investment risk measurement and...

INVESTMENT RISKMEASUREMENT AND

REPORTINGCommittee on Investments /

Investment Advisory CommitteeJanuary 7, 2003

January 7, 2003 Regents COI / IAC Meeting

CONTENTS

Introduction to Investment RiskIntroduction to Investment RiskOrganizationRisk PolicyMeasuring RiskPreliminary ResultsNext Steps


WHAT IS INVESTMENT RISK?

Risk is the chance of loss accepted by an investor in order to earn a return

Risk management should identify and boundpossible losses

Risk tolerance measures the loss an investor is willing to sustain in order to generate an acceptable return

Risk management implements guidelines andcontrols on the investment process to maintain the probability of loss within acceptable limits


FRAMEWORK FOR RISK MGMT

Risk is an essential part of investingRisk in itself is intrinsically neither good nor bad - risk is a scarce resource used to generate investment returnsRisk management does not require the elimination of risk, but the balancing of risk and expected return“You can’t control outcomes, you can

only manage risk”*

* source: Peter Bernstein


RISK MGMT. VALUE ADDED

Ensuring that sources of risk (“risk factors”) are identified, understood, and quantifiedEnsuring that assumption of risk is intentional and consistent with investment objectivesEnsuring that risks are adequately compensated(expected return is commensurate with risk)Ensuring that the risk exposures in each portfolio are consistent with the risk target / budget set for that portfolio Enabling fiduciaries to assume the maximum amount of risk consistent with investment objectives and standards of prudence


CONTENTS

Introduction to Investment RiskOrganization Organization Risk PolicyMeasuring RiskPreliminary ResultsNext Steps


MISSION

The Investment Risk Manager’s primary objective is to ensure that the University of California Treasurer’s Office financial, investment and operational activities do not expose the University to potential or unexpected losses beyond the Regents risk tolerance levels


RISK MGMT. PROCESS

Articulate risk

tolerance

Develop risk policy, guidelines,

and targets

Implement risk standards and methodologies

Periodic measurement,

monitoring, analysis, and stress testing

Feedback, recommend-ations, and corrective

actions

Review and revise process


STAFFING

Director, Investment Risk ManagementDevelop and implement risk framework and processesConduct research in risk and portfolio managementManage special projects and asset allocation studies

Manager, Quantitative AnalysisManage periodic measurement, analysis, and reporting processAssist with special projects

Risk AnalystAssist with analysis and reportingManage databases and vendor data links


CONTENTS

Introduction to Investment RiskOrganizationRisk PolicyRisk PolicyMeasuring RiskPreliminary ResultsNext Steps


RISK POLICY

Proposed risk policy for UC RegentsAssumption of risk is necessary to meet plan objectivesRisk should be taken intentionally

Regents / IAC should review risk exposures on a regular basis

Risks taken should be rewardedappropriately

Goal of risk management is to balancerisk and expected returns


POLICY IMPLEMENTATION

Regents express tolerance for risk inMetrics for risk (e.g., volatility)Targets and ranges for those metrics

Treasurers’ Office is responsible forBudgeting (allocating) risk to various strategiesMeasuring and reporting risk vis a vis these targets and ranges

Measuring returns from risk exposuresTaking corrective action when risk falls outside range


CONTENTS

Introduction to Investment RiskOrganizationRisk PolicyMeasuring RiskMeasuring RiskPreliminary ResultsNext Steps


RISK MEASUREMENT

Investment risk is characterized jointly by the possibility of loss and the severity of lossThe investment process is segmented into multiple decision levels, with different risk metrics for each level

Surplus Risk: risk of insufficient assets to meet liabilities / spending targetsTotal Asset / Systematic Risk: risk of under-performing strategic investment policyActive / Residual Risk: risk of unacceptable deviation from style or benchmark


RISK MEASUREMENT 2

The most widely accepted measures of asset riskfocus on the volatility of returns

Typically around a benchmark or target returnTwo types of volatility measures are used

Historical (based on actual returns)Forecast or (based on current holdings)

