying to use a trowel to saw a piece of wood in half. The lending environment is undergoing a worrying change.

Lionel Martellini

Funds liojel European direct lenders have raised but not yet deployed are at an all-time high and banks in most Western-European jurisdictions have renewed lending following years of reticence after the global financial crisis, leading to increased competition amongst lenders in the small and medium enterprise SME market.

Alternative risk premia strategies can be helpful for institutional investor portfolios through diversification and risk reduction. September Magazine By Lionel Martellini. For many decades, the industry has focused on a single source of added-value: Given the difficulty in delivering added-value through security selection only, the old paradigm has been questioned.

In particular, the marte,lini on adding value through security martdllini has somewhat distracted the industry from another key source of added value: Today, the industry is witnessing a shift in perceived added-value – there is an emerging consensus about the need to move away from stand-alone asset management products towards risk and asset management solutions that can address investors’ needs through customised dynamic asset allocation strategies.

One critical advance in risk and asset allocation techniques has been made possible by the work of Robert Mertonwho extended portfolio construction techniques beyond the static setting, and has shown how to solve dynamic portfolio optimisation problems using the dynamic programming approach. A key academic insight is that there is a deep correspondence between pricing and portfolio problems.

On the one hand, asset pricing problems are equivalent to dynamic asset allocation problems. On the other hand, dynamic asset allocation problems are equivalent to asset pricing problems: From a practical standpoint, dynamic allocation strategies allow for the maximisation of investors’ long-term objectives while respecting a number of short-term – self-imposed, accounting, or regulatory – constraints.

One key practical implication of this approach, sometimes referred to as dynamic core-satellite DCS approach, is that optimal investment in a performance-seeking satellite portfolio PSP is not only a function of risk aversion, but also of risk budgets margin for error defined in terms of a distance with respect to various kinds of floor levels of wealthas well as probability of the risk budget to martellinu spent before horizon.

In a nutshell, a pre-commitment to lionle management allows one to adjust risk exposure in an optimal state-dependent manner, and therefore marhellini generate the highest exposure to upside potential of PSP while respecting risk constraints. This stands in sharp contrast to fix-mix strategies, where the target allocation to the PSP is constant over time, regardless of the distance with respect to the investors’ goals and constraints.


Theoretical arguments show that lioonel quantity maftellini the risk budget to the allocation to performance-seeking assets, known as the multiplier, should be inversely proportional to the variance of excess returns of the satellite with respect to the martellni portfolio.

As opposed to taking a constant multiplier value, as is typically done in base case examples of implementation, one can show that significant value can be added by making the multiplier a suitably-defined function of mmartellini forecasted level of tracking error between the core and satellite portfolios.

Using a parsimonious GARCH model with a Student-t distribution fatter tails for the independent and identically distributed random shocks that accounts for the presence of autocorrelation, heteroskedasticity and asymmetry leverage effectand re-estimating the model parameters using a growing window sample to estimate the next period variance, we generate forward-looking estimates of tracking error levels, and used these forecasts to dynamically adjust the multiplier values.

On a fast-rising volatile bull market for the satellite eg, a stock indexthe time-varying multiplier value would lag with respect to a constant multiplier value calibrated with respect to the long-term unconditional mean. On the other hand, in a slowly-rising bull market and in all bear market environments, the strategy with time-varying multiplier value would perform better and it reacts fast enough to reversions due to the related increase in volatility.

Using a strategy with time-varying multiplier value allows for substantial increase in mean returns, as well as a decrease in risk parameters relative to the benchmark case with constant parameter values. While the original approach was developed in a simple framework, it can be extended, allowing for the introduction of more complex floors max drawdown risk budget, liability-driven risk budget, competition-related risk budget, etc.

The goal-directed strategies recognise that the investor has no utility over a ceiling target level of wealth, which represents the investor’s goal actually a capwhich can be a constant, deterministic or stochastic function of time. Goal-directed strategies involve an optimal switching at some suitably-defined threshold level, which defines the switching point between fear- and hope-dominated behaviour.

