Risk Tolerance and Strategic Asset Management

Pedro Gonzalez Cerrud PhD,CPA, CFP, CFA INVESCO Institutional Puerto Rico Nov. 15, 2002

Topics

Importance of Risk Tolerance in the Investment Process Budgeting for Risk Tolerance

Risk Budget Risk Budget and top down and bottom up investment decisions

A Real World Example

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Importance of Risk Tolerance in the Investment Process

Definition of risks

Volatility Losses Unknown Increases with expected returns Decreases with volatility of returns

Expected Utility of Investors:

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Importance of Risk Tolerance in the Investment Process

The lower the risk tolerance more sensitive is the investor to the volatility of returns Ultimate objective of any investment program should be:

Maximum returns per unit of risk

Both expected returns and risk tolerance of investors are dynamic variables

Change in factor affecting expected returns are faster than those impacting the level of risk tolerance

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Budgeting for Risk Tolerance

Risk Budget

Subset of understanding the clients risk appetite Is a way of taking a finite risk resource, and deciding how best to allocate it Use of tracking error to set the downside risk A method to identify, quantify and monitor the value at risk of the portfolio

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Budgeting for Risk Tolerance

Top Down Risk Budget: A Global Approach Liability Structure Benchmarks, Target alphas, Tracking Errors Alpha Diversification, Max Information Ratio

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Budgeting for Risk Tolerance

Bottom-Up Risk Budget: A Global Approach

Historical Relationship among asset classes Alpha Correlation of Asset Classes/Styles Information Ratios per Asset Class/Style on a Global Basis

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A Real World Example

The Plan Sponsors Dilemma

Every Investors Goal: To build a successful multi-asset, multi-manager structure. Definition of Success: To build wealth by maximizing returns with minimum risk

The Multi-Asset Problem: Alphas are perishable Style and asset class cycles can be very long Lower return environment expected in the future

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Why Global Asset Allocation?

Solution for Multi-Asset Investing:

Create a risk habitat that seeks to enhance & preserve alpha Two sources of alpha allows one to strive for higher returns Valuation and Dynamic approach to investing

Model cyclical and secular forces of relative return Quantitative and Fundamental investment platform The path to higher returns is through the eye of risk management Build bottom-up risk budget (understand alpha cycles) Build top-down risk budget (understand asset class cycles) Overall risk budget that targets realistic goals and objectives

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Two Sources of Alpha

Over 50 sources of top-down alpha

Top-Down

Top-Down Active Asset Allocation Strategies

Returns are additive, risks are not Create the optimal risk habitat Solve for an information ratio of 1.0 Higher probability of achieving 300 bps alpha with 300 bps tracking error

Bottom-Up

Bottom-Up Active Security Selection Strategies 15 Bottom-up managers

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Asset Allocation Philosophy

Beliefs

Inefficiencies across asset classes are meaningful enough and powerful enough to prompt us to capture them in an active mode. A disciplined, systematic approach (grounded in financial theory and devoid of human emotion) can provide incremental valueadded. We believe that to consistently add value from a top-down perspective, an investment approach needs to combine information from long-run valuation measures with insights about the near-term investment environment.

Philosophy

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Asset Allocation Process

Step One Step Two

Identify the Key Cyclical and Secular Drivers Valuation and Dynamic approach to determine the relative return signal Build a top-down risk budget: Asset Classes Countries Currencies Build a bottom-up risk budget Complete risk budget for the total portfolio

Step Three

Step Four Step Five

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Domestic vs. International: Economic Fundamentals

The primary driver of US vs. non-US equities is relative earnings. The magnitude of relative earnings is determined by the investment cycle.
Relative Cash Earnings vs. Relative Market Price US vs. International
1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 69 72 75 78 81 84 87 90 93 96 99 02 Relative Price Relative Earnings

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Understanding Asset Class Cycles

US vs. International and G7 Nominal Growth Indicator
30 25 20 15 10 5 0 -5 -10 -15 -20 -25 80 82 84 86 88 90 92 94 96 98 00 12 mo. Change in US vs Intl Nominal Growth -30 -25 -20

