Actuarial Investments STAT 4444

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Actuarial Investments(STAT 4444)

• Shane Whelan
• L527

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Actuarial Investments

• Course Objectives
• To give flavour of (institutional) investment
  in practice.
• To break the back of the professional courses
  CA11 (and samll part of ST5) in the Faculty
  Institute of Actuaries.
• This course is not an exception course from the
  Faculty Institute of Actuaries examination.
• Course Syllabus
• Asset types their markets?asset valuation ?
  market behaviour ?indices ?performance
  measurement ?portfolio construction to meet set
  objectives ?risk control.

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So what is our approach to Actuarial Investment?

• Overview of perspective we wish to achieve before
  we treat each major capital market in turn

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The Investor

• Begin always from viewpoint of investor
• The generic investment objective is to achieve
• the highest possible return within an acceptable
  level of risk
• So need
• An understanding of constraints (risk tolerance)
  of investor
• Then selecting a suitable portfolio an
  optimisation problem (of reward) subject to
  generally non-explicit constraints (the risk).
• The investor objectives are every bit as
  important as the investment opportunity.
• Reward and risk must be interpreted from the
  standpoint of the investor.
• Typically actuaries advise long-term investors
• Pension funds, charities, life office with
  profits, shareholders funds, unit-linked funds,
  etc.
• So long term view important when it comes to
  markets.

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Objectives of Investor

• Typically funds accumulated to meet liabilities
  so must consider
• the nature of liabilities real, monetary.
• Term of liabilities
• Currency of liabilities
• Uncertainty in timing, in amount.
• Surplus of funds over liabilities (free assets)
• Legislation Regulation
• Taxation only net return matters
• Other factors
• enforcing of contract,
• ethical dimension,
• appropiateness of investment from broader
  perspective

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The Investment or Asset

• Old acronym of actuarial students used to
  consider investment attributes relative to the
  liabilities
• S
• Y
• S
• T
• E
• M
• T

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The Investment or Asset

• Old acronym of actuarial students used to
  consider investment attributes relative to the
  liabilities
• Security
• Yield
• Spread
• Term
• Exchange Rate
• Marketability
• Taxation

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The Different Asset Types

• Cash money-market instruments
• Government fixed interest
• Corporate fixed interest
• Index-linked bonds
• Equities
• Property
• Currency
• Derivative instruments constructed from the above
• Various Pooling Vehicles

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Investor Three Core Questions

• What return can realistically be expected from
  each investment type?
• What is the range of possibilities?
• What are the risks and how can I mitigate them?
• So any advice must be framed in these terms.

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Simplicity of Long-Term Investment

• Capital assets are bought for their promise of
  future income
• Three things matter when trying to evaluate this
  promise
• ...the amount of the future payoff
• ...the timing of the future payoff
• ...the certainty of the future payoff

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For Equities, Nobody knows out-turn

• If we speak frankly, we have to admit that our
  basis of knowledge for estimating the yields
  returns ten years hence of a railway, a copper
  mine, a textile factory, the goodwill of a patent
  medicine, an Atlantic liner, a building in the
  City of London amounts to little and sometimes to
  nothing
• J.M. Keynes, The General Theory of Employment,
  Interest, and Money (1936), IV, C 12.

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Basis of our knowledge of asset price behaviour

• Largely historic behaviour, wisely interpreted.
• Validity of past data to model the future
  difficult to assesswe know that, at a minimum,
  knowledge of past affects the future.
• So historic returns, their standard deviations
  and their correlation relationship with other key
  variables used at least as a starting point.
• See lecture 2.
• Newer asset classes, e.g. index-linked stock,
  must guesstimate their properties.
• Issued since 1981 in UK, since 1998 in eurozone.
• Taxation - generally use current code and rates.

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Riskier Assets Produce Higher Returns

• Comment

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History of Capital Markets(and their returns)
That which has been is that which shall be and
that which has been done is that which shall be
done and there is no new thing under the
sun. Ecclesiastes 19 (World English Bible)
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History not long enough

• First legal interest bearing loan in modern times
  issued in City of London in 1545.
• First equity shares 1553 by London firm, Muscovy
  Company.
• General Limited Liability allowed 1811 in NY,
  since 1850s in UK.
• Interest rates, in the modern sense, since about
  1700.

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(Long) Rate of Interest, 1700-2000
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Irish Equity Market History

• The Irish Society, chartered 1613 with a capital
  of 40,000, arranged the plantation of Ulster and
  held Derry and Coleraine until the 20th Century.
• Adventurers for Lands in Ireland, 1642, to fund
  an army and be rewarded by seized lands (at the
  rate of about 8s-12s an acre in Leinster).
• But 1783 is really the earliest date we can say
  Irish capital markets existed as Bank of Ireland
  founded in that year.
• 1799 Dublin Stock Exchange opened - making it the
  6th longest surviving stock market it the world.

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Modest Beginnings
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Irish Wage Inflation and Price Inflation,1900-200
1.
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Irish Asset Classes Real Returns, 1900-2001
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Histogram of Annual Real Returns from Irish
Capital Markets, 1900-2001.
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What is a Realistic Long-Term Return?
Real Returns on Irish Financial Markets to End
1999

• Years to Inflation Equities Gilts Cash
• 1999 p.a p.a. p.a. p.a.
• 50 6.4 8.2 1.5 1.5
• 70 5.4 7.1 1.4 0.5
• 100 4.5 6.7 1.0 0.7
• 200 2.1 6.5 2.5 2.4

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What are the Risks?

• Best Worst Decades in Each Market 1783-1999.
• Irish Market 10 Years Ending Return (
  p.a.)
• Equity 1986 28.7
• Equity 1835 0.6
• Gilt 1989 19.1
• Gilt 1974 -0.2
• Cash 1983 13.8
• Cash 1951 0.8

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Annualised Real Returns on Major Markets, 101
Years Ending 31st Dec. 2000
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Nightmares

• US
• 1929 Crash. Fall of 71 from start 1929 to start
  1933. (It took until 1952 to regain high).
• Depression, calling on pension fund assets.
• Japan
• Real return on equities 5.2 p.a in 1990s (i.e.,
  a cumulative fall of 41)
• Real return on bonds 7.0 p.a.
• From March 2000 to End 2002 World equity
  markets (FTSE World) fall over 50
• We are still living through the consequences

Source Market Volatility, Robert Schiller, 1989,
MIT Press, Chapter 26 for US ABN-AMRO LBS for
Japan.
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Further Reading Suggestions

• From Canals to Computers The Friends First Guide
  to Long-Term Investment in Ireland.
• Whelan, S. (1999)
• Friends First, Dublin. 56 pp.
• Specialist Readings
• Triumph of the Optimists 101 Years of Global
  Investment Returns
• Dimson, E., Marsh, P., Staunton, M.
• Princeton Unversity Press, 2002.
• A History of Interest Rates (3rd Edition)
• Homer, S. Sylla, R.
• Rutgers University Press, 1996.

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Concludes our Brief History of Capital
Markets(and their returns)