International portfolio optimisation with integrated currency overlay costs and constraints

International financial portfolios can be exposed to substantial risk from variations of the exchange rates between the countries in which they hold investments. Nonetheless, foreign exchange can both generate extra return as well as loss to a portfolio, hence rather than just being avoided, there are potential advantages to well-managed international portfolios. This paper introduces an optimisation model that manages currency exposure of a portfolio through a combination of foreign exchange forward contracts, thereby creating a “currency overlay” on top of asset allocation. Crucially, the hedging and transaction costs associated with holding forward contracts are taken into account in the portfolio risk and return calculations. This novel extension of previous overlay models improves the accuracy of the risk and return calculations of portfolios. Consequently, more accurate investment decisions are obtained through optimal asset allocation and hedging positions. Our experimental results show that inclusion of such costs significantly changes the optimal decisions. Furthermore, effects of constraints related to currency hedging are examined. It is shown that tighter constraints weaken the benefit of a currency overlay and that forward positions vary significantly across return targets. A larger currency overlay is advantageous at low and high return targets, whereas small overlay positions are observed at medium return targets. The resulting system can hence enhance intelligent expert decision support for financial managers

On optimising risk exposures with trend-following strategies in currency overlay portfolios

This paper proposed an optimisation mechanism in the currency overlay portfolios construction process, an area that has not been explored in the literature that tend to focus on pre-determined fixed weights, such as the trading volume of currencies from the survey of the Bank for International Settlement, to construct overlay portfolios and may not always be optimal. This paper optimises the portfolio using the Cholesky Decomposition-based multivariate TVC (Time varying correlation)-GARCH and CC (Constant correlation) GARCH models as allocation schemes, with underlying currencies’ returns originated from a moving average-based trend following single FX strategy in a certain hedging criterion. This paper includes a FX strategy based on the equally weighted (average) of the three different single moving average days to determine hedging needs underlying the hedging criterion. The paper uses the returns of the strategies of EW (equally weighted)-TFX and TFX to construct the optimal currencies overlay portfolios. The findings reveal the EW-TFX portfolios with the TVC-GARCH scheme have the best risk-adjusted portfolio returns. There are some evidences on the significant differences of the portfolios' returns of the EW-TFX overlay portfolios with other currencies portfolios, hence supporting the outperformance. The findings also support existing evidence in the literature

Macroeconomic Volatility and Sovereign Asset-Liability Management

For most developing countries, the predominant source of sovereign wealth is commodity related export income. However, over-reliance on commodity related income exposes countries to significant terms of trade shocks due to excessive price volatility. The spillovers are pro-cyclical fiscal policies and macroeconomic volatility problems that if not adequately managed, could have catastrophic economic consequences including sovereign bankruptcy. The aim of this study is to explore new ways of solving the problem in an asset-liability management framework for an exporting country like Ghana. Firstly, I develop an unconditional commodity investment strategy in the tactical mean-variance setting for deterministic returns. Secondly, in continuous time, shocks to return moments induce additional hedging demands warranting an extension of the analysis to a dynamic stochastic setting whereby, the optimal commodity investment and fiscal consumption policies are conditioned on the stochastic realisations of commodity prices. Thirdly, I incorporate jumps and stochastic volatility in an incomplete market extension of the conditional model. Finally, I account for partial autocorrelation, significant heteroskedastic disturbances, cointegration and non-linear dependence in the sample data by adopting GARCH-Error Correction and dynamic Copula-GARCH models to enhance the forecasting accuracy of the optimal hedge ratios used for the state-contingent dynamic overlay hedging strategies that guarantee Pareto efficient allocation. The unconditional model increases the Sharpe ratio by a significant margin and noticeably improves the portfolio value-at-risk and maximum drawdown. Meanwhile, the optimal commodities investment decisions are superior in in-sample performance and robust to extreme interest rate changes by up to 10 times the current rate. In the dynamic setting, I show that momentum strategies are outperformed by contrarian policies, fiscal consumption must account for less than 40% of sovereign wealth, while risky investments must not exceed 50% of the residual wealth. Moreover, hedging costs are reduced by as much as 55% while numerically generating state-dependent dynamic futures hedging policies that reveal a predominant portfolio strategy analogous to the unconditional model. The results suggest buying commodity futures contracts when the country’s current exposure in a particular asset is less than the model implied optimal quantity and selling futures contracts when the actual quantity exported exceeds the benchmark.Open Acces