US/Non-US Relative Return

Cyclical Drivers

-15 -10 US Equity Market is a Stable Grower -5 G7 Nominal Growth (Inverted %) 0 Outperforms during Global Weakness 5 Under performs during Global Strength 10 15 20 25

Relative Capital Spendin

12 Mo Change in US vs.
30 25 20 15 10 5 0 -5 -10 -15 -20 -25 80
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US vs. International and Change in Relative Investment

0.5 Rel CapEx US vs. Intl. 0.4 0.3 0.2

Secular Drivers
Relative earnings determines relative performance of relative earnings is determined by the investment cycle

0.1 US vs. InternationalMagnitude 0.0 -0.1 -0.2 -0.3 -0.4

82

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Non-US vs. US Equities: Valuation

US Equities tend to get overvalued against non-US equities following periods of strong relative growth and investment.
Relative Valuation: US vs. Developed Non-US
0.3 Valuation 0.2

0.1

-0.1

-0.2 75 78 80 82 84 86 88 90 92 94 96 98 00

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Non-US vs. US Equities: Dynamics

In the near-term, the US tends to outperform when:

Relative earnings expectations favor US companies, US liquidity is more abundant than non-US liquidity

40 30

40

Relative Liquidity High; US Outperforms

15.0

30

Global Growth Low; US Outperforms

15.0

Relative Liquidity (%)

20 10 0 -10 -20 -30 75 78 81 83 86 88 91 94 96 99 02 -5.0 5.0

20 10 0 -10 -20 -5.0 5.0

Relative Liquidity Low; Non-US Outperforms

-15.0

Global Growth High; Non-US Outperforms

-15.0 75 78 81 83 86 88 91 94 96 99 02

-30

Relative Liquidity

Relative Return

Global Growth

Relative Return

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Relative Returns (%)

Relative Returns (%)

Global Growth (%)

Asset Allocation Country Example

Japan vs. World: Relative Index and Market Share Proxy
0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 -0.02 69 72 74 77 79 82 84 87 89 92 94 97 99 02 Relative Index Market Share Proxy 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

Valuation
Shifts in global market share lead relative price performance Japan tends to gain share within global economic up-turns and lose within down-turns This measure, combined with other valuation measures, suggests that Japan is still reasonably valued despite out-performance year-to-date

Japan vs. World: Relative Index and Inventory/Sales Ratio

12m Chg in Relative Index 80% 60% 40% 20% 0% -20% -40% -60% -80% 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 Rel Index 12m Chg d12 Invent / Sales -30% Chg in Inventory / Sales Ratio -20% -10% 0% 10% 20% 30%

Dynamics
Like most of Asia, Japan outperforms the rest of the world at the beginning of the economic cycle One of the leading indicators of the economic cycle is the Inventory/Sales ratio low readings imply strong potential in the global economy The Inventory/Sales ratio is currently very low (inverted at left); Japan should outperform. Other cyclical indicators confirm this message

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Principles of Risk Management

Goal:

Deliver the best possible return within acceptable total and active risk budgets.

Properties of Risk:

Definition: On a stand alone basis, risk is the decay of compound returns. Diversification: Returns are additive, but risk is not. In a portfolio, risks can be diversified allowing the return of whole to exceed the sum of the returns of its parts. Universal Nature: Applicable in active or passive context, across asset classes, markets, securities, top-down alpha sources and bottom-up alpha sources.

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Top-Down Risk Management: Alpha Diversification

SINGLE A LPHA STRUCTURE Active Asset Allocation Stock/Bond Total Alpha Mix 100% Implied Alpha 0.90% 0.90% Tracking Error 2.75% 2.75% Information Ratio 0.33 0.33

Por t folio St ruct ure

High 100% Neutral 60% Low 0%

MULTI- A LPHA STRUCTURE Active Asset Allocation Value/Growth Small/Large US/Non-US Equity Stock/Bond Alpha Mix 30% 20% 20% 30% Implied Alpha 0.33% 0.33% 0.33% 0.33% 1.32% Tracking Error 1.00% 1.00% 1.00% 1.00% 2.01% Information Ratio 0.33 0.33 0.33 0.33 0.66

Por t folio St ruct ure

High 35% 20% 20% 70% Neutral 20% 10% 10% 60% Low 5% 0% 0% 50%

Alpha diversification delivers superior top-down information ratio.

