Risk and Return in Rapidly Changing Markets

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1 Risk and Return in Rapidly Changing Markets Edward Fishwick Managing Director Global Co-head Risk & Quantitative Analysis

2 Lesson 1: The Paramount Importance of Liquidity Liquidity is the life blood of a modern economy. The ability to meet immediate obligations is critical to financial survival. Many market participants p assumed that liquidity was a fact of life rather than a special condition. Continuous time finance is, after all, just an abstraction, not a guarantee. 2 The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

3 Lesson 1: The Paramount Importance of Liquidity Maximizing wealth, assuming efficient markets exists, permits liquidity concerns to be addressed as an afterthought. Value can be extracted from portfolios through the mechanism of the market. The folly of wealth maximization In the absence of functioning markets, cash may not necessarily be generated from wealth. Alternatively, the cost of doing so becomes exceedingly onerous. Bonds are much better than you think. Reliable cash flows should be used to meet critical future liabilities. If the portfolio contains cash or cash producing securities, liquidity can be extracted relatively efficiently. 3 The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.

4 Lesson 1: The Paramount Importance of Liquidity Free Riding: when market participants anticipate liquidity, investors can trade products they do not fully understand. Arbitrage and relative value trading preserve the intrinsic value. Severe disruptions in a complex and opaque product space may hit expert investors the worst since they will tend to have concentrated exposures. The more complex the product, the fewer genuinely expert investors exist. Non-expert investors will pass on cheap securities to avoid poisoned chalices. As a result, the only bids, if any, come from vulture investors who will pay prices that are too cheap to be wrong. Just being smart is not enough! 4

5 Lesson 2: Assumptions are just Assumptions Mean-variance; iid Volatility Correlation Higher moments zero Zero means T-series structure Stationary Slow evolution Regimes Linearity 5

6 Lesson 2: Assumptions are just Assumptions VIX /21/ /02/ / /30/ /24/ /23/ /20/ /18/ /16/ /15/ /11/ /10/ /05/ /04/ /03/ /02/ /30/ /25/ /22/ /19/2008 Source: FactSet 6

7 Lesson 2: Assumptions are just Assumptions VIX /02/ / /30/ /24/ /23/ /20/ /18/ /16/ /15/ /11/ /10/ /05/ /04/ /03/ /02/ /30/ /25/ /22/ /21/ /19/2008 Source: FactSet 7

8 Lesson 2: Assumptions are just Assumptions VIX /02/ / /30/ /24/ /23/ /20/ /18/ /16/ /15/ /11/ /10/ /05/ /04/ /03/ /02/ /30/ /25/ /22/ /21/ /19/2008 Source: FactSet 8

9 Lesson 2: Assumptions Are Just Assumptions Monthly Cross-Sectional Volatility FTSE / 29/ 30/ 29/ 30/ 01/ / / / / / / / / / / / / / / / / / / / / Source: FactSet; FTSE

10 Lesson 2: Assumptions Are Just Assumptions Trailing 60 Day Correlation Momentum & Value /01/ /01/ /01/ /02/ /02/ /03/ /03/ /04/ /04/ /05/ /05/ /06/ /06/ /07/ /07/ / /08/ /08/ /09/ /09/ /10/ Source: FactSet; Barra; BlackRock

11 Lesson 2: Assumptions Are Just Assumptions 220 Day Cumulative Returns to Barra Factors From June 30, LEVERAGE Source: FactSet; Barra; BlackRock

12 Lesson 2: Assumptions Are Just Assumptions 220 Day Cumulative Returns to Barra Factors From June 30, US: Leverage LEVERAGE US: Value VALUE LEVERAGE EUR: Leverage VALUE EUR: Value Source: FactSet; Barra; BlackRock

13 Lesson 2: Assumptions are Just Assumptions Serious risk managers always understood the limitations of models Model based forecasts require assumptions - Mean-variance; volatility; correlation; etc It was always understood that these could be violated in practice But the last 2 years show this is at levels previously unimagined - Rapidly varying volatility (absolute & relative) - Diversification works until it doesn t - Persistence or trending makes the measurement of risk horizon dependant Highlights the need for caution in the use of models, and expert judgement in their interpretation and use 13

