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The Actuary The magazine of the Institute & Faculty of Actuaries

A new way of thinking

What is your background in the investment field?
I have been managing fund-of-funds or multi-manager portfolios for the past eight years. Prior to that, I worked for a banking and life assurance group in South Africa in a variety of corporate actuarial roles from stochastic modelling and valuations to business strategy.

Do you have an example of where actuarial thinking and techniques might be applied in an investment management role?
An actuarial background has served as a good base for understanding many of the techniques that hedge funds are using to extract value from investment markets. While it is likely in any particular sub-strategy that the hedge fund manager is going to have far more specialist knowledge and experience than you will have as a fundof- funds manager, you have got to be able to grasp the key concepts behind their approach quickly.

In a fixed income and derivative-related setting, a good understanding of cashfl ow modelling and of financial economics and derivatives is necessary.

In some strategies, a more traditional actuarial analysis comes into play. As an example, some hedge funds focus on investing in asset-backed securities such as pools of mortgages. These are typically split into tranches in collateralised debt obligation structures (CDOs), where different portions of the risk and cashflows are allocated to different investors. Understanding the cashfl ows to a particular tranche under a variety of pre-payment and default scenarios is akin to a traditional cashfl ow modelling and scenario analysis exercise that a life company might do to understand the profitability of a specific sector of existing business.

How do you then assess the investment opportunity?
Of course there is much more to making an investment than just understanding the maths behind the investment strategy — that simply forms the basis for a common understanding to begin assessing the opportunity. One then needs to spend time understanding the reasons why markets may be ineffi cient in pricing these securities and what is creating an ‘arbitrage’ opportunity that is repeatable and exploitable.

In the case of asset-backed securities, the regulatory regime of many institutions such as pension funds, insurance companies and banks, requires them to invest in securities rated as ‘investment grade’, resulting in excessive demand for investment grade-rated debt. In turn, the credit rating agencies have developed fairly complex models to rate the various tranches of asset-backed securities and CDOs. The excessive demand for investment graderelated tranches from such investors can result in distortions that push a disproportionate part of the economic value in the structure towards the more risky ‘unrated’ and non-investment grade portions of the debt.

Understanding the regulatory regimes for pensions, life insurance companies and banks assists in understanding the creation of these anomalies. At the same time, it is necessary to apply risk assessment techniques because if hedge funds are investing in the higher-risk parts of these structures, they are, by defi nition, more likely to be exposed to losses, so one has to ask how they assess and hedge these risks.

All of this, of course, is still part of understanding the investment process and doesn’t even begin to address the even more important soft issues of assessing the individuals managing the hedge fund, the operational and legal issues and so forth.

Which other parties have you typically worked with when assessing investment opportunities?
Other investment managers and analysts with different backgrounds bring a new perspective. Some have had direct experience in trading at investment banks or working at hedge funds, which brings an important viewpoint on market technicalities and dynamics.

I have also worked with auditors and lawyers who are involved in looking through all of the documentation and assessing the operational and fi nancial controls of a fund before proceeding with an investment.

What lessons can the actuarial and investment communities learn from each other?
From my perspective as an actuary, there is a lot of terminology and jargon in each sector of the market with which you have to familiarise yourself quickly. To communicate effectively with traders you need to be able to speak their language. Concepts are often similar or analogous to ones in other investment or actuarial areas but understanding ‘trader-speak’ can be a steep learning curve in every different investment area.

It’s also important to appreciate how easily regulation and reserving standards have the ability to create economic distortions within markets that can then be exploited by sophisticated fi nancial players. Differences between traditional actuarial and financial economic models can create arbitrage opportunities. There is no such thing as a perfectly efficient market, yet neither (or very seldom) is there a risk-free arbitrage.

How might actuaries generally fit into the alternative investment world?
I would say that the transition is possible but it can be challenging. There is no automatic assumption that an actuary can add value in an investment context but I do think that the techniques and thought processes that actuaries possess are useful in the investment world. The key is in educating professionals in the investment community about what contributions actuaries can make.

In a multi-manager context, actuaries can bring greater sophistication to the risk management and risk analysis of hedge funds, though they are sure to find themselves in competition with many financial economists obsessed with the subject. Many actuaries do have investment consulting experience and will be familiar with some of the issues involved in manager selection in a multi-manager context. That said, a traditional actuarial consultant’s approach to advising on manager selection can be quite different to one of managing money on a discretionary basis.

What about hedge funds?
Asset-backed securities and CDOs are structures that actuaries should be able to model using traditional and more sophisticated actuarial techniques.Many other such modelling opportunities exist within hedge funds in all sorts of different strategies. As an example, actuaries may have a valuable role to play in the analysis of investments for insurance companies, given their unique understanding of these institutions.

The same is true in many takeover situations, where pension liabilities and the interaction of pension trustees and the corporation can be critical factors in determining the viability of a proposed mergers and acquisition transaction.

Find out more
» This article is one of a series promoted by the Actuarial Profession’s Action Group for Banking (AGB) and explores situations where the actuarial and banking worlds overlap to the benefit of both sectors. The articles serve the following broad purposes:
Push: To demonstrate where actuarial skills and thinking have been applied in a banking or financial context to add real commercial value.
Pull: To highlight tools and skills available in banking and finance that may be of use to traditional life and pensions actuaries.
Please contact Mark Symons mark.symons@actuaries.org.uk for more information on the AGB’s activities.