Transcript Outline

A Primer on Overlays
www.mcubeit.com
Dr. Arun Muralidhar
Arun Muralidhar - Bio

Chairman of Mcube Investment Technologies, LLC and
Managing Director at FX Concepts, Inc.

Head of Investment Research and Member of Investment
Management Committee, World Bank Investment Department,
1995-1999

Derivatives and Liability Management, World Bank Funding
Department, 1992-1995

Managing Director and Head of Currency Research, JPMIM,
1999-2001

BA, Wabash College (1988); PhD, MIT Sloan (1992)
2
Agenda
 Overlays – TAA or Currency
 Underused
by most funds
 Internal versus External

Capability, fees and product offerings

New paradigm: alpha from good decisions
 AlphaEngineTM: empower clients to make better
decisions
3
Case for Overlays
 Markets are inefficient – currency is best example
 Low correlations across assets - “informed
decision making” will be profitable
 Can be implemented with little cash (derivatives)
 An excellent source of uncorrelated alpha
Sophisticated Clients can Implement at Low Cost
4
TAA Case Study: Many Possible Ideas
Total Portfolio
US Equity
50%
EAFE
20%
US Fixed
Income 25%
Cash
5%
Decisions to be made on allocation between asset classes:
 Domestic vs International Equities (Stock-Stock)
 Domestic Equities vs Domestic Bonds (Stock-Bonds)
 Domestic Bonds vs Cash (Bonds-Cash)
Assume Asset Limits of +/- 5% from Benchmark Weight
5
Simple/Intuitive Rules Tested
Rule
Rule Description
Cash vs. Bonds, based on
Gold
Duration choice based on price of gold. If the spot price of gold is higher than it
was a year ago, overweight cash, otherwise overweight bonds
Stocks vs Bonds:
Halloween Effect
Stocks vs Bonds:
Inflation/Growth
Market Volatility
Stocks tend to underperform bonds between June and Sept - apparently works in
16 out of 18 stock markets, so underweight stocks during this period
Equities undervalued when inflation rises (Modigliani-Cohn insight); equities
favored when industrial production is increasing
Low equity volatility in a rising stock environment is bullish for equities.
Oil and Economy
Rising oil prices affect the economy and tend to depress equities.
P/E Ratio Rule
Value rule for equity (vs FI) using the S&P 500 P/E
Fed Model
When equity yield is higher than treasury yield then buy equity, else sell equity
Unemployment Rate
Buy stocks when the unemployment rate is falling (good for economy)
US/EAFE: LIBOR Rates
Overweight equity market with the stronger currency (higher interest rate)
US/EAFE: Favor
Underperformer
Overweight equity market which has underperformed over past year (i.e., buy
the laggard)
6
Rule Performance (1998-2004)
Excess
Annualized Information Confidence Success Ratio Good
Max
Return
Ratio
in Skill
Ratio
/Bad Risk Drawdown
Rule
Cash vs. Bonds, based on Gold
0.04%
0.20
68.8%
56.4%
1.30
-0.44%
Halloween Effect
0.98%
0.88
98.0%
63.8%
1.42
-1.58%
Inflation/Growth
0.50%
0.57
93.1%
79.7%
1.07
-1.31%
Market Volatility
0.12%
0.11
67.8%
56.4%
1.41
-2.74%
Oil and Economy
0.45%
0.57
91.6%
70.5%
1.16
-0.84%
P/E Ratio Rule
0.17%
0.39
87.1%
50.0%
2.12
-0.80%
Fed Model
Unemployment Rate
0.47%
0.51%
0.50
0.61
91.8%
94.1%
61.5%
59.0%
1.43
0.99
-2.17%
US/EAFE: LIBOR Rates
US/EAFE: Favor Underperformer
0.17%
0.53%
0.43
0.95
84.7%
99.3%
55.1%
64.1%
1.07
1.33
-0.71%
-1.11%
-1.07%
Monthly Decisions – No Transactions Costs
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Strategies (Mix of Rules) Tested
Strategy Name
Strategy Description
Rebalancing I
Quarterly Rebalancing to Benchmark Weights
Rebalancing II
Rebalance to Benchmark Weights when Range of +/-5% Breached
Combination of Rules:
6 Best Excess Annualized Returns () and Information Ratios – Cash
vs Bonds, Halloween Effect, Inflation/Growth, Unemployment Rate, Fed
Model, US/EAFE: Favor Underperformer (all equally weighted)
6 Lowest Annualized Standard Deviation (Risk) - Cash vs Bonds, Oil
and Economy, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates,
US/EAFE: Favor Underperformer (all equally weighted)
3 Highest  and 3 Lowest Risk - Cash vs Bonds, Halloween Effect, P/E
Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor
Underperformer (all equally weighted)
Strategy 1
Combination of Rules:
Strategy 2
Combination of Rules:
Strategy 3
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Strategy Performance (1998-2004)
Strategy
Rebalancing I Quarterly
Rebalancing II Range of 5%
Strategy 1 (highest 6
Excess Returns/IR)
Strategy 2 (lowest 6
risk)
Strategy 3 (Highest 3
Excess, lowest 3 Risk)
Excess
Annualized
Return
Information Confidence Success Ratio Good Max
Ratio
in Skill
Ratio
/Bad Risk Drawdown
-0.22%
-0.87
NM
29.5%
1.26
-1.50%
-0.42%
-1.11
NM
33.3%
0.96
-2.74%
0.44%
1.29
99.97%
64.1%
2.11
-0.21%
0.32%
1.20
99.90%
61.5%
1.54
-0.28%
0.36%
1.42
99.99%
57.7%
2.09
-0.20%
Informed decisions significantly outperform rebalancing
Rule diversification enhances information ratios
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Fixed Income
30%
Strategy 1
Strategy 2
Strategy 3
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Historical Allocations to Asset Classes
US Equity
25%
Intl Equity
50%
20%
45%
15%
25%
5%
20%
0%
Strategies 2 & 3
have same
rules/allocation
10%
Cash
All strategies
have same
rule/allocation
10
Currency Case Study: Easy Alpha
Currency Portfolio
JPY (30%)
EUR (50%)
GBP (20%)