Exchange rate modelling and forecasting

The objective of this thesis is to assess the current state of exchange rate modelling and forecasting. The thesis has four distinct essays, each one analysing a current interest topic in this wide and vibrant area of economic research. But a common thread runs through all four: to determine whether it is possible to use the results of this research to develop trading strategies that can add persistent value to international investment portfolios with significant exposure to the foreign exchange market. This market has a daily turnover of $1.9 trillion (BIS, 2004) and is the most liquid financial exchange in the world, by some distance. Nonetheless, we argue that the market is also inefficient, in the sense that profitable trading opportunities persist and that prices do not reflect all available public information on a continuous basis. If we are correct-and we present simulation results that suggest we are-then the opportunity to derive and test plausible trading rules for the management of international investment portfolios though rigorous academic research is enormous. Yet all too often academic exchange rate research appears to be conducted in a cocoon, with the result that conclusions are sometimes difficult to apply in a practical context by portfolio managers. These difficulties reflect the computational requirements of implementing highly intensive trading strategies, associated trading costs and size limitations, and the practical limitations on implementation raised by publication lags and general data limitations. We aim to address these difficulties throughout this thesis. By assessing the merits of various theoretical models that collectively encompass all of the main themes on the current research agenda, we will be in a position to appreciate both the statistical and economic value of existing academic research, isolating areas of real merit for the investment community, and suggesting areas for further attention

Australian managed funds: investment strategies and property allocation

The Australian managed funds industry is the largest and fastest growing investment sector in Australia. Underpinned by the Australian government’s compulsory superannuation policy, the industry has grown nearly ninefold from A$171 billion in 1988 to A$2.0 trillion in 2012. Even with this phenomenal growth rate, the level of allocation to property asset class in institutional portfolios has remained constant in recent decades, restricted at 10% or lower. While several overseas studies have suggested property allocations within a range of 10-30%, comprehensive empirical evidence on Australian institutional property asset allocation strategies and decision-making process is underdeveloped. The focus of this research is to identify the important steps and considerations that influence Australian fund manager’s property allocation decisions, and to suggest ways to improve institutional allocation decisions towards property investments, which traditionally offers stable, income focused returns. Research was undertaken using a mixed method (qualitative and quantitative) approach. First an in-depth industry survey was conducted of all major groups in the Australian managed funds industry including superannuation funds, investment managed funds, property funds and asset consultants. The evaluation of the 79 survey respondents indicated that Australian fund manager’s property allocation decision-making process is an interactive, sequential and continuous process involving multiple decision-makers (internal and external) complete with feedback loops. It involves a combination of quantitative analysis (mainly efficient frontier) and qualitative overlay (mainly judgement, or ‘gut-feeling’, and experience). In addition, the research provided evidence that the property allocation decision-making process varies depending on the size and type of managed fund. The findings from the survey were developed further through a series of quantitative research analyses. In particular, the performance of the A$302 billion industry superannuation funds' strategic balanced portfolio was compared against ten different investment strategies to examine how property allocation changes with different asset allocation models. The results show that the eleven different asset allocation models perform as well as the industry fund conventional Strategic approach and in many instances property allocation is found to be under-allocated on a return optimisation basis. For an Australian superannuation balanced fund, the empirical results show that there is scope to increase the property allocation level from its current 10% to 26%. Upon excluding unconstrained strategies, the recommended allocation to property for industry funds is 17% (12% direct and 5% listed). This high allocation is backed by improved risk-adjusted return performance. This research contributes to both practical and academic fields as it offers a methodological approach to how institutional allocation to property assets can be improved. The conceptual frameworks developed from the survey will enhance academic theory in the area of property allocation decision-making. The eleven different asset allocation models developed will attract fund managers to explore alternative strategies (passive and active) where risk-adjusted returns can be improved, compared to the common Strategic approach with increased allocation to property assets. The research contributes to the transfer of broader finance and investment market theories and practice to the property discipline and so provides flow on support to the continued growth of the Australian property market

