RISK ALLOCATION IN THE 21 ST CENTURY. February SEATTLE LOS ANGELES

Transcription

1 RISK ALLOCATION IN THE 21 ST CENTURY February 2012 SEATTLE LOS ANGELES

2 AGENDA INVESTMENT APPROACH SAMPLE RISK DASHBOARD GOVERNANCE 2

3 INVESTMENT APPROACH 3

4 WHY DOES RISK ALLOCATION MATTER? Compound Return 10 Years at 10% return produces an annualized return of 10% What would the annualized return be if on the 10 th year we have a -30% return? The Importance of Limiting Drawdowns 9 years at 10% return plus a one year return of -30% produces an annualized return of 5.14% 4

5 PROBLEM: ASSET ALLOCATION Buy and Hold Mean-Variance Optimization Black-Litterman Model Endowment Model Risk Parity Programmatic Tail Risk Hedging Wurts Risk Allocation Strategy 5

6 OPTIMAL DOLLAR ALLOCATION? Goldman Sachs Average Public Fund PIMCO Bridgewater GMO AQR Government Bonds Corporate Bonds Equities TIPS Commodities Real Estate & Infrastructure Absolute Return & Other 6

7 OPTIMAL RISK ALLOCATION? Goldman Sachs Average Public Fund PIMCO Bridgewater GMO AQR Government Bonds Corporate Bonds Equities TIPS Commodities Real Estate & Infrastructure Absolute Return & Other 7

8 I NVESTMENT PRINCIPLES Diversification Risk Valuation Principles 8

9 RISK ALLOCATION BUILDING BLOCKS Liquid Beta & Alpha Hedge Funds and Real Return Managers Illiquid Beta & Alpha Bank Loans Mezzanine Debt Private Equity Distressed Debt Real Estate Infrastructure Timber Agriculture Energy High Fees Liquid Beta & Alpha Rates Credit Equity Real Assets Currency Moderate Fees 9

10 INVESTMENT PHILOSOPHY Risk is Not Volatility Drawdown risk and failure to satisfy liabilities Allocate Risk, Not Assets Seemingly dissimilar assets carry the same risks Diversification Determined by risk factors and economic sensitivities Price Matters Valuation based asset allocation methodologies Micro-efficiency of Markets Manager alpha is fleeting and hard to find Macro-inefficiency of Markets Opportunistically allocating to risk factors can add value Minimize Fees and Costs Trading costs and fees should be expertly managed Security Selection Manager Selection Active Risk Budgeting Risk Allocation Risk Framework Delegated to Investment Managers 10

11 WHAT IS RISK MANAGEMENT? Risk is NOT just the standard deviation of returns! Risk is first and foremost the risk of losing principal. At what point is the drawdown too deep? Deployment of Capital Alignment of Risk & Objectives Culture Defining Boundaries Risk is failing to meet the demands of the organization. Risk is an unexpected negative event. Seizing Opportunities Communication Tool Risk Response Not a System! 11

12 APPLICATIONS FOR RISK MANAGEMENT Active Defensive Managing risk through capital allocation Controlling risk through limits Passive Information reporting on aggregate risk 12

13 ASSETS CONTAIN MULTIPLE RISK FACTORS Volatility Credit Spread Currency Interest Rate Corporate Bond Inflation Bonds for Safety? NOTE: Not all are Created Equal! 13

14 RISK GUIDELINES Absolute Risk Limits Dollar Allocation Limits Asset class Private assets Relative Risk Limits Normal Market Risk Value-at-Risk Tail Risk Specific Risk Limits Scenario analysis Stress testing Liquidity Counterparty Concentration Leverage Pricing Derivatives notional exposure Derivatives delta equivalent exposure Etc. Active Risk Ex ante tracking error 14

15 WURTS RISK ALLOCATION STRATEGY (WRAS) Economic factor analysis Risk factor analysis Equity, rates, credit, currency, co mmodities, etc. Scenario analysis Stress testing Relative risk (VaR & active risk) Return composition (ex ante) Income vs capital appreciation Return by risk factor 15

16 RISK FACTOR BUILDING BLOCKS Primary Risk Factors Rates Credit Equity Inflation Currency Domestic Investment Grade Domestic TIPS Secondary Risk Factors International High Yield Emerging Markets International Emerging Markets Commodities Developed Emerging Market Emerging Markets Private Private Private Curve Curve Country Country Tertiary Risk Factors Duration Liquidity Duration Liquidity Country Value Momentum Sector Curve Duration Country Carry Country Sector Size Liquidity 16

17 ECONOMIC RISK MAP Rising GROWTH Falling Rising Commodities Infrastructure Real Estate Equities Corporate bonds Emerging market debt Inflation linked bonds Commodities Infrastructure Real Estate INFLATION Falling Equities Corporate Bonds Emerging market debt Infrastructure Mortgages Government Bonds Real Estate Commodities Government Bonds Corporate bonds Emerging market debt Inflation linked bonds 17

