Alternative Investments: Measuring the Risks

Transcription

1 Alternative Investments: Measuring the Risks Steven Hartt, CAIA Senior Vice President Meketa Investment Group May 21, 2013 NCPERS 2013 Annual Conference

2 Agenda What are Alternative Investments? Why is it Important for Trustees to Understand Alternatives? How are Alternatives Similar to Traditional Investments? Why Invest in Alternatives? What are the Risks with Alternative Investments? Summary

3 What are Alternative Investments?

4 What is an Alternative? Something other than US stocks, bonds and cash Anything you don t understand Something that sounds risky or makes you uncomfortable Something you never heard of before Anything outside your mainstream thinking

5 Today s Alternatives Can Become Tomorrow s Mainstream 1975: Mortgage backed bonds (e.g., Fannie Mae) 1985: European and Japanese stocks 1990: High yield bonds 1995: Emerging markets (e.g., China) 2000: Treasury Inflation Protected Securities (TIPS)

6 What is Considered an Alternative in 2013? Private Equity Infrastructure Real Estate Commodities Hedge Funds

7 Why is it Important for Trustees to Understand Alternatives?

8 This Used to be Easier 18% 65% Stock / 35% Bond 10-Year Rolling Return Average 16% 14% 20-year average = 10.4% 12% 10% 8% 6% Current = 4.6% 4% 2% 0% Oct-91 Jan-94 Apr-96 Jul-98 Oct-00 Jan-03 Apr-05 Jul-07 Oct-09 Sep-11 The return for a standard investment portfolio has declined dramatically over the past decade.

9 Normalized Price-Earnings Ratio Current Investment Challenges Stocks remain relatively expensive Std. Dev. Average -1 Std. Dev Year Source: Shiller, Global Financial Data, S&P 500, Meketa Investment Group

10 10-Year Treasury Yield Current Investment Challenges Bond yields remain near historic lows 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Year A traditional portfolio of stocks and bonds will not get your 7.5%!

11 How are Alternatives Similar to Traditional Investments?

12 Characteristics of Traditional and Alternatives Alternatives have many of the Same Characteristics as Traditional Investments Traditional Alternatives Stocks Public Equity Private Equity Bonds Bonds Private Debt Real Estate REITs Private Real Estate Infrastructure Utility Stocks Private Infrastructure Commodities & Natural Resources Natural Resources Stocks Commodities Alternatives are exposed to many of the same risks as traditional investments

13 Why Invest in Alternatives?

14 What Can Alternatives Offer? Chance to participate in new opportunities A higher expected return for giving up some liquidity Greater alpha potential Ability to moderate risks associated with ordinary stocks and bonds Diversification benefits

15 What have been the returns? Source: Thomson Reuters. All Regions all Styles Historical Private Equity Returns As of December 31, Year 10 Years 20 Years Upper Quartile 22.8% 20.3% 33.0% Median 12.6% 11.3% 11.1% S&P 500 Index 16.0% 7.1% 8.2% Over the last twenty years, Median Private Equity has returned 11.1% annually, while Upper Quartile has returned 33.0% This compares to 8.2% for the S&P 500 Index

16 What are the Risks with Alternative Investments?

17 Common Issues with Alternatives Issue Lower level of liquidity or illiquid Consideration Subject to redemption terms (if any at all) Limited/no market for investor s interest Lower level of transparency into underlying assets Specific assets often not identified at the time of investment Limited/no ability to control the assets in the portfolio Some managers utilize leverage and/or derivatives Hard to value Many assets are not publicly traded and are subject to appraisal based valuation techniques No clear benchmarks Best managers are critical to success Spread between top performing and median managers is wide

18 Common Issues with Alternatives Issue Higher fees Lumpy cash flows Consideration Managers typically charge both management fees (1% - 2%) and performance fees (20% +) Investments may have unpredictable capital call and return patterns Self liquidating structures require reinvestment in order to maintain target allocation Administrative burden Potential headline risk Alternative investments often require monitoring, accounting and tax specialists Limited ability to exit manager in case of investment or other issue

