QMS Advisors - Liability Driven Investments and Portable Alpha Solutions by Q.M.S Advisors

Liability Driven Investments & Portable Alpha Solutions: Efficient Deployment of Capital to Alpha Sources

Q M S Advisors .

This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

Av. C.-F. Ramuz, 85 | 1009, Pully | CH tel: 078 922 08 77 | 021 711 40 89 e-mail: info@qmsadv.com website: www.qmsadv.com

Liability Driven Investments And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources

LDI And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources Approach To assist Private and Institutional clientsâ&#x20AC;&#x2122; in structuring optimal investment solutions by making efficient use of capital to meet the following criteria

TARGET

Improve plansâ&#x20AC;&#x2122; funded ratio

Maintain stable contribution levels

Improve return per unit of surplus risk

Reduce drawdown risks

Quasi-costless beta exposure results in lower overall fees: achieving a higher uncorrelated alpha/fees ratio

Q.M.S Advisors

Page 2

LDI And Portable Alpha Capability Profiting From New Constraints Originating From Regulatory Changes Catalyst

A new focal point for pension plans: liabilities’ sensitivities to interest rates • Minimization of asset-liability mismatches to reduce interest rate risks • Altering pension funds’ liability profile to minimize surplus volatility Alternative strategies as the new main generator of returns Pension plan managers’ reduced opportunity set and the new alpha imperative • Transferring out of equity market overexposure to uncorrelated alpha strategies • Increased allocation to uncorrelated alpha vehicles: a necessity to help reaching funding ratio requirements Efficient asset allocation combined with active liability management Hedge interest rate risks and cash-flow mismatches Constrain equity market beta to the pension plan manager’s utility function Increase exposure to uncorrelated sources of alpha Introduce assets with built-in inflation hedges

Q.M.S Advisors

Page 3

LDI And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources Approach

Model the dynamics of plans’ assets and liabilities in a simulation framework

Introduce levered instruments to extend duration, enhance curve duration and convexity hedges to

Minimize asset-liability tracking error

Maximize information ratio

Apply Portable Alpha principles to allow for a flexible and efficient use of capital to diversify across all sources of uncorrelated alpha

Optimal utilization of Plans’ Risk Budget

Assess the impact of introducing alternative investments to Defined Benefit plans’ assets and its implications on expected risks and returns in surplus space

Introduction of bespoke baskets of Alternative Investments

Q.M.S Advisors

Page 4

LDI And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources LDI Implementation

Duration lengthening strategies can provide enhanced returns Benefits to be had by leveraging duration exposure (assetsâ&#x20AC;&#x2122; parallel and twist duration) 7.4 Portfolio 3

7.3

Total Return (% )

Portfolio 2 7.2 Portfolio 1

7.1 7 6.9 6.8

Current Portfolio 6.7 5.3

5.4

5.5

5.6

5.7

5.8

5.9

Surplus Risk (%)

Cash based instruments do not provide an appropriate venue: Lack of long term bonds to match liabilities of ultra long durations Liquidity intensive Solution (sub-efficient use of capital) Derivative instruments: the capital efficient solution to mitigating interest rate risks

For illustrative purposes only

Q.M.S Advisors

Page 5

LDI And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources LDI Implementation – Interest Rate Futures

The price of interest rates futures contracts are negatively correlated to changes in interest rates; buying an interest rate future contract increases a portfolio’s sensitivity to interest rates, increasing the total portfolio’s duration An efficient instrument for duration management Liquidity (Depth of the futures market) Cost Effectiveness (Low transaction costs) Duration Management Specification of a duration target (Duration of the Plan’s liabilities or index) Offsetting or hedging the Pension Plan’s existing interest rate exposure • Introduces basis risk (between the liability exposure and futures price) To minimize basis risks, Q.M.S’ methodology aims at hedging the changes in both the level and twist of the yield curve Simultaneously hedging the price response to both level and twist scenarios or “Two Bond Hedge”, to provide further accuracy to the hedging strategy.

Q.M.S Advisors

Page 6

LDI And Portable Alpha Capability Efficient Deployment of Capital to Alpha Sources LDI – Interest Rate Risk Immunization

Mitigating interest rate risks by extending duration can allow for a more efficient use of the plan’s tracking error budget Reallocation to uncorrelated strategies with high expected information ratios can help the plan meet its objective

Risk Contribution - Current Portfolio

EXAMPLE OF AN INTEREST Risk Contribution RATE RISK MITIGATION Current Portfolio STRATEGY

Net Interest Rate Risk Risk from Investment Policy Unhedgeable Liability Risk Surplus Risk Expected Return

Duration Duration Extension Extension

66.2% 31.8% 2.0% 14.0% -1.0%

Duration Extension Example

Full Liability Driven Solution Example

58.6% 39.0% 2.4% 13.3% -1.0%

0.0% 92.1% 7.9% 10.8% -0.6%

Full Liability Driven Solution

39.0% 39.0% 31.8%

7.9%

92.1%

Duration Gap: 0

66.2% 2.0% Net Interest Rate Risk Risk from Investment Policy Unhedgeable Liability Risk

