The Role of Hedge Funds in In-stitutional Portfolios: Part I Contributed by Hilary Till Principal, Premia Capital Management, LLC www.premiacap.com PRMIA Member Since February 2002 This article is the first in a four-part series on the role of hedge funds in institutional portfo-lios. In this introductory article we discuss how the hedge fund industry and institutional fund management arise from different intellectual traditions. The next articles in this series will cover the competing conceptual frameworks for incorporating hedge funds into institutional portfolios. After the dramatic losses in the equity markets from 2000 to 2003, there has been a struggle to understand how hedge funds, with their prom-ise of absolute returns, might fit into institu-tional portfolios. The idea with “absolute re-turn strategies” is that an investment manager will explicitly manage downside risk rather than solely manage risk relative to a bench-mark. In “relative return strategies,” for exam-ple, it is acceptable for a manager to lose say –20% as long as this return is broadly consistent with the manager’s benchmark returns. As in late 1987 when there was doubt about the Efficient Market Hypothesis, the scale of the recent equity bubble and the magnitude of the subsequent losses have created “a sort-of crisis” in belief in the Modern Portfolio Theory (MPT), according to Siegel (2003): “We regard the original or pre-MPT investment paradigm as one that requires the investor to justify each investment on its own merits. This view was largely replaced, between about 1964 and 1980, by the body of knowledge loosely known as Modern Portfolio Theory, which re-

lies on capitalization-weighted benchmarks as both the starting point for building actively managed portfolios and as the reference asset for measuring the performance and risk of port-folios. [Italics added.]”

Siegel notes that one current concern is that the widespread belief in MPT and capitalization-weighted benchmarks might have actually led to the creation of the equity bubble. According to Siegel (2003), the current frame-work for institutional decision-making is one where: “… plan sponsors are in charge of the asset and style allocations of their portfolios [while] the [investment] manager’s job is to beat the benchmark, not to serve as a surrogate plan sponsor.” This prevailing institutional framework clashes with a view of fund management whereby a manager should balance investment opportuni-ties with total risk, as advocated by Ineichen (2003). With such a mandate, the fund man-ager would indeed become a “surrogate plan sponsor.” Studies such as Brinson et al (1986) have shown that U.S. pension plans have historically chosen to emphasize the asset allocation deci-sion over other types of investment choices. Given the empirical evidence thus far on (lack of) manager skill, it is no wonder that institu-tions have focused on creating long-run policy portfolios and then have allowed individual managers limited discretion around investment benchmarks. One might argue that the conceptual framework for hedge funds and fund-of-funds is at least partly based on pre-MPT principles, including: Every investment on its own merits, and a (Continued on next page)

Hedge Funds in Institutional Portfolios; Bank Balance Sheet Buffering, RAROC for Energy & Commodity Trading Firms

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Featured Jobs 2

Four Hundred Attend PRMIA Philippines Risk Conference

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Top PRM Candidates 3

Laurent Denayer and Dan Burke Named Regional Directors

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PRMIA Montreal Profile

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• PRMs and Candi-dates Pursuing the PRM up 225% Year-over-Year

• Over 300 Chief Risk Officers / Heads of Risk in PRMIA C-Suite

• Membership crosses 17,000

• Windale Group Makes Donation to PRMIA Annual Campaign

Standards, Education & Leadership —Champions for the Global Risk Profession

MEMBERS’ UPDATE

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If you’re looking to hire, you can post your openings for free and can even use the search utility to find a certified PRM to meet your needs.

The PRMIA Jobs Board is a free resource to PRMIA members. Over 25,000 job searches take place each month on the board and this month, over 400 Jobs in twelve countries are listed.

Each month we randomly feature some of the latest postings, but be sure to search the entire database to see what is available. All job listings can be found by clicking Jobs Board.