19 Summary

20 Summary Investing in Alternatives The Eight Golden Rules Understand it first Adopt a well-considered long-term strategy Take your time to get invested Avoid fads Plan for the necessary illiquidity Avoid unnecessary pyramided costs Use the right professionals Diversify, diversify, diversify

21 Contact Information M E K E T A I N V E S T M E N T G R O U P BOSTON MIAMI SAN DIEGO 100 Lowder Brook Drive Suite 1100 Westwood, MA Telephone Number: (781) Fax Number: (781) Brickell Bay Drive Suite 2000 Miami, FL Telephone Number: (305) Fax Number: (305) Armada Drive Suite 110 Carlsbad, CA Telephone Number: (760) Fax Number: (760)

22 Alternative Investments: Measuring the Risks Matt Appel, CFA Vice President State Street Global Exchange Analytics May 21,

23 Agenda Introduction Alternative Investments Trends Importance What are the Risks Quantitative Hedge Funds Private Equity & Real Estate Risk Measurement and Solutions Assimilating Risks into Total Portfolios Trends in Alts 2

24 State Street Global Exchange State Street Bank &Trust State Street Global Markets State Street Global Services State Street Global Advisors State Street Global Exchange State Street Global Exchange (SSGX) is a global provider of advisory, analytics, investment, information, and electronic trading solutions. SSGX is committed to providing value to the front office in the same way State Street has and continues to do in the middle and back office. SSGX leverages State Street s unique data sets and industry-leading technology platforms to provide information products, software, and services across all asset classes and buy-side industry segments. 3

25 State Street Global Exchange - Analytics State Street Global Exchange Information Solutions Research & Advisory Analytics Independent valuation What-if performance attribution Risk/Return Optimization Analytics for regulatory risk Structured investment products Trading & Clearing Solutions Software Solutions 4

26 Full Service Risk Solution for Institutional Clients History We have been in existence since 2001 for 11+ years Global Pension Fund Clients 36 Pension Fund Clients Over 125 Clients Globally Extensive history with derivatives and alternative investments Grown from servicing only HFs to servicing all of the State Streets clients 17 Public 19 Corporate Staff Global Staff consists of 90+ people dedicated to risk services Client Support Development Risk Advisory Financial Engineering Research Business Development Administration Assets Serviced More than $1.5 trillion across ALL asset classes including private markets 5

27 Public Pension Funds Increase Allocation to Alternative Investments State pension systems shifted 10% of their assets from public equities to alternatives over the five years ending June 30, 2011 Alternatives now average 20% of total state fund assets Private equity and real estate allocations were the primary driver behind the better performing state funds Median allocation to alternatives by public plans with assets >$1B was 15.07% as of June 30, 2012, up from 1.81% as of June 30, % 90% 80% 70% 60% 50% 40% 30% 20% 10% Public Pension Plan Portfolio Allocation 2003 v % 15.07% Other Alternatives Fixed Income Equities 0% 1-Jan-03 1-Jan-11 Sources: Pension & Investment and Cliffwater Inc. 6

28 What are the Risks? 1. Lose Money 2. Liquidity can t get your money out when you need it 3. Over invested in certain exposures 4. Don t make expected return 7

29 How do I get the Information to Model? 1. Transparency Services 2. Proxy 3. Open Protocol 4. Regulation & Industry Standard Reporting 8

30 Transparency Today, more than ever, hedge fund investors are seeking ways to better measure and understand the dynamics and risks in their alternative investments. Execution of non-disclosure agreements to protect confidential information Monthly aggregation of hedge fund positions from: Fund administrators Fund prime brokers Fund custodians Funds themselves Position verification, cleanse, and augmentation with market data each reporting period Independently calculated position pricing Exposure reporting, including standardized and client-driven tags attributed to each position, enabling high flexibility Full range of position-based analytics including stress testing, VaR analysis, risk decomposition, sensitivities and what-if analysis 9

