1. Asset Allocation in a Low Rates Environment
Eric Bissonnier, CFA
GIW, INSEAD
June 8, 2011

2. Asset Allocation in a Low Rates Environment
A Brief Look at History
Scenario Building
Expected Returns
Asset Allocation in a Low Rates Environment

3. Asset Allocation in a Low Rates Environment, How Rather than What
We will focus on the process that needs to take place to deal with an potential outcome that is tough to model historically
Inflationary environments are ancient -> markets, instruments, asset allocations have changed
Post 2008 fear factor, distrust of models and consultants
Investment Methodologies can be made more dynamic…
Hedge Funds
Overlay
… but the investment pools’ governance requires the largest adjustment

4. Asset Allocation in a Low Rates Environment
Traditional Asset Allocation and the Reality
Traditional Asset Allocation tools rely on some consistency between past and future
A stability in asset returns
A coherent behaviour (upside/downside)
A stable covariance matrix (the past IS the future)
Adjustments can be made to work around the model
Change expected returns (Risk Premia)
Use shorter term data for the asset class correlation
Not use the model at all…

5. A Brief Look at History Asset Allocation in a Low Rates Environment
Scenario Building
Expected Returns
A Brief Look at History

6. A Brief Look at History: Long Term Changes in Interest Rates

7. A Brief Look at History: What the Model Sees…

8. A Brief Look at History: Equity Performance

9. A Brief Look at History: Changing Correlation Between Bonds and Equities

10. A Brief Look at History: Average S&P Correlation to so called Diversifiers

11. A Brief Look at History: The Amazing Regime Change of Correlation Between Equities and Oil

12. A Brief Look at History: Real Yields have been Well Behaved until Recently

13. Scenario Building Asset Allocation in a Low Rates Environment
A Brief Look at History
Scenario Building
Expected Returns
Scenario Building

14. Uncontrolled Inflation (Over 5%)
Scenario Building
And Now What?? Do we have a Collective Sense of What the Future Holds, Plausibly?
Next 12 – 24 months
Deflation
Controlled Inflation
( up to 3-4%)
Uncontrolled Inflation
(Over 5%)
Recession
Low Growth 2%)
Growth

15. Can you Describe a Scenario?
Scenario Building
Can you Describe a Scenario?
The “controlled inflation” scenario:
Inflation due to growth;
Monetary action to reduce excess money supply;
Commodity tightening:
What would be the expected return for:
Equities developed;
Equities EM;
Default rates IG and HY;
Cash and Bonds;
Commodities;
Volatility;
Correlation:

16. Scenario Building Asset Allocation in a Low Rates Environment
A Brief Look at History
Scenario Building
Expected Returns
Scenario Building

17. EIM Economic Scenario Roadmap
Scenario Building
EIM Economic Scenario Roadmap
2010
Print / Borrow / Spend
Model
Current Consensus
Forecast
Fundamental Growth Cycle
Subpar Growth Cycle
Drop in Fiscal Income
Inflation under control ?
Voluntary Exit: anticipating budget constraints
Forced Exit: mistrust in ability to repay debt
EIM View
20…
YES
Sustained Growth NO
Inflation Growth
No Growth
Systemic Deflation

18. Risk Factors Scenario Building Scenario Market Factors
Systemic Deflation
Sub-Par / No Growth
Sustained Growth
Inflation Growth
Interest rates
Short term (∆bps)
Long term (∆bps)
+ 80
+ 400
+ 300
+ 700
Credit Spreads
High grade (∆bps)
High yield (∆bps)
+ 100
+ 600
-100
Default rates
High grade (%)
High yield (%)
0.5%
11.0%
0.0%
1.0%
Equities
US (∆%)
Rest of the world (∆%)
Volatility (∆bps)
- 50%
1000
+ 15%
+ 20%
- 500
+ 5%
Commodities (∆%)
- 30%
+ 25%
+ 30%
CPI (%)
- 2% 0% 4% 7%

19. Expected Returns Asset Allocation in a Low Rates Environment
A Brief Look at History
Scenario Building
Expected Returns
Expected Returns

20. Forward-looking Scenario Analysis – Integrated View
Expected Returns
Forward-looking Scenario Analysis – Integrated View

21. Now, What Can we Really do if Yields go Up?? The Obvious:
Expected Returns
Now, What Can we Really do if Yields go Up?? The Obvious:
Cash
Short rates go up depending on scenario
Riskiest asset if you have a target return, 100% probability of not reaching return target of Libor +…
Inflation Linked Bonds
May be overbought, i.e. expensive, due to high demand
Buy a bond put warrant from an Investment Bank
When timing is unknown, options are expensive
OTC prices may not be efficient…
Short bonds outright (“delta one”)
Very expensive over time due to negative carry
Risky of yields go down

22. And the Not so Obvious Futures based systematic options replication
Expected Returns
And the Not so Obvious
Futures based systematic options replication
Such models do not require to get the timing right as the strikes
adapt to “current” market conditions: short OTM 10 year bond put
Futures based breakout models
Liquid systematic exposure to strong trends: short bonds, long Commodities, long commodity currency short developed markets
Long Prepayment Risk in Mortgages

23. Eric Bissonnier E.I.M. S.A. 2, Chemin de Chantavril 1260 Nyon Switzerland Tel | Fax