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T h e P e r u v i a n M o d e l
FIAP International Seminar
Melvin Escudero Villavicencio
Intendente de AFP
Supervision Department of Pension Fund Portfolio Management
Santiago de Chile, May, 2006
MULTIFUNDS:
Value Creation Chain in the Private Pension Fund System
Investment Management:
Portfolios Optimized for Risk-Adjusted Returns
Fiduciary Obligations:
Supervision based on Investment and Risk Management:
SUPERVISION AND REGULATION BASED ON VALUE CREATION.
Maximize the
Affiliates’ Pension
Access to a wide range of instruments
Disciplined investment policy Benchmarking Performance Attribution.
Investment Risk Management:
Market Risk Credit Risk Operational Risk Liquidity Risk Risk exposure limits
Prudent Investor Rule Fiduciary governance of Pension
Funds Best Practices in investment and
risk management.
Monitoring of decision-making and investment policies.
Auditing of investment management capabilities at the Front-, Middle-, and Back-Office levels
On-Line access to Fund investments Market watch: Vigilance of marketplace
transactions.Value Circle
Salary (Employer)
Pension Fund(AFP)
Pension (Insurance Co)
VALUE
FOR
THE
AFFILIATE
SUPERVISION AND REGULATION BASED ON VALUE CREATION.
Continually building credibility and a reputation for trustworthiness.
International standards of regulation and supervision
Promotion and development of new investments and markets
Knowledge of and experience in local and foreign markets.
Highly trained and experienced staff
Interaction with major market players
Contact with a global network of investment specialists.
On-line access to risk and investment information.
Exemplarily ethical and professional standards
Best investment and risk practices
SBSSupervision and
Regulation Based on Value Creation
Portfolio Managers
Mutual Funds Investment Funds
Investment Advisors Benchmarks Houses.
Regulators
Local
Foreign
IntermediariesInvestment banks
Broker dealers
Law Firms
Rating Agencies
Research CompaniesForeign IssuersSovereigns
Corporates
Mutual Funds
Trusts, SPV
Local Issuers
Sovereign
Corporates
Inka Bond
AFPInvestment Policy
Front office
Middle office
Back office
Fiduciary Obligations
MarketsStock Exchanges
Settlement/Clearing
Depositories
OTC Markets
Factors which create value:
INVESTMENT MANAGEMENT
2 Ample Investment Flexibility:
3 Multifunds: Three clearly differentiated risk profiles.
Multifund SystemGlobal Systemic Risk
1 Objective: Maximize Risk Adjusted Returns for Each Portfolio
Retu
rn
Risk
The major challenge is to find the optimal portfolio given each funds’ objective.
Fund
Retu
rn
Risk
Efficient Frontier: Multifund System
Efficient Frontier: Previous System
Fund
Investment Alternatives
Ris
k
Earlier System
Expected
ReturnExpected
Risk
Fund 1 (Conservative)
Low Low
Fund 2 (Mixed/Balanced)
Moderate Moderate
Fund 3 (Growth)
High High
Local Market
Common StockDeveloped
Markets
Emerging Markets
Risk Free Sovereigns
Investment Grade
Corporates
Structured Products
BondsGovernment / Central Bank
Inflation Adjusted
Private Equity High Yield Corporates
Asset Class
Real EstateStructured Products
Commodities
Hedge Funds
ForwardsCurrency
Underlying
FuturesInterest Rate Underlying
OptionsAsset Prices Underlying
SwapsCredit Risk Underlying
Tradicional Assets (Liquid)
Alternative Assets (Illiquid)
Derivatives
Fixed Income Local Currency
Fixed Income Foreign Currency
Inflation Adjusted
Eligible Instruments in Multifund System
Equity
Common Stock Warrants ADR / GDR
Equity Mutual Funds Equity Investment Funds Equity Structured Products
Fixed Income
Corporate Bonds Preferred Stock Sovereign Bonds and Notes
Agency Issues Regional Bonds Munis
International Organizations (IFC, World Bank)
Central Bank CDs Mortgage Backed Securities
Leasing Bonds Subordinated Bonds Structured Debt
Revenue Bonds Concession-Linked Bonds Convertible Bonds
Bank CDs Fixed Income Investment and Mutual Funds
Real Estate Funds
Structured Products Repos Mortgage Notes
Derivatives
Futures Options Forwards
Swaps Underling can be Exchange Rate, Prices, Rates, or Credit-linked.
