Leveraging the Investment Decision Process: Dynamically

Managing Beta and Alpha

Dr. Arun S. Muralidhar

Chairman

Mcube Investment Technologies, LLC

22 July 2005

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Roadmap: From Static to Dynamic Roadmap: From Static to Dynamic PortfoliosPortfolios

• Traditional approach – Alpha from external managers

• New approach – Add alpha from informed decisions

• Transparency and governance are critical

Dynamic “Alpha”

Management

Dynamic “Beta”

Management

Consider Simple

Rebalancing Strategies

Hire Managers on a Static Basis (incl. Currency)

Set Static Strategic

Asset Allocation Using ALM

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Client’s Investment Philosophy

• Asset allocation: key source of return

• Ranges will be maintained through a disciplined rebalancing program

• Diversification by and within asset class is the primary risk control element

• Passive alternatives to actively managed portfolios are preferred, especially in highly efficient markets

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Key Conclusions

• Separating “alpha” from “beta” - Too much focus on alpha, not on beta

• Little focus on impact versus liabilities

• Dynamic alpha and beta management may be more valuable than static alpha

• All portfolio decisions (incl. rebalancing) impact returns and risks; Must make decisions in an informed manner

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Investment Decision Process (IDP): Many Embedded Decisions

Total Portfolio/Liabilities

LCSCACWI EMG SC

Equity64%

Cash 0%

Alternatives13%

Fixed Income23%

Non US 24%

Domestic40%

Core21%

HY1.5%

Emerging0.5%

PE 4%

RE 9%

Benchmark Misfit Risk

Asset Allocation Decision

Manager Selection and AllocationImportant to manage/monitor each decision and understand

individual and aggregate contribution to risk/return

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• Passive: Calendar or range-based rebalancing

• Dutch model: benchmark includes drift until range is met or calendar period is completed

• When range hit, go either to range or target or in-between (what happens within range???)

• +/- 3% range for most assets; 4% for RE

• Client policy gives discretion = Tracking Error

The “Old” Static Framework for Beta

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• Single asset class focus: Optimize information ratio on active managers for a risk budget

• M3 measure shows why this is incorrect (for single and multi-manager portfolios)

• Modigliani2: Could hire a negative IR manager!

• Dynamic management of alpha: Cash flows make pension funds active – already make decisions on who to give money to and when!

The “Old” Static Framework for Alpha

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• Also means asset class performance will go through cycles – this aspect is often ignored

• Intelligent staff cannot sit by as markets evolve • Managers can have low correlation with others• Manager cyclicality – why fund a manager who is

starting to underperform?• Role of cash flows in implementing DYNAMISM

Understanding Diversification or “Low Correlations”

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Passive Rebalancing: Can Be “Risky”*

• Buy and Hold: Let Portfolio Drift

─ 0.16% annualized return; 1.09% tracking error

─ Worst drawdown = -2.15% (multi-year period)

• +/-3% range for most assets; 4% for RE**

─ Impact: 0.01% annualized return for 0.21% risk

• Worst drawdown: much lower at –0.43%

*Rebalancing was evaluated from 01/99 – 04/05. Only tested at the highest portfolio benchmark level. Transactions costs (one way) = 15 bps for equity; 10 bps for fixed

income; 0.5% for alternatives

**Range-based rebalancing = if any asset drifts to the range limit, all assets are rebalanced to benchmark

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“Passive” Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr)

Buy and Hold

Ann Ret: 0.16%

Drawdowns!!

Rebalancing

Ann Ret: 0.01%

Source: AlphaEngineTM

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“Passive” Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr)

Buy and Hold

Ann Ret: 0.16%

Rebalancing

Ann Ret: 0.01%

Source: AlphaEngineTM

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Informed Decisions within Ranges – Dynamic Beta Management

• Portfolio rebalancing is an “active” decision

• Use cash flows to structure fund appropriately

• Investment decision process creates opportunity

• Large cap vs. Small cap (+/-2%)

• Core vs. HY vs. EMG (+/-2%)

• EAFE vs. EMG vs. Small (+/-2%)

Can staff use discretion to create value?Key: Have a robust, transparent, consistent

process

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Improving the Quality of Decisions

• Test variety of rules to use for specific decisions

• Consistent evaluation and performance metrics

• Many resources can be tapped

• Internal staff – have ideas that are unused

• Research: many articles on when asset classes do well

• Leverage external managers/relationships – Verizon

• Transparency and process key for good governance

“Prudence is Process”

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Focused on a Few “Beta” Decisions

Total Portfolio/Liabilities

LCACWI EMG SC

Equity64%

Cash0%

Alternatives13%

Fixed Income 23%

Foreign24%

Domestic40%

Core HY

Chose a few decisions to make the pointDeveloped multiple rules to diversify the risk for

each strategy

Asset Allocation - Equity vs FI

Foreign Equity -

ACWI vs EMG

Domestic Eq. - LC vs SC

Fixed Income - Core vs HY

Asset Allocation - Equity vs

Cash

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Description of “Beta Management” Rules

