Managing the Risk of Alternative Investments Presented by Frances Barney, CFA Managing Director, Performance & Risk Analytics Consulting BNY Mellon Asset Servicing December 2011

2 Agenda I.Risk Trends in the Market II.Evolving Solutions for Risk III.Questions

Section I. Risk Trends in the Market

Asset Owners’ Top Risk Concerns 4 Source: MSCI Inc., Global Asset Owners Survey Results, “Back to the Future of Risk Management”, October 2011

5 Evolving Investor Demands for Risk & Transparency  Need for increased investment analysis with robust risk monitoring and measurement capabilities  Broader look across all asset types  Deeper analysis on details behind investments  More frequent analysis with robust risk assessment and measurement tools  Greater demand for transparency and exposure reporting  Meaningful information required across asset classes, especially alternatives like hedge funds  Delivering information that showcases where exposures are across countries, issuers, types, etc.  Risk management today has more resources dedicated to measuring, evaluating and actively managing risk exposures  Increased reporting to investment teams and Boards  Teams are now dedicated to measuring, monitoring, managing and reporting on risks  Need for standardized systems to fulfill requirements for risk management

6 Evolving Investor Demands for Risk & Transparency  Increased transparency and risk control sought from asset managers  Strict guidelines to manage assets and control exposures  Specific reporting requirements to monitor risk  Clients are focused more today than ever on investment analysis  Performance/Attribution/Analysis: more frequent analysis, more granularity  Exposure Reporting: full exposure including derivative impacts, issuer and counterparty reporting  Compliance: monitoring investments to adhere to mandates  Proactive Risk Measurement, Management and Budgeting: forward looking and stress test /scenario analysis  Liabilities: monitoring, managing and reporting on assets and liabilities  Liquidity: an increasing focus for asset owners

Percentage of Investment in Alternatives 7

8 The Challenge for Alternative Investments  Allocations to alternatives have increased significantly over the past decade for institutional investors  Investors are no longer content to take managers on their word or to view asset class in a vacuum  Demands for:  More transparency of hedge fund investments Full transparency still a challenge for many Concept of “mid-level” data (e.g. country/sector exposures, top positions/issues)  Improved consolidated reporting reflecting traditional and alternative investments Exposure analysis with private equity “look through” Better reflection in risk reporting  Better comparison tools Asset owners seeking something better than current tools Improved peer grouping with more flexibility and insight

Greatest Challenges in Overseeing Alternatives 9

Tools Available to Help Manage the Bigger Risks? 10

Section II. Evolving Reporting Solutions for Risk

Main Barriers to Effective Risk Management 12 Actual results do not add up to 100%

13 Traditional Risk Statistics Alpha Beta Information Ratio R-Squared Sharpe Ratio Standard Deviation Tracking Error Treynor Ratio Historic Risk Measures

Fundamental Risk Characteristics Asset Class Specific: Equity: P/E, ROE, P/B, Fundamental Beta, EPS Growth, P/CF, etc Fixed Income: Leverage, Duration, Convexity, Yield, Maturity, Quality, etc Hedge Funds: Fund of Fund Strategies, Exposures General Across Asset Classes: Regional/Country Exposures Economic Sector Exposures Company Exposures (Issuer/Counterparty) 14

15 Risk Factors Betas: Sensitivity to one or more factors in a statistical sense (not like greeks) Historical beta uses the actual returns of a fund; fundamental beta looks through to the positions of the fund by rolling up their historical returns Very important to know how good the fit is to a particular factor: you can always calculate a beta and get a value. How well that factor fits is not given by beta but rather by R 2 }   = 1

16 Exposure, VaR, Correlations Market Stresses Visualizations Historical Scenarios VaR Backtesting PCA Analysis Market Stresses Goodness of Fit Custom Models Fixed Income Analysis Risk Analytics Source: Investor Analytics

17 Risk Transparency Multiple pieces to the puzzle of transparency Most often associated with an understanding of underlying exposures  Look across all assets  Look through fund vehicles Broader understanding of the investment through qualitative data  When is it valued?  What’s the fee structure and costs? Liquidity also an integral part of the mix  What gates or lock ups exist  What is my exposure to ….  Identifying a liquidity profile  Cash forecasting across all assets Liquidity Disclosures Exposure

18 Issuer Concentration Counterparty Hierarchy Mapping Drill into Direct and Ultimate Issuer, Guarantor, Obligor Exposure Examination of credit exposure to an entity and any level as above

Private Equity Risk: Concentration of Wealth 19

Liquidity Risk Publicly-traded investments Maturity schedule, income, dividends Trading volume measures Private Equity Known, likely, average capital calls Return of capital Secondary markets Hedge Funds Lock-ups, Redemption terms Derivatives Margin calls Collateral liquidity 20

21 Private Equity Capital Calls – Demand for Liquidity 21 © 2011 The Burgiss Group, LLC.

Benchmark Discount Rate for Pension Liabilities 22

23 Asset-Liability Mismatch Risk Monitor the change in the firm’s asset and liability values and the resulting impact on the funding status. Analyze the relative sensitivity of the firm’s assets and liabilities to changes in certain economic conditions e.g. changes in the level of interest rates.

24 In conclusion…  In any market environment, performance and risk analysis will remain critical for asset owners and managers –Robust performance, risk and compliance analysis is common and best practice –Regulatory pressures will not go away  Demands will continue to grow for more transparency with more frequent and detailed reporting  Investors are demanding analytical tools for alternative investments, expecting same robustness and immediate accessibility when compared to those used for traditional investments