2007 Phoenix Conference

Enhancing Fixed Income Returns Using

Alternative Alpha Sources
1
Contents
What is the role of fixed income in portfolios?
Are investors satisfied with the contribution from fixed income?
How can investors enhance fixed income returns?
What are desirable characteristics for alpha porting strategies?
What are viable alpha strategies to port onto fixed income?
What are the risks?
How do alpha sources compare?
GTAA as a source of alpha
What is GTAA?
Why is it a credible source of alpha?
Examples of alpha sources within GTAA
How can alpha porting using GTAA be implemented?
How are current investors enhancing fixed income returns?
2
What is the role of fixed income in portfolios?
Reduce portfolio risk
Match liability characteristics (ALM framework)
Diversify equity risk
Source of liquidity e.g. cash account
3
Are investors satisfied with the contribution
from fixed income?
Reduce portfolio risk
For a 60/40 stock / bond allocation, equity dominates the risk budget
Match liability characteristics - ALM framework
Reduces surplus volatility & de-risks pension plan and balance sheet
Returns insufficient to cover liability costs. Need ~1.5 X collateralization
Diversify equity risk
Works best in deflationary environment (negative correlation btwstocks &
bonds)
Okay in stable growth/inflation environments (low/moderate correlation
between stocks & bonds)
Poor in high inflation or stagflation (positive correlation between stocks &
bonds when needed the most)
4
Percent contribution to Total Portfolio Risk
(Equity & Fixed Income Portfolio: Stdev Eq = 15%; Stdev FI = 5%; Correlation = 0.3)
0%
20%
40%
60%
80%
100%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
% Allocat ion to Equity
C
o
n
t
r
i
b
u
t
i
o
n

t
o

R
i
s
k

(
F
I
)
Fixed Income
Equity
Source: Deutsche Asset Management Quantitative Strategies
5
Are investors satisfied with the contribution
from fixed income?
Last 3 Years Last 5 Years Last 10 Years
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
Group: CAI Core Bond Fixed-Inc Style
for Periods Ended September 30, 2006
Returns
10th Percentile 4.17 5.48 6.97
25th Percentile 4.03 5.33 6.85
Median 3.67 5.12 6.66
75th Percentile 3.50 4.83 6.46
90th Percentile 3.31 4.57 6.35
Member Count 33 31 31
LB:Aggr Bd A 3.38 4.81 6.42
A (84)
A (78)
A (83)
Source: Consultant Manager Universe
Past performance is not an indication of future results.
6
How do you enhance reurns from fixed income?
Portable Alpha: Decouple alpha from undesired beta.
Transport or port alpha from undesired beta exposure
to desired beta exposure.
Minus
Cash
Govt Bonds
+ 5%
Alpha Transport
Swap or Futures
Cash
+ 5%
Alpha Source Final Portfolio
Plus
Govt Bonds
Manager
Alpha
Undesired
Exposure
Desired
Exposure
Conceptual example, no transaction costs assumed
7
What are desirable characteristics for alpha
porting strategies?
High IR
Capital efficiency
Non-episodic
Low correlation to beta sources
Liquidity
Transparency
Risk controlled
8
What are viable alpha porting strategies ?
GTAA/Global macro
Fund of hedge funds
Multi-strategy hedge funds
Long only alpha strategy short beta exposure
passively
9
What are the issues and risks?
Alpha sources promising alpha but delivering beta
Convertible arbitrage
Emerging markets hedge funds
Long/short equity with uncompensated & unmanaged embedded beta &
factor risks
Paying incentive fees on beta vs. alpha
Porting alpha and/or beta is not free - erodes alpha
Liquidity rebalance due to changes in alpha and beta portion
10
How do alpha sources compare?
depends X
depends on
underlying
mgrs
X
Risk controlled
X depends X
Transparency
X depends X
Liquidity
X X X X
Low correlation
depends depends depends depends
Non-episodic
depends on
target risk level
X
Capital efficient
depends
X X X
High IR
Long
Only
Short
Beta
Multi-
Strategy
Hedge Fund
Fund of
Hedge
Funds
GTAA/
Global
Macro
GTAA as a source of alpha
12
What is GTAA?
Strategic Asset Allocation
Explains >90% of the variability of a pension plans returns over time Brinson, et al 1986
Explains 35-40% of the variability of returns across pension plans Ibbotson & Kaplan 2000
What comprises the unexplained portion?
Tactical asset allocation
Style within asset classes
Manager alpha
Fees
Global Tactical Asset Allocation (GTAA) as a credible source of alpha
Exploit short-term mis-pricings within and across global equities and global
bonds, currencies, credit, volatility and commodities.
13
What is GTAA?
Major milestones
1950s 1960s 1970s
1990-
1995
1995-
1999
2003-
2006
Markowitz
publishes
Portfolio
Selection
TAA first
used by US
pensions
Maturing
futures
markets.
1st generation
GTAA
Growing
interest in
GTAA/
Global Macro
1987 Crash;
increased
TAA interest
GTAA
struggles.
2nd
generation
GTAA
2000-
Sharpe,
Lintner
CAPM
1980s
Emergence
of portable
alpha
14
Why does GTAA work?
Exploitable Inefficiencies
Many non-profit motivated players
Segmentation of global investment universe
Different economic drivers across regions
Overlooked as a potential alpha source
Broad Investment Universe
Derivatives facilitated ~15 fold increase of investment opportunity set
Fundamental Law of Active Management:
IR = IC * TC * SQRT (N)
IR: Information Ratio (alpha / volatility of alpha)
IC: Information Coefficient (measure of managers skill in forecasting market returns)
TC: Transfer Coefficient (measure of how well alpha ideas are captured in a live portfolio)
N: Breadth of investment universe
15
How is alpha generated?
Examples of alpha signals
Total Information Ratio: 1.2, Turnover: 1.3, Percentage Positive: 56.2%, MaximumDrawdown: -
1.469%
5-J un-02
20-Sep-00
25-Aug-98
99.10%
101.10%
103.10%
105.10%
107.10%
109.10%
111.10%
113.10%
115.10%
117.10%
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Total Information Ratio: 0.8, Turnover: 1.4, Percentage Positive: 54.4%, MaximumDrawdown: -
1.49%
2-Oct-06
23-J an-06
17-Oct-05
98.78%
100.78%
102.78%
104.78%
106.78%
108.78%
110.78%
2
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Carry differential among
currencies
Commodities: mean reversion
of refinery profit margin
Cross sectional yield curve
Fed Model stock/bond
timing
Total Information Ratio: 0.8, Turnover: 0.4, Percentage Positive: 52%, MaximumDrawdown: -
1.609%
8-Apr-99
20-J ul-98
19-Nov-96
99.92%
100.92%
101.92%
102.92%
103.92%
104.92%
105.92%
106.92%
107.92%
108.92%
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Total InformationRatio: 0.7, Turnover: 0.8, Percentage Positive: 50.2%, MaximumDrawdown: -2.391%
19-Aug-98
23-Sep-96
9-J an-95
97.66%
99.66%
101.66%
103.66%
105.66%
107.66%
109.66%
111.66%
5
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3
0
-
O
c
t-
0
3
8
-
J
a
n
-
0
4
1
8
-
M
a
r
-
0
4
2
7
-
M
a
y
-
0
4
5
-
A
u
g
-
0
4
1
4
-
O
c
t-
0
4
2
3
-
D
e
c
-
0
4
3
-
M
a
r
-
0
5
1
2
-
M
a
y
-
0
5
2
1
-
J
u
l-
0
5
2
9
-
S
e
p
-
0
5
8
-
D
e
c
-
0
5
1
6
-
F
e
b
-
0
6
2
7
-
A
p
r
-
0
6
6
-
J
u
l-
0
6
1
4
-
S
e
p
-
0
6
T
o
t
a
l
P
e
r
f
o
r
m
a
n
c
e
Source: G-Cube
Data: 1/5/1995 to 2/27/2007
Data: 1/5/1995 to 9/29/2006
Data: 2/27/1997 to 2/28/2007
Data: 1/5/1995 to 6/1/2006
16
How is GTAA overlay onto FI implemented?
1.0% overlay onto fixed income strategy:
Fixed Income Strategy + 1% GTAA Overlay
GTAA Overlay @
1% risk
$98 Million
Fixed Income
Instruments
$2 million
Margin for GTAA
Futures