Over 400 Jobs Posted On the PRMIA Jobs Board: 128 New This Month

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Salary: US$Competitive

New Orleans, USA

Banks Working to Cushion Balance Sheets, Evidence Suggests

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Salary: US$Competitive

Sydney Australia

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casualness about diversification. With each individual hedge fund, the core idea is that total risk is managed by neutralizing systematic risk through shorting or hedging while in institutional management, total risk is man-aged at the plan level through the diversification provided by balanced portfolios of uncorrelated assets. This brief introduction has been meant to illustrate that hedge funds do not easily fit into the current way institutions go about investing. The next articles in this series will discuss how in-stitutions are forging ahead in incorporating hedge funds into their portfolios despite the clashing conceptual frameworks alluded to in this introduction. Brinson, Gary, L. Randolph Hood, and Gilbert Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986, pp. 39-44. Ineichen, Alexander, “Asymmetric Returns and Sector Specialists,” Journal of Alternative Investments, Spring 2003, pp. 31-40. Siegel, Laurence, Benchmarks and Investment Management, Association for Investment Management and Research, Charlottesville, Va., 2003. For the full version of this article which originally appeared in in the Spring 2004 Journal of Alternative Investments, link: Till: Institutional Portfolios I.

Banks Acting to Cushion Balance Sheets Contributed by Christopher Whalen Institutional Risk Analytics www.institutionalriskanalytics.com PRMIA Member Since January 2004 With the Federal Reserve Board attempting to raise interest

rates, so far with little success, people are asking how well commercial banks are prepared for this next leg of the credit cycle. Below we review how banks protect themselves from interest rate risk. Assessing bank operations with respect to interest rate change is not the same as the examining a portfolio of term structured instruments. Not all bank assets are liquid instruments that can be swapped every time the shape of the treasury/swap curve twists. Because lending and operations profiles take years to develop, banks protect themselves from market shocks by building buffers within their asset structures. The classic cushion against shock used by banks to guard against shocks is equity. Banks have been increasing equity over the last decade with the Credit Card, International and Mortgage Lending sectors doubling their buffers during this period.

After equity the next shock absorber available to a bank is in its deposit base; specifically, the non-interest bearing portion of (Continued on Page 4)

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Philippines Steering Committee for his drive and initiative in promoting the Convention and our chapter in the Philippines. Laurent Denayer Named First Regional Director for PRMIA Luxembourg PRMIA’s growth continues with the addition of our new chapter in

Luxembourg/ Laurent Denayer has been approved by the PRMIA Board of Directors as the first Re-gional Director for PRMIA Luxem-bourg. He was nominated by and will serve with the PRMIA Luxem-bourg Steering Committee which consists of Boris Beyer, Dresdner Bank, Marcello Depaola, Mi-zuho, Josee Deroy, Nationwide Global and Laurent Schyns, Safra Bank. Mr. Denayer is em-ployed by Ernst and Young. Dan Burke Named New Regional Director for PRMIA Chicago The PRMIA Chicago Steering Committee has nominated Dan Burke of BP Energy to be the new Regional Director of PRMIA Chicago. The PRMIA Board approved Mr. Burke’s nomination last week. Mr. Burke replaces Rizwan

Kadir, who has served in the role for nearly two years and has presided over substantial local activity and growth. Our thanks go to Rizwan and the Chicago Steering Committee for their dedication and service.

Over 450 Delegates Register for First PRMIA Philippines Risk Management Conference

PRMIA Philippines along with the Governor Jose B. Fernandez Jr. Center for Banking and Finance (JBF Center) held the 2004 Risk Management Convention on Sept. 13 in Manila. Over 450 delegates registered to attend. The convention was held at the SGV Hall of the Asian Institute of Management Con-ference Center Ma-nila, celebrated the 1st year anniversary of PRMIA Philippines and marked the new focus of the JBF Cen-ter into the field of Risk Management. With the theme, "Risk Professional: Mandate and Responsibilities", the convention high-lighted as speakers, Securities and Ex-change Commissioner Joselia Poblador, Bango Sentral ng Pilipinas Deputy Gov-e r n o r A m a n d o Tetangco Jr., and Jose L. Cuisia, president and CEO of Philip-pine American Life and General Insurance Co. Our congratula-tions and thanks go to Anastasia Marina, our Regional Director in Manila, the JBF Center, the PRMIA Philippines Steering Committee and particularly to Dr. Noet Ravalo of the PRMIA

