Managing Alpha, Beta and the Funded Ratio: Implementing Effective Portfolios after an ALM Analysis By Dr. Arun Muralidhar Author: Innovations in Pension Fund Management with assistance from Sanjay Muralidhar and Rahul Rauniyar of M cube Investment Technologies, LLC

2 © Copyright of M cube Investment Technologies, LLC Agenda 1)A quick review of the pension fund balance sheet a. Actuarial Liabilities – converting into a measurable Liability Benchmark 2)Implementing an Effective Portfolio and Impact on Funded Position a. Static SAA versus Liabilities – would have reduced Surplus b. Hiring External Managers c. Adding an Active Currency Program to Manage Currency Risk d. Simple Rebalancing Decisions 3)Managing Alpha and Beta to Improve Funded Position a. Beta Management: How Asset Allocation/Style Decisions can increase Surplus and Lower Risk of Shortfall (and even improve some risk aspects) b. Alpha Management: Manage Your Managers for Better Performance 4)Summary: Intelligent Management of Alpha and Beta can Lower Funded Ratio Risk

3 © Copyright of M cube Investment Technologies, LLC Roadmap: From Static to Dynamic Portfolios  Traditional approach – Alpha from external managers  New approach – Add alpha from “informed decisions”  Transparency and governance are critical  Must monitor impact on Surplus and risk Dynamic “Alpha” Management Dynamic “Beta” Management Consider Simple Rebalancing Strategies Hire Managers on a Static Basis (incl. Currency) Set Static Strategic Asset Allocation Using ALM

4 © Copyright of M cube Investment Technologies, LLC 1. The Pension Fund Balance Sheet Future Contributions Current Assets Future Returns PENSION OBLIGATIONS (LIABILITIES) = Funded ratio = assets/liabilities + + =

5 © Copyright of M cube Investment Technologies, LLC 1. Creating Liability Benchmarks: Cash Flows Pension Cash Flows (Euros) Time (Years)

6 © Copyright of M cube Investment Technologies, LLC 1. Creating Liability Benchmarks: Using Swaps  Liabilities modeled as a portfolio of swaps (where pension fund can lock in cash flows) or zero coupon bonds  Liability BenchmarkWeight  1 Year Swap 1%  2 Year Swap 4%  5 Year Swap 9%  10 Year Swap 21%  20 Year Swap 25%  30 Year Swap 40% 100%  Now Annual Growth in Surplus/Deficit = Asset Return – Liability Return  Assets and Liabilities can be marked-to-market daily!

7 © Copyright of M cube Investment Technologies, LLC 2. Invested Fund can be Modeled vs. Liabilities INVESTED FUND Alternatives 5% Equity 32% Europe North America Emerging GPR Property Japan Pacific ex Japan Fixed Income 53% Euro Govt. High Yield EMG Debt Global Credit Real Estate 10% Currency Overlay 10% Cash 0% Surplus PENSION LIABILITIES Liabilities, as modeled, had an annual return of approximately 8% = External Managers

8 © Copyright of M cube Investment Technologies, LLC 2. Assumptions for Analysis  Decision analysis performed for the period from January 2002 to December 2004 (period for which swaps data was available)  Liabilities modeled as a portfolio of swaps  Assumed initial funding ratio (FR) in January 2002 was 110%  All analysis is based on one historical path and projected forward  Rebalancing/Asset Allocation/Style decisions assume no transaction costs  Client had a strategic currency hedge on international equities = 100% hedge to base currency – many Japanese funds are similar and this can be a major contributor to returns and risk  Excess return computed using arithmetic excess return calculation

9 © Copyright of M cube Investment Technologies, LLC 2a. Performance of Static SAA vs. Liabilities Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Probability (FR < 105) At end 2006 Max Drawdown of Surplus -0.72%6.64%30%-8.68% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 7.5% (Portfolio) * Asset return – Liability return FR = Funded Ratio Over this period, Static SAA underperformed liabilities – surplus would decline

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11 © Copyright of M cube Investment Technologies, LLC 2b. Impact of External Managers – Static Allocations INVESTED FUND Alternatives 5% Equity 32% Europe North America Emerging GPR Property Japan Pacific ex Japan Fixed Income 53% Euro Govt. High Yield EMG Debt Global Credit Real Estate 10% Currency Overlay 10% Cash 0% Surplus PENSION LIABILITIES Only look at external managers in mainstream asset classes = External Managers

12 © Copyright of M cube Investment Technologies, LLC 2b. Managing Alpha – External Managers  Many clients hire external managers to generate alpha  Static contribution of all managers is one source of return  Impact of all managers not always positive…..  May pay high fees for negative impact…..