31 Proxy What Information Do you Need 1. Exposures 2. Return Streams 3. Indices 4. Blended Proxies 10

32 Open Protocol Regulatory Reform and Strong Investor Pressure has Necessitated Standard Risk Reporting Procedures for Alternative Investments Reasons for Open Protocol Reporting 1 The UK Financial Authority recognized reporting inconsistencies as it discussed assembling its first template to capture capital market risk in Where investors were able to see transparency into their hedge fund investments, it was complicated to view and monitor risk due to: Multiple sources of data Inconsistent calculation methods Different reporting formats 3 Post US financial crisis, there was a growing demand from institutional investors for standardized risk reporting to ensure consistency of data to better aggregate risk information. THE WORKING GROUP responsible for developing the first draft of Open Protocol reports for consultation by a wider audience as well as ongoing maintenance and development of the protocols Alongside Albourne Partners, State Street was a champion in the working group and continues to be actively involved in the Open Protocol initiative. Source: 11

33 What is Open Protocol? Completed in August 2011, the Open Protocol Template Provides Your Investors With a Consistent Level(s) of Hedge Fund Transparency 1. Counterparty Information (10%) Open Protocol brings together three types of information State Street uniquely provides counterparty and investor information 2. Investor Information (10%) 3. Risk Information (80%) Predefined levels of granularity allow managers to provide consistent information without compromising the trade in the market Grade I Grade II* Granularity Low Medium Mandatory Yes, for all metrics Manager / Client Discretion Example (Sector Exposure) Materials Industry Materials Chemicals * In development Grade III* High Manager / Client Discretion Materials Chemicals Diversified Chemicals 12

34 Who Does OP Benefit? Open Protocol Benefits Hedge Fund Managers, Institutional Investors and Regulators Beneficiaries Benefits Hedge Fund Managers Institutional Investors Regulators 1. Fund Transparency X X X 2. Standardized Reporting Procedure X X X 3. Decreased Reporting Costs X X Transparency of asset classes traded (not trading strategy) makes hedge funds more attractive investments for institutional investors (no more black box investing) The standard reporting template is flexible, easy to implement and comprehensive Aggregate reports will minimize managers and investors investment in additional technology and resources 13

35 3. Regulatory and Industry Standard Risk Reporting SEC Form PF A rule that requires private fund advisors to report regulatory assets under management to the FSOC. These requirements are intended to provide risk exposure statistics regarding the type and size of assets held by private firms. CFTC Form CPO-PQR A rule designed to provide information about operations and strategies of commodity pools in order to establish a baseline picture of potential systemic risk in the industry Regulatory Reporting Industry Standard Reporting UCITS IV AIFMD Solvency II Open Protocol The Committee of European Securities Regulators (CESR) requires Undertakings for Collective Investments in Transferable Securities (UCITS) funds to employ a risk management framework that monitors and measures the risk of their holdings and contribution to overall portfolio risk at any time. A regulatory directive whose primary objective is to provide common rules for the authorization and supervision of alternative investment fund managers (AIFM). All managers of AIFs operating in the EU, providing investment management services to non- UCITS, irrespective of legal form or domicile, are subject to transparency requirements. An EU directive that codifies and harmonizes the EU insurance regulation regarding the amount of capital that EU insurance companies must hold to reduce the risk of insolvency An 11-tab spreadsheet report that standardizes reporting procedures for the collection, collation and conveyance of hedge fund risk information. US-domiciled EU-domiciled Both 14

36 Losing Money Value at Risk (VaR) Drop Down Risk Sensitivities Stress Scenarios 15

37 Liquidity Legal Terms Gates Lock-ups Fees 16

38 Exposures Currencies Countries Sector Counterparties Issuers 17

39 Stress Scenarios Custom 6% 4% 3.64% 4.10% Historic Economic 2% 0% (2%) 0.36% 1.18% (4.32%) (4%) (2.97%) (2.80%) (3.53%) (6%) (8%) 9/11 Attack - 5 Day Asian Crisis day (7.20%) Bond Crash: Feb 94 - May 94 Emerging Markets Rally: Jan 99 - May 99 Fed Tightening: April - June 99 IR Steepening: Sept 98 - Nov 98 Nadaq Rally: Nov 99 - Jan 00 (6.55%) Nasdaq Russian Crisis Government Correction: July 98 - Aug 98-5 Day Intervention Fixed Income Domestic Equity Alternative Investments International Equity Total 18

