Active Alpha Investing 23 September 2004 Philip Gardner Head of GSAM Asia ex Japan This material is provided for educational purposes only and we are not soliciting any action based upon it. It does not take into account the particular investment objectives, financial situation or needs of individual clients. This material is not to be construed as an offer to sell or the solicitation of an offer to buy any security. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. No part of this material may be i) copied, photocopied or duplicated in any form, by any means, or ii) redistributed without Goldman Sachs Asset Management's prior written consent.
The evolution of an idea Robert Litterman, Ph.D www.activealpha.gs.com 2
What is Alpha? Return in excess of market return, awarded for taking active risk 3
The three basic sources of risk Interest rate risk from liabilities: Uncompensated risk Can be hedged via derivatives or bonds Market risk: Basically available for free (no fees) Has relatively low expected return per unit of risk Active risk: Uncorrelated risk implies low impact on portfolio risk Skill-based Opportunities require deviations from equilibrium Active management fees 4
There are only three basic sources of return Sources of Total Return in a $1 Billion Portfolio: 1 Risk Free Rate Risk free rate = 4.5% $45 mm 2 Market Risk Premium 20% Equity Allocation 0.7% ER 3.4% Vol 70% Equity Allocation 2.6% ER 12.0% Vol $7 mm $26 mm Beta 3 Active Manager Return 100% Indexed 0.0% ER 3% Tracking Error at IR = 0.75 $0 mm $22.5 mm Alpha Note: Simulated performance results do not reflect actual trading and have certain inherent limitations. Please see appendix for further disclosures. The above is provided for illustrative purposes only and should not be relied upon as representative of actual or future characteristics for any Goldman Sachs strategy/account. 5
Adding active risk can dramatically shift the portfolio frontier upward Excess Return Volatility Sharpe Ratio Original Portfolio (50% equity) 1.8% 8.6% Additional Market Risk (25% equity) 0.9% 4.4% Benefit from Diversification (0.1%) New Portfolio 2.8% 12.9% 0.21 Original Portfolio (50% equity) 1.8% 8.6% 3% Active Risk (assumed IR = 0.75) 2.3% 3.0% Benefit from Diversification (2.5%) New Portfolio 4.1% 9.1% 0.45 Sharpe Ratio improves with the addition of market independent return Adding exposure to active risk can boost long-run expected returns without meaningfully increasing fund volatility. Note: Simulated performance results do not reflect actual trading and have certain inherent limitations. The figures above represent global indices. Excess returns for global indices do not reflect the deduction of any management fees. Please see appendix for further disclosures. 6
The Active Risk Puzzle: Why do funds have such modest expectations? Allocations to active risk of typical pension funds range between 50 and 200 basis points. Optimal Risk Allocations Reveal Modest IR Expectations Optimal Allocation to Active Risk 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 0 0.1 0.2 0.3 0.4 0.5 0.6 Source: Goldman Sachs Aggregate Asset Management. Active Risk Information Ratio Source: Goldman Sachs Asset Management. 7
Possible explanations Funds may be unsure of their ability to select skilled managers Career risk Governance restrictions Active risk and strategic asset allocation have historically been linked 8
The Active Alpha Approach: Key ideas Traditionally, investors exposure to active risk has been a byproduct of the asset allocation decision: Investors choose the asset allocation in accordance with the output from an asset-liability study or to comply with other longterm objectives Once the asset allocation is determined, investors choose the active-passive split in each asset class and implementation 9
The Active Alpha Approach: Key ideas The Active Alpha approach builds on the insight that it is not necessarily the case that active risk is best taken in those asset classes in which strategic exposure is desired. In the Active Alpha approach, investors Choose the desired market risk exposures in accordance with strategic objectives (ALM or otherwise); Determine the optimal allocation of active risk independent of the market risk exposures; Use completion strategies to achieve the desired market risk exposures; Take full advantage of their views on active returns 10
The 5 C s: Finding more Alpha for your plan Correlation: Active risk should be uncorrelated across sources (and, by definition, with market risk) Consistency: Alpha per unit of active risk (information ratio) should be as high as possible Capacity: For any manager, increasing assets will cause their information ratio to decline. The best hedge funds are closed Capital: The alpha in most plans is constrained by the capital allocation, rather than the impact on portfolio risk The best alpha sources require little capital to potentially generate high expected excess returns. More active risk is a good thing! Cost: Maximize the net expected return 11
