Unicredit's approach to asset allocation and they way it constructs its portfolios is based on two principles. Firstly, the basic strategy depends on the results of its three-yearly actuarial reviews, which establish a clear picture of the position of its liabilities. Next, using the Markowitz model, which attempts to define the relationship between diversification, risk and correlation to make a portfolio efficient, it re-adjusts its allocations with the aim of generating excess returns to those needed to cover the liabilities for the coming three years.
Unicredit uses indices as benchmarks for each asset class when setting its asset allocation and these are valued only in local currency to eliminate exchange risk. It invests in a wide selection of traditional asset classes as well as some alternatives. The traditional investments include varied fixed income and equity portfolios. Fixed income assets comprise long euro government bonds; corporate bonds; money market instruments; UK gilts; emerging market government bonds; US government bonds; high-yield euro and high-yield US dollar bonds; high-yield global bonds, and convertible bonds. The equity investments cover emerging market equities; Japanese equities; European equities, and US equities. In addition to the alternative investments in hedge funds, private equity and real estate, Unicredit says it also now invests in commodities.
Unicredit says its asset allocation strategy is revised tactically each year in line with the investment committee's view of the how the markets are moving. This depends on various factors. Firstly, the scheme makes use of three forecasting models looking at equities, bonds and foreign exchange which it uses to predict how the markets might develop. Next, it considers the asset managers' views about their respective markets. Finally, it processes all the information and analyses how any trends are likely to impact the basic asset allocation strategy. This, it says, allows it to determine the asset allocation tactically from year to year.
Unicredit doesn't pay mere lip service to the claim. The investment committee meets once a month to fine-tune the tactical allocation.
Of course there is little point having a well-structured and efficient allocation strategy if you don't have good asset managers to implement it for you. Unicredit takes a close look at the market and chooses what it considers to be the best products to invest in before targeting the best managers for that product class.
Selecting managers for the traditional assets portfolio depends on their performance vis-à-vis indices and benchmarks. Unicredit says basic appropriate quantitative measurements are used to help it draw up short lists. Monthly reports are then generated by a specially developed internal software application that constantly monitors manager performance.
For short-listed managers, Unicredit takes a closer at their performance records to ascertain how well they have performed against their benchmark. Next, the scheme meets with them to assess whether their investment strategy is compatible with the fund's proposed asset allocation strategy.
At this point, Unicredit says it also checks the way the investment products are classified. Whether it goes for actively or passively managed products depends on their availability and to what degree the managers outperform their benchmarks on a consistent basis. Those products it is attracted to but which do not quite meet these requirements are invested passively, tracking relevant indices. Whether it goes for actual funds or issues segregated mandates depends how much it decides to allocate to each asset class. In general, funds will be chosen where this is less than €20m.
The portfolio is subject to continuous monitoring, with weekly reports charting the assets' daily movements being prepared. Unicredit says this makes it possible to ensure the three-monthly rolling risk values remain compatible with the annual risk values it determines as part of the asset allocation strategy. The weekly reports contain negative impact single investments may have on overall performance and they are used additionally to assess rolling volatility which Unicredit bases on daily valuations it takes of its assets. Risk contribution and performance attribution applications are currently being developed so Unicredit can keep track of how well it is doing when measured against its benchmarks.
Looking ahead, Unicredit believes a greater concept of risk management could be incorporated into its strategic asset allocation with an overlay programme that would seek to eliminate unrewarded risk. The idea is to limit the impact of a sharp decline in the market by using derivatives. In particular, in periods of low volatility and bull markets, these could be used to generate profits from an overlay that limits losses to 10% and maintains quarterly earnings at 15%. Unicredit claims such an approach could protect it against periods of irregular returns because of market shocks, without the need to review the way the asset allocation strategy is determined.
Highlights and achievements
Asset allocation strategies that are based on the conventional three-year actuarial reports are not set in stone and will need re-adjusting to allow for market movements, changes to risk profiles and manager performance.
Unicredit has come up with a balanced method that enables it to complement its basic allocation strategy with tactical modifications that are based on reports produced as regularly as monthly and weekly. This is an efficient means of keeping track of not only individual investment performance but its overall position.
Moreover, it allows Unicredit to maintain a tight risk control policy which it is ready to take to the next level by developing a derivative-led liability matching programme. This will eliminate unrewarded risk and makes full use of risks that bring extra benefit and generate the excess returns which form part of its investment objectives.