District energy system optimisation under uncertain demand: Handling data-driven stochastic profiles

Current district energy optimisation depends on perfect foresight. However, we rarely know how the future will transpire when undertaking infrastructure planning. A key uncertainty that has yet to be studied in this context is building-level energy demand. Energy demand varies stochastically on a daily basis, owing to activities and weather. Yet, most current district optimisation models consider only the average demand. Studies that incorporate demand uncertainty ignore the temporal autocorrelation of energy demand, or require a detailed engineering model for which there is no validation against real consumption data. In this paper, we propose a new 3-step methodology for handling demand uncertainty in mixed integer linear programming models of district energy systems. The three steps are: scenario generation, scenario reduction, and scenario optimisation. Our proposed framework is data-centric, based on sampling of historic demand data using multidimensional search spaces. 500 scenarios are generated from the historical demand of multiple buildings, requiring historical data to be nonparametrically sampled whilst maintaining interdependence of hourly demand in a day. Using scenario reduction, we are able to select a subset of scenarios that best represent the probability distribution of our large number of initial scenarios. The scenario optimisation step constitutes minimising the cost of technology investment and operation, where all realisations of demand from the reduced scenarios are probabilistically weighted in the objective function. We applied these three steps to a real district development in Cambridge, UK, and an illustrative district in Bangalore, India. Our results show that the technology investment portfolios derived from our 3-step methodology are more robust in meeting large possible variations in demand than any model optimised independently with a single demand scenario. This increased robustness comes at a higher monetary cost of investment. However, the high investment cost is lower than the highest possible cost when each of the initial 500 scenarios is optimised independently. In both our case studies, building level energy systems are always more robust than district level ones, a result which disagrees with many existing studies. The outcomes enable better examination of district energy systems. In addition, our methodology is compiled as an open-source code that can be applied to optimise existing and future energy masterplans of districts

Exchange rate modelling and forecasting

The objective of this thesis is to assess the current state of exchange rate modelling and forecasting. The thesis has four distinct essays, each one analysing a current interest topic in this wide and vibrant area of economic research. But a common thread runs through all four: to determine whether it is possible to use the results of this research to develop trading strategies that can add persistent value to international investment portfolios with significant exposure to the foreign exchange market. This market has a daily turnover of $1.9 trillion (BIS, 2004) and is the most liquid financial exchange in the world, by some distance. Nonetheless, we argue that the market is also inefficient, in the sense that profitable trading opportunities persist and that prices do not reflect all available public information on a continuous basis. If we are correct-and we present simulation results that suggest we are-then the opportunity to derive and test plausible trading rules for the management of international investment portfolios though rigorous academic research is enormous. Yet all too often academic exchange rate research appears to be conducted in a cocoon, with the result that conclusions are sometimes difficult to apply in a practical context by portfolio managers. These difficulties reflect the computational requirements of implementing highly intensive trading strategies, associated trading costs and size limitations, and the practical limitations on implementation raised by publication lags and general data limitations. We aim to address these difficulties throughout this thesis. By assessing the merits of various theoretical models that collectively encompass all of the main themes on the current research agenda, we will be in a position to appreciate both the statistical and economic value of existing academic research, isolating areas of real merit for the investment community, and suggesting areas for further attention.EThOS - Electronic Theses Online ServiceGBUnited Kingdo

PRIME Toolkit: Primer For Responsible Investment Management of Endowments

This toolkit for foundations aims at helping trustees better understand and integrate Responsible Investment (RI) practices (often called Socially Responsible Investment or SRI) into mandates they give to asset managers entrusted with the management of their endowments. It aims to provide readers with a resource to assist them as these factors become increasingly relevant to good asset management and the expectations of the public and various stakeholders

Investment Manager Characteristics, Strategy and Fund Performance.