18 INVESTMENT PROCESS Uncover and Understand Client s Liabilities and Objectives Usually deciphered through scenario analysis Identify Client s Risk Exposures & Tolerances In-depth review of the multitude of risks associated with institutional portfolios Communication Client Liabilities & Objectives Client Risk Tolerances Portfolio Construction Assume markets are in equilibrium, e.g. risk premiums are normal Start with a foundation of diverse primary risk factors: Interest Rates Credit Equity Real Assets Currencies Subject to economic and geographical diversification Risk Rebalancing Portfolio Construction Diversify explanatory factors of expected returns. If appropriate, layer in private assets to enhance overall long-term risk and return characteristics. Establish an active risk budget to strategically tilt the portfolio based upon risk premiums which have drifted far from normal. Risk Monitoring Manager Selection Portfolio Implementation 18

19 INVESTMENT PROCESS Portfolio Implementation Focus on preserving the ability to effectively implement ideas using low-cost, highly-liquid vehicles in order to manage risk factor exposures. Manager Selection Risk culture Integrity and ethics Operational excellence Team & business stability Investment philosophy Experience Alignment of Interest Track record true alpha Emotional discipline Risk Rebalancing Communication Client Liabilities &Objectives Client Risk Tolerances Portfolio Construction Continuous Risk Monitoring Market risk, liability risk and operational risk Active Risk Management Overlay tactical tilts of hedges based upon risk premiums that drifted far from normal Risk Monitoring Manager Selection Portfolio Implementation Effectively and Timely Communication No surprises 19

20 SAMPLE RISK DASHBOARD 20

21 DOLLAR ALLOCATION LIMITS Policy allocation benchmark per Investment Policy 21

22 DOLLAR ALLOCATION LIMITS BY ASSET CLASS Policy allocation benchmark per Investment Policy

23 TAIL RISK SCENARIO ANALYSIS Subprime Mortgage Meltdown (Oct. to Feb.) 2001 Dot-com Slowdown 1998 Russian Financial Crisis Asian Financial Crisis 1994 Rate Hike EMS Turbulence Nikkei Crash 1987 Market Crash (Oct. 14 to Oct. 19) Oil Crisis (Dec. to Sep.) -40% -30% -20% -10% 0% 10% 20% Portfolio Benchmark 1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 2-Real estate and infrastructure are modeled as real estate investment trusts 23

24 TAIL RISK STRESS TESTING USD FX 20% US Tre Shift Long End US Spread Corp 100bps US Rates 200bps US Eq -20% Global Rates 200bps Global Eq -20% EM FX -20% EM Eq -30% -14% -12% -10% -8% -6% -4% -2% 0% Portfolio Benchmark 1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 2-Real estate and infrastructure are modeled as real estate investment trusts 24

25 RELATIVE COMPONENT RISK - VAR Portfolio Company Exposure Interest Rates Equities Real Assets Credit Currencies Special Opportunities 25

26 HISTORICAL MONTHLY RELATIVE VAR PORTFOLIO VS POLICY RISK BENCHMARK 1- Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 26

27 TRACKING ERROR RISK Tracking Error: A measure of how closely a portfolio follows the index to which it is benchmarked. Usually the standard deviation of the difference between the portfolio and benchmark returns. Tracking Error is annualized. Portfolio Company Exposure Interest Rates Equities TIPS Credit Currency Investment Grade 27

28 RELATIVE RISK - VAR 97.5 %, 1 year VaR or 1 event every 40 years under normal market conditions. Cash Bonds 60/40 Plan APFC Benchmark Avg. Pension Avg. Endowment Equities -40% -35% -30% -25% -20% -15% -10% -5% 0% Bonds: Global Treasury Index, Hedged Equities: MSCI All Country World Investable Market Index (ACWI IMI) 1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 28

29 R ELATIVE COMPONENT RISK Contribution to Total Risk from Equities 79% Components together do not equal 100% due to Diversification 97.5 %, 1 year VaR or 1 event every 40 years under normal market conditions -40% -35% -30% -25% -20% -15% -10% -5% 0% Currency Interest Rates Fixed Income Special Opportunities Absolute Return Real Assets APFC Plan Company exposure Equities 1-Real estate and infrastructure are modeled as leverage adjusted real estate investment trusts 29

30 C URRENCY RISK Dollar Non-Dollar* Non-Dollar* 0% 10% 20% 30% 40% 50% 60% 70% 80% EM 5% 6% 29% 33% 67% 71% 0% 5% 10% 15% 20% 25% 30% 35% Portfolio Benchmark 29% 33% Developed Market Currency Risk Top Five Exposure $ US Dollar $ 29,029 Euro $ 2,560 British Pound $ 2,009 Japanese Yen $ 1,536 Canadian Dollar $ 794 Total $ 35,927 Emerging Market Currency Risk Top Five Exposure $ Brazil $ 366 Korean Won $ 358 New Taiwan Dollar $ 277 Indian Rupee $ 215 Mexican Peso $ 153 Total $ 1,369 1-Non-Dollar (*) includes emerging markets 2-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 30

