1. 1 Using the Latest Asset Allocation Techniques to Benefit Your Portfolio Presented at IIR’s Understanding Asset Allocation and Investment Policy Conference Design for Pension Funds June 19, 2000 Michael D. Smith, CFA Research Director Hewitt Investment Group Hewitt

2. 2 Asset Allocation Asset Allocation Overview Importance of asset allocation. Risk tolerance. Impact of investment time horizon on risk tolerance. Diversification principles. Definition of asset classes. Assumption setting for asset classes. Limitations of modeling for asset allocation. Asset allocation in the context of liabilities. Rebalancing policy.

3. 3 Importance of Asset Allocation How Much Does Asset Allocation Explain? The correct answer is that it depends on how you ask the question. Following the Brinson/Beebower studies in 1986 1 and 1991 2, most people answer 90%. The Brinson study asked what percentage of the variability of return was explained across time by asset allocation. The formulation regresses a fund’s monthly return against the monthly return of its policy benchmark. There are more interesting questions worth asking! Earlier this year Roger Ibbotson 3 repeated the Brinson analysis, and asked and answered two new questions.

4. 4 Importance of Asset Allocation Asset Allocation and Return Variability Across Time Ibbotson’s study examined 94 U.S. balanced mutual funds and 58 pension funds. The answer to the question of variability across time is confirmed by Ibbotson, but the impact of active management and capital market exposure is demonstrated.

5. 5 Importance of Asset Allocation Asset Allocation and Return Variability Among Funds While many people still refer to Brinson’s 90% to answer this question, the true answer is much different. To answer this question, Ibbotson regressed the 10-year compound annual return for each fund against its policy return. For mutual funds, asset allocation explained only 40% of the return difference for mutual funds, and 35% for the pension funds.

6. 6 Importance of Asset Allocation Asset Allocation and Return Level The is probably the most important question of the three, and the answer is higher than convention wisdom. To answer this question, Ibbotson simply took the ratio of the policy return to the fund return for the full period. The results show the asset allocation accounts for about 100% of fund returns. Skewed MF distribution

7. 7 Asset Allocation The “Big Picture” Capital Market Expectations Risk Tolerance Asset Allocation Funding Goal

8. 8 Asset Allocation The “Big Picture” The goal of the asset allocation process is to select an “optimal” portfolio of assets given a plan’s risk tolerance and capital market expectations. Risk tolerance includes factors such as: —Time horizon; —Demographics; —Plan design; —Funded level; and —Ancillary goals. Typically, assets are modeled with a “mean/variance” optimizer, and the results are integrated with liability modeling. Goal analysis determines the probability of achieving various funding targets. The most important result for asset allocation is the target level of equity exposure.

9. 9 Asset Allocation Risk Tolerance  Public Pensions There are three major determinants of risk tolerance for a public plan: Business and financial position. —Ability to get additional contributions if investments perform poorly in the short-term; Workforce demographic characteristics; and —Average age and years of experience, active/inactive ratio, retiree liability to plan assets (i.e., duration of liabilities). Actuarial and funded status. —Funded ratios, actuarial smoothing, actuarial assumptions.

10. 10 Asset Allocation Risk Preference The complete risk posture of a plan is more than the hard numbers. Risk preference incorporates the psychological stance of the plan sponsor, along with ancillary goals. Risk preference includes factors such as: —The importance of short-term losses versus the chance of long-term gains; —The importance of plan value versus long-term funding; —Predictability of returns versus long-term results. Ancillary goals may include desired improvements in pension benefits, credit rating goals, tax policy goals, or “excess interest” account considerations.

11. 11 Asset Allocation Risk Posture Business and Financial Characteristics Demographic Characteristics Actuarial and Funding Characteristics Risk Preference Below Average AverageAbove Average Overall Risk Posture

12. 12 Asset Allocation What is Risk? Volatility Sovereign risk Counter-party risk Tracking error risk Credit risk Career risk Interest rate risk Peer risk Inflation risk PR risk Model risk Tax rise risk Liquidity risk

13. 13 Performance of Best Asset Class Annual Returns Emerging Markets U.S. Large U.S. Small Int’l Equity HY Bonds Real Estate U.S. Bonds

14. 14 Performance of Best Asset Class Annual Returns Emerging Markets U.S. Large U.S. Small Int’l Equity HY Bonds Real Estate U.S. Bonds

15. 15 Asset Allocation Diversification — Asset Assumptions

16. 16 Asset Allocation Diversification — Asset Assumptions

17. 17 Asset Allocation Diversification — Asset Optimization

18. 18 Asset Allocation Diversification — Asset Optimization

19. 19 Asset Allocation Diversification — Theory

20. 20 Asset Allocation Diversification — Theory and Practice

21. 21 Asset Allocation What is an “Asset Class”?

