Asset Allocation:Strategic vs. Tactical

Risk Tolerance and Strategic Asset Management

Pedro Gonzalez Cerrud PhD,CPA, CFP, CFAINVESCO Institutional

Puerto RicoNov. 15, 2002

2Risk Tolerance 11_02.ppt

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



Definition of risks— Volatility— Losses— Unknown

Expected Utility of Investors:— Increases with expected returns— Decreases with volatility of returns



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


Budgeting for Risk Tolerance

Risk Budget— “Subset of understanding the client’s 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”



Top Down Risk Budget: A Global Approach

Liability Structure

Benchmarks, Target alphas, Tracking Errors

Alpha Diversification, Max Information Ratio



Bottom-Up Risk Budget: A Global Approach

Historical Relationshipamong asset classes

Alpha Correlation of Asset Classes/Styles

Information Ratios per Asset Class/Style on a Global Basis

A Real World Example


The Plan Sponsors Dilemma

Every Investor’s 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:

Alpha’s are perishable

Style and asset class cycles can be very long

Lower return environment expected in the future


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


Two Sources of Alpha

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

Top-Down

Bottom-Up

Top-Down Active Asset Allocation Strategies

Over 50 sources of top-down alpha

Bottom-Up Active Security Selection Strategies

15 Bottom-up managers


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 value-added.

Philosophy— 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.


Step One

Step Two

Step Three

Step Four

Step Five

Asset Allocation Process

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


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

0.60

0.70

0.80

0.90

1.00

1.10

1.20

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69 72 75 78 81 84 87 90 93 96 99 02

Relative Price

Relative Earnings


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80 82 84 86 88 90 92 94 96 98 00

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12 mo. Change in US vs IntlNominal Growth

US vs. International and G7 Nominal Growth Indicator

Secular Drivers

Relative earnings determines relative performance

Magnitude of relative earnings is determined by the investment cycle

US vs. International and Change in Relative Investment

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80 82 84 86 88 90 92 94 96 98 00

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0.5Rel CapExUS vs. Intl.

G7 Nominal Growth (Inverted %)

12 Mo Change in US vs. Intl (%)

Cyclical Drivers

US Equity Market is a Stable Grower

Outperforms during Global Weakness

Under performs during Global Strength

US vs. International

Relative Capital Spending Growth

US/Non-US Relative Return

Understanding Asset Class Cycles


Non-US vs. US Equities: Valuation

US Equities tend to get overvalued against non-US equities following periods of strong relative growth and investment.

-0.2

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0

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

Valuation

Relative Valuation: US vs. Developed Non-US


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

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

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Global Growth Relative Return

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75 78 81 83 86 88 91 94 96 99 02

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Relative Liquidity Relative Return

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tive L

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%) R

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) Glo

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%)

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(%)

Global Growth Low; US Outperforms

Global Growth High; Non-US Outperforms

Relative Liquidity High; US Outperforms

Relative Liquidity Low; Non-US Outperforms


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69 72 74 77 79 82 84 87 89 92 94 97 99 02

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

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16.00%

18.00%

Relative IndexMarket Share Proxy

Japan vs. World: Relative Index and Market Share Proxy

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

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

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

Asset Allocation – Country Example

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m C

hg

in

Rela

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03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03

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0%

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30%

Rel Index 12m Chgd12 Invent / Sales


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.


Alpha diversification delivers superior top-down information ratio.

SINGLE ALPHA STRUCTURE

Active Asset Allocation Alpha MixImplied Alpha

Tracking Error

Information Ratio High Neutral Low

Stock/Bond 100% 0.90% 2.75% 0.33 100% 60% 0%Total 0.90% 2.75% 0.33

MULTI-ALPHA STRUCTURE

Active Asset Allocation Alpha MixImplied Alpha

Tracking Error

Information Ratio High Neutral Low

Value/Growth 30% 0.33% 1.00% 0.33 35% 20% 5%Small/Large 20% 0.33% 1.00% 0.33 20% 10% 0%US/Non-US Equity 20% 0.33% 1.00% 0.33 20% 10% 0%Stock/Bond 30% 0.33% 1.00% 0.33 70% 60% 50%

1.32% 2.01% 0.66

Portfolio Structure

Portfolio Structure

Top-Down Risk Management: Alpha Diversification


Chart 3:Large Cap Core: Trend Deviation: Relative Strength vs. Benchmark

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85 88 90 92 94 96 98 00

GrowthValue

Chart 1:Large Cap Core’s Alpha Correlation to Growth & Value

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94 95 96 97 98 99 00

GrowthValue

Chart 2:Small Cap Core’s Alpha Correlation to Growth & Value

Bottom-Up Risk Budget: Alpha Modeling

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1

1.1

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89 90 91 92 93 94 95 96 97 98 99 00 01


Trailing 24-month Excess Returns

Bottom-Up Risk Budgeting: Alpha Diversification

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Dec-90 Feb-92 Apr-93 Jun-94 Aug-95 Oct-96 Dec-97 Feb-99 Apr-00 Jun-02

Growth

Large Cap Core


Trailing 24-month Excess Returns

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Mar-94 Dec-94 Sep-95 Jun-96 Mar-97 Dec-97 Sep-98 Jun-99 Mar-00 Dec-00 Sep-01

Core-All Cap

All Cap w/ Growth/Value Wings

Corr

ela

tion

Coeffi

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Bottom-Up Risk Budget: Striving for Higher Returns


Bottom-Up Risk Budget: Striving for Higher Return

Alpha Correlations:

TError:ExcessReturn:Allocation: 4321

2.14%Tracking Error

2.08%Excess Return

US Equity Portfolio:

45.0%Total:

0.450.000.100.454.00%2.67%2.5%Small5

0.000.100.103.50%2.33%2.5%Mid Cap Core4

0.650.153.00%2.00%12.5%Large Growth3

0.203.00%2.00%17.5%Large Value2

3.00%2.00%10.0%Core1

Alpha diversification delivers superior bottom-up information ratio.

Information Ratio 0.97


Portfolio Implementation Target Alpha

Average Tracking

Error

Target Information

Ratio

U.S. Equity Large Cap Value 2.00 3.00 0.66 U.S. Equity Large Cap Growth 2.00 3.00 0.66 U.S. Equity Large Cap Core 2.00 3.00 0.66 U.S. Equity Mid Cap Core 2.25 3.50 0.62 U.S. Equity Small Cap Core 2.75 4.25 0.62 International Developed Equity 3.50 7.00 0.50

International Developed Equity Small Cap 5.00 10.00 0.50 Emerging Equity 4.00 8.00 0.50 U.S. Bonds 0.75 1.50 0.50 High Yield Bonds 1.00 2.00 0.50

International Developed Bonds 1.75 3.50 0.50 Emerging Bonds 4.50 9.00 0.50 Cash 0.20 0.10 0.50

Total From Portfolio Implementation 2.06 2.03 1.03

Total From Asset Allocation 0.95 1.90

Grand Total 3.03 2.78

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

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

Global Asset Allocation Risk Budget

0.50

1.09


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

Asset Allocation:Strategic vs. Tactical

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