Managing the Asset Allocation of Complex Portfolios

1. 1 Managing the Asset Allocation of Complex Portfolios OV MS AA/mmgr Diff: AA through MM � 96 very unusual � mostly consultants MMGROV MS AA/mmgr Diff: AA through MM � 96 very unusual � mostly consultants MMGR

2. 2 Evolution in Investment Management Conventional Portfolio: Single team responsible for stock picking & asset allocation Explain� � chart � The purpose of Altis: to integrate good managers, good product ideas like you heard from Roel Menken, but to integrate it all from a macro-perspective like Richard Davidson gave you. Explain� � chart � The purpose of Altis: to integrate good managers, good product ideas like you heard from Roel Menken, but to integrate it all from a macro-perspective like Richard Davidson gave you.

3. 3 Opinion:After four years of tremendous returns in �Peripheral Markets� (in Hedge Funds, Emerging Market Debt, High Yield, Small Caps) it becomes all the more important to know the true extent of exposure to �peripheral performance factors� Fact:Multi-Manager Investing, with its lack of transparency, makes your asset allocation much more vulnerable to this issue. We will illustrate this using one single theme: the abundance of Small Cap exposure in portfolios today Solution:Tools to bring an asset allocator or CIO back into control over his complex portfolio The main challenge in our work is to maintain overview of the aggregated exposures of such complex �multi asset� portfolios. That is esp true today: bullet 1 Bullet 2: The problem of your real, underlying, exposures becomes all the more difficult with MA Bullet 3: our solution to this has always been a fairly elaborate �see-through� tool to understand the asset allocation of a MMMA portfolio. Recently, the challenge in doing this has become bigger, as managers and investment products become increasingly hard to see through. I will present a basic overview of the risk mgt tool we have developed. RJ will then go into the developments of the past year, in which we focused on dealing as good as possible with hedge funds. My basic overview focuses almost exclusively on one risk factor that has become enlarged through the past few years of �peripheral bull market�: the concentration of portfolios into small caps. This is not to say there are no other risk concentrations to look at; but it serves as a single example given that time is limited today!The main challenge in our work is to maintain overview of the aggregated exposures of such complex �multi asset� portfolios. That is esp true today: bullet 1 Bullet 2: The problem of your real, underlying, exposures becomes all the more difficult with MA Bullet 3: our solution to this has always been a fairly elaborate �see-through� tool to understand the asset allocation of a MMMA portfolio. Recently, the challenge in doing this has become bigger, as managers and investment products become increasingly hard to see through. I will present a basic overview of the risk mgt tool we have developed. RJ will then go into the developments of the past year, in which we focused on dealing as good as possible with hedge funds. My basic overview focuses almost exclusively on one risk factor that has become enlarged through the past few years of �peripheral bull market�: the concentration of portfolios into small caps. This is not to say there are no other risk concentrations to look at; but it serves as a single example given that time is limited today!

4. 4 Contents Style Bias in Manager Selection Multi Asset Investing: Portfolio Diversification or a New Bubble? Efficient Implementation Summary: Bringing the Asset Allocator back into Portfolio Management Mention: sel bias ? you�re setting yourself up for a disappointment...Mention: sel bias ? you�re setting yourself up for a disappointment...

5. 5 Style Biasin Manager Selection

6. 6 1. Most Managers Underperform Especially in the most developed �core� markets Survivorship Bias: only products with good track records survive Survivorship/selection bias, explain what you meanSurvivorship/selection bias, explain what you mean

7. 7 2. Most Investors Are Poor Asset Allocators True for all DEVELOPED markets... Explanation of second gap: rehearse explanation. Hear about mgr only when he�s been successful... Clients have b=not been with the manager for his whole career, just from a certain moment. And that moment can be poorly timed!True for all DEVELOPED markets... Explanation of second gap: rehearse explanation. Hear about mgr only when he�s been successful... Clients have b=not been with the manager for his whole career, just from a certain moment. And that moment can be poorly timed!

8. 8 Load testing->Case 1 WHAT YOU�LL SEE IS INTERACTIVE MONTHLY REPORT, TOP CLIENT� Talk funds list (public source), good MMGR, decent track record Show <backtest>: 15%, allmost all alpha since market runed up though .. Show Konzept: <real> Track record 15% lower� ? so autoselection in MS! (take time to explain 2001-now and the meaning of green vs red, hard to read on screen, don�t forget!) .. Show EU & US: Too many funds, too many are Core, alpha ranked in time (EU) Show exposure: 15% scap. Calc with me: SCAP 64% * 15% = 9% alpha is style So you see, assume I�m right and this is good MMGR team, NOBODY IS FREE from buying past style performance. That�s OK unless you think style trend is going to break Show Backtest: show UBS in green: 2001: still had old growth style! MMGRS do tend to buy last years performers, very hard to avoid for all of us!Load testing->Case 1 WHAT YOU�LL SEE IS INTERACTIVE MONTHLY REPORT, TOP CLIENT� Talk funds list (public source), good MMGR, decent track record Show <backtest>: 15%, allmost all alpha since market runed up though .. Show Konzept: <real> Track record 15% lower� ? so autoselection in MS! (take time to explain 2001-now and the meaning of green vs red, hard to read on screen, don�t forget!) .. Show EU & US: Too many funds, too many are Core, alpha ranked in time (EU) Show exposure: 15% scap. Calc with me: SCAP 64% * 15% = 9% alpha is style So you see, assume I�m right and this is good MMGR team, NOBODY IS FREE from buying past style performance. That�s OK unless you think style trend is going to break Show Backtest: show UBS in green: 2001: still had old growth style! MMGRS do tend to buy last years performers, very hard to avoid for all of us!