40 Investment Vehicles to Mitigate Hedge Fund Risk Hedge Fund of Funds Commingled Funds Separate Accounts Funds of One 1940 Act Funds (Registered Products) 19

41 Liquid Alternative Strategies Liquid Products 1. Fidelity/Arden 2. Blackstone 3. KKR 4. Goldman 5. ARIA Traditional and Hedge FOF 1. Franklin Templeton / K2 2. NYLIM / Private Advisors 3. Legg Mason / Permal 20

42 ARIA Alternative Road Investment Advisors Registered 1940 Act Mutual Fund Access to Veteran Hedge Fund Managers Single 1.97% Fee (No performance fees or multiple layers of fees) Daily Liquidity Real-Time Transparency Multiple Hedge Fund Subadvisers & Strategies Endowment Asset Allocation Model Uncorrelated Return Stream Versus Broad Market Indices Downside Risk Protection Absolute Return Stream Long Term Capital Appreciation 21

43 Private Equity & Real Estate Investments 1. Liquidity 2. Exposure 3. Volatility 4. Opportunity Costs 22

44 PE Market parameter and assumption: PE Market Parameter is served as a Probability Density Function, which generates a random process from its observed behavior during a finite period of time, within user defined range. For example, based on SSPEI database observations, first year Buyout Fund on average drawdown 16% of commitment in year 1 with 6% Standard Deviation. Parameter Description Possibility Lower End Upper End 1 Robust 13.4% 1sd 1.96sd 2 Sound 15.0% 0.5sd 1sd 3 Neutral 38.2% -0.5sd 0.5sd 4 Slow 15.0% -1sd -0.5sd 5 Weak 13.4% -1.96sd -1sd Total: 95.0% Parameter Lower bound Upper bound 1 4% 10% 2 10% 13% 3 13% 19% 4 19% 22% 5 22% 28% 23 23

45 PESM provides a range of possible outcomes Simulation: Percentile Distribution 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Simulation: Histogram % 0.3% 1.3% 2.3% 3.3% 4.3% 5.3% 6.3% 7.3% 8.3% 9.3% 24 24

46 Sample of Simulation Result: Year 2013 to 2021 PE Market Barometer (CF Projection Parameters): 3, Neutral T0 T1 T2 T3 T4 T5 T6 T7 T8 T9 Contribution (253.3) (316.1) (361.0) (414.9) (428.2) (446.1) (459.9) (485.6) (504.4) (419.7) Buyout (147.2) (203.1) (252.8) (284.6) (294.9) (309.5) (322.7) (343.9) (365.0) (311.9) Venture Capital (16.1) (21.7) (27.0) (29.6) (37.5) (36.9) (37.2) (42.0) (39.5) (34.5) Debt Related (90.0) (91.3) (81.1) (100.7) (95.9) (99.7) (100.0) (99.6) (99.9) (73.2) Distribution Buyout Venture Capital Debt Related Net Cash Flow 1.3 (69.2) (109.8) (159.4) (132.7) (89.8) (33.0) (22.8) (11.2) 91.6 Buyout 13.4 (46.8) (121.3) (151.5) (124.4) (74.1) (16.2) Venture Capital (8.9) (19.5) (23.0) (22.8) (27.6) (22.4) (20.9) (24.2) (19.3) (8.6) Debt Related (3.2) (2.9) (9.6) (7.9) 17.2 Fair Marktet Value 1, , , , , , , , , ,324.4 Buyout , , , , , , ,715.1 Venture Capital Debt Related T0 T1 T2 T3 T4 T5 T6 T7 T8 T9 Ending AUM Value 18,503 21,278 24,470 28,141 30,955 34,050 37,455 41,201 45,321 49,853 Ending PE Allocation % 6.11% 6.01% 5.82% 5.71% 5.73% 5.61% 5.49% 5.33% 5.16% 4.66% 25