Money Market
Short-term Mutual Funds Money Market Accounts Time deposits
Bank CDs Commercial Paper Repos
Reverse Repos Bankers Acceptance Bills
INVESTMENT MANAGEMENT
>60
year
s>4
5 an
d <
60 y
ears
>20
and
<45
yea
rs
Fund 1
0
20
40
60
80
100
120
Common Stock Fixed Income Money Market Derivatives
Positiion Remaining Capacity
10 126
6510 10
40
100
Fund 2
-20
0
20
40
60
80
100
Common Stock Fixed Income Money Market Derivatives
Position Remaining Capacity
0.211
4345
45
10
30
75
Fund 3
0
20
40
60
80
100
Common Stock Fixed Income Money Market Derivatives
Position Remaining Capacity
74
11015
80
2030
70
INVESTMENT MANAGEMENT
4 Disciplined Investment Policies: 5 Benchmarking and Performance Attribution Analysis:Activity Best Practices
• Analysis of risk-adjusted return performance• Rebalancing policy based on asset class and investment
type.
6. Fund monitoring and portfolio rebalancing.
• Portfolio construction criteria• Characteristics of trading policy• Optimization models
5. Construction of optimized portfolio
• Define criteria for selecting between internal and external management
• Investment objective for each instrument type• Allowable instruments.• Applicable restrictions and limits.• Define risk parameters
4. Investment policy for each type of instrument.
• Describe strategic criteria for varying from long-term asset allocation
• Explain the criteria for deciding between active or passive management
• Monitoring procedures and methodologies• Describe investment styles• Define internal limits and maximum variation allowed.
3. Tactical Asset allocation
• Eligible asset classes• Long term investment objectives• Target long-term diversification• Benchmark for each asset class
2. Strategic Investment Allocation
• Risk-Adjusted Return Profile.• Profile of targeted investor• Risk profile
1. Define Fund Objectives Benchmarking allows the managers
performance and measurement of risk-adjusted return on a comparative basis.
Each asset class has its own benchmark
Each AFP chooses their own benchmark
Benchmarks can be different between funds, even when they are compared to the same or similar asset classes.
Benchmarks allow for Performance Analysis
Performance information will initially be restricted to the SBS and the AFP. Later, the information will be made public.
Sharpe Ratio Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark
Tracking ErrorInformation Ratio
BenchmarkBenchmark BenchmarkBenchmark Benchmark
Nominal Return Standard Dev. Benchmark
Benchmark Benchmark
Benchmark
Real ReturnBenchmark Benchmark Benchmark Benchmark
Benchmark BenchmarkBenchmark BenchmarkNominal Return
Benchmark
Fund 1Local Market International Markets Local Market International Markets
Asset Class
Measure of Return
Equity Fixed Income
Local Money Markets
PERFORMANCE ATTRIBUTION ANALYSIS
Sharpe Ratio Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark
Tracking ErrorInformation Ratio
BenchmarkBenchmark BenchmarkBenchmark Benchmark
Nominal Return Standard Dev. Benchmark
Benchmark Benchmark
Benchmark
Real ReturnBenchmark Benchmark Benchmark Benchmark
Benchmark BenchmarkBenchmark BenchmarkNominal Return
Benchmark
Fund 1Local Market International Markets Local Market International Markets
Asset Class
Measure of Return
Equity Fixed Income
Local Money Markets
INVESTMENT RISK MANAGEMENT
1 Best Practices in Management Company Structure and Reduction of Conflicts of Interest:
2 Professional Risk Management:
Responsibility: The AFPs must identify, measure, analyze, monitor, control, and
disclose the investment risk of the funds under management, whether or not those risks are quantifiable.