• Equity vs Fixed Income vs Cash─ Price of Oil; Slope of Yield Curve, Equity Momentum,

“Halloween Rule”; Fed Model─ Annual Turnover was only 5%

• Equities (ACWI vs EMG; Large vs Small Cap)─ Liquidity, EMG spreads; VIX, Yield Curves, Credit─ Annual Turnover was only 5%

• Bonds (HY vs Governments)─ Eq performance and VIX; Yield Curve, Halloween─ Annual Turnover was only 4%

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Informed Decisions/Managing Beta: Improved Risk/Return *

• Asset allocation level: Keep return relative to “Buy and Hold”; lower risk relative to Rebalancing

• Stay within passive rebalancing guidelines

• Add returns at every level of IDP – alpha compounds

*All Decision regimes were evaluated from 01/99 – 04/05. Transactions costs were higher for sub-asset class level. Decision

making frequency was monthly

Excess Annualized

ReturnTracking

ErrorInformation

RatioWorst

Drawdown Confidence

in SkillSuccess

Ratio

Asset Allocation level 0.16% 0.19% 0.81 -0.21% 98% 57%

Domestic Equity

Foreign Equity

Fixed Income

0.08% 0.19% 0.43 -0.35% 85% 55%

0.04% 0.12% 0.36 -0.21% 82% 53%

0.04% 0.07% 0.57 -0.18% 92% 56%

Source: AlphaEngineTM

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Comparing Impact on Entire Fund

Excess

Annualized

Return

Tracking

Error

Information

Ratio

Worst Drawdown

Confidence

in Skill

Success

Ratio

Buy and Hold 0.16% 1.09% 0.14 -2.19% 69% 51%

Strict +/-3% Rebalancing 0.01% 0.21% 0.03 -0.43% 53% 42%

Informed Decisions 0.32% 0.21% 1.5 -0.18% 99% 64%

• At total fund level, better return with lower risk

• Drawdown at total fund level is also lower

• Translates into meaningful $$s = $180 mn/yr!

Source: AlphaEngineTM

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Managing Beta = “Alpha” ($) + Risk Management = Good Governance

Informed Decisions

Ann Ret: 0.32%

Drawdown is ½!!

Rebalancing

Ann Ret: 0.01%

Source: AlphaEngineTM

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Ideas for “Alpha” Management

• UK vs Euro ex-UK managers: favor mgr in market with a higher interest rate ─ Added 0.37% annualized over a static mix

• Govt. bonds: favor the manager with greatest momentum over last 3 months─ Added 0.27% ann. over a static mix of 4 mgrs

• Convertible Arbitrage vs Fixed Income Arb─ Allocate to mgrs depending on VIX and OAS─ Added return over static with 12% turnover!

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Dynamic Alpha and Beta Management can Lower A-L Risk

Annualized Liability Return (Benchmark) = 8.2%Note: These results are indicative and were obtained from another fund using the “informed decision” approach ( 2001-2005)

Option Ann. Growth in Surplus

Volatility of Surplus

Prob. Funded Ratio < 105% at y/e

Static SAA -0.72% 6.64% 34%

+ Managers -0.64% 6.59% 29%

+ Rebalancing -0.57% 6.72% 28%

+ Dynamic +0.29% 7.00% 21%

+ Dynamic +0.34% 6.96% 19%

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Summary

• Many clients focus only on SAA, Rebalancing and Static Allocations to External Managers

• Using dynamism in portfolio can lead to additional returns and lower Surplus-at-Risk

• Dynamism: both managing beta and alpha

• Cheaper source of excess return at total fund level (than any other “alpha” option)

• Easy to adopt by leveraging external relationships

AppendixAppendix

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Where Should a Fund Take Risk?

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-1

0

1

2

3

4

5

0 2 4 6 8 10

Tracking error

Exc

ess

retu

rn

Tracking error vs. excess returns (net of fees) US Equity Large Cap

US Fixed Income

High Yield

Non-US Equity EAFE

Non-US Equity EAFE- Japan LiteEmg Mkt Equities

Non-US FixedIncomeUS Equity Small Cap

US Equity Mid Cap

Non-US FixedIncome - Japan Lite

Source: Muralidhar (2001), Innovations in Pension Fund Management

• Consistent with Client philosophy – WHO IS THE MUG?

From 12/87 to 12/97

Contact Information

Name: Dr. Arun S. Muralidhar

Title: Chairman

Company: Mcube Investment Technologies, LLC

Phone: 1-646-591-6991

E-mail: asmuralidhar@mcubeit.com

Website address: www.mcubeit.com