22. 22 Asset Allocation What is an “Asset Class”? — Less is More Many asset/liability studies attempt to model too many “asset classes.” Mean/variance optimizers are referred to as “error maximizers” for a reason. The “Mini-max” approach models the “big picture,” and leaves the finer distinctions to implementation.

23. 23 Asset Allocation Why “Mini-max”? Small estimation errors can lead to vastly different portfolios. There are only a few assets from which we have sufficient history to draw summary statistics. “Assets” with little or no passive alternatives and high dispersion are particularly poor choices for modeling. Minimize the maximum damage that estimation errors can do to modeling results.

24. 24 Asset Allocation Why “Mini-max”? 6.55% Return, Minimum Variance Portfolio

25. 25 Asset-Liability Interaction Higher Nominal Benefits Higher Liabilities Higher Inflation Higher Pay Increases Lower (Present Value of) Liabilities Higher Discount Rate Higher Interest Rates Lower Value of Financial Assets

26. 26 Process of Asset-Liability Analysis Asset Mix Portfolio Return Liabilities Demographics Plan Design Actuarial Assumptions Contributions Funded Ratio Expense Inflation Interest Rates Correlation FAS 87 Discount Rate Salary Increases Duration

27. 27 Good Reasons for Conducting an Asset-Liability Study Developing Strategic Asset Allocation Policy —Equity exposure level —Duration of bonds Pension Planning —Funding policy Understanding Cost and Benefits in Tangible Terms —Cash costs

28. 28 Wrong Reasons for Conducting an Asset-Liability Study Evaluating Modest Changes to Sub-asset Classes, e.g. —Small cap stocks —Emerging market equities

29. 29 Potential Pitfalls in Conducting Asset- Liability Studies (and how to avoid them) ProblemExclusive focus on a single variable, e.g., Surplus SolutionFocus on “True Economic Cost” ProblemNot everything has a “random walk” Solution— Take into account autocorrelation of inflation and interest rates ProblemAssets and liabilities are not truly integrated Solution — Use Monte Carlo simulations to generate assets and liabilities simultaneously

30. 30 Potential Pitfalls in Conducting Asset- Liability Studies (and how to avoid them) ProblemFocus on summary statistics, e.g., mean and variance SolutionFocus on the entire distribution of outcomes ProblemAsset-liability results are “all over the place” SolutionConduct goal-oriented analysis

31. 31 True Economic Cost True Economic Cost = PV of Change in Funded Status (times) Value Multiplier (minus) PV of Contributions Value multiplier can range between 0 and 1 Typically very well funded plan would assign a lower value to the multiplier

32. 32 Goal Analysis Don’t just evaluate the risk (variance) and expected return (mean), evaluate your ability to meet specific goals Examples Minimize True Economic Cost over 10 years Keep funded ratio above 100% in each year Keep cash contributions below $10 million Hold contributions at current levels while adding COL adjustments.

33. 33 Asset Allocation Diversification — The Role of Rebalancing Diversification Example — No Rebalancing Diversification Example —With Rebalancing Note: The composition of the “No Rebalancing” portfolio is 57.1% stocks and 42.9% bonds at the end of year 1.

34. 34 Rebalancing Overview Why Rebalance?—Investment Policy During the last five years, rebalancing has “cost” plan sponsors relative to a “Let Run” policy. The strong stock market increased the average equity exposure of a 65%/35% portfolio to 74% during the five years ended 1999. The time based and exposure based rebalancing rules resulted in similar results during the last five years. The “Let Run” portfolio outperformed both rebalancing rules by 1.6% per year. “Let Run” was riskier, but can you “eat” risk adjusted return? Why rebalance?

35. 35 Rebalancing Overview Why Rebalance?—Investment Policy You can “eat” risk-adjusted return when it comes to rebalancing! Allowing the equity exposure of the 65%/35% portfolio to increase over time results in a portfolio that averages 74% equity. Comparing the “Let Run” with rebalanced portfolios is like comparing portfolios with different equity allocations—and contains the same “information.” Rather than letting equity exposure “creep,” it is preferable to adopt a higher equity exposure, and rebalance.

36. 36 Asset Allocation Diversification — The Role of Rebalancing Most mean/variance models assume that assets are rebalanced back to target levels at some point. Without rebalancing, diversification is incomplete. Without rebalancing, the addition of non-correlated assets will reduce volatility, but will not enhance returns. A clear policy avoids costly ad-hoc revisions. If you do not rebalance, the market will do it for you. Rebalancing is a vital part of investment policy.

37. 37 Asset Allocation References 1 Brinson, Gary P., L Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, vol. 42, no. 4 (July/August): 39-48. 2 Brinson, Gary P., L Brian D. Singer, and Gilbert L. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, vol. 47, no. 3 (May/June): 40-48. 3 Ibbotson, Rodger, Paul D. Kaplan. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, vol. 56, no. 1 (January/February): 26-33.