14 Lesson 3: Garbage (or Worse) In/ Garbage Out Investors need to be more hands-on and develop a visceral understanding of the origination processes and borrowers. Recently, the quality and performance of underlying assets were materially worse than expected. The underwriting process was much worse than ever indicated in the data. Originators created loans primarily for sale and retained little, if any, interest in their ongoing performance. Going forward, investors will need to get more deeply involved in the information cycle. Relying on ratings alone was a failed strategy. Previous default and delinquency data was artificially low because, for a while, increasingly attractive lending terms masked defaults with refi s. Even using a more rigorous analytical approach based on taking historical performance data and building and relying only on statistical models and stress test is insufficient. Bottom Line: Main Street t played Wall Street. t 14 The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

15 Lesson 4: The Sources of Market Risk are Changing Global Government Support US Treasury s Financial Stability Plan: Financial Stability Trust A comprehensive stress test for major banks Increased balance sheet transparency and disclosure Capital Assistance Program Public-Private Investment Fund ($500 bn - $1tr) Consumer and Business Lending Initiative (up to $1tr) Term Asset-Backed Securities Loan Facility (TALF) Transparency and accountability agenda Affordable housing support and foreclosure prevention plan A small business and community lending initiative Troubled Assets Relief Program (TARP): Allows the US Treasury to purchase or insure up to $700 bn of troubled assets from banks and other financial institutions Obama s $775 bn Stimulus Plan: Aid the economy through tax rebates, mortgage assistance, public spending, etc. Homeowner Affordability and Stability Plan (HASP) Help homeowners refinance and modify mortgages Conservatorship of FNMA and FHLMC: $400 billion commitment Federal Reserve Agency MBS Purchase Program: Approximately $160bn in transactions from January 5th to February 25th Canadian Government Support: Given the low level of the target overnight rate, the Bank of Canada is refining its approach in providing additional monetary stimulus, if required, through credit and quantitative easing UK Government Quantitative Easing and Asset Purchases: Program of asset purchases, including corporate bonds, commercial paper, and gilts, totaling 75 bn UK Government plan to guarantee up to 20bn: The 20bn guarantees loans to small and medium-sized firms UK Government nationalizes: UK government called for the complete nationalization of Lloyds and Royal Bank of Scotland French Government: Pumps 6bn into ailing auto industry Japanese Buy-Back Program: The Japanese Ministry of Finance is conducting two buy-back programs of Japan Government Bond Inflation-Linked (JGBi) and Japan Government Bond Floating Rate Note (JGB FRN) Australia s AUD $47bn Stimulus Package: The package includes AUD $29bn for infrastructure projects and AUD $13 in cash handouts to low to middle-income groups. 15 Source: BBC News

Lesson 4: The Sources of Market Risk are Changing Fed Balance Sheet Expansion Fed Purchase Program Expansion Agency MBS Purchases from $500 billion to $1.

Breakdown of Adjusted Monetary Base & Liquidity Facilities Net Demand is Expected to Far Exceed Net Supply in 2009* 16 Source: Federal Reserve, Treasury,

16 Lesson 4: The Sources of Market Risk are Changing Fed Balance Sheet Expansion Fed Purchase Program Expansion Agency MBS Purchases from $500 billion to $1.25 trillion Agency Debenture from $100 billion to $200 billion Longer-Term Treasuries $300 billion Gross Demand is Expected to Exceed Supply in 2009* Breakdown of Adjusted Monetary Base & Liquidity Facilities Net Demand is Expected to Far Exceed Net Supply in 2009* 16 Source: Federal Reserve, Treasury, Banc of America Securities-Merrill Lynch; *2009 numbers are estimates; Source: Credit Suisse (US Mortgage Strategy), Federal Reserve, Freddie Mac, Fannie Mae, Treasury

17 Lesson 4: The Sources of Market Risk are Changing As more power over the financial system shifts to global political capitals, market dynamics may shift from economic fundamentals or market technical conditions to political considerations. Developed markets may become more like emerging markets. Risk management teams may rely less on economists and statisticians and more on politically-oriented analysts. Quants may find themselves getting traded in for politicos. The longer term impact on productivity from an increase in political control over the economy is not known. If history is to be believed, the prognosis is not positive. 17 The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