The AFPs provide mandatory risk limits with the above mentioned criteria.
Minimum returns are established based on Relative VaR.
Market Risk: Models and systems sufficient to monitor and evaluate all
positions. Calculate VaR, including sensitivity analysis to key factors,
using historical information and stress testing of key risk factors. Contingency planning.
Credit Risk: Credit analysis procedures Calculate default probability for each instrument and issuer
(transition matrix) Analyze expected losses.
Liquidity risk Estimate withdrawals. Estimate losses from sales of illiquid assets Plans for mitigating illiquidity.
Operational risk: Propose and monitor the implementation of internal controls Define processes, identify points of failures, and contingency
planning. Balance Score Card.
Board of Directors
Risk Committee Investment Committee
Investment Unit Risk Unit Custody Records and Accounting
Internal Audit
CEO
Design and implement the investment policy for each fund
Optimize the portfolio.
Manage the portfolio.
Investment Analysis
Evaluate investment alternatives.
Identify, measure, analyze and monitor:
Market Risk.
Credit Risk.
Operational Risk.
Liquidity Risk.
Establish investment and risk limits
Clearing and settlement
Monitoring of physical movements and registers
Centralized record keeping.
Daily Investment Report.
Fund Accounting.
Independent OutsideAuditor
MANAGEMENT COMPANY STRUCTURE
3 New Pricing System provided by the SBS:
INVESTMENT RISK MANAGEMENT
Recently Adopted Improvements: Best Practices in Valuation. Improved transparency in the valuation of illiquid assets Experienced Outside Auditor (international price vendor) Price Vector Committee, with outside independent
members. AFPs can object to specific, individual prices. Published zero-coupon sovereign curves. Price estimation of illiquid corporate bonds via a credit
spread over the sovereign curve makes visible the portfolios volatility.
The greater visibility of volatility requires the development of an appropriate risk management system.
Incentives for the development of a derivatives market for interest rate hedging (FRAs and swaps)
Arbitrage possibilities between local and external bond markets.
PRICE VECTOR GENERATION
Send Final Price Vector (6:00 pm)
Price vector Committee: 5 Representatives from the SBS 2 Independent professionals named by the SBS 1 Representative of the AFPs
Functions: Approve and validate the policies, criteria, methodologies and manuals regarding valuation and review objections to pricing. Meets periodically, at minimum, monthly..
Valuation Committee: 4 Representatives of the SBS
Functions: Approves the final version of the price vector on a daily basis, verifies compliance with the pricing manual, evaluates pricing objections and reports to the Price Vector Committee.
Establishes Policies, Criteria, and
Methodologies.
Reports compliance with the policies, criteria and methodologies and
objections received.End Users of Price Vector (AFP)
Represented on the Price Vector Committee
Can present objections on a daily basis.
Can Object to Preliminary Price Vector (5:00–5:30 pm)
Transmits Preliminary Price Vector (5:00 pm)
Department of Investment Valuation. Technical Team.Functions: Produce and distribute the preliminary price vector ( ) and, if there are objections accepted by the Valuation Committee, produce and distribute an updated final price vector ( ).
Directs the modification of the preliminary price vector, in the case of a sustained objection (5:00 pm – 6:00 pm)
SOVEREIGN CERO CUPON CURVE
FIDUCIARY OBLIGATIONS
1 Pension Funds Fiduciary Governance :
Mitigate conflicts of interest and agency problems.
Aligns interests with those of the affiliates
Fiduciary Obligation with the Fund
Prudent
Investor
Investment and decision making based in processes with an adequate basis.Specialists professionals in investment and risk management.
