Risk Tolerance and Strategic Asset Management Pedro Gonzalez Cerrud PhD,CPA, CFP, CFA INVESCO Institutional Puerto Rico Nov. 15, 2002

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Risk Tolerance and Strategic Asset Management
Pedro Gonzalez Cerrud PhD,CPA, CFP, CFAINVESCO
InstitutionalPuerto RicoNov. 15, 2002
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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

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Importance of Risk Tolerance in the Investment
Process

• Definition of risks
• Volatility
• Losses
• Unknown
• Expected Utility of Investors
• Increases with expected returns
• Decreases with volatility of returns

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Importance of Risk Tolerance in the Investment
Process

• 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

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Budgeting for Risk Tolerance

• Risk Budget
• Subset of understanding the clients 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

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Budgeting for Risk Tolerance
Top Down Risk Budget A Global Approach
Alpha Diversification, Max Information Ratio
Benchmarks, Target alphas, Tracking Errors
Liability Structure
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Budgeting for Risk Tolerance
Bottom-Up Risk Budget A Global Approach
Information Ratios per Asset Class/Style on a
Global Basis
Historical Relationshipamong asset classes
Alpha Correlation of Asset Classes/Styles
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A Real World Example
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The Plan Sponsors Dilemma

• Every Investors GoalTo build a successful
  multi-asset, multi-manager structure.
• Definition of SuccessTo build wealth by
  maximizing returns with minimum risk
• The Multi-Asset Problem
• Alphas are perishable
• Style and asset class cycles can be very long
• Lower return environment expected in the future

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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

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Two Sources of Alpha
Top-Down

• 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

Bottom-Up
Bottom-Up Active Security Selection Strategies
15 Bottom-up managers
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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.

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Asset Allocation Process
Step One Step Two Step Three Step
Four Step Five
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
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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
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Understanding Asset Class Cycles

US/Non-US Relative Return
US vs. International and G7 Nominal Growth
Indicator

• Cyclical Drivers
• US Equity Market is a Stable Grower
• Outperforms during Global Weakness
• Under performs during Global Strength

12 Mo Change in US vs. Intl ()
G7 Nominal Growth (Inverted )
US vs. International and Change in Relative
Investment

• Secular Drivers
• Relative earnings determines relative performance
• Magnitude of relative earnings is determined by
  the investment cycle

Relative Capital Spending Growth
US vs. International
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Non-US vs. US Equities Valuation

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

Relative Valuation US vs. Developed Non-US
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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

Relative Liquidity High US Outperforms
Global Growth Low US Outperforms
Relative Liquidity ()
Relative Returns ()
Global Growth ()
Relative Returns ()
Relative Liquidity Low Non-US Outperforms
Global Growth High Non-US Outperforms
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Asset Allocation Country Example

Japan vs. World Relative Index and Market Share
Proxy

• 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

• 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
12m Chg in Relative Index
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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.

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Top-Down Risk Management Alpha Diversification
Alpha diversification delivers superior top-down
information ratio.
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Bottom-Up Risk Budget Alpha Modeling

Chart 1Large Cap Cores Alpha Correlation to
Growth Value
Chart 2Small Cap Cores Alpha Correlation to
Growth Value
Chart 3 Large Cap Core Trend Deviation
Relative Strength vs. Benchmark
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Bottom-Up Risk Budgeting Alpha Diversification
Trailing 24-month Excess Returns
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Bottom-Up Risk Budget Striving for Higher Returns
Trailing 24-month Excess Returns
Correlation Coefficient
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Bottom-Up Risk Budget Striving for Higher Return
Information Ratio 0.97
Alpha diversification delivers superior bottom-up
information ratio.
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Global Asset Allocation Risk Budget
The risk budget is constantly monitored by each
top-down and bottom-up alpha source.
Average
Target
Tracking
Information
Portfolio Implementation
Target Alpha
Error
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
0.50
Grand Total
3.03
2.78
1.09
All tracking error estimates are based on 3-year
time horizon.
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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