Multiple approaches required, e.g., Aggregate vs. componentsAbsolute vs. relativeFundamental factors vs. statisticalTotal variability vs. negative outcomes

Volatility is a proxy for Return expectationsProcess quality


SYSTEMATIC VS RESIDUAL RISK

Diversification reduces risk, but “systematic” investment risks cannot be diversified

Pension fund must be invested in the marketCan be temporarily hedged, but it is costly

Principal investment decisions areWhich market risks / systematic factors to assume

Managed through asset allocation and risk budgeting

How much market risk to assume (“beta”)Greatest impact on total risk (after benchmark)

How much non benchmark risk to assume (“residual”)Risk of multiple active strategies mostly diversifiableTypically results in only a small increase to total risk


RISK DECISION VARIABLES

Assumes benchmark risk (volatility) of 10%

0.00

%

0.50

%

1.00

%

1.50

%

2.00

%

2.50

%

3.00

%

3.50

%

4.00

%

4.50

%

5.00

%

0 .80 0.85 0.90 0.95 1.00 1.05 1.10 1.15 1.20 1.25

RES ID U A L RIS K

BETA

IN CR EA SE IN TO TA L R ISK (B P)

(200)- (100) (100)- 0 0 - 100

100 - 200 200 - 300 300 - 400


CONTENTS

Introduction to Investment RiskOrganizationRisk PolicyMeasuring Risk

Preliminary ResultsPreliminary ResultsSurplus and Spending RiskSurplus and Spending RiskCapital Market AssumptionsCapital Market AssumptionsAsset Allocation and Equity %Asset Allocation and Equity %Risk DecompositionRisk DecompositionTotal Risk and Active RiskTotal Risk and Active RiskActive Risk and Return Active Risk and Return –– Equity and Bond PortfoliosEquity and Bond PortfoliosEquity and Bond Risk FactorsEquity and Bond Risk Factors

Next Steps


PENSION - SURPLUS RISK

Source: UCRS Annual Reports

UCRP FUNDED STATUS

100%

110%

120%

130%

140%

150%

160%19

92

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Funded Ratio (Actuarial)


ENDOWMENT - SPENDING RISK

UC GEP Funding Ability

50,000

100,000

150,000

200,000

250,000

300,000

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

5% of Assets (Nom $) 5% of Assets (2002 $)


Risk [X] and Return [Y] - Actual Results through Sept 2002

-2.04.06.08.0

10.012.014.016.018.020.0

8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 12.0

Last 5 Years - Fund Last 5 Years - Bench Last 10 Years - FundLast 10 Years - Bench First 5 Years - Fund First 5 Years - Bench

RISK AND RETURN - ACTUAL

1992-1997

1992-2002

1997-2002


RISK AND RETURN - FORECAST

Risk [X] and Expected Return [Y]Wilshire Asset Allocation Assumptions

6.006.507.007.508.008.509.009.50

10.0010.5011.00

10.00 11.00 12.00 13.00 14.00 15.00

Aug-02 Jan-02 Jan-01 Jan-00 Jan-99

Graph shows Wilshire risk and return assumptions for past four years for current policy allocation

Actuarial Required Return:

7.5%

Latest Forecast


ASSET ALLOCATION - PAST

Constrained Efficient Frontier, actual results, 5 YR ended 09/02

A ct ual Risk [x] v s. Ret urn [y] 1997-2002

(20.0)

(10.0)

-

10.0

20.0

30.0

- 5.0 10.0 15.0 20.0 25.0 30.0

U S Stocks - Interna l U S Stocks - Passiv e Non U S Stocks - Dev .