Three rules make money: Trend, Carry/Yield and Options

Work in Divergent, Convergent and Sideways Markets, respectively

Potential to add in other currencies and make more complex

Rules will, by construct, have high tracking error: +100%/-100%
11
Simple Rules Work (1994-2004)
 Trend – if 25 day moving average > 65 days
moving average, BUY, else SELL
 Carry – SELL currency with low interest rate
 Yield – SELL currency with steep yield curve
 Options – Are overpriced, SELL
 Not highly correlated – good diversification
Need Not Pay Active Fees for Simple Rules
12
Performance of JPY Rules/Strategies
 Rules Evaluated: (a) yield curve; (b) carry; (c) moving average
 USD/JPY Strategy = 40% Yield curve and Carry, 20% MA
 Diversification improves information ratio, skill, & drawdown
Strategy/
Rules
USD/JPY
Strategy
USD/JPY
Yield Curve
USD/JPY
Carry
USD/JPY
MA 20-65
Annualized
Annualized Std
Return
Deviation
Information Cumulative Confidence Success
Ratio
Return
in Skill
Ratio
Ratio Good Max
/Bad Risk
Drawdown
4.59%
8.56%
0.5365
57.45%
94.17%
52.86%
0.9103
-20.45%
4.54%
11.59%
0.3919
56.68%
85.59%
53.43%
0.8564
-26.21%
4.33%
11.59%
0.3741
53.57%
84.26%
52.37%
0.8613
-26.21%
3.62%
11.59%
0.3121
43.22%
79.05%
51.12%
1.06
-20.51%
13
Performance of EUR Rules/Strategies
 Rules Evaluated: (a) yield curve; (b) carry; (c) moving average
 USD/EUR Strategy = 40% Yield curve and Carry, 20% MA

Trend model losses are meaningful; but moderate lower
drawdown and worst single performance of the strategy
Strategy/
Rules
USD/EUR
Strategy
USD/EUR
Yield Curve
USD/EUR
Carry
USD/EUR
MA 20-65
Annualized
Annualized Std
Information Cumulative Confidence Success Ratio Good Max
Return
Deviation
Ratio
Return
in Skill
Ratio
/Bad Risk Drawdown
3.79%
5.09%
0.7444
45.69%
98.89%
55.21%
0.9793
-7.78%
5.20%
6.26%
0.8301
40.10%
98.42%
82.95%
0.8599
-8.08%
8.48%
9.71%
0.8729
127.66%
99.56%
55.21%
0.8997
-13.07%
-5.22%
9.72%
-0.5372
-41.86%
3.13%
46.68%
1.1392
-49.12%
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Can Be a Consistent Alpha Source
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Internal versus External
 Internal
 May
require use of derivatives (not critical as portfolio
drift/rebalancing is an active decision)
 Can
keep costs down; better control
 External
 Some
 Less
strategies better suited – Options
career risk; long record of having added alpha
16
AlphaEngineTM: Empower Clients
 Brings state-of-the-art management to pension funds
 Easy to use: Clients generate ideas – software does work
 Test strategies in a few minutes
 Client can customize to their structure and objectives
 No consulting!! Client can make all decisions better
 Very transparent: See impact of all decisions on individual
asset class or entire fund (easy to read)
17
Summary
 Many (explicit and implicit) decisions in a portfolio
 Each is an opportunity for alpha/risk management
 Overlays can help manage these risks for return
 Good governance: cost/return impact of every decision
 Must aggregate impact of all decisions on portfolio
 AlphaEngineTM: adopt best practices quickly and easily
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Appendix
Fund Responsibilities
AssetLiability
Risk
Tactical &
Benchmark
Risk
Manager/
Active
Risk
Responsibility
Responsibility
Trustees
Internal Staff
Managers
Monitor
Decision
Frequency
Annually
Daily/Monthly
Monthly
Manage
How to
Manage the
Risk
Strategic
Allocations &
Funding
Policy
Asset, Sector,
Style and
Currency
Allocations
Manager
Selection and
Allocation
Staff are Making Many Decisions (Implicitly) Periodically
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Effective Decision Making
 Low asset correlations allow “informed decision making”
 Identify rule ideas to allocate across asset classes
 Select criteria for rule/strategy evaluation (excess return,
information ratio, skill, success rate, drawdown)
 Analyze rule performance, test different strategies (rule
combinations) - diversification benefits not obvious
 Test alternative policies versus rebalancing options
Assumed Monthly Decisions (1998-2004); No Transaction Costs
21
Extensions
 Each decision is an opportunity for more returns/risk management

