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Core/Satellite PortfolioConstruction

Budgeting for Active Manager Risk

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Agenda

What is Core/Satellite?

Asset allocation policy & active manager risk budgeting

Implementation

Example

3

10 largest US defined benefit pension plans

Source: Nelson’s Directory of Plan Sponsors, January 2001.

Plan sponsorDB assets

$BReport both index and

active portfolios

California Public Employees Retirement 171.9 X

New York State Common Retirement 122.5 X

California State Teachers Retirement 110.0 X

Florida State Board of Administration 107.8 X

New York City Retirement System 101.7 X

New York State Teachers Retirement System 89.3 X

Teachers Retirement System of Texas 85.0

New Jersey Division of Investment 83.1

General Motors 81.8

State of Wisconsin Investment Board 65.6 X

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Top managers ranked by worldwide institutional assets

Source: Pensions & Investments, May 2001

Rank Firm Assets $B

1 Barclays Global Investors 756,300

2 State Street Global 712,203

3 Fidelity Investments 646,986

4 Deutsche Asset 436,990

5 JP Morgan Fleming 396,056

6 Merrill Lynch 289,500

7 TIAA-CREF 281,249

8 Vanguard Group 259,499

9 Alliance Capital 236,518

10 Prudential Insurance 235,106

Source: Pensions and Investments, May 2001.

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Institutional strategy evolves toCore/Satellite

Modern portfolio theory

Active-only produced benchmark risk

Solution: Index/active blend

Index core portfolio (multi-asset class)

Active managers layered to enhance returns

“Core/Satellite”

Index ETF (Core)

Activemanagers(Satellites)

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Potential return %

Risk %

0

Overall strategy starts with asset allocation policy

Treasury Bills

Long Term Treasury Bonds

Large Cap US Stocks

Small CapUS Stocks

InternationalStocks

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0

Overall strategy starts with asset allocation policy

Treasury Bills

Lehman Bros.Gov’t/Credit

Russell 1000Russell 2000

MSCI EAFE

“Optimization” combines historical returns with expected future estimates, using asset

class benchmarks to create an “efficient portfolio”

(hypothetical illustration)

0Risk %

Potential return %

“Optimized Portfolio”

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Active portfolio management presents “Active manager risk”

Active manager return

The over- or under- return earned by an active manager relative to a benchmark (“selection alpha” is “active return” or “excess return” relative to a specific style benchmark)

Active manager risk

The annualized standard deviation of a manager’s active return

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Risk %

Potential active risk %

-3

+3

-2

-1

+1

+2

0

Core/Satellite implementation presents risk-return tradeoff

When implementing their asset allocation strategy with active managers, investors seek active return and experience active risk, relative to each asset class benchmark

Potential activereturn %

Russell 1000

Potential return %

2 4 6

There can be no assurance that an investment strategy based on the core/satellite hypothetical analysis will be successful.

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-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

10

Positive alpha

Negative alpha

Russell 1000 Growth

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Active manager tracking error

Active Manager Risk Hypothetical

Alp

ha

%

5.1% Avg. Annual Tracking Error1.26% Avg. Annual Alpha

Large-cap growth manager historical selection alpha vs. Russell 1000 Growth

For illustration only. Not indicative of any investment or manager.

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11

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

All active portfolio

Portfolio with a 2% risk budget implementing active and index managers

Alp

ha

%

Lower Active Manager Risk HypotheticalUsing Risk Budgeting

2% Risk Budget = 2% Avg. Annual Tracking Error

Large-cap growth manager historical selection alpha vs. Russell 1000 Growth

For illustration only. Not indicative of any investment or manager.

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2/3 of time selection alpha falls within this range

(4 out of 6 years)

+5.1%

-5.1%

Illustration of 5.1% Hypothetical Tracking Error

A Model of Active Manager Returns

Tracking Error

— Standard Deviation of a Manager’s Selection Alpha

1/6 of time negative selection alpha is –5.1% or more (1 out of 6 years)

1/6 of time positive selection alpha is +5.1% or more (1 out of 6 Years)

Benchmark Return

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2/3 of time selection alpha falls within this range

(4 out of 6 years)

+5.1%

-5.1%

Illustration of 5.1% Hypothetical Tracking Error

A Model of Active Manager Returns

Tracking Error

— Standard Deviation of a Manager’s Selection Alpha

1/6 of time negative negative alpha is –5.1%

or more (1 out of 6 years)

1/6 of time positive selection alpha is +5.1% or more (1 out of 6 years)

+2.0%

-2.0%

2% Risk Budget

Benchmark Return

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Real world comparison

Actively managed funds that underperformed their index before tax (and after tax)

Source: Morningstar. US equity mutual funds. Russell Indexes. All total returns reflect 10 year annualized figures. Funds are categorized by their Morningstar objective; Specialty funds were categorized by their December 31, 2001 Morningstar style box.

12/31/91–12/31/01 Value Blend Growth

Before tax %

After tax %

Before tax %

After tax %

Before tax %

After tax %

Large-cap 84 93 76 94 56 82

Mid-cap 56 85 63 89 58 88

Small-cap 74 97 21 57 9 30

Past performance is no guarantee of future results

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Benchmark =Mgr. Avg.