Possible solutions The most attractive alternative investment strategies should have the following properties: Low correlation with market risk Minimal capital requirements High Expected Information Ratio Good examples of these are: Overlay strategies (currency, GTAA, fixed income, commodities) Market-neutral hedge funds Portable Alpha Investments that may fall into the category of uncorrelated assets, such as hedge funds, may be regulated less stringently and can involve significant use of leverage, making them potentially riskier than the other investments shown. Investments in alternative investments may entail substantial risks. 12
Who invests in hedge funds? Total Return 1 on Endowment or Pension Fund 800 700 600 500 400 300 200 100 Yale Harvard Avg. Large Corporate DB Plans 2 0 1988 1990 1992 1994 1996 1998 2000 2002 Historical Returns 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Large Corp DB Plans 2 12.4% 20.1% -0.3% 24.2% 7.5% 14.7% -0.5% 25.3% 15.9% 19.7% 14.1% 18.5% 1.5% -5.6% -10.1% Harvard Endowment 3 5.4% 12.4% 7.4% 1.1% 11.7% 16.4% 9.7% 16.5% 25.5% 25.1% 20.2% 11.8% 31.8% -2.7% -0.5% Yale -0.2% 17.3% 13.1% 2.0% 13.2% 17.3% 12.0% 15.7% 25.7% 21.8% 18.0% 12.2% 41.0% 9.2% 0.7% % Endowment Hedge Funds 3 at Yale 0% 0% 0% 15% 15% 15% 20% 20% 20% 22% 25% 23% 23% 23% 25% Notes: (1) Total return indexed to a base of 100.0 as of 30 June 1987 for the endowment funds of Yale and Harvard and to a base of 100.0 as of 31 December 1986 for the corporate defined-benefit (DB) pension plans. (2) Large Corporate DB Plans represents 23 plans having both a 15-year history in the Trust Universe Comparison Service (TUCS) database and greater than $1 bn in assets as of 30 June 2003. The 23 individual plan returns are shown in the thin dotted lines and the average of all plans is shown in the thick solid line and in the table in the lower half of the page. (3) Yale and Harvard historical returns are based on a 30 June fiscal year end. Sources: Yale Endowment, Harvard Management Company, and Trust Universe Comparison Service (TUCS). 13
Case study I Implementing Active Alpha solutions with a liability benchmark Objective: This client needed a portfolio that would perform in-line with its pre-determined liability index and provide the opportunity for increased alpha Sample Client s Original Portfolio Cash 3% Active Equities 68% Active Fixed Income 29% GSAM Portfolio Solution Passive Equities 5% Hedge Funds 40% Bonds and Fixed Income Derivatives* 55% Annual Return Target: 8.5% (4.5% in annual excess return over the company s liability index) Annual asset liability volatility target: 8.5% (4.5% in annual excess return over the company s liability index) 15% 5% Targeted returns remain unchanged with only one third of the target volatility relative to liabilities * Designed to replicate the behavior of the company s liability index. This information is provided for illustrative purposes only and we are not soliciting any action based on it. It is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations and should not be construed as research or investment advice. Accordingly, such information should not be relied upon in whole or in part in making an investment decision. Expected returns are statistical estimates of hypothetical average returns of economic asset classes, derived from statistical models. Actual returns are likely to vary from expected returns. Expected return models apply statistical methods and a series of fixed assumptions to derive estimates of hypothetical average asset class performance. Reasonable people may disagree about the appropriate statistical model and fixed assumptions. These models have limitations, as the assumptions may not be consensus views, or the model may not be updated to reflect current economic or market conditions. Accordingly, these models should not be relied upon to make predictions of actual future account performance. Goldman Sachs has no obligation to provide recipients hereof with updates or changes to such data. Please see appendix for further information. There can be no assurance that the targeted returns stated above can be achieved. Please be advised that the targets shown above are subject to change at any time and are current as of the date of this presentation only. Targeted returns are objectives and should not be construed as providing any assurance or guarantee as to the returns that may be realized in the future from investments in any asset or asset class described herein. 14
Case study II Implementing Active Alpha solutions without a liability benchmark Objective: After making a large contribution to its defined benefit pension fund, this client was seeking a portfolio strategy to achieve a specified performance target with substantially lower risk than its traditional pension portfolio Sample Client s Original Portfolio Alternatives 10% Active Fixed Income 30% Active Equities 60% GSAM Portfolio Solution GTAA 5% Active Fixed Income 12.5% Hedging Strategies 7.5% Active Equities 20% Hedge Funds and Fund of Funds 55% Annual Return Target: 9% 9% Annual asset volatility target: 10% 5% Targeted returns remain unchanged with only half of the target volatility This information is provided for illustrative purposes only and we are not soliciting any action based on it. It is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations and should not be construed as research or investment advice. Accordingly, such information should not be relied upon in whole or in part in making an investment decision. Expected returns are statistical estimates of hypothetical average returns of economic asset classes, derived from statistical models. Actual returns are likely to vary from expected returns. Expected return models apply statistical methods and a series of fixed assumptions to derive estimates of hypothetical average asset class performance. Reasonable people may disagree about the appropriate statistical model and fixed assumptions. These models have limitations, as the assumptions may not be consensus views, or the model may not be updated to reflect current economic or market conditions. Accordingly, these models should not be relied upon to make predictions of actual future account performance. Goldman Sachs has no obligation to provide recipients hereof with updates or changes to such data. Please see appendix for further information. There can be no assurance that the targeted returns stated above can be achieved. Please be advised that the targets shown above are subject to change at any time and are current as of the date of this presentation only. Targeted returns are objectives and should not be construed as providing any assurance or guarantee as to the returns that may be realized in the future from investments in any asset or asset class described herein. 15
Additional notes This material is provided for informational purposes only and we are not soliciting any action based upon it. It does not take into account the particular investment objectives, financial situation or needs of individual clients. This material is not to be construed as an offer to sell or the solicitation of an offer to buy any security. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. The information provided herein should not be construed as providing any assurance or guarantee as to returns that may be realized in the future from investments in any asset or asset class described herein. Past performance is not a guide to future performance and the value of investments and the income derived from them can go down as well as up. Future returns are not guaranteed and a loss of principal may occur. Alternative Investments such as hedge funds are subject to less regulation than other types of pooled investment vehicles such as mutual funds, may make speculative investments, may be illiquid and can involve a significant use of leverage, making them substantially riskier than the other investments. Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor's capital. Performance can be volatile. Simulated performance results have inherent limitations. Such results are hypothetical and do not represent actual trading, and therefore may not take into account material economic and market factors, such as liquidity constraints, that would impact the adviser s actual decision-making. Simulated results are also achieved through the retroactive application of a model designed with the benefit of hindsight. The results shown reflect the reinvestment of dividends and other earnings, but do not reflect advisory fees, transaction costs, and other expenses an investor would have paid, which would reduce returns. No representation is made that an investor will achieve results similar to those shown herein. Industry data shown herein, has been supplied by outside sources and is believed to be reliable, although Goldman Sachs does not guarantee its accuracy. References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time (each, an index ) are provided for your information only. Reference to an index does not imply that investors can achieve returns, volatility or other results similar to the index. Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) redistributed without Goldman Sachs Asset Management's prior written consent. In the event any of the assumptions used in this presentation do not prove to be true, results are likely to vary substantially from the examples shown herein. These examples are for illustrative purposes only and do not purport to show actual results. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices. We strongly recommend that these factors be taken into consideration before an investment decision is made. This presentation has been issued in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W). Copyright 2004 Goldman Sachs Asset Management. All Rights Reserved. 16
Active Alpha Investing 23 September 2004 Philip Gardner Head of GSAM Asia ex Japan This material is provided for educational purposes only and we are not soliciting any action based upon it. It does not take into account the particular investment objectives, financial situation or needs of individual clients. This material is not to be construed as an offer to sell or the solicitation of an offer to buy any security. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. No part of this material may be i) copied, photocopied or duplicated in any form, by any means, or ii) redistributed without Goldman Sachs Asset Management's prior written consent.