Duration Gap: 9.1

2.4% 2.4%

58.6% 58.6%

NetNet Interest Interest Rate Rate Risk Risk Risk Risk from from Investment Investment Policy Policy Unhedgeable Unhedgeable Liability Liability Risk Risk

Net Interest Rate Risk Risk from Investment Policy Unhedgeable Liability Risk

Duration Gap: 7.9

Duration Gap: 0

For illustrative purposes only

Q.M.S Advisors

Page 7

LDI And Portable Alpha Capability Derivatives Overlay Program CASH-BASED APPROACH

OVERLAY-BASED APPROACH

Liability hedging: futures or swap overlay strategy Asset-liability and asset management have to be accommodated in one process â&#x20AC;˘ typically achieved through mix of high grade credit / government bonds â&#x20AC;˘ Subject to limitations of cash market

The swap portfolio is managed as a passive fund with the objective of tracking the liabilities via a portfolio of interest rate futures or swaps and inflation linked swaps

Asset management: active alpha generation The manager can implement active strategies to their full extent The fund can be invested in asset classes that are independent of the liabilities, therefore providing better diversification and increased investment opportunities

For illustrative purposes only

Overall risk adjusted return is improved

Q.M.S Advisors

Page 8

LDI And Portable Alpha Capability Optimal Allocation of Active Risk Defining the Optimal Active Risk Exposure 18%

100%

80%

14%

70%

12%

60% 10%

Optimal Equity Allocation (RHS)

50% 40%

30%

Optimal Active Risk (LHS) 2% 0% 0.00

Equity Allocation (%)

Total Required Risk (%)

90%

Total Required Risk (LHS)

16%

20% 10%

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

0% 1.00

Active Risk Information Ratio

Required Total Risk (LHS) Optimal Equity Allocation (RHS)

Optimal Active Risk (LHS) Return / Risk

OPTIMAL ACTIVE RISK ALLOCATION: Equity Market Beta and Total Active Risk Exposure As a Function of Active Risk Information Ratio For illustrative purposes only

Q.M.S Advisors

Page 9

LDI And Portable Alpha Capability Optimal Allocation of Active Risk Portable Alpha Implementation: Optimal Allocation Of Active Risk

Transport alpha efficiently to virtually any asset class or market Portfolio Returns

Market Returns

Alpha/ Skill Returns

Benchmark Returns

Value Added

Synthetic strategies allow for flexible and efficient use of capital when porting alpha Long Index Futures (= b) Return on Index + Alpha (= a + b)

Current Portfolio

Long Alpha Strategies (= a)

Futures Collateral (Rf)

Return on Collateral (Rf)

Total Return on Portfoli o (= a + Beta + Rf)

Fixed Incom e 40% Long Index Futures 20% Equity 40%

Absolute Return Strategy 10%

Overlay Managers 10%

Improving portfolio efficiency by making optimal use of capital to increase active risk

For illustrative purposes only. These materials do not contain any recommendation to buy or sell or a solicitation of an offer to buy or sell any securities or investment services. Q.M.S Advisors provides no determination of suitability or assurances or guarantees regarding the performance of any investment or investment strategy. You are responsible for conducting your own independent investigation and analysis, taking into account your particular circumstances, before deciding upon a particular investment or investment strategy. Investments in certain asset classes, including hedge funds, carry significant additional risks that you should consider prior to investment. You accept complete responsibility for any investment decisions you may make as a result of your use of this material.

Q.M.S Advisors

Page 10

LDI And Portable Alpha Capability Formulation of Client-Specific Alpha Solutions: Spectrum of Potential Sources of Alpha

Downward sloping strategies offer negative correlation to traditional 60/40 portfolios Assessing the simultaneity of extreme values (tail dependencies) Evaluating assetsâ&#x20AC;&#x2122; cyclicality and shifts in correlations D e d ic aShort t e d SBias h o r t B iaManaged s M a n a g e d FFixed u t u r eIncome s F ix e d In c o m eMulti-Strategy Ar b it r a g e Dedicated Futures Arbitrage

I n fo r m a ti o n Information R a ti o Ratio

-0.17 -0 . 1 7

0.49

1.85

M u lt i- S t r a t eArbitrage gy Convertible 2 . 0 71.81

2.07

-5

-2

-4

-1

-2

-3 -6

-5

-6

-4

-2

-4

-8 -8

-4

-10 -10

-10

C o n v e rtib le A rb itra ge re tu rn s (% )

M u lti-S tra teg y retu rn s (% )

F ix e d In c o m e A rbitrag e retu rn s (% )

M an a ge d F utu re s re turns (% )