18 Lesson 5: You Can t Cram for a Crisis Effective risk management is an expensive long term investment. Professional risk managers with substantive subject matter expertise are critical to have impact. Analytics and information management technology are required for a reliable information utility. Organizations need to prevent internal information wars. Accessing and using information must be fast and easy. How Can You Manage the Black Swan? Having a team and an efficient information infrastructure in place will allow an organization to respond to unanticipated issues or challenges. While every potential contingency cannot be anticipated, a comprehensive database of portfolio holdings and their characteristics facilitates a fast response. Risk mitigation is a critical part of risk management. 18 The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

19 Lesson 6: Unconditional Risk Doesn t Matter Much! 2.50E-02 US Quality 1973 to Date 2.00E E E E E E E E E E Source: FactSet; Barra; BlackRock

20 Lesson 6: Unconditional Risk Doesn t Matter Much! 8.00E s 1980s 1990s 2000s 6.00E E E E E E E E Source: FactSet; Barra; BlackRock

21 Lesson 6: Unconditional Risk Doesn t Matter Much! Ex-ante & 5Y ex-post return - UK equity Quintiles ranked by Ex-ante return Source: FactSet; BlackRock

22 Lesson 6: Unconditional Risk Doesn t Matter Much! Equity & Bonds: Conditional Distributions Source: FactSet; BlackRock

23 Lesson 6: Unconditional Risk Doesn t Matter Much! 0.45 Equity & Bonds: Conditional Distributions Source: FactSet; BlackRock

24 Lesson 6: Unconditional Risk Doesn t Matter Much! Equity & Bonds: Conditional Distributions Source: FactSet; BlackRock

25 Lesson 6: Unconditional Risk Doesn t Matter Much! Long Run Average Earnings Yield Broken by Junk / Quality Dec 1988 to Dec 2007 Active Earnings Yield (Net of the Median Earning gs yield in the mkt ) 400% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% Historic Premium for Junk at ~3% Junk Quality 25 Source: FactSet; BlackRock

26 Lesson 6: Unconditional Risk Doesn t Matter Much Active Earnings Yield of the FTSE 350 Junk Deciles % Absolute Junk (Decile 10) Near Junk (Decile 9) 15.00% Jan: Junk is extremely cheap 10.00% 5.00% 0.00% -5.00% Yield Premium (FY1/P) 03/ /11/ / /03/ /11/ / / /11/ /07/ / /11/ / /03/ /11/ / / /11/ /07/ / /11/ / /03/ /11/ / / /11/ /07/ / /11/ / / /1 1/ May: Junk is priced in historic range.

27 Lesson 6: Unconditional Risk Doesn t Matter Much Active Earnings Yield Broken down by Junk / Quality January 2009 yield in the mkt) 14.00% 12.00% 10.00% Jan: Extreme Junk is massively cheap Activ ve Earnings Yield (Net of the Median Earnings 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% 200% -4.00% Jan Long Run Average Junk Quality 27

28 Lesson 6: Unconditional Risk Doesn t Matter Much! 8.00E s 1980s 1990s 2000s 6.00E E E E E E E E Source: FactSet; Barra; BlackRock

30 For distribution to Professional Clients and should not be relied upon by any other persons. The following notes should be read in conjunction with the attached document: 1. Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Services Authority. Registered office: 33 King William Street, London, EC4R 9AS. Tel: Registered in England No For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. 2. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. 3. Mandates we manage may be exposed to finance sector companies, as a service provider or as counterparty for financial contracts. In recent months, liquidity in the financial markets has become severely restricted, causing a number of firms to withdrawn from the market, or in some extreme cases, becoming insolvent. This may have an adverse affect on the mandates we manage. 4. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy. 5. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer. 6. This material is for distribution to Professional Clients (as defined by the FSA Rules) and should not be relied upon by any other persons. 7. Subject to the express requirements of any client-specific investment management agreement or provisions relating to the management of a fund, we will not provide notice of any changes to our personnel, structure, policies, i process, objectives or, without limitation, any other matter contained in this document. 8. Unless otherwise specified, all information contained in this document is current as at {10 th June 2009]. 30

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