1. Current Investment Issues Florent Salmon, VP Portfolio Engineering November 20 th, 2009 2009 General Meeting ● Assemblée générale 2009 Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires Ottawa, Ontario ● Ottawa (Ontario)

2. 2 Executive Summary  General Framework –Relative weights of money management functions  Portfolio Insurance –Entry barriers and common issues  Alternative Beta –Concepts and characteristics

3. 3 ALM (interest rate) Risk Budget (long term objective) Asset Allocation (Sharpe ratio) Risk Budget, Insurance Immunisation, Passive hedging 60/40 Relative Market Views Money management functions (pension funds) Only one management tool to achieve three distinct and often conflicting objectives

4. 4 Liability Driven Investing (LDI) & Leverage  Leverage allows to decouple asset selection and risk management  Managers can focus on relative value and liquidity profile (Sharpe ratio)  Immunisation (interest rate hedging) is a simple passive protocol. It defines the benchmark. Immunisation Asset (with/without overlay) Liabilities Asset Allocation (Return profile) Risk Budget (sizing) Maximization of Sharpe ratioInvestment objectives Not a focus

5. 5 Importance of asset allocation  Too much emphasis on asset mix and not enough on risk management  Asset mix only goal is to maximize Sharpe ratio. Risk budgeting and Insurance will rescale the return pattern so that it fits investor requirement This is just CAPM

6. 6 LDI + Conditional Risk Budget Portfolio insurance = Dynamic Risk budget Fix Risk Budget Return Return – Insurance Cost Conditional Risk Budget  must be set beforehand (objective and protocol)  Insurance helps dealing with intermediary risks  Only way to avoid Black Swan scenarios  Nature of the obligation of a pension fund is a collar  Insurance protocol is set beforehand and its efficiency is measurable  Must be internalised!

7. 7 Pension assets: Collar profile Surplus : Contribution break Deficit : Impact on Corporate Benefits Market Level Return on Pension Fund assets

8. 8 Risk Tolerance  Long-term investor doesn't exist. Bankruptcy risk is always a possibility.  The most important thing is to define risk objectives (horizon). Running the protocol that allows to meet these objectives is fairly easy.  2008 crisis and the weakness of solvency ratio: are we changing our "modus operandi"  Framework is valid for institutional investors and retail investors

9. 9 Solvency Dilemma

10. 10 Solvency Dilemma (continued)

11. Portfolio Insurance

12. 12 Objectives  Avoid dramatic losses while maintaining an advantageous participating rate in favorable markets  Fit the invesment return profile to investor's utility function  Key stake is the internalisation of insurance protocol (delta) –Allows costs minimization, a tailored strategy (when needed) and facilitates modifications –Models have been known and used for many decades –Options offered by brokers are often inadequate (discomfort for the one year and over segments) –Since the option (insurance) associated with a pension fund is over a long period, frequency of rebalancing is low.

13. 13 Objectives (continued)  Implementation : Portfolio insurance is typically handled as an overlay on the existing pension fund position –No change to the existing management process –Easier efficiency measurements

14. 14 Buying Listed Put Options Systematic Market Insurance is very expensive 1.7% premium paid on positive years on average Not optimal for long term investments 60/40 60/40 + Option Return0.78%0.35% Vol.9.29%9.04% Min.-16.08%-8.34% Max.11.86%8.25% Corr.100.00%99.24%

15. 15 Variable Insurance Portfolio Dynamic insurance is more efficient No premium paid on positive years on average The paid insurance premium is usually small in market growth cycles 60/40 60/40 + Insurance Return0.78%2.39% Vol.9.29%5.83% Min.-16.08%-8.38% Max.11.86%11.01% Corr.100.00%91.93%

16. 16 Internalisation of Insurance Management Process Portfolio insurance allows for a quick and effective adjustment of asset allocation to market environment Goes beyond standard fixed risk budgeting Fully liquid and transparent No counterparty risk involved Can be adjusted at any time, with no fees, to take into account new risk constraints No market depth limitations Low cost Avantages

17. Alternative Beta

18. 18 Risk premium and indexation  Recent crisis will favor passive beta (indexation) with liquidity, low fees and no counterparty risk.  Whether you believe in active management or not, index products create useful tradable benchmarks in all markets  How many pure risk premiums are available?

19. 19 Basis for Alternative Beta Products Academic research and increased competition have helped change the dominant paradigm that hedge funds are pure absolute return investment products. Traditional Assets Beta Return Alpha Return Total Return Alternative Assets Beta Return Alpha Return Traditional Assets Beta Return Alpha Return Alternative Assets Beta Return Alpha Return Dominant Paradigm : 1960-2000 Emerging Paradigm : 2000-current Basis for the creation of index funds and hedge fund replication : Common sources of return

20. 20 Reasons for the Apparition of Alternative Beta Funds  Hedge funds main criticisms –Insufficient transparency –Insufficient liquidity –Heavy fees structure –Complex and hard to explain –Insufficient capacity –Reputation risk  Some investors agree with the initial hedge fund proposition (absolute return) but not in its current format (transparency, fees)

21. 21 Alternative Beta Categories Main objective is to replicate the risk/return characteristics of hedge fund investments or of indices and to avoid aforementioned drawbacks.  Factor based –Captures hedge fund managers asset allocation decisions  Rule based replication –Reproduces in a systematic fashion certain management strategies used by hedge fund managers  Synthetic Payoff –Reproduces on a synthetic basis the risk-return profile and correlation of a fund

22. 22 Principles of Factorial Approach  90 % of a manager's return (alternative or not) is justified by main asset allocation decisions –Exchanges –Currencies –Interest rate –Corporate credit –Resources/Metals –Money Market  Factor-based replication aims to capture the main allocation decisions while ignoring marginal positions Tradable factors (futures)

23. 23 Results

24. 24 Management Protocol Approach

25. 25 Strategies Examples Carry Beta Barclays FX CTA Return4.92% 2.10% Volatility4.90% 4.67% Correlation10.02% 7.02% Carry Trade : Profit from the premium embedded in the forward contracts of higher yielding currencies It's not arbitrage; it's a risk premium, but a different risk premium therefore diversifying. Comm. Beta Barclays Commodity CTA 5.09% 4.06% 2.51% 7.13% -1.60% 11.54% Commodity Spread : Profit from variations in the convenience yield and market cyclicality in the commodity space Momentum Beta Barclays Momentum CTA 6.49% 5.86% 9.01% 11.19% -37.88% -19.61% Momentum Diversified CTA : Profit from exposure to market trends (both up and down) across different asset.

26. Conclusion

27. 27 Conclusion : fiduciary responsability  Risk Management ≠ Risk control and asset mix –In order to add value, asset selection should be made independant of risk management (key concept for hedge funds)  Portfolio insurance –Proactive –Better fit to client requirements (maximum loss over different horizons) –Room for improvement  Alternative Beta –Return, liquidity, transparency  Fees and desintermediation –Alternative beta: a quarter of hedge fund fees –Portfolio insurance: Sell side vs. Buy side  Convergence

28. 28 Questions / Comments  florent.salmon@desjgam.com Everything should be made as simple as possible, but not simpler. Albert Einstein