Other PRMIA News and Items of Interest

Top Scores in Third Quarter 2004 (to-date) Exam I - Finance Theory, Financial Instruments and Markets Kit Yee Ng, Hong Kong Exam II - Mathematical Foundations of Risk Measurement Michal Goss, Warsaw, Poland Konrad, Augustynski, Krakow, Poland

Exam III - Financial Risk Management Practices

Viktoria Baklanova, New York, USA Exam IV - Case Studies, Standards of Best Practice, Conduct and Ethics, PRMIA Governance Christopher Brady, Berkeley, CA, USA Edward Wright, Rye, NY, USA Martin Sheerin, Quincy, MA, USA

Donald Meek, Austin, TX, USA Wei Chung Choi, Hong Kong Michal Dubrow, New York, USA

Congratulations to the Top PRM Candidates

November 9-10, 2004

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outside these traditional loan specialties over the last decade. Significantly, the International group accounted for an average of 45% until 2001. The shift to just 27.0% occurred in the last two years and resulted, in part, from the surge in U.S. home fi-nancing during the last downward move in rates. Mortgage lenders reached their present position of just 4.0% of such loans in adjustable rate assets in two steps, both tied to the consequences of refinancing booms. One half of the move came in 1991 and the other half around 2001, both years, by no coin-cidence, when the Fed was aggressively easing rates. To the extent that excessive Fed credit creation fueled a bubble in real estate, commercial banks and the GSEs happily provided the necessary credit. Finally, we look at operational decisions that increase the banks exposure to interest rate risk, specifically the distribution of fee income from non-lending and noninvesting sources -- activities such as securitization, advisory, underwriting and venture capi-tal activities. These sources of income tend to decline during rising interest rate scenarios and the degree to which a bank’s operations depend on this source of income provides insight into institutional risk.

Note the dramatic increases in fee income dependence among the large international specialty and credit card institutions. For the Credit Card lenders, the percentage of bank income derived from fees jumped from nearly nil in 1989 to 20% by 1991, then climbed steadily, peaking at 41% in 1999. The sector retreated back to 20% by 2001 but has been growing about 2% per year since then. The International sector has climbed steadily during the decade with significant jumps in the average occurring in 1991 and 1998. The rate of increase in fee income for the largest universal banks has been around 6% per year over the last two years of Fed easing, begging the question as to the contribution to future earnings. (Continued on Page 5)

Evidence Suggests Banks are Moving to Buffer Their Balance Sheets deposits. Most sectors of the US banking industry started 2004 with similar proportions of interest rate insulated assets as a dec-ade before, but the paths were circuitous. Notable among the group are Credit Card lenders, who peaked at 32% non-interest deposits in 4Q 1997, before declining to present levels. The International banking group actually aver-aged 20% from 1989 to 1995, then dipped into the mid-teens from 1995 to 2000, bringing them into alignment with the other bank industry groups. The International segment has since moved back to its pre-95 profile. The Mortgage banking sector has been increasing the proportion of assets supported by non-interest bearing liabilities steadily since 1989 but is still well below all other types of banks.

The next area to examine is the lending base of the bank; that is, what proportion of total loans have regular re-pricing features that are not likely to pre-pay or default as interest rates shift. The core of these this type of asset are the Agricultural, Commercial and Industrial, and Commercial real estate loans of the bank. Examining the proportion of these loan categories versus the entire loan and lease base of the bank provides a measure of the depth of this buffer.

Here we see a pattern of softening buffers by key banking sec-tors. In particular, the Agricultural and Commercial lending sec-tors have redeployed 15 to 20 percent of their lending portfolios

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a link with shareholder value creation. Many energy firms are still using VaR as a proxy for Economic Capital. We will also argue that there are superior measures to VaR, particularly for Economic Capital and Liquidity Adequacy determination.