This dissertation presents five research essays evaluating the performance of managed funds in light of the investment strategy and manager characteristics exhibited by institutional investment companies. An analysis of investment performance with respect to a fund managers strategy provides important information in determining whether performance objectives have been achieved. There are a number of different types of investment strategies managed funds may adopt. However, the primary dichotomy is on the basis of whether the portfolio manager implements either an active or index approach. Active managers attempt to outperform the market through the use of price-sensitive information, whereas a passive manager's objective is to replicate the returns and risk of a target benchmark index. The evaluation of investment manager characteristics is also evaluated. This is motivated on the basis that asset management entities place significant emphasis on both the articulation and differentiation of their investment style relative to competitors, and selling the strengths of their portfolio management skills (in terms of past performance) as well identifying the key individuals comprising their investment team and their unique attributes. For active equity managers, the methods used in constructing portfolios and implementing the investment strategy include security selection, in terms of 'top-down' or 'bottom-up' strategies, value-biased, growth-biased or style-neutral strategies, and portfolios exhibiting market capitalisation biases (i.e. preferences to large or small-cap securities). In terms of active bond portfolio management, the most common strategies include duration management and yield curve positioning. Active managers' strategies are likely to extend beyond stock selection, in particular, where the fund manager adjusts the portfolio's composition in anticipation of favourably capitalising on future movements in the market. For index managers, replication of both the returns and risk of the underlying index may be achieved through either full-replication of constituent stocks comprising the index, or through non-replication techniques (stratified sampling and/or optimisation). Each essay provides a unique contribution to the literature with respect to the performance of active and index funds, as well as an analysis of funds that invest specifically in domestic equities, domestic fixed interest, and diversified funds that invest across the broad spectrum of asset classes. The origins of the performance evaluation literature are ascribed to Cowles' (1933) pioneering work, and the literature has given increasing attention to the topic. However the most fundamental issue considered in almost all previous studies of managed fund performance is the extent to which actively managed portfolios have earned superior risk-adjusted excess returns for investors. The literature has overwhelmingly documented (with a small number of exceptions) that active funds have been unable to earn superior returns, either before or after expenses (e.g. Jensen (1968), Elton et al. (1993), Malkiel (1995), Gruber (1996)). While the international evidence is supported by the few Australian managed fund studies available, Australian research remains surprisingly scarce. This is perplexing considering the sheer size of the investment industry in Australia (around $A717 billion as at 30 June 2001) and the importance placed on the sector with respect to successive Federal Governments' retirement income policies. The objectives of this dissertation therefore involve an analysis of managed fund performance with respect to differences in investment strategies (i.e. active and index), as well as providing an analysis of funds invested in equities, bonds and diversified asset classes (or multi-sector portfolios). The first essay evaluates the market timing and security selection capabilities of Australian pooled superannuation funds. These funds provide institutional investors with exposure to securities across many different asset classes, including domestic and international equities, domestic and international fixed interest, property and cash. Surprisingly, the specific analysis of multi-sector funds is scarce in the literature and limited to Brinson et al. (1986, 1991), Sinclair (1990), and Blake et al. (1999). This essay also evaluates performance for the three largest asset classes within diversified superannuation funds and their contribution to overall portfolio return. The importance of an accurately specified market portfolio proxy in the measurement of investment performance is demonstrated, where the essay employs performance benchmarks that account for the multi-sector investment decisions of active investment managers in a manner that is consistent with their unique investment strategy. This approach rectifies Sinclair's (1990) analysis resulting from benchmark misspecification. Consistent with the literature, the empirical results indicate that Australian pooled superannuation funds do not exhibit significantly positive security selection or market timing skill. Given the evidence in the literature surrounding the inability of active funds to deliver superior returns to investors, lower cost index funds have become increasingly popular as an alternative investment strategy. Despite the significant growth in index funds since 1976, when the first index mutual fund was launched in the U.S., research on their performance is sparse in the U.S. and non-existent in Australia. The second essay provides an original analysis of the Australian index fund market, with specific analysis applicable to institutional Australian equity index funds offered by fund managers. While indexing is theoretically straightforward, in practice there