:: brintoneaton.com Next Generation Investment Risk Management Jerry Miccolis CFA ®, CFP ®, FCAS, MAAA Annual Conference May 23, 2012

:: brintoneaton.com Next Generation Investment Risk Management Company confidential1

:: brintoneaton.com Modernized Modern Portfolio Theory Next Generation Investment Risk Management Company confidential2

:: brintoneaton.com Modernizing MPT  More realistic asset distributions  Non-normal/fat tails  More representative investment horizons  Multi-period/compound returns/risk drag  Rules-based rebalancing  More meaningful risk measures  Shortfall risk  Conditional VaR  More useful dependency measures  Correlations  copulas Company confidential3

:: brintoneaton.com Correlation — it gets the obvious cases right Company confidential4 ρ = +1 ρ = -1

:: brintoneaton.com Correlation — does it measure what matters? Company confidential5

:: brintoneaton.com We need to move from correlations… Company confidential6

:: brintoneaton.com …to copulas Company confidential7

:: brintoneaton.com Dynamic Asset Allocation Next Generation Investment Risk Management Company confidential8

:: brintoneaton.com DAA is a more proactive way than traditional rebalancing to exploit risk  Dynamic asset allocation  Explicitly treats momentum/mean reversion  Utilizes early warning signals  Signals can be internal and external  Moving average algorithms  Valuation measures  DAA reflects the fact that MPT is only as good as its inputs  Recognizes that inputs can change dynamically  Structurally sound way to:  Test your fundamental inputs  Nimbly make adjustments as appropriate Company confidential9  Leading Economic Indicators  Credit spreads/money flows

:: brintoneaton.com Our sector rotation strategy is an example of DAA  Stable-weighting  Exit/entry signaling  Trade-offs between stability and responsiveness  Three “momentum” algorithms  Each has its own strengths/ weaknesses  Rules that determine which algorithm to use at different times  Dynamically move between responsiveness and stability based on market characteristics  Filtering  To avoid too-frequent trading  Parameters optimized based on data  Tested “out of sample” with data Company confidential10

:: brintoneaton.com How does this strategy compare to the S&P500 Total Return Index? 11Company confidential

:: brintoneaton.com How does this strategy compare to the S&P500 Total Return Index? 12Company confidential

:: brintoneaton.com How else did we test this strategy?  Rolling annual returns  Maximum drawdowns  Parameter robustness Company confidential13

:: brintoneaton.com This strategy can be continuously improved upon  Stable-return investments in lieu of cash  Tactical moves into volatility  LEIs and other external signaling  Expand beyond US large-cap equity sectors  Global/international sectors  Commodities and other alternatives Company confidential14

:: brintoneaton.com Enlightened Tail Risk Hedging Next Generation Investment Risk Management Company confidential15

:: brintoneaton.com Our three criteria for an effective buy-and-hold tail risk hedge  Sudden appreciation in severe market downturns  “Severe” denoting sudden, substantial, unexpected decline in market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)  Appreciation to a degree sufficient to meaningfully offset the decline  No “give-back” during market recovery!  Very low cost  Minimize diversion of funds from productive use  No sacrifice of upside portfolio potential!  Minimal disruption to portfolio  Maintain what works in vastly more likely markets  “Don’t throw the baby out with the bathwater!” Company confidential16

:: brintoneaton.com Our criteria helped narrow our search  Traditional direct protection (e.g., puts, collars) violate our criteria  “Black Swan” funds violate our criteria  Promising idea: Exploit volatility spikes that coincide with sudden market declines  But, long-only volatility (e.g., VIX) violates our criteria  Transitory benefit  Can’t invest in directly  VIX futures: Severe negative roll yield  very high carry cost Company confidential17

:: brintoneaton.com Does anything meet our criteria?  Dynamic hedging  Puts/put spreads/VIX futures opportunistically applied  Needs constant monitoring  Potentially high cost  Correlation plays  “Call-on-call” strategies  Not yet well developed  Long/short volatility plays  Realized volatility: daily vs. weekly  Implied volatility: medium-term vs. short-term  Spread: implied vs. realized  Combinations Company confidential18

:: brintoneaton.com Our criteria in a picture Company confidential19

:: brintoneaton.com Some combinations are promising Company confidential20

:: brintoneaton.com The combined effect can be game-changing Company confidential21

:: brintoneaton.com Next Generation Investment Risk Management Company confidential22

:: brintoneaton.com For further reading on these ideas… Company confidential23