Governance, Transparency and Good Portfolio Management with Internet- based Tools Dr. Arun Muralidhar

2 Outline 1)Keys to Effective Portfolio Management: 5 Key Steps 2)Good Process Overcomes Challenges in Managing Funds 3)Technology Challenges: Where Web Applications Help 4)Using Web-based Technologies Effectively – Demo Structuring portfolios; understanding risks; converting risks into higher returns; using attribution to improve decisions 5)Using the Internet to Empower Investors 6)Summary and Conclusions

3 Who Benefits from This Presentation? Country pension funds Central banks Funds-for-the-future (e.g., funds to preserve wealth from the extraction and sale of commodities) Liability management organizations IT Departments: Help make front and middle office effective

4 1. Key to Success – Effective Decisions Good management = must make many decisions well Must make these decisions in an informed manner Process, transparency and governance are critical Challenge: Can technology integrate front & back office? Measure Risk Evaluate Performance Outperform Benchmark Determine Benchmark Set Objectives Annual Daily Monthly

5 1. Many Share Responsibility for a Fund Asset- Liability Risk Tactical & Benchmark Risk Manager/ Active Risk Responsibility Monitor Manage Board of Governors Internal StaffOutside Managers AnnuallyDaily/MonthlyMonthly Strategic Decisions – Need Good Reporting Effective Investment Decisions – Need IT Support Manager Selection Decisions – Good Reporting Responsibility Decision Frequency How to Manage the Risk Need good technology to track and manage all decisions

6 1. Portfolio =Many Decisions Asset Allocation Sector/ Regional Style Selection Manager Selection Cash/ Currency = 20% Equity = 40% By Market (Local, US etc.) Large Stocks/ Small Stocks By Market (Local, US, Euro) Govt./Agency etc. Bonds = 40% P o r t f o l i o Mgr A Mgr B Mgr C Mgr D Mgr E Mgr F Bank 1 for Deposits Bank 2 for Deposits

7 1.Manage ongoing cash inflows and outflows 2.Evaluate and implement rebalancing strategies 3.Manager selection and allocations 4.Asset, country, style, sector or currency allocation 2. Challenges in Managing Portfolios A portfolio is very dynamic – impacted daily. Each decision can be a source of return or, if badly managed, can reduce returns

8 1.Resource constrained: financial (budget) and staffing 2.In public eye: decisions are reviewed publicly 3.Need to demonstrate that decisions not political; need to show financial impact of political constraints 4.Good governance and transparency critical 2. Challenges in Public Entities Challenge: Can technology empower staff, to raise return and lower risk while maintaining control?

9 SILO SYSTEMS – Narrow Applicability: 1)Focus on only one asset (stocks/bonds) or one aspect (e.g., risk or performance measurement; trading) 2)Multiple systems; high cost to integrate/maintain 3)Required extensive training and client IT backup 4)Not designed by people who managed funds 3. Current Technology Challenges Senior managers are at risk – not knowing what is impacting the fund or how to correct it

10 EXCEL based models are often used to make investment decisions, which from a technology perspective pose serious challenges: EXCEL models prone to error (not transparent) Key man risk (if staff leaves); create large teams as insurance Difficult to share ideas/analyses across organization Managers are at risk if the models have errors 3. Current Technology Challenges Alternative technology must be transparent, robust, inexpensive and easy to use!

11 Enterprise system can be implemented at low cost Easy to use and can customize their overall fund Support all asset areas in one technology Link portfolio management, risk and performance in one system/framework: transparent, flexible, quick Data management can be simplified 3. Web/ASP Model Overcomes Problems Senior managers are empowered – access results from their desktop (intranet or internet)

12 Integrated system that allows user to follow specific process steps: 1.Specify a clear investment process (i.e., who makes what decisions at what level of the fund) = GOVERNANCE 2.Understand all the risks taken by the fund = GOVERNANCE 3.Model decisions in a TRANSPARENT way (i.e., simple so that anyone can understand/evaluate) 4.Attribute performance to improve decisions 4. Using Web-based Technologies Effectively Governance, process & transparency = better returns A Case Study:

13 Case Study: Step 1 Articulate Responsibilities/Decisions Asset Allocation Sector/ Regional Style Selection Manager Selection Cash/ Currency = 20% Equity = 40% By Market (Local, US etc.) Large Stocks/ Small Stocks By Market (Local, US, Euro) Govt./Agency etc. Bonds = 40% P o r t f o l i o Mgr A Mgr B Mgr C Mgr D Mgr E Mgr F Bank 1 for Deposits Bank 2 for Deposits

