ESTABLISHING A RISK CULTURE AMONG INSTITUTIONAL INVESTORS San Diego County Employees Retirement Association August 2013 SEATTLE 206.622.3700 LOS ANGELES 310.297.1777 www.wurts.com
SESSION OBJECTIVES Begin the process of establishing a culture of risk within the Board Convey the critical importance of understanding risk when making investment decisions Describe different approaches for estimating risk (and their inherent drawbacks) Demonstrate that there is no single right answer to the investment question Introduce the concept of risk allocation Re-introduce the Risk Dashboard as a primary risk measurement tool 2
INSTITUTIONAL INVESTMENT INDUSTRY Reaching for alpha (alpha higher returns than market returns) Everyone s focused on the search for alpha Beta the low hanging fruit (beta market returns) Risk Management? Diversification? Source: Penrose, Colorado Chamber of Commerce. http://www.penrosechamber.com/localinformation/history.aspx 3
LARGE DRAWDOWNS COST MORE THAN YOU THINK Compound Return 10 Years at 10% return produces an annualized return of 10% What would be the annualized return if on the 10 th year the portfolio experiences a -30% return? The Importance of Limiting Drawdowns 9 years at 10% return plus a one year return of -30% produces an annualized return of 5.1% 4
AND HAPPEN MORE THAN YOU THINK 0% 5-Year Monthly Rolling Observations -10% Maximum Drawdown -20% -30% -40% -50% -60% -70% -80% Example: in the 5-year period ending April 1976, a pension fund suffered -35% maximum drawdown. Five Year Rolling Maximum Drawdown -20% *Typical pension fund risk equivalent asset allocation portfolio Period End At Average drawdown in a 5-year period -28% Percent of of 5-year periods with a drawdown of -20% or greater 40% 5
THEORY 6
PROBLEM: ASSET ALLOCATION Buy and Hold Mean-Variance Optimization Black-Litterman Model Endowment Model Risk Parity Liability Driven Investment Risk Allocation Strategy 7
MEAN VARIANCE OPTIMIZATION 8
REBALANCING A PORTFOLIO USING MEAN VARIANCE Equilibrium expected returns on bonds (1991) U.S. JP GE FR UK CA AU Unhedged 9.77 9.81 9.37 9.18 9.93 9.60 8.30 Hedged 0.00 8.98 9.21 9.03 9.65 9.55 8.19 Slightly modified equilibrium expected returns on bonds (1991) U.S. JP GE FR UK CA AU Unhedged 9.77 9.81 9.47 9.18 9.93 9.60 8.30 Hedged 0.00 8.98 9.21 9.03 9.65 9.55 8.19 9
OPTIMAL PORTFOLIO WEIGHTS? Equilibrium expected returns on bonds (1991) U.S. JP GE FR UK CA AU Cash 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Bonds 53.6 18.3 9.4 7.1 6.3 4.4 1.0 Forwards 14.6 7.5 5.6 5.1 3.5 0.8 Slightly modified equilibrium expected returns on bonds (1991) U.S. JP GE FR UK CA AU Cash -56.8 0.0 56.9 0.0 0.0 0.0 0.1 Bonds 57.7 17.0 8.7 9.0 5.5 2.0 0.0 Forwards 15.2 0.0 71.4 5.0 1.9 0.0 10
BLACK LITTERMAN 11
RISK PARITY Credit/Currency Risk Equity Risk 25% 25% Inflation Risk 25% 25% Nominal Int. Rate Risk 12
REALITY 13
OPTIMAL DOLLAR ALLOCATION? Goldman Sachs Average Public Fund PIMCO Bridgewater GMO AQR Government Bonds Corporate Bonds Equities TIPS Commodities Real Estate & Infrastructure Absolute Return & Other 14
RISK REBALANCING Conventional Approach: Static Asset Allocation with Dynamic Risk 35 30 S&P 500 10 Year US Treasury 60/40 6-month Rolling Volatility (1/31/1993 12/31/2012) 25 20 15 10 5 0 Our Approach: Static Risk with Dynamic Asset Allocation 15