13 © Copyright of M cube Investment Technologies, LLC 2b. Performance of Static SAA+ Managers Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Prob (FR < 105) At end 2006 Max Drawdown of Surplus -0.92%6.64%33%-8.76% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 7.3% (Portfolio) Over this period, external managers underperformed – surplus declines more * Asset return – Liability return FR = Funded Ratio

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15 © Copyright of M cube Investment Technologies, LLC 2c. Impact of Adding Alpha – Currency Alpha INVESTED FUND Alternatives 5% Equity 32% Europe North America Emerging GPR Property Japan Pacific ex Japan Fixed Income 53% Euro Govt. High Yield EMG Debt Global Credit Real Estate 10% Currency Overlay 10% Cash 0% Surplus PENSION LIABILITIES Assume initially that only currency is managed actively = External Managers

16 © Copyright of M cube Investment Technologies, LLC 2c. Explaining Currency Management  Funds invest abroad for higher yield = inherit currency risk  Passive hedge ratio = 100% hedged back to base currency  Active currency management involves buying and selling currencies (USD/JPY, USD/EUR, JPY/EUR etc.) for profit  These strategies are typically uncorrelated to other strategies  Currency strategies do not need funding and generate cash!  Active currency management can lower Asset-Liability risk (Chap 5: Innovations in Pension Fund Management)  Can have a meaningful impact on pension fund

17 © Copyright of M cube Investment Technologies, LLC 2c. Currency: USD/JPY and EUR/JPY USD has declined nearly 25% from 2001 high – full hedging added returns EUR has gained appx. 40% from 2000 low – full hedging hurt returns

18 © Copyright of M cube Investment Technologies, LLC 2c. Why Currency Management is Useful  Good programs have an information ratio close to 1  Risk can scale easily: typical overlay = 2% alpha  Contribution to total fund can be as much as 20 bps  If successful – such strategies generate cash without requiring funding  Many US funds are using higher alpha strategies as a way of generating cash to cover shortfall between contributions and pension payments

19 © Copyright of M cube Investment Technologies, LLC 2c. Static SAA+ Managers + Currency Overlay Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Prob (FR < 105) At end 2006 Max Drawdown of Surplus -0.64%6.59%29%-8.62% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 7.6% (Portfolio) Active currency added 0.27% at fund level – surplus decline reduced; risk is lower * Asset return – Liability return FR = Funded Ratio

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21 © Copyright of M cube Investment Technologies, LLC 2d. Implementing a Rebalancing Policy  Typical rebalancing is either calendar or range-based  Example: +/- 5% range around benchmark weight for most assets; 4% for Real Estate  When range hit, go either to range or target or in-between  Such a policy gives staff discretion = Tracking Error  MOST IMPORTANT: Most policies are silent about what to do inside the ranges (most funds do nothing!!)  Board or staff are taking implicit bets on the market – must make explicit decisions for good governance

22 © Copyright of M cube Investment Technologies, LLC 2d. Impact of Rebalancing  Most rebalancing decisions have some element of “active” decision making in them  “Pure” passive is the Dutch model of only annual rebalancing (Calendar-based rebalancing)  However, portfolio can drift dramatically away from SAA  Alternative Rebalancing options such as volatility based rebalancing also have an active element  Can the pension fund staff do better by making decisions explicit?

23 © Copyright of M cube Investment Technologies, LLC 2d. Performance of Portfolio with Rebalancing Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Prob (FR < 105) At end 2006 Max Drawdown of Surplus -0.57%6.72%28%-8.63% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 7.6% (Portfolio) Annual rebalancing added 0.07% at fund level – surplus decline reduced * Asset return – Liability return FR = Funded Ratio

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25 © Copyright of M cube Investment Technologies, LLC 2. Summary Findings on Static Portfolios  In this case, the SAA would have caused Surplus to fall  Over this period, external managers also detracted returns  Active currency management (as did the passive hedge) added returns and lowered risk  Rebalancing added some returns, but surplus is still declining  Must use additional decisions that are under the control of pension fund staff to improve overall portfolio and ALM profile