14 Case Study: Step 2 Use Portfolio Tree to Pinpoint Risk Risk= 1.5% Maximum Drawdown = -7.5% Structuring risk at total fund level=1.5% (or $300 mn) From asset allocation and style tilts (excludes managers) From allocations to assets other than fund benchmark Allocation decisions have historically had big drawdowns Risk = 1.5% Maximum Drawdown = -5.5% Risk = 3.2% Maximum Drawdown = -11% Risk = 1.8% Maximum Drawdown = -6.8% Pension Fund

15 Case Study: Step 3 Ensure Decisions Generate Returns Excess Return = 0.5% Total Excess = 2% Local Bonds Foreign bonds Mortgage/ Corporate Government Bonds Total Portfolio EquitiesCurrency Cash 1-mo LIBOR Asset allocation strategy Country allocation strategy Sector allocation strategy + + Manager Excess Return = 0.5% + Internal/External Managers

16 Local Bonds Foreign bonds Mortgage/ Corporate Government Bonds Total Portfolio EquitiesCurrency Cash 1-mo LIBOR Naïve Rebalancing Let Portfolio Drift Sector allocation strategy Internal/External Managers Case Study: Step 4 Use Attribution to Improve Decisions Excess Return = 0.5% Excess Return = - 0.5% Total Excess = 0% + Manager Excess Return = 0.5% + Too much focus on manager selection

17 Case Study: Step 5 Portfolio Rules: Web = Transparency Good decisions add returns and reduce risk Rule Criteria: IF (( Price of Gold Today > Price of Gold a Year Ago )) THEN Allocate more to Cash ELSEIF (( Price of Gold Today < Price of Gold a Year Ago )) THEN Allocate less to Cash ELSE Do Nothing Investment Idea: Cash vs Bonds: Apparently, the price of gold is a good indicator of whether funds should be invested in cash or higher duration assets (bonds). Rising gold prices are good for cash relative to bonds. Performance Statistics: Excess Annualized Return: 0.61% Risk: 0.94% Information Ratio: 0.65 Max Drawdown: -1.24% on 3/31/1999 Success Ratio: 61.1% Confidence in Skill: 97.95% Example: *Purely hypothetical example and not an investment recommendation

18 Case Study: Step 6 Deliver Detailed Reports Through Web Performance Measures Benchmark Strategy Return % Cum. Return % Risk % Return / Risk Ratio Excess

19 1.Boards/Senior Managers can set fund structure and monitor all decisions easily 2.Portfolio managers can use to make better decisions 3.Middle office can use to evaluate risks/performance 4.Web-technology for 3 Ms of Portfolio Management: Measure, Monitor and Manage 5. M cube IT: Better Governance/Returns Through Web Applications

20 6. Summary & Conclusions Portfolio management = many decisions and requires many groups to coordinate (board, front office, back office, external managers) Silo systems make it difficult and expensive to manage fund Web (internet/intranet) can overcome challenges Can create customized portfolio structure, analysis and reports Can create transparency for good governance, returns and risk management AlphaEngine TM : adopt best practices quickly and easily

Appendix

22 RuleRule Description Cash vs. Bonds, based on Gold Duration choice based on price of gold. If the spot price of gold is higher than it was a year ago, overweight cash, otherwise overweight bonds Stocks vs Bonds: Halloween Effect Stocks tend to underperform bonds between June and Sept - apparently works in 16 out of 18 stock markets, so underweight stocks during this period Stocks vs Bonds: Inflation/Growth Equities undervalued when inflation rises (Modigliani-Cohn insight); equities favored when industrial production is increasing Market Volatility Low equity volatility in a rising stock environment is bullish for equities. Oil and Economy Rising oil prices affect the economy and tend to depress equities. P/E Ratio Rule Value rule for equity (vs FI) using the S&P 500 P/E Fed Model When equity yield is higher than treasury yield then buy equity, else sell equity Unemployment Rate Buy stocks when the unemployment rate is falling (good for economy) US/International: LIBOR Rates Overweight equity market with the stronger currency (higher interest rate) US/EAFE: Favor Underperformer Overweight equity market which has underperformed over past year (i.e., buy the laggard) 5. Converting Ideas To Rules to Give Good Process and Add Value

23 Rule Performance ( )