A STRATEGY TO MEET THE OBJECTIVE Past 7.75% Future 7.75% Private Equity Equity Credit Interest Rate Inflation Current 5.5% Private Equity Equity Credit Interest Rate Inflation Diversification Risk Management Alternative Risk Premia Alpha Risk Free Risk Premia Breakdown for Historical 60/40 Portfolio *For illustrative purpose only Risk Free Risk Premia Breakdown for Today s 60/40 Portfolio Risk Premia Breakdown for Future? 16
TRUE DIVERSIFICATION Traditional Diversification Sub-Asset Class Allocation Group Asset Class Allocation Risk Allocation US Mid Cap US Small Cap EAFE Int'l Small Cap Stocks US Large Cap EM Stocks High Yield Bonds EM Bonds Private Equity Real Estate MBS Hedge Funds Int'l Bonds US Gov Bonds Corporate Bonds US Stocks Int'l Stocks Private Equity Real Estate Hedge Funds Bonds Stocks Other Real Estate True Diversification EAFE EM Stocks EM Bonds US Stocks Private Equity Private Real Assets Private Credit Int'l Stocks US Stocks Private Equity Private Real Assets Private Credit Other Real Assets Currency Int'l Gov. Bonds US Gov. Bonds IG Corp. Bonds HY Bonds US TIPS Hedge Funds Hedge Fund "Beta" Comm. Bonds Comm. Hedge Funds Equity Interest Rates Credit Inflation Int'l TIPS 17
PORTFOLIO CONSTRUCTION HEDGE FUND Alpha ALTERNATIVE RISK PREMIA PRIVATE CREDIT PRIVATE EQUITY PRIVATE REAL ASSETS GLOBAL GOVERNMENT BONDS GLOBAL CORPORATE BONDS GLOBAL STOCKS GLOBAL INFLATION SENSITIVE SECURITIES Interest Rate Risk Premia Credit Risk Premia Equity Risk Premia Inflation Risk Premia 18
Rates Domestic International Emerging Markets Curve Duration Liquidity Country Credit Investment Grade High Yield Emerging Markets Private Curve Duration Liquidity Country Sector Equity Domestic International Emerging Markets Private Country Value Momentum Sector Size Inflation TIPS Commodities Private Country Curve Duration Liquidity Currency Developed Emerging Market Country Carry Primary Risk Factors Secondary Risk Factors Tertiary Risk Factors RISK FACTOR BUILDING BLOCKS 19
WHY RISK MATTERS? 20
ASSETS CONTAIN MULTIPLE RISK FACTORS Volatility Credit Spread Currency Interest Rate Corporate Bond Inflation Bonds for Safety? NOTE: Not all Bonds are created equal! 21
W HAT IS RISK MANAGEMENT? Risk is NOT just the standard deviation of returns! Risk is first and foremost the risk of losing principal. At what point is the drawdown too deep? Deployment of Capital Alignment of Risk & Objectives Culture Defining Boundaries Risk is failing to meet the demands of the organization. Seizing Opportunities Communication Tool Risk is an unexpected negative event. Risk Response Not a System! 22
T HE WORLD OF RISKS Cash Flow Business Peer Refinancing Inflation Partner Fiduciary Political Counterparty Margin Active Risk Credit Deflation Real Estate Leverage Pricing Volatility Interest Rate Principal Company Currency Model Turnover Liabilities Country Asset Allocation Concentration Spending Rule Operational Drawdowns Derivatives Headline Liquidity Risk Commitment Funding Ratio Investment Income Staff Solvency Time Horizon 23
LOCAL CURRENCY BOND FUND HOLDINGS 505 Securities: 283 Sovereign Bonds / Short-term notes 71 Currency FX Forward Contracts 53 Single Currency Vanilla Interest Rate Swaps 15 Swaptions 20 Brazilian Zero Coupon Interest Rate Swaps 8 Credit Default Swaps ( Sell protection) 55 Misc. Cash / Equivalents 24