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Bottom-Up Risk Budget: Alpha Modeling

Chart 1: Large Cap Cores Alpha Correlation to Growth & Value
0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 85 88 90 92 94 96 98 00 Growth Value

Chart 2: Small Cap Cores Alpha Correlation to Growth & Value

0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 94 Growth Value 95 96 97 98 99 00

Chart 3: Large Cap Core: Trend Deviation: Relative Strength vs. Benchmark
1.5 1.4 1.3 1.2 1.1 1 0.9
89
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Bottom-Up Risk Budgeting: Alpha Diversification

Trailing 24-month Excess Returns
14 12 10 8 6 4 2 0 -2 -4 -6 Dec-90 Growth Large Cap Core

Feb-92

Apr-93

Jun-94

Aug-95

Oct-96

Dec-97

Feb-99

Apr-00

Jun-02

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Bottom-Up Risk Budget: Striving for Higher Returns

Trailing 24-month Excess Returns
8 Core-All Cap All Cap w/ Growth/Value Wings 6

Correlation Coefficient

-2

-4 Mar-94

Dec-94

Sep-95

Jun-96

Mar-97

Dec-97

Sep-98

Jun-99

Mar-00

Dec-00

Sep-01

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Bottom-Up Risk Budget: Striving for Higher Return

Excess Return: 2.00% 2.00% 2.00% 2.33% 2.67% Alpha Correlations: TError: 3.00% 3.00% 3.00% 3.50% 4.00% 0.20 0.15 0.10 0.45 0.65 0.10 0.10 0.00 0.00 0.45 1 2 3 4

Allocation: 1 2 3 4 5 Core Large Value Large Growth Mid Cap Core Small 10.0% 17.5% 12.5% 2.5% 2.5%

Total:

45.0%

US Equity Portfolio: Excess Return Tracking Error 2.08% 2.14%

Information Ratio 0.97

Alpha diversification delivers superior bottom-up information ratio.

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Global Asset Allocation Risk Budget

The risk budget is constantly monitored by each top-down and bottom-up alpha source.

Portfolio Implementation U.S. Equity Large Cap Value U.S. Equity Large Cap Growth U.S. Equity Large Cap Core U.S. Equity Mid Cap Core U.S. Equity Small Cap Core International Developed Equity International Developed Equity Small Cap Emerging Equity U.S. Bonds High Yield Bonds International Developed Bonds Emerging Bonds Cash Total From Portfolio Implementation

Average Tracking Target Alpha Error 2.00 2.00 2.00 2.25 2.75 3.50 5.00 4.00 0.75 1.00 1.75 4.50 0.20 2.06 3.00 3.00 3.00 3.50 4.25 7.00 10.00 8.00 1.50 2.00 3.50 9.00 0.10 2.03

Target Information Ratio 0.66 0.66 0.66 0.62 0.62 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 1.03

Total From Asset Allocation Grand Total

0.95 3.03

1.90 2.78

0.50 1.09

All tracking error estimates are based on 3-year time horizon.

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Conclusions
R eturns are volatile I nvestment objectives defined as liabilities S ensitivity to changes in market and risk parameters K nowledge of long term and cyclical trends in the market T ake into consideration risk appetite O ptimal distribution of assets to maximize returns L ink of risk appetite and optimal assets E xpressed in a risk adjusted format R isk Budget to quantify and monitor risk A sset allocation based on alpha trends N umber and types of assets change based on sensitivity to volatility C onstant monitoring of sources of alpha and their risk characteristics E motions of investors taken into consideration
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