47 Private Equity & Real Estate Exposures 1. Country 2. Currency 3. Sector 4. Industry 5. Leverage 6. Vintage 26

48 Volatility & Opportunity 1. Proxy 2. Funds 3. Portfolio Companies 4. Leverage 5. PME 27

49 Actual BM BM Oversight, Analysis and Actionable Information Exposures Tracking Error 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Allocation by Market Cap 11% 14% Risk Contribution by Market Cap 12% 45% Large Med/Lrg Med/Small Medium 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Allocation by Sector Actual 0.0% -2.0% Monthly Risk 95% VaR 18% Small -4.0% Mid cap overweights vs. Large Cap Energy, Financial, and Software & Services are largest contributors to risk 4 out of top 5 relative under weighted securities stay constant from prior qtr with rankings changed; 3 out of top 5 relative over weighted securities remain constant from prior qtr with rankings changed Industry R ankings R elat ive W eig ht A b so lut e W eig ht R isk Tracking Pharmaceuticals Biotechnology & Life Sciences 2.3% Software & Services 11.5% Energy -1.1% Pharmaceuticals Biotechnology & 0.4% Software & Services 1.9% Pharmaceuticals Biotechnology & Life 10.1% Diversified Financials -0.8% Software & Services 0.3% M edia 1.4% Energy 9.1% Sof t ware & Services -0.7% Technology Hardware & 0.3% Consumer Services 1.1% Technology Hardware & Equipment 7.6% Capital Goods -0.7% Semiconductors & Semiconductor 0.3% Retailing 0.8% Capital Goods 7.2% Pharmaceuticals Biotechnology & Life -0.5% Consumer Services 0.2% Capital Goods -0.9% Utilities 1.6% Energy -1.1% Household & Personal Products 1.2% Telecommunication Services -1.2% Real Estate 1.2% Utilities -2.0% Automobiles & Components 0.8% Real Estate -2.4% Commercial Services & Supplies 0.4% Issuer Rankings Relative Weight Absolute Weight M IC R OSOFT C OR P 0.9% A PPLE IN C 3.2% TIM E W A R N ER IN C 0.8% M IC R OSOFT C OR P 2.3% NATIONAL OILWELL V ARCO INC 0.7% GOOGLE INC 1.6% C OM C A ST C OR P 0.7% EX X ON M OB IL C OR P 1.3% F ED EX C OR P 0.6% PF IZ ER IN C 1.3% APPLE INC -0.8% 25% 20% 15% 10% 5% 0% Allocation By Risk Allocatio n Risk -6.0% -8.0% -10.0% -12.0% -14.0% -9.7% -10.4% -9.9% -9.6% -9.4% -9.6% -10.2% -9.9% -9.8% -9.8% -9.4% -9.5% -9.4% -9.4% -10.3% -10.9% -10.5% -10.4% -10.4% -10.1% -10.0% -10.1% -9.7% -10.6% 10/11 11/11 12/11 01/12 02/12 03/12 04/12 05/12 06/12 07/12 08/12 09/12 TOTAL ASRS FUND POLICY BENCHMARK V ER IZON C OM M U N IC A TION S IN C -0.8% IN TER N A TION A L B U SIN ESS M A C HIN ES C OR P -0.9% A T &T IN C -1.0% EX X ON M OB IL C OR P -1.4% Stress Scenarios Transparency 6% 4% 2% 0% (2%) (4%) (6%) (8%) (2.97%) 9/11 Attack - 5 Day (2.80%) 3.64% 0.36% (7.20%) Asian Crisis Bond Crash: Emerging Fed day Feb 94 - May Markets Rally: Tightening: 94 Jan 99 - May April - June % IR Steepening: Sept 98 - Nov % Nadaq Rally: Nov 99 - Jan 00 (6.55%) (3.53%) (4.32%) Nasdaq Russian Crisis Government Correction: July 98 - Aug 98-5 Day Intervention COMPLETE TRANSPARENCY INTO ALL ASSET CLASSES Hedge Funds position level information assimilated with rest of your assets Private Equity portfolio company proxy capturing exposures and volatility Real Estate - portfolio company proxy capturing exposures and volatility Co-mingled integration of all positions with rest of portfolio International Equity Alternative Investments Domestic Equity Fixed Income Total 28