9. 9 Multi Asset Investing:Portfolio Diversification or a New Bubble?

10. 10 Valid Strategic Reasons to go �Multi Asset�

11. 11 2002~2005: A Run Towards the Periphery Note axis � how much reduction Admittedly, from very high peak Partly, the effect of easy money providing ST stability and LT moral hazard Partly, the effect of The Quest For Yield from multi-asset investorsNote axis � how much reduction Admittedly, from very high peak Partly, the effect of easy money providing ST stability and LT moral hazard Partly, the effect of The Quest For Yield from multi-asset investors

12. 12 2001~2005: A Run Towards the Periphery

13. 13 Returns in EUR from January 2002 � October 2005: MSCI World -4% JPM Global Govt Bonds 5% (20% LC) Listed Property 69% Emerging Markets Equity 58% Emerging Markets Debt 32% European High Yield 39% (since Jan. 2003) European Small Caps 60% Peripheral Bull Market? It all makes the risk of buying past performance even more real. The Eur bond manager with 5% EMD; the LC manager with 20% SC; was it brilliance or is it just autoselection/survivorship bias? The question is not just about avoiding the waste of fees where there�s no alpha The bigger question is: �what about the risk of my newly selected managers all compounding exposure to some factors that have done well for years?� MENTION that you illustrate Peripheral risk with just one dimension: SC. Similar findings, maybe more subtly, in Credit/EM/Illiquidity premium It all makes the risk of buying past performance even more real. The Eur bond manager with 5% EMD; the LC manager with 20% SC; was it brilliance or is it just autoselection/survivorship bias? The question is not just about avoiding the waste of fees where there�s no alpha The bigger question is: �what about the risk of my newly selected managers all compounding exposure to some factors that have done well for years?� MENTION that you illustrate Peripheral risk with just one dimension: SC. Similar findings, maybe more subtly, in Credit/EM/Illiquidity premium

14. 14 Risk of Buying Past Performance is Real Study, September 2005: Analysis of 10 Family Offices/Endowments,  investing in a total of 67 equity managers Aggregated holdings: 32% overweight in Small Caps Explicit hiring of Small Cap specialists �Auto-selection� bias towards Large Cap managers with a Small Cap drift Conscious asset allocation or by-product of manager selection? Again, we focus simplistically on one single �peripheral factor�, SC. We ignore the EM factor, the illiquidity factor, etc. Compounding: clients buy SC specialists, mainstream mgrs go there quietly as wellAgain, we focus simplistically on one single �peripheral factor�, SC. We ignore the EM factor, the illiquidity factor, etc. Compounding: clients buy SC specialists, mainstream mgrs go there quietly as well

15. 15 Risk of Buying Past Performance is Real Sources of Performance: 2000-2005 is a very special situation: one of the longest and most constant style cycles in history,making the separation of sustainable alpha and bias all the more important Style exp through sel.bias?? Inefficient mkts Style exp through sel.bias?? Inefficient mkts

16. 16 Style exposure for alpha, for outperformance� Fund list: Multi-Asset, not an equity FoF. Professional FO bought from bank (HF cust, all active govtFI, some gold and comm) Show backtest: just 6% backtest alpha? FI -> sust. Neg. Clariden green! HF -> had to sell $ EU-EQ: 35% alpha in eff � sust?! Other EQ normal Show exposure: Green XYZ �Eur�. Open up XYZ, holdings, show hist. � roll to stoxx ? get more normal picture, like Konzept. Go to funds, add SSGA, go to backtest, roll to SSGA Now 5% instead of original 6% backtest alpha � but a lot more sustainable Such a simple sanity check, that�s what makes a CIO effective� Third step, RJ, selling Eq L/S style elverage for Abs return!! Style exposure for alpha, for outperformance� Fund list: Multi-Asset, not an equity FoF. Professional FO bought from bank (HF cust, all active govtFI, some gold and comm) Show backtest: just 6% backtest alpha? FI -> sust. Neg. Clariden green! HF -> had to sell $ EU-EQ: 35% alpha in eff � sust?! Other EQ normal Show exposure: Green XYZ �Eur�. Open up XYZ, holdings, show hist. � roll to stoxx ? get more normal picture, like Konzept. Go to funds, add SSGA, go to backtest, roll to SSGA Now 5% instead of original 6% backtest alpha � but a lot more sustainable Such a simple sanity check, that�s what makes a CIO effective� Third step, RJ, selling Eq L/S style elverage for Abs return!!

17. 17 Efficient Implementation That last comment brings us to the end part of this short presentation: Select managers that make sense WITHIN your portfolio!That last comment brings us to the end part of this short presentation: Select managers that make sense WITHIN your portfolio!

18. 18 Manager Selection should not be done in isolation. Rather, Manager Selection serves Portfolio Construction: Not on past performance But on (1) Desirable market exposures (2) Sustainable alpha generation skills And on the suitability within a Multi-Manager portfolio Avoiding �diwastification� ? requires concentrated portfolios� �or �good� Equity L/S managers � In this field, investment consultants are out of their depth Manager Selection = Asset Allocation Remove last point... Challenge for...Remove last point... Challenge for...

19. 19 Manager Selection = Asset Allocation

20. 20 Summary

21. 21 In the past few years, did we forget about the importance of managing portfolios top-down? The emergence of widespread Multi-Asset investing at least coincided with (maybe was even partly responsible for) the bull market in the periphery �Everybody� is long Small Caps (and credit, EM, �) May set the stage for high risk and disappointing returns Yet, relatively simple tools can be employed to understand, control, and manage Multi-Asset portfolios through the coming years Hopefully, this will be �The Return of the Asset Allocator�� Summary & Conclusions