+5.5%

-5.5%

Before fees and costs

Benchmark

-6.5%

+4.5%

“Good”Managers

“Bad”Managers

After fees and costs

Mgr. Avg. = -1%

A model of active manager returns

“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”

— Bill Sharpe, The Arithmetic of Active Management

Source: Sharpe, “Arithmetic of Active Management”, Financial Analyst Journal, Jan-Feb, 1991. Waring, Whitney, Pirone and Castille, “Optimizing Manager Structure and Budgeting Manager Risk,” Journal of Portfolio Management 25, Spring 2000.

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Benefits of active manager risk budgeting

Implement client’s asset allocation with more benchmark “purity” than an all-actively managed portfolio

Allow active managers to still add active return (alpha)

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Active manager risk budgeting

The lower an investor’s tolerance for active risk, the lesser proportion of the portfolio that will be devoted to active managers, greater proportion to index managers

Portfolios and risk budgets are customizable

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82 4 6 Tracking error %

Alpha %

Benchmark

(Russell 1000)

Moderate risk

Index fund 65%

Active mgr 35%

Implementing large-cap US equity managers An example

The real question:

How much active risk is too much?

Source: BGI analysis. Alpha and Tracking Error are not the only criteria to consider when developing an investment strategy. One cannot invest directly in an index. Indexes do not incur management fees, expenses or transactions costs

5.5

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82 4 6 Tracking error %

How much active manager risk?

Alpha %

Moderate risk

Index fund 65%

Active mgr 35%

Implementing large-cap US equity managers An example

Risk control “dial” controls the mix of selected managers

Source: BGI analysis.

Higher risk

Index fund 20%

Active mgr 80%

Benchmark

(Russell 1000)

5.5

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Potential returns %

Risk %

0

Core/satellite active risk budgeting can be applied independently across asset classes

Russell 1000

MSCI EAFE

Lower active risk

Index fund 65%

Active mgr 35%

Higher active risk

Index fund 20%

Active mgr 80%

6% Active Risk Budget

2% Active Risk Budget

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Conclusions

“Active or Index” is the wrong way to look at the question

Instead see a “risk-control dial”, set an active manager risk level

Larger or smaller core investment depending on tolerance for risk

Ongoing monitoring and re-balancing adds annual value

Active manager risk budgeting involvesconsulting process, not product sales

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在經濟週期中﹐尋找投資契機

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醫療保健 高科技 醫療保健 高科技 高科技 醫療保健 黃金

高科技 能源 主要消費 電訊 礦業 公用事業 礦業

主要消費 醫療保健 高科技 醫療保健 電訊 主要消費 能源

電訊 主要消費 電訊 選擇性消費 選擇性消費 金融 選擇性消費

能源 選擇性消費 能源 公用事業 能源 能源 主要消費

金融 金融 金融 主要消費 金融 礦業 金融

公用事業 電訊 公用事業 金融 黃金 選擇性消費 醫療保健

選擇性消費 公用事業 選擇性消費 能源 醫療保健 黃金 公用事業

礦業 礦業 礦業 黃金 公共事業 電訊 電訊

黃金 黃金 黃金 礦業 主要消費 高科技 高科技

1995 1996 1997 1998 1999 2000 2001*

行業輪動

最差

.....

..… 行

業績

效表

現 ..

.....…

最佳

全球產業輪動

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全球債市輪動

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001High High High Bank High High High Investment High US InvestmentYield Yield Yield Loans Yield Yield Yield Grade Yield Govt Grade

Bonds* Bonds Bonds Bonds Bonds Bonds Corporates Bonds Securities Corporates40.22% 18.36% 19.84% 10.32% 17.38% 12.98% 13.17% 7.87% 4.78% 11.89% 8.22%

Investment Muni Muni Money Investment Bank Muni US Money Muni USGrade Bonds Bonds Markets Grade Loans Bonds Govt Markets Bonds Govt

Corporates Corporates Securities Securities16.18% 8.90% 12.43% 3.74% 17.12% 7.48% 9.39% 7.84% 4.74% 11.10% 6.67%

US Investment Bank Investment Muni Money US Muni Bank Investment MuniGovt Grade Loans Grade Bonds Markets Govt Bonds Loans Grade Bonds

Securities Corporates Corporates Securities Corporates14.63% 7.22% 11.17% -3.21% 17.31% 5.01% 9.12% 5.64% 4.69% 10.58% 4.15%

Muni Bank Investment High US Muni Investment Bank Investment Money MoneyBonds Loans Grade Yield Govt Bonds Grade Loans Grade Markets Markets

Corporates Bonds Securities Corporates Corporates12.04% 6.75% 10.00% -3.68% 16.94% 3.58% 8.79% 5.31% -0.98% 5.94% 3.80%Money US US US Bank Investment Bank Money US Bank Bank

Markets Govt Govt Govt Loans Grade Loans Markets Govt Loans LoansSecurities Securities Securities Corporates Securities

5.82% 6.10% 8.32% -4.74% 8.91% 3.43% 8.30% 5.10% -2.66% 4.94% 2.65%Bank Money Money Muni Money US Money High Muni High HighLoans Markets Markets Bonds Markets Govt Markets Yield Bonds Yield Yield

Securities Bonds Bonds BondsN/A 3.45% 2.72% -6.04% 5.53% 2.16% 5.14% -0.07% -4.07% -9.71% -1.04%

* Fixed Income Sector Performance is based on Lipper sector indices. Past performance is no indication of future performance.

FIXED INCOME SECTOR PERFORMANCE, 1991-2001

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Q&AQ&A

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