A Primer on Overlays Dr. Arun Muralidhar

2 Arun Muralidhar - Bio  Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc.  Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department,  Derivatives and Liability Management, World Bank Funding Department,  Managing Director and Head of Currency Research, JPMIM,  BA, Wabash College (1988); PhD, MIT Sloan (1992)

3 Agenda  Overlays – TAA or Currency  Underused by most funds  Internal versus External  Capability, fees and product offerings  New paradigm: alpha from good decisions  AlphaEngine TM : empower clients to make better decisions

4 Case for Overlays  Markets are inefficient – currency is best example  Low correlations across assets - “informed decision making” will be profitable  Can be implemented with little cash (derivatives)  An excellent source of uncorrelated alpha Sophisticated Clients can Implement at Low Cost

5 TAA Case Study: Many Possible Ideas EAFE 20% Total Portfolio US Equity 50% Cash 5% US Fixed Income 25% Decisions to be made on allocation between asset classes:  Domestic vs International Equities (Stock-Stock)  Domestic Equities vs Domestic Bonds (Stock-Bonds)  Domestic Bonds vs Cash (Bonds-Cash) Assume Asset Limits of +/- 5% from Benchmark Weight

6 Simple/Intuitive Rules Tested 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/EAFE: 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)

7 Rule Performance ( ) Monthly Decisions – No Transactions Costs

8 Strategies (Mix of Rules) Tested Strategy NameStrategy Description Rebalancing I Quarterly Rebalancing to Benchmark Weights Rebalancing II Rebalance to Benchmark Weights when Range of +/-5% Breached Combination of Rules: Strategy 1 6 Best Excess Annualized Returns (  ) and Information Ratios – Cash vs Bonds, Halloween Effect, Inflation/Growth, Unemployment Rate, Fed Model, US/EAFE: Favor Underperformer (all equally weighted) Combination of Rules: Strategy 2 6 Lowest Annualized Standard Deviation (Risk) - Cash vs Bonds, Oil and Economy, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted) Combination of Rules: Strategy 3 3 Highest  and 3 Lowest Risk - Cash vs Bonds, Halloween Effect, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted)

9 Strategy Performance ( ) Informed decisions significantly outperform rebalancing Rule diversification enhances information ratios

10 Historical Allocations to Asset Classes Strategy 1 Strategy 2 Strategy 3 All strategies have same rule/allocation Strategies 2 & 3 have same rules/allocation

11 Currency Case Study: Easy Alpha JPY (30%) Currency Portfolio GBP (20%)EUR (50%)  Three rules make money: Trend, Carry/Yield and Options  Work in Divergent, Convergent and Sideways Markets, respectively  Potential to add in other currencies and make more complex  Rules will, by construct, have high tracking error: +100%/-100%

12 Simple Rules Work ( )  Trend – if 25 day moving average > 65 days moving average, BUY, else SELL  Carry – SELL currency with low interest rate  Yield – SELL currency with steep yield curve  Options – Are overpriced, SELL  Not highly correlated – good diversification Need Not Pay Active Fees for Simple Rules

13 Performance of JPY Rules/Strategies  Rules Evaluated: (a) yield curve; (b) carry; (c) moving average  USD/JPY Strategy = 40% Yield curve and Carry, 20% MA  Diversification improves information ratio, skill, & drawdown 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 4.59%8.56% %94.17%52.86% % USD/JPY Yield Curve 4.54%11.59% %85.59%53.43% % USD/JPY Carry 4.33%11.59% %84.26%52.37% % USD/JPY MA %11.59% %79.05%51.12% %