exist potential difficulties in exactly matching the return of the underlying index. Therefore the magnitude of tracking error is likely to be of concern to investors. This essay documents the existence of significant tracking error for Australian index funds, where the magnitude of the difference between index fund returns and index returns averages between 7.4 and 22.3 basis points per month for funds operating at least five years. However, there is little evidence of bias in tracking error, implying that these funds neither systematically outperform or underperform their benchmark on a before cost basis. Further analysis documents that the magnitude of tracking error is related to fund cash flows, market volatility, transaction costs and index replication strategies used by passive investment managers. The third essay presents evidence of the performance of U.S. mutual funds, where attention is given to both active and index mutual funds for which the applicable benchmark index is the S&P 500. This essay examines both the magnitude and variation of tracking error over time for S&P 500 index mutual funds. The essay documents seasonality in S&P 500 index mutual fund tracking error, where tracking error is significantly higher in the months of January and May, together with a seasonal trough in the quarters ending March-June-September-December. Statistical evidence indicates tracking error is both positively and significantly correlated with the dividend payments arising from constituent S&P 500 securities. In terms of a performance comparison between actively managed and index funds, active funds on average are found to significantly underperform passive benchmarks. On the other hand, S&P 500 index mutual funds earned higher risk-adjusted excess returns after expenses than large capitalisation-oriented active mutual funds in the period examined. These results suggest the S&P 500 is consistent with capital market efficiency, implying an absence of economic benefit accruing to the average investor utilising actively managed U.S. equity mutual funds. The fourth essay presented in the dissertation examines the performance of Australian investment management organisations with direct reference to their specific characteristics and strategies employed. Using a unique information source, performance is evaluated for actively managed institutional balanced funds (or diversified asset class funds), Australian share funds and Australian bond funds. Performance is evaluated with respect to the investment strategy adopted, the experience and qualifications held by investment professionals, and the tenure of the key investment professionals. This essay also evaluates the performance of senior sector heads to determine the skills of individuals driving the investment process, even though these individuals may migrate to competitor organisations. The essay finds evidence that a significant number of active Australian equity managers earned superior risk-adjusted returns in the period, however active managers perform in line with market indices for balanced funds and Australian bond funds. A number of manager characteristics are also found to predict risk-adjusted excess returns, systematic risk and investment expenses. Of particular note, performance of balanced funds is negatively related to the institution's age and the loyalty of non-senior investment staff. Performance is also found to be significantly higher for managers that predominantly operate their portfolios using a bottom-up, stock selection approach. Interestingly, the human capital of managers, measured as the years of tertiary education undertaken, does not explain risk-adjusted excess returns. Systematic risk is positively related to an institutions age and negatively related to both senior manager loyalty and the implementation of bottom-up portfolio management strategies. In terms of management expenses, fees are directly related to the Australian equities benchmark allocation, the years of tertiary education, the number of years service (loyalty) for non-senior investment professionals and the total years experience of senior money managers. This concluding essay also documents that changes in top management have significant performance effects. In the 12-month period after a change in fixed income director or chief investment officer, performance is significantly lower and significantly higher, respectively. There is no significant difference in performance where changes in top management occur for Australian equities. The years of service (loyalty) provided to asset management firms by equities directors is inversely related to risk-adjusted return. The fifth and final essay examines the investment performance of active Australian bond funds and the impact of investor fund flows on portfolio returns. This essay represents a significant and original analysis in terms of its contribution to the literature, given the absence of Australian bond fund performance analytics and also the limited attention provided in the U.S. Both security selection and market timing performance is evaluated using both unconditional models and conditional performance evaluation techniques, which account for public information and the time-variation in risk. Overall, the results of this essay are consistent with the U.S. and international mutual fund evidence, where performance is found to be consistent with an efficient market. While actively managed institutional funds perform broadly in line with the index before expenses, the paper documents significant underperformance for actively managed retail bond funds after fees. The study also documents that retail fund flows negatively impact on market timing coefficients when flow is not accounted for in unconditional models