It is not clear why any investor should want to impose a strict limit on upside potential. The thought is that by forgiving performance beyond a certain threshold, where they have relatively lower utility from higher wealth, investors benefit from a decrease in the cost of the downside protection short position in a convex payoff in addition to the long position – collar flavour.

Putting it differently, without the performance cap, investors have a better chance of failing an almost-reached goal when their wealth level is very high. Generally, the dynamic core-satellite framework can be extended to allow one to take into account forward-looking views if and when available, eg, views based on mean-reversion in equity returns, within the framework of a sound risk-control process.

This extension is a critical improvement where the two motivations behind dynamic asset allocation decisions, namely the risk management and the tactical motivations, are often perceived as inconsistent and mutually exclusive.

EconPapers: Lionel Martellini

Hence, dynamic risk-controlled strategies, which typically imply a reduction to equity allocation when a drop of equity prices has led to a substantial reduction of the risk budget, have often been blamed for their pro-cyclical nature that leads to sell equity holdings in those states of the world where equity markets have become particularly attractive for long-term investors believing in the presence of mean-reversion in equity risk premium. In fact, an explicit analytical representation of the relationship between optimal strategies in the presence and in the absence of short-term constraints can be derived, which allows us to disentangle the impact of short-term constraints from the impact of return predictability on the optimal allocation decision.


Depending on market conditions and parameter values, the risk-controlled motivation may outweigh the tactical motivation, or vice-versa, with risk management always prevailing ultimately. In other words, risk-control technology can be made entirely consistent with internal or external processes aiming at generating active asset allocation views.

In fact, casting the active view generation process within the formal framework of a dynamic risk-control strategy can be shown to be the only way to successfully implement active asset allocation decisions while ensuring the respect of risk limits.

In the past, investment banks have been at ease with dynamic asset allocation techniques, but have typically applied them to inefficient underlying assets typically market cap weighted indiceswithout any systematic effort to design optimal payoffs.

llionel Overall, by explicitly introducing investors’ goals, constraints and risk budgets in the design of asset allocation solutions, the asset management industry has an opportunity to evolve towards providing more value-added towards investment solutions that better fit investors’ need. EUR to million. Fixed Income Investment Grade.

Latest Analysis Liabilities remain in focus Given overall pressure on funding rates and falling asset markets, martellihi set to be a year where good governance and adaptability to external events will be crucial The right tool for the job Applying economics models to understand politics is like trying to use a trowel to saw a piece of wood in half.

The audit F-word Sat, 1 Dec Ahead martellini the Curve Ahead of the curve: Sporting a safety jacket in a market of weak protections The lending environment is undergoing a worrying change. Ahead of the Curve: The risk premium of downturns Alternative risk premia strategies can be helpful for institutional investor portfolios through diversification and risk reduction.

On the Record On the Record: The question of hedging Sat, 1 Dec On the Record: Sat, 1 Sep On the Record: Mon, 2 Jul Lionle, 1 Dec Macro Matters: Currency returns to the fore Sat, 1 Dec German Longevity: Are the tables turning? Thu, 1 Nov Turkey: Rethinking auto-enrolment Thu, 1 Nov Benchmarking: Redefining investment classes Thu, 1 Nov Liquid Alternatives: The long and marteloini short of it Thu, 1 Nov Country Reports Nordic Region: Shifting borders Thu, 1 Nov Asset Allocation: Lione and sound Thu, 1 Nov Search this martdllini Search.

Search the site Search. Home Analysis Guest Viewpoint. Have your say You must sign in to make a comment Sign In Register. Pension funds must tender fiduciary mandates, regulator says. Too much choice could lead to paralysis, think-tank finds [updated]. Most Popular Controversial weapons exclusion initiative gathers steam New company takes on the challenge of direct investment Top Asset Managers Reporting on natural capital. IPE Quest is a manager search facility that connects institutional investors and asset managers.