D ed ic ated S h ort B ias returns (% )

-10

-8

-6

-4

60/40 portfolio returns (%)

-2

-5

-8

-6

-4

-2

-6

-8

-6

-4

-2

-10

-5

60/40 portfolio returns (%)

Global Macro

Equity Market Neutral

Emerging Markets

Event Driven

Long/Short Equity

1.34

3.44

0.45

2.01

1.18

Information Ratio 20

20 3

-5

-10

-20

Long/S hort E quity returns (% )

E v ent D riv en returns (% )

E m erging M ark ets returns (% )

E quity M ark et N eutral returns (% )

G lobal M ac ro returns (% )

-2 -4 -6 -8

10 5 0 -5 -10

-10

-15

-12

-20

-1

-15

-20 -10

-30

-2

-8

-6

-4

-2

60/40 portfolio returns (%)

-8

-6

-4

-2

60/40 portfolio returns (%)

-25

-14

-8

-6

-4

-2

60/40 portfolio returns (%)

-10

-8

-6

-4

-2

60/40 portfolio returns (%)

-10

-5

60/40 portfolio returns (%)

Source: Credit Suisse First Boston/Tremont. Return calculations based on unadjusted CSFB/Tremont historical returns from Apr 1994 to May 2005. Bivariate return distributions modeled as mixture of multivariate Normal distributions.

Q.M.S Advisors

Page 11

LDI And Portable Alpha Capability Formulation of Client-Specific Alpha Solutions: Optimal Combination of Uncorrelated Sources of Alpha

Seek alpha managers with little or no beta exposure: Evaluate each strategyâ&#x20AC;&#x2122;s potential exposure to systematic risks and market cycles Include all explicit and implicit costs inherent to alpha extraction Analyze interactions among alpha managers: Define the origin of returns and risk for each source of alpha Identify risk and return relationships in different market cycles Allocate active risk across uncorrelated sources of return for optimal diversification: The less dependent or correlated the assets, the more the potential gains from diversification. Addition of uncorrelated assets results in a reduction of portfolio-level volatility, thus enhancing risk-adjusted returns

Hypothetical Backtested Performance Analysis

8.0%

R2 = 0.0053 Current Portfolio in Asset-Liability space

6.0% 4.0% 2.0%

-4.0%

-3.0%

-2.0%

0.0% -1.0% 0.0% -2.0%

1.0%

2.0%

3.0%

4.0%

-4.0% -6.0% -8.0% CS' Optimal Model Alpha Solution*

Q.M.S Advisors

Page 12

LDI And Portable Alpha Capability Enhancing Portfolio Returns In A Risk Controlled Framework By Introducing Uncorrelated Alpha Efficient Redeployment Of Liquidity In Uncorrelated Active Risk Historical Risks: Assetâ&#x20AC;&#x201C;Liability space

2.61% 2.5%

2.24% 1.87%

2.0% 1.50% 1.5%

1.13%

1.0%

0.77% 0.40%

0.5% 0.03%

90% of Fixed Income notional ported to CS' Alpha Strategy

60% of Fixed Income notional ported to CS' Alpha Strategy

30% of Fixed Income notional ported to CS' Alpha Strategy

0% of Fixed Income notional ported to CS' Alpha Strategy

0.0%

6.0%

5.98% 5.94%

6.0% 5.91% 5.9%

5.88% 5.85%

5.84% 5.9% 5.84% 5.83% 5.83% 5.83% 5.8% 5.8% 90% of Fixed Income notional ported to CS' Alpha Strategy

3.0%

6.03%

60% of Fixed Income notional ported to CS' Alpha Strategy

2.98%

Historical Portfolio Standard Deviation (%)

3.35%

3.5% Historical Portfolio Returns (%)

6.1%

3.73%

30% of Fixed Income notional ported to CS' Alpha Strategy

4.0%

0% of Fixed Income notional ported to CS' Alpha Strategy

Historical Returns: Assetâ&#x20AC;&#x201C;Liability space

Q.M.S Advisors

Page 13

LDI And Portable Alpha Capability Defining An Optimal Uncorrelated Alpha Risk Exposure To Reach Pension’s Risk Budget And Return Target Efficient Redeployment Of Liquidity In Uncorrelated Active Risk

Porting alpha to traditional beta exposure ensures additional diversification at the portfolio level, without significantly altering the original risk profile The less dependent or correlated the assets, the more the potential gains from diversification Porting alpha drastically improves the portfolio’s return per unit of risk Optimal allocation of active risk in surplus space : Addition of uncorrelated assets results in a reduction of portfolio-level volatility, thus enhancing risk-adjusted returns

Equity Exposure Risk-Return Frontier: Asset–Liability space

4.0% 3.5% Historical Returns (% )

3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 5.80%

5.85%

5.90% 5.95% 6.00% Historical Standard Deviation (%)

6.05%

Q.M.S Advisors

Page 14