In the process of investing Fund resources, the AFPs must act :
With the objective of providing benefits to each Fund’s affiliates;
With the diligence and competency required of an investment expert;
With impartiality, care, reserve, discretion, prudence and honesty;
Maintaining a risk-return balance appropriate with each Fund’s objectives;
Diversifying the investments in such a way that the portfolio maintains a level of risk reasonable for the Fund’s objectives; and
Respecting and complying the applicable rules and laws.
Responsibilities defined at governing, managerial and operational levels.
2 Prudent Investor Rule:
Investments (Front Office)
Risks (Middle Office)
Custody, Record Keeping, and Accounting
(Back Office)
Pension Fund Fiduciary Governance
Corporate Governance
AFP Board of Directors
FIDUCIARY OBLIGATIONS
Code of Ethics:
Based on international standards and applicable to all personnel involved in the investment process, it includes Personal Investment Policy, Conflict of Interests, Proper Use of Information, etc.
3 Best Practices:
Professional Capacity:
The AFP define the minimum requirements for training and experience for investment and risk management personnel to guarantee a sufficiently high level of technical competence. The AFP have indicated a preference for requiring that covered employees pass the CFA Level I exam. Conflicts of Interest:
The AFP cannot redistribute gains or losses between funds, within funds, to the management company, or to related third parties.Prohibited Trading Practices:
The AFP have drawn up a detailed list of trading practices which will not be used. Some of these practices are Front Running, Cherry Picking, Insider Trading, etc.
Marketwatch:
Both the AFP and the SBS have marketwatch systems to detect possible trading violations.
Evaluation of Trading Costs:
The AFP should take an inclusive approach to evaluating investments, including all relevant trading and execution costs, to ensure that they acquire the most competitively priced instruments.
SUPERVISION OF INVESTMENT AND RISK MANAGEMENT
Front Office: Expertise (Specialists) Middle Office: Appropriate Risk Evaluation Back Office: Adequate settlement and clearing, record
keeping, and accounting capacity.
Market Watch Prudent Investor Rule Best Practices Investment Policies Performance Analysis Risk Limits Appropriate Personnel and Resources Prevent adverse situations for the affiliate.
Daily Investment Report including details of all transactions.
Direct access to depository and custodian accounts Validation, checks, and daily audit of the investments and
NAV of each fund Register of instruments and counterparties.
Focus on the supervision of processes and the management of investments and risk.
Specialists with the required know-how to adequately audit investment and risk management.
Adjust regulation based on market evolution and promote more efficient investment options.
4 Modern and flexible regulation and supervision based on best practices:
2 Daily access to detailed risk and investment information:
1 Requirements for the authorization of new asset classes and instruments:
3 Monitoring the diligence of investment management:
Start Date: December 9, 2005 Initial low levels of inter-fund movement due to:
Fund 1: Mandatory transfer for persons over 60.
Fund 2: Perceived as neutral and well-known
Fund 3: Perceived as risky.
Competition caused by the entrance of a new AFP interfered with new system’s publicity campaign
Electoral uncertainty.
Wait-and-see attitude.
EVOLUTION OF THE MULTIFUND SYSTEM TO DATE
Expected higher levels of inter-fund transfers based on return differential between funds.
Structural limitations on the supply of investment opportunities drives the development of new domestic investment alternatives (private placements, structured products, project finance, etc.) and an evaluation of the external investment limits. Pension funds in the last 6 years have grown at a 27% annual rate.
Portfolio Value (mills. US$)
-
2,000
4,000
6,000
8,000
10,000
12,000
Abr-01 Abr-02 Abr-03 Abr-04 Abr-05 Abr-06
0%
5%
10%
15%
20%
25%
30%
35%
Portfolio Value Annual Growth Rate
Amount %Fund 1 141.73 3.8%Fund 2 3,592.75 96.0%Fund 3 9.55 0.3%Total 3,744.03 100.0%*In thousends, preliminary numbers.