31 COUNTRY RISK 70% 60% 50% 40% 30% 20% 10% 0% North America Europe Pacific EM Asia Other Latin America Portfolio EM Europe & Middle East Developing Country Exposure $ China $ 491 Korea $ 355 Taiwan $ 263 Brazil $ 248 India $ 211 South Africa $ 133 Mexico $ 120 Israel $ 110 Indonesia $ 105 Turkey $ 103 Total $ 2,140 Benchmark 1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 31

32 PRIVATE VS. PUBLIC Public 71% 79% Portfolio (%) Private 21% 29% Asset Allocation Benchmark (%) 0% 10% 20% 30% 40% 50% 60% 70% 80% 21% Private Investment Limits 0% 10% 20% 30% 40% 50% 1-Public: 144A, securities registered and/or traded on an exchange. 2-Private: securities that are not registered and do not trade on an exchange. The price is set through negotiation between the buyer and the seller/issuer (Private Equity, Real Estate, Infrastructure, Hedge Funds, Mezzanine Debt, Distressed Debt). 3-Allocation Benchmark: 2% Cash, 6% Interest Rates, 53% Company Exposure, 18% Real Assets, 21% Special Opportunities 32

33 FUTURE COMMITMENT RISK Investment Total Undrawn Forecast 1 Year Private Equity $1,579 $427 Infrastructure $603 $269 Distressed Debt $396 $264 Mezzanine Debt $440 $100 Total $3,018 $1,060 Future Commitments Limits 8% 0% 10% 20% 30% 33

34 BUSINESS COUNTERPARTY RISK Firm Name SWF Assets (mm) % of Manager Business % of SWF Portfolio % of Top 3 Clients ex SWF Crestline $1,109 19% 3% 15% L&B $596 15% 1% 58% Mariner $1,157 11% 3% 20% McKinley $712 6% 2% 24% Global Infrastructure $315 6% 1% 17% Pathway $1,218 5% 3% 37% AQR $1,601 5% 4% 17% Cap Guardian $2,172 4% 5% 14% Citi Infrastructure $382 3% 1% 11% 34

35 BUSINESS COUNTERPARTY RISK Firm Name Fixed Income (mm) Equity (mm) Alternative (mm) Total % of SWF Mellon $6,050 $6,050 15% Cap Guardian $203 $1349 $621 $2173 5% GMO $1206 $711 $1917 5% DFA $1760 $1760 4% Lazard $1290 $365 $1655 4% AQR $647 $628 $1275 3% RCM $1530 $1530 4% GE $1419 $1419 4% Pathway $1218 $1218 3% Mariner II $1157 $1157 3% 35

36 ACTIVE RISK CONTRIBUTION 6% 91% 28% Risk Active Risk 9% 47% 5% 14% Cash Interest Rates Company Exposure Real Assets Opportunity Pool 36

37 LIQUIDITY RISK 100% 90% 80% Liquidity Risk- Limited ability to liquidate an asset or asset classes 70% 60% 50% 40% 30% 20% 10% 0% Cash Liquid Quasi-liquid Illiquid Cash: Portfolio Cash, External Managers Cash Liquid: US Rates, Global Rates, Domestic Large Cap Equity, International Large Cap Equity, REITs, TIPS, Real Return Quasi-liquid: CDs, MBS/ABS, Investment Grade Debt, High Yield, CMBS, Domestic Small Cap Equity, Emerging Markets Equity, Emerging Market Debt, Real Return Illiquid: Private Equity, Private Real Estate, Infrastructure, Absolute Return, Distressed Debt, Mezzanine Debt, Real Return Assets are subject to reclassification 37

38 PRICING RISK Listed 42% 55% Readily 16% 18% Less Readily 12% 21% Non-readily 13% 21% 0% 10% 20% 30% 40% 50% 60% 1-Listed: Cash, Domestic Equities, International Equities, Small Cap Equity, Emerging Market Equity, Real Return 2-Readily: Alaska CD Program, MBS, ABS, Investment Grade Debt, US Rates, Global Rates, Real Return 3-Less Readily: High Yield Debt, Hedge Funds, Distressed Debt, CMBS, Mezzanine Debt, Emerging Market Debt 4-Non Readily: Private Equity, Private Real Estate, Infrastructure 5-Allocation Benchmark: 2% Cash, 6% Interest Rates, 53% Company Exposure, 18% Real Assets, 21% Special Opportunities 38

39 GOVERNANCE 39

40 DEFINITION OF FUND GOVERNANCE Fund Governance Define Key Risks Set Risk Tolerance Clearly delineate Authority Responsibility Accountability Escalation protocol 40

41 FUND GOVERNANCE IN PRACTICE Monitor & Oversee Policies Spending, Asset Allocation, Management, Manager, Compensation, etc. Corrective Action Mission & Philosophy Education Delegation of Authority Communication 41

42 IMPORTANCE OF POLICIES Risks Documented & Monitored Continuity Compliance Structure Facilitates Continuous Improvement Policies Transparency Effective Decision Making Prudence & Diligence 42

43 EFFECTIVE BOARDS Sound understanding of the institution Mission, goals and objectives Policy-focused Risk tolerances, strategic asset allocation, structure, etc. Prudence through defined process Risk oversight, risk allocation, manager selection, etc. Effective oversight Communications, conflicts of interest, performance, etc. 43