most useful to look at the historical information ratio, which is the excess
return of the portfolio divided by the tracking error.
While it is important to know the skill at the overall portfolio level,
managers should also know their skill set at each individual sub-strategy.
Before employing a specific active management strategy, a reinsurer, or
its investment manager, should provide some (quantifiable, based on
performance attribution) estimate of the manager’s historic ability to add
value by employing the strategy.
3. Diversification benefits
Lastly, we believe there are diversification benefits from combining
different sources of active risk. If a reinsurer possesses skill in several areas,
and if those skills are uncorrelated (e.g. the ability to pick the highest-
performing corporate bonds has no correlation with the ability to pick
the future direction of interest rates), employing multiple strategies should
improve the expected risk-adjusted returns.
Exhibit 4 is a graphic representation of the effect of combining different
Exhibit 3: Top-down and bottom-up risks
strategies. The return from passive exposure to the strategic benchmark
is the market, or beta component of return. Here we focus on the alpha
The risks available within a mandate are a function of both guideline components, i.e. how to add value across a number of different strategies.
flexibility and market opportunity. For certain strategies, the market affords For more yield-focused clients, some of these opportunities can be thought
the reinsurer meaningful opportunity to take risk. Duration and yield of as ‘yield alpha’.
curve risk, for instance, are plentiful. The deviations from the benchmark
Notice that the discs representing each active strategy are different sizes,
can be quite high, but are usually constrained by the allowable duration
as each strategy’s contributions to portfolio risk and total return has a
band in the guidelines. Other risks are not as plentiful, due to the fact that
different weighting. Intuitively, you should place a larger weighting on
there may be a reasonably high correlation in spread movements within
strategies with higher information ratios and favourable diversification
certain sectors (e.g. the government/agency strategy). Although investment
benefits.
guidelines may allow for unlimited item selection risk, the risk available
Putting it all together—making every basis point count
from the marketplace is not large. Therefore, reinsurers need to judge how
market and self-imposed constraints affect their risk-taking abilities. A broad investment opportunity set, investor skill and diversification
benefits are necessary ingredients, but alone do not guarantee successful
2. Historical evidence of manager skill
active fixed-income investing. A risk-budgeting framework that effectively
While it is great to be able to quantify the level of risk-taking opportunities
combines these elements is also required. Individual skilled decision-makers
available to a reinsurer, the reinsurer should only deviate from its strategic need to know how much risk to take. The risk budget communicates
benchmark if it feels it has the skill to capitalise on these opportunities. quantitatively the amount of risk-taking allowable within each top-down
There are several ways to judge skill in a fixed-income manager. We find it and bottom-up strategy.
Duration/Yield curve
MBS/ABS
Currency
High yield
Country
Alpha
Corporate credit
Sector
Govt/Agency
EMD
Beta
Passive returns
+
Alpha components
=
Active alpha
fixed-income investing
Exhibit 4: Combining passive and active strategies
Bermuda Re/insurance . September 2007 59
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