NUMBER OF AFFILIATES*
Mar-06
Amount % Amount % Amount % Amount % Amount % Amount %Fund 1 679.44 6.9% 670.45 7.0% 699.97 6.8% 705.39 6.7% 691.27 6.7% 708.75 6.4%Fund 2 9,147.75 92.5% 8,793.76 92.3% 9,535.28 92.4% 9,732.41 92.4% 9,465.63 92.3% 10,180.77 92.4%Fund 3 65.55 0.7% 63.15 0.7% 85.63 0.8% 99.14 0.9% 102.65 1.0% 124.46 1.1%Total 9,892.74 100.0% 9,527.36 100.0% 10,320.87 100.0% 10,536.94 100.0% 10,259.55 100.0% 11,013.98 100.0%*Amounts in millions of USD
**December 9th 2005
Funds Value
Start** Dec-05 Jan-06 Feb-06 Mar-06 Apr-06
Portfolio Value (mills. US$)
-
2,000
4,000
6,000
8,000
10,000
12,000
Abr-01 Abr-02 Abr-03 Abr-04 Abr-05 Abr-06
0%
5%
10%
15%
20%
25%
30%
35%
Portfolio Value Annual Growth Rate
BENEFITS OF THE MULTIFUND SYSTEM
Higher expected pension benefits due to compounding effect (1% increase in returns during 30 years implies around 20% higher expected pension benefit)
The improved decision-making process and the alignment of the affiliate’s and AFP’s interests towards more efficient investment management, guarantees a transparent process which will generate value for everyone.
Greater efficiency in the savings-investment cycle of the economy improves the virtuous circle of development and growth, improving the permanent income of affiliates.
THE MULTIFUND SYSTEM’S ENVIRONMENT
IMPACT AND ADDED VALUE OF THE MULTIFUND SYSTEM
Factor Changed by Multifund System Impact and Value Added
Affiliates
Age, investment horizon and risk tolerance Expected pension benefit. Period of association with a particular AFP
Higher account capitalization and expected pension benefit Higher level of financial understanding Choice based on risk-return profile.
Pension Funds
Fund 1 (conservative) Fund 2 (mixed) Fund 3 (growth)
Optimized portfolios Higher expected risk-adjusted return Better diversification across asset classes and instruments Necessity for better access to international capital markets to
compensate for scarcity of local supply
AFP
Disciplined investment policy Front Office Middle Office Back Office Prudent Investor Rule Fiduciary governance of funds Global Asset Allocation Ethical Conduct and professional
requirements
Compliance with international fund management standards Higher volume of assets under management Improved competition (3 market segments) Economies of scale Improved confidence in the Private Pension Fund System.
Local Issuers
Government and Central Bank Corporations Investment and Speculative Grade issuers
More financing alternatives. New issuers via private placement and new projects. Drives the development of new funds, i.e. private equity, venture
capital, REITs. Drives the development of a local derivatives market. Inclusion of small and medium enterprises, both by direct and
indirect investment Highly competitive financing costs for local issuers.
Factor Changed by Multifund System Impact and Added Value
Foreign Issuers
Sovereign Corporates Mutual Funds
Access to new markets (venture capital, private equity, emerging markets, high yield, real estate, hedge funds)
Access to derivatives for hedging purposes Better diversification across currencies, instruments, regions, and
countries
Intermediaries
Investment banks broker-dealers Law Firms Rating Agencies Research Companies
Greater number of issuers Higher transaction volumes Greater sophistication Greater number of counterparties Improved research demand Improved competition between counterparties.
Portfolio Managers
Mutual Fund Administrators Investment Fund Administrators Investment Advisors
New methods of investment Increased number of available asset classes Promotes more investment advisory services Greater specialization in illiquid and more sophisticated investments Improved competition and lower costs.
Government Pension Policy Minimum Pension
Possibility of lower expected draw on Treasury to cover minimum pension shortfalls.
Strengthening of Pension Reform Better pension coverage.
Economic Growth
Savings Investment Production Employment
Improved depth and sophistication of local capital markets. Drives a virtuous circle of savings and investment. Increased contribution towards financing and economic growth.
IMPACTO Y VALOR AGREGADO DE LOS MULTIFONDOS