GTAA
= 1.0%
GTAA
= 1.0%
FI
= 6.0%
FI, GTAA
= 0.10

FI +GTAA
= 6.2%
$100 Million
Fixed Income Strategy
17
How is GTAA overlay onto FI implemented?
1.0% overlay onto fixed income strategy:
Fixed Income Strategy + Investment into 20% GTAA Fund
$5 Million Investment
in 20% Risk GTAA
Fund
$95 Million
Fixed Income
Instruments
$100 Million
Fixed Income Strategy
18
Examples of enhancing fixed income with GTAA
& other alpha strategies
Stable value 1% excess return over core/core+ bond portfolio. Get an
immediate 50 bp increase in crediting rate due to alpha overlay.
TIPs 1.25% alpha overlay onto TIPs mutual fund
Canadian Bonds 1.5% alpha overlay onto Scotia McLeod
intermediate and long passive bond indices
LBAG fund with fund of hedge funds alpha
GNMA & Govt. Bond Mutual Funds 1.25% alpha overlay
19
Important information
The information in this presentation reflects prevailing market conditions and our judgment as of this date, which are subject to change. In
preparing this presentation, we have relied upon and assumed without independent verification, the accuracy and completeness of all
information available from public sources. We consider the information in this update to be accurate, but we do not represent that it is complete
or should be relied upon as the sole source of composite performance or suitability for investment.
The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that we
believe to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this
date. The underlying assumptions and these views are subject to change without notice.
Certain information in this material constitutes forward-looking statements. Due to various risks, uncertainties and assumptions made in our
analysis, actual events or results or the actual performance of the markets covered in this material may differ materially from those described.
The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader.
There can be no certainty that events will turn out as we have opined herein.
Past performance is not indicative of future results. No representation or warranty is made as to the efficacy of any particular strategy or the
actual returns that may be achieved.