RISK OVERSIGHT Portfolio Complexity Alternatives Multitude of Risks Liabilities Geopolitical Risk Sovereign Debt Risk Heighten Market Volatility Extreme Tail Events Which risk dashboard is appropriate for your organization? 25
A HOLISTIC APPROACH TO RISK MANAGEMENT Decomposing all portfolio risk across asset classes, strategies and vehicle types and reaggregating into identifiable risk buckets is critical to gaining a comprehensive, actionable perspective of total Plan-level risk. Total Plan Risk Traditional Assets Alternative Assets 26
RISK DASHBOARD LEVEL I Risk Allocation Allocations by risk buckets and asset class analysis Risk Diversification Diversification: risk factors, geographic, economic sensitivity, and ex ante returns Active Risk Budgeting Who and where are the active risks Primary Risk Factor Analysis Attributes of Rates, Credit, Equity, Inflation and Currency risk buckets Performance Review Did the portfolio meet the objectives? Performance Attribution Positive and negative contributions to absolute and relative returns 27
RISK DASHBOARD LEVEL 2 Pension Plan Protection Act Risks Liquidity & Cash Flow Liabilities Counterparty Risks Leverage Risks Derivatives Risks Private Asset Risks Valuation Risks Manager Risks Hedge Fund Risks Fees & Expenses Peer & Headline Risks Liability Risks Cyclical Risks 28
RISK FACTOR VALUATION DASHBOARD Risk Premia Rich/Cheap Analysis Risk factor fundamentals + behavioral indicators + economic fundamentals Risk Factor Fundamental Evaluation Global interest rates, global credit, global equities, commodities and currencies Behavioral Indicators Global interest rates, global credit, commodities and currencies global equities, Economic Fundamentals Evaluation of twenty-four countries 29
EXAMPLE: VIEWING RISK THROUGH MULTIPLE LENSES 30
DIVERSIFICATION? Average Portfolio 60% Global Stocks Risk Designed Portfolio 20% Global Rates 40% US Bonds 20% Global Credit 30% Global Equity 15% Global Inflation 15% Sophisticated Beta 31
NORMAL MARKET RISK 13% 12% 11% 10% 9% 7% 5% 3% 1% -1% 60 / 40 Risk Wurts Designed Portfolio Portfolio 32
DIVERSIFICATION: RISK FACTORS 120% 100% 80% 60% 40% 88% 20% 38% 0% -20% 60 / 40 Risk Designed Wurts Portfolio Equity Rates Credit Currency Inflation 33
DIVERSIFICATION: ECONOMIC SENSITIVITY 60/40 Risk Designed Portfolio Falling Growth Rising Inflation Rising Growth Rising Inflation Falling Growth Rising Inflation Rising Growth Rising Inflation Falling Growth Falling Inflation Rising Growth Falling Inflation Falling Growth Falling Inflation Rising Growth Falling Inflation 34
GEOGRAPHICAL DIVERSIFICATION 60 / 40 Risk Designed Portfolio Europe 14% Europe 22% US 66% Other Developed 11% US 48% Other Developed 4% Emerging Markets 9% Emerging Markets 26% 35
EX- ANTE RETURN DIVERSIFICATION 60 / 40 Risk Designed Portfolio Dividends 22% Price Appreciation 58% Yield Corporates 37% Hedge Fund 12% Real Estate Income 8% Yield Corporates 6% Yield Rates 8% Dividends 9% Yield Rates 14% Commodity 5% Price Appreciation 21% 36
RISK OVERSIGHT IN THE REAL WORLD 37
A REAL RISK DASHBOARD 38
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HISTORICAL MONTHLY RELATIVE VAR PORTFOLIO VS POLICY RISK BENCHMARK 1- Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS 41