26 © Copyright of M cube Investment Technologies, LLC 3. Intelligent Management of Assets  Many clients look for low correlation among assets = good diversification  Low correlation also means asset class performance will go through cycles – this aspect is often ignored  Intelligent staff should not sit by as markets evolve – similar principle applies to cyclicality of managers  Analysis of SaR (Surplus at Risk) must include “automatic, intelligent decisions” that go beyond rebalancing

27 © Copyright of M cube Investment Technologies, LLC 3a. Intelligent Management of Assets INVESTED FUND Alternatives 5% Equity 32% Europe North America Emerging GPR Property Japan Pacific ex Japan Fixed Income 53% Euro Govt. High Yield EMG Debt Global Credit Real Estate 10% Equity vs. FI Europe vs. US HY vs. IG  Modeled a few asset allocation decisions possible in portfolio structure  Built a few simple rules (see Appendix) that are intuitive and available from academic literature  Similar decisions can be developed for all asset pairings  Can add more rules for additional diversification (more returns/better risk)

28 © Copyright of M cube Investment Technologies, LLC 3a. Portfolio with Dynamic “Beta” Decisions Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Prob (FR < 105) At end 2006 Max Drawdown of Surplus 0.29%7.00%21%-8.0% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 8.5% (Portfolio) Intelligent beta decisions added 0.96% at fund level – SURPLUS NOW INCREASES * Asset return – Liability return FR = Funded Ratio

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30 © Copyright of M cube Investment Technologies, LLC 3a. Asset Allocation Recommendations Fixed Income Equity Real Estate Alternatives Results achieved with relatively low turnover – impact of transaction costs should be low Period when liability value rose

31 © Copyright of M cube Investment Technologies, LLC 3a. Summary Findings from Beta Management  Can take advantage of low correlation across assets to do better than a static mix or simple rebalancing  Intelligent “automatic” decisions can increase Surplus and lower SaR (or the probability that the funded ratio will be below some threshold in the future)  Requires only moderate tilts at infrequent intervals to add meaningful value  Such decisions are within the scope of well-run pension plans

32 © Copyright of M cube Investment Technologies, LLC 3b. Managing Alpha – External Managers  Static manager “alpha” is one source of return  Managers can have low correlation with others  Manager performance goes through cycles – why fund a manager who is starting to underperform?  However, since portfolio is dynamic, clients can use cash flows to make intelligent “alpha management”

33 © Copyright of M cube Investment Technologies, LLC 3b. External Managers – Dynamic Allocations INVESTED FUND Alternatives 5% Equity 32% GPR Property North America Emerging Europe Japan Pacific ex Japan Fixed Income 53% Euro Govt. High Yield EMG Debt Global Credit Real Estate 10% Currency Overlay 10% Cash 0% Surplus PENSION LIABILITIES Look at managers who are not highly correlated = External Managers Europe vs. UK Loans vs. Mortgages vs. Govt

34 © Copyright of M cube Investment Technologies, LLC 3b. Ideas for “Alpha” Management  In deciding between UK and Euro ex-UK managers, favor the manager covering the market with a higher interest rate  Added 0.37% annualized over a static mix  In Euro Government bonds, favor the manager with the greatest return momentum over last 3 months  Added return over a static mix of 4 managers  Again, can do more rules for better returns/risk

35 © Copyright of M cube Investment Technologies, LLC 3b. Impact of Dynamic Alpha Management Annualized Growth in Surplus * Volatility of Ann. Growth in Surplus Prob (FR < 105) At end 2006 Max Drawdown of Surplus 0.34%6.96%19%-8.21% Ann. Liability Return = 8.2% (Benchmark) Ann. Asset Return = 8.6% (Portfolio) Intelligent alpha decisions added 0.05% – SURPLUS INCREASES MORE * Asset return – Liability return FR = Funded Ratio

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37 © Copyright of M cube Investment Technologies, LLC Summarizing Impact of Alpha and Beta Management Annualized Liability Return (Benchmark) = 8.2% Option Ann. Growth in Surplus Volatility of Surplus Prob. Funded Ratio < 105% at year end 2006 Static SAA-0.72%6.64%34% + Managers (incl. FX) -0.64%6.59%29% + Rebalancing-0.57%6.72%28% + Dynamic Beta (  +0.29%7.00%21% + Dynamic  +0.34%6.96%19%