14 Performance of EUR Rules/Strategies  Rules Evaluated: (a) yield curve; (b) carry; (c) moving average  USD/EUR Strategy = 40% Yield curve and Carry, 20% MA  Trend model losses are meaningful; but moderate lower drawdown and worst single performance of the strategy Strategy/ Rules Annualized Return Annualized Std Deviation Information Ratio Cumulative Return Confidence in Skill Success Ratio Ratio Good /Bad Risk Max Drawdown USD/EUR Strategy 3.79%5.09% %98.89%55.21% % USD/EUR Yield Curve 5.20%6.26% %98.42%82.95% % USD/EUR Carry 8.48%9.71% %99.56%55.21% % USD/EUR MA %9.72% %3.13%46.68% %

15 Can Be a Consistent Alpha Source

16 Internal versus External  Internal  May require use of derivatives (not critical as portfolio drift/rebalancing is an active decision)  Can keep costs down; better control  External  Some strategies better suited – Options  Less career risk; long record of having added alpha

17 AlphaEngine TM : Empower Clients  Brings state-of-the-art management to pension funds  Easy to use: Clients generate ideas – software does work  Test strategies in a few minutes  Client can customize to their structure and objectives  No consulting!! Client can make all decisions better  Very transparent: See impact of all decisions on individual asset class or entire fund (easy to read)

18 Summary  Many (explicit and implicit) decisions in a portfolio  Each is an opportunity for alpha/risk management  Overlays can help manage these risks for return  Good governance: cost/return impact of every decision  Must aggregate impact of all decisions on portfolio  AlphaEngine TM : adopt best practices quickly and easily

Appendix

20 Fund Responsibilities Asset- Liability Risk Tactical & Benchmark Risk Manager/ Active Risk Responsibility Monitor Manage TrusteesInternal StaffManagers AnnuallyDaily/MonthlyMonthly Strategic Allocations & Funding Policy Asset, Sector, Style and Currency Allocations Manager Selection and Allocation Responsibility Decision Frequency How to Manage the Risk Staff are Making Many Decisions (Implicitly) Periodically

21 Effective Decision Making  Low asset correlations allow “informed decision making”  Identify rule ideas to allocate across asset classes  Select criteria for rule/strategy evaluation (excess return, information ratio, skill, success rate, drawdown)  Analyze rule performance, test different strategies (rule combinations) - diversification benefits not obvious  Test alternative policies versus rebalancing options Assumed Monthly Decisions ( ); No Transaction Costs

22 Extensions  Each decision is an opportunity for more returns/risk management  More tiers = greater diversification, efficacy = more returns  Within asset classes (Fixed Income, Equities, Currencies)  Managers: Active versus passive and across managers  Leverage asset managers to generate research ideas for decisions  Rule were equally weighted; opportunity to further improve  Evaluate ideas in isolation as well as part of a total portfolio (aggregation produces results that are not obvious) Improve fund governance, and in turn, returns and risk

23 Relaxing Asset Limits to +/- 10% Change in asset range produces higher  ; other measures improve or stay within acceptable range

24 Multi-tiered Alpha Aggregation Alpha = 0.5% Alpha = 1.5% Asset allocation/ rebalancing strategy Small Cap Russell 2000 Large Cap S&P500 Equity strategy – Large vs Small Cap Manager rule to determine allocation between managers/index Intl Equity (EAFE) 20% Total Portfolio US Equity 50% Cash 5% US Fixed Income 25% Active (Manager B) Enhanced Index (Manager A) Passive (S&P500)

25 Performance of GBP Rules/Strategies  Rules Evaluated: (a) yield curve; (b) carry; (c) moving average  USD/GBP Strategy = 40% Yield curve and Carry, 20% MA  GBP is hardest to model Strategy/ Rules Annualized Return Annualized Std Deviation Information Ratio Cumulative Return Confidence in Skill Success Ratio Ratio Good /Bad Risk Max Drawdown USD/GBP Strategy 1.50%5.56% %77.97%53.20% % USD/GBP Yield Curve 0.15%7.80% %47.49%49.53% % USD/GBP Carry 3.00%7.80% %86.41%53.54% % USD/GBP MA %7.80% %53.18%52.97% %

26 Allocation Results