Ultimately, these tools provide a bridge to tie risk/reward rela-tionships through the different activities and balance sheet items of a firm, and therefore serve as common analysis and commu-nication tools. Energy trading firms that successfully adopt and implement eco-nomic capital and RAROC models throughout the firm will have a competitive advantage by being able to run their businesses with less capital, while also showing greater transparency and improving the confidence on their ability to manage risk to credit rating agencies, shareholders, regulators and creditors. The implementation of a capital allocation model based on risk-adjusted returns for energy firms should be specifically tailored to the business activities of each firm rather than taking existing models used in the financial services and insurance industries. As Hickman, Rich and Tange (2002) point out, “energy compa-nies should also resist the urge of seeing every problem as a “nail” simply because they possess a first-rate VaR analytics hammer.” For the full version of this article which originally appeared in in The Risk Desk, link to: Blanco: RAROC.

Economic Capital & RAROC at Energy and Commodity Trading Firms Each of the above measures characterizes a family of test points that illustrate the actions of bank management. The above fig-ures are sector averages that can be used to compare an individ-ual institution to its peers. Individual institutions will exhibit profiles that differ from the average depending on what actions management has taken in the past. As a special benefit, Institutional Risk Analytics provides PRMIA Members with free trial subscriptions to their products and extended term paid subscriptions. Login at www.PRMIA.org and click on Members-Only Links / Discounts.

Summary: Economic Capital and RAROC for Energy and Commodity Trading Firms Carlos Blanco, Ph.D. Principal, Black Swan Risk Advisors, LLC. Regional Director, PRMIA San Francisco (Bay Area) PRMIA Member Since January 2004 Identifying, measuring, managing and pricing risk at a firm-wide level involves designing appropriate policies and systems to allow for the evaluation of different business units and risk taking activities within the firm from a risk-adjusted return point of view. How can managers determine who are the most effi-cient generators of revenue on a risk-adjusted basis? What type of returns should be expected given the risk assumed to generate them? Risk-adjusted return on capital (RAROC) measures, which are widely used in the financial services industry, provide a com-mon measurement unit for risk-adjusted returns on allocated (ex-ante) and utilized (ex-post) risk capital. The allocation of risk capital amongst different units is one of the key activities performed by senior management of trading firms, and also one of the building blocks of an integrated risk management framework. Determining the economic capital allo-cated to each activity or business unit provides senior manage-ment with a mechanism to link risk and return, and therefore provide a risk/reward signal that can be used at different levels of the firm. An investment evaluation process based on eco-nomic capital considerations, where decisions are based on a risk-adjusted return basis, encourages corporate managers to become risk managers, due to the fact that risk must be taken into consideration explicitly at the time of allocating resources internally and making investment and divestment decisions. In this article, we introduce Economic Capital and its role in Risk-Adjusted Return on Capital (RAROC) calculations by pre-senting some strategic uses for senior managers in energy trad-ing firms. Economic Capital lies at the heart of enterprise-wide risk management and its management and optimization provide

PRMIA receives no remuneration for articles that ap-pear in the Members Update. Any opinions expressed, or statements made in the articles above are those of the author and are not necessarily those of PRMIA. Mem-bers interested in contributing material to the PRMIA Members Update should contact resources@prmia.org.

Example of Credit Loss Distribution — Expected and Unexpected

Regional Director

David Streliski, PricewaterhouseCoopers

Steering Committee

Lisa Busca Pinheiro, CIRANO Tarek Dakhli, PricewaterhouseCoopers Jean Desrochers, University of Sherbrooke Brian Gelfand, Derivatives Insti-tute of Montreal Christian Lachaussée, Watson Wyatt Canada Pierrette Lacroix, National Bank of Canada François Laurin, Business De-velopment Bank of Canada

Statistics Membership: Chapter Formed: January, 2002 Members’ Areas of Interest: 38.6% Derivatives 38.2% Credit Risk 34.9% VaR 33.3% Financial Risk 31.9% Financial Engineering 30.5% Market Risk 29.3% Fixed Income 29.1% Traditional Asset Management 29.0% Asset/Liability Management 28.7% RAROC /RAPM

Luc St-Arnault, IFM2 Alicia Zemanek, Laurentian Bank of Canada

Recent Events

Performance Measures for Bank Trading Portfolios; The New Basel II Accord and Its Impact on the Banking Industry; Practical implementation issues for Basel II; Risk Management and Perform-ance Evaluation Using an Overlay Approach

Regional Chapter Profile: PRMIA Montreal

PRMIA Montreal Regional Director,

David Streliski

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