Non U S Stocks - Emg. Priv ate M arkets U S Bonds

Cash TIPS TO TAL

Const Effic Front


ASSET ALLOCATION - FORECAST

Efficient Frontier, Wilshire 2002 asset class assumptions

Forecast Risk [x] vs. Return [y] Wilshire Aug 2002

-

2.0

4.0

6.0

8.0

10.0

12.0

- 5.0 10.0 15.0 20.0 25.0 30.0 35.0US Stocks Non US Stocks - Dev . Non US Stocks - Emg.REITS / Real Estate Priv ate Markets Hedge FundsUS Bonds Non US Bonds CashTIPS High Yield Debt POLICY TOTALConst Effic Front


EQUITY % TOTAL ASSETS

UCRP ASSET ALLOCATION (%)

-10.0%-8.0%-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%8.0%

10.0%

Jun-

97

Dec

-97

Jun-

98

Dec

-98

Jun-

99

Dec

-99

Jun-

00

Dec

-00

Jun-

01

Dec

-01

Jun-

02

Dec

-02

30%37%44%51%58%65%72%79%86%93%100%

Equity Ov er/ (Under) Total Equity

Domestic Equity Internal Equity

Addition of Index & Intl Funds


RISK DECOMPOSITIONHistorical Contribution to Risk - UCRP Total Fund

0%

20%

40%

60%

80%

100%Ju

n-92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Systematic Risk % Residual Risk %

Systematic = Risk from benchmark related decisions (incl. asset allocation) Residual = Risk from other active decisions (manager and security selection)


RISK DECOMPOSITION

Contribution to Risk [Variance] UCRP Total Fund

-

50

100

150

200

250

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Bench Risk Systematic Risk Residual Risk

Note: Systematic Risk differs from benchmark due to asset allocation and degree of market exposure (“beta”)


TOTAL (SYSTEMATIC) RISKUCRP - Rolling 12 Month Portfolio Risk

-2.04.06.08.0

10.012.014.016.0

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Total Fund Total Fund Benchmark

“Rolling 12 Months” = each point represents volatility (standard deviation) of previous 12 months’ returns (equally weighted)


ACTIVE (RESIDUAL) RISK

UCRP - Rolling 12 Month Active Risk

-0.51.01.52.02.53.03.54.0

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Total Fund

“Active Risk” = volatility of difference between fund and benchmark returns

Begin risk control of internal

portfolios


EQUITY & BOND ACTIVE RISK

UCRP - Rolling 12 Month Active Risk

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0Ju

n-92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Internal Equity Internal Bonds


EQUITY & BOND ACTIVE RETURN

UCRP - Rolling 12 Month Active Return (Geom)

(10.0)

(5.0)

-

5.0

10.0

15.0Ju

n-92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02



EQUITY & BOND INFO RATIOS

UCRP - Roll ing 12 Month Information Ratios

(4.0)

(3.0)

(2.0)

(1.0)

-

1.0

2.0

3.0Ju

n-92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02


“Information Ratio” = Active return (above benchmark) ÷ active risk


FIXED INCOME RISK FACTOR

UCRP Bond Duration vs Benchmarks

4

6

8

10

12

14

16

Jun-

97

Dec

-97

Jun-

98

Dec

-98

Jun-

99

Dec

-99

Jun-

00

Dec

-00

Jun-

01

Dec

-01

Jun-

02

Dec

-02

SALOMON LPF LONG BONDBROAD MARKET UCRP Bonds


EQUITY RISK FACTOR

UCRP IM Equity vs. Benchmarks: Price/Book

2468

1012141618

Jun-

98

Sep-

98

Dec

-98

Mar

-99

Jun-

99

Sep-

99

Dec

-99

Mar

-00

Jun-

00

Sep-

00

Dec

-00

Mar

-01

Jun-

01

Sep-

01

Dec

-01

Mar

-02

Jun-

02

Sep-

02

UCRP Russell 3000 S&P 500


CONTENTS

Introduction to Investment RiskOrganizationRisk PolicyMeasuring RiskPreliminary ResultsNext StepsNext Steps


NEAR and MID TERM PRIORITIES

Refine and expand quantitative analysis of bond portfolio, including risk measurementDevelop comprehensive package of risk reportsDevelop risk policy consistent with plan policy documents Develop risk budgets consistent with risk policy and Regents’ risk toleranceExplore products for total fund risk measurement (including liabilities)Develop and train risk management staff

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