38 © Copyright of M cube Investment Technologies, LLC 4. Summary Conclusions  Many clients focus only on SAA, Rebalancing and Static Allocations to External Managers  Currency management may be critical to add uncorrelated alpha  More importantly, using dynamism in portfolio can lead to additional returns and lower Surplus-at-Risk  Dynamism can be in both managing beta and alpha

39 © Copyright of M cube Investment Technologies, LLC 4. Practical Choices to Improve Manage ALM  Be smart about portfolio structure – allow for a passive allocation for each asset class. This will allow for more intelligent rebalancing while minimizing transactions costs  Evaluate managers not on an individual basis, but also how they impact the total fund  Can leverage your external managers to help develop intelligent rules for alpha and beta – Verizon Model

Contact Information: Dr. Arun Muralidhar Phone: Website:

41 © Copyright of M cube Investment Technologies, LLC Information on M cube and AlphaEngine TM  Company was formed to help investors make better decisions on asset allocation and managers with a quick and easy-to-use web-based product  Flagship product is the AlphaEngine TM  Product is being used by corporate and public pension funds, hedge fund fund-of-funds and even investment managers in US, Europe and Canada  Meant to Ensure Governance and Generate Alpha

Appendix

43 © Copyright of M cube Investment Technologies, LLC 2c. Some Simple Rules Make Money in Currency Tested rules include:  Yield Curve Slope (Allocate to currency having flatter yield curve)  Carry Rule (Allocate to currency with higher 1 month LIBOR rate)  Day Moving Average Crossover (Allocate to currency that is trending or has momentum) Will only test for USD/JPY – very conservative implementation Either hedge (+10%) or short 10%

44 © Copyright of M cube Investment Technologies, LLC 2c. Performance of USD/JPY Rules and Strategy  Rules Evaluated: (a) yield curve; (b) carry; (c) moving average  Tested from Jan 1990 – April 2005 (15 years)  USD/JPY Strategy = Equally weight Yield curve, Carry, and MA  Diversification improves information ratio, skill, & drawdown  Can either be scaled up for more currencies, risk and alpha Strategy/ Rules Annualized Return Annualized Std Deviation Information Ratio Cumulative Return Confidence in Skill Success Ratio Ratio Good /Bad Risk Max Drawdown USD/JPY Strategy 0.35%0.76% %96%52.5% % USD/JPY Yield Curve 0.34%1.11% %88%52% % USD/JPY Carry 0.29%1.11% %84%52% % USD/JPY MA %1.11% %91.4%52% %

45 © Copyright of M cube Investment Technologies, LLC TAA/Style: Improved Risk/Return  Used 4 simple/intuitive rules - scope for fine tuning and adding a broader set of rules  Assumes that over/underweight allocation for Equity and Fixed Income are allowed in a +/- 5% range relative to benchmark allocation – moves are small and infrequent  TAA/Style decisions would have generate significant additional alpha of over Euros 160 million in 2004 (0.93% annualized) with impressive information ratio and confidence in skill over static benchmark allocation to asset classes – even if a small fraction of this is consistent/sustainable, it is meaningful after transactions costs  Rule based TAA/Style decisions normally also lower risk (tracking error and drawdown) relative to other approaches

46 © Copyright of M cube Investment Technologies, LLC TAA/Style Decisions: 4 Simple Rules Used  Rules manage allocations between Equity and Fixed Income, North America vs Eurobloc, High Yield vs Credit RuleDescription Trade Frequency Equity vs. Fixed: Halloween Effect Stocks tend to underperform bonds between June and Oct – paper by a Dutch academic (works in US also)Monthly Equity vs Fixed: Oil and Economy High oil price causes equity market to fall. Tilt towards bonds when prices are rising and vice versa Monthly US vs Eurobloc: interbank rates Overweight market with stronger Currency (based on carry indications). Here we use Euro vs $.Monthly HY vs Credit: Yield CurveMonthly When the yield curve is upward sloping (pro- growth) then high yield bonds outperform

47 © Copyright of M cube Investment Technologies, LLC 2c. Efficacy of TAA/Style Allocation: ’02 -’04  Evaluation period from 2002 to December 2004  Alpha represents pure asset allocation return (no manager alpha included) – kept within the rebalancing range  Ideally test rules over longer historical period for better indication of long term value-added and risk profile