More tiers = greater diversification, efficacy = more returns

Within asset classes (Fixed Income, Equities, Currencies)

Managers: Active versus passive and across managers
 Leverage asset managers to generate research ideas for decisions
 Rule were equally weighted; opportunity to further improve
 Evaluate ideas in isolation as well as part of a total portfolio
(aggregation produces results that are not obvious)
Improve fund governance, and in turn, returns and risk
22
Relaxing Asset Limits to +/- 10%
Excess
Annualized Information Confidence Success
Return
Ratio
in Skill
Ratio
Strategy
Ratio Good Max
/Bad Risk Drawdown
Rebalancing II - 5% Range
Rebalancing II - 10% Range
-0.42%
-0.11%
-1.11
-0.16
NM
31.95%
33.3%
46.2%
0.96
1.60
-2.74%
-2.48%
Strategy 1 - 5% limit
Strategy 1 - 10% limit
0.44%
0.93%
1.29
1.29
99.97%
99.97%
64.1%
68.0%
2.11
1.91
-0.21%
-0.50%
Strategy II - 5% limit
Strategy II - 10% limit
0.32%
0.51%
1.20
1.16
99.90%
99.85%
61.5%
62.8%
1.54
1.91
-0.28%
-0.26%
Strategy III - 5% limit
Strategy III - 10% limit
0.36%
0.75%
1.42
1.50
99.99%
99.99%
57.7%
66.7%
2.09
1.90
-0.20%
-0.44%
Change in asset range produces higher ; other
measures improve or stay within acceptable range
23
Multi-tiered Alpha Aggregation
Alpha = 1.5%
Total Portfolio
Asset allocation/ rebalancing strategy
US Equity
50%
Intl Equity
(EAFE) 20%
US Fixed
Income 25%
Cash
5%
Alpha = 0.5%
Equity strategy – Large vs Small Cap
Small Cap
Russell 2000
Alpha = 0.5%
Large Cap
S&P500
Manager rule to determine allocation between managers/index
Passive
(S&P500)
Enhanced Index
(Manager A)
Active
(Manager B)
Alpha = 0.5%
24
Performance of GBP Rules/Strategies
 Rules Evaluated: (a) yield curve; (b) carry; (c) moving average
 USD/GBP Strategy = 40% Yield curve and Carry, 20% MA

GBP is hardest to model
Strategy/
Rules
USD/GBP
Strategy
USD/GBP
Yield Curve
USD/GBP
Carry
USD/GBP
MA 20-65
Annualized
Annualized Std
Information Cumulative Confidence Success
Return
Deviation
Ratio
Return
in Skill
Ratio
Ratio Good Max
/Bad Risk Drawdown
1.50%
5.56%
0.2703
16.29%
77.97%
53.20%
0.9408
-17.50%
0.15%
7.80%
0.0192
1.53%
47.49%
49.53%
1.0048
-29.22%
3.00%
7.80%
0.3847
34.85%
86.41%
53.54%
0.9758
-17.95%
0.50%
7.80%
0.0642
5.18%
53.18%
52.97%
0.8862
-29.63%
25
-20%
0%
Jun-04
Dec-03
Jun-03
-100%
Dec-02
-80%
Jun-01
Jun-04
Dec-03
Jun-03
Dec-02
Jun-02
Dec-01
Jun-04
Dec-03
Jun-03
Dec-02
Jun-02
Dec-01
Jun-01
Dec-00
Jun-00
Dec-99
Jun-99
Dec-98
Jun-98
Dec-97
Jun-97
Dec-96
Jun-96
Dec-95
Jun-95
Dec-94
Jun-94
0%
Jun-02
-60%
Sell USD Short……Hedge 100%
-40%
-20%
Dec-01
Jun-00
Dec-00
20%
Jun-01
Jun-99
Dec-99
USD/JPY HEDGE POSITION
Dec-00
Jun-98
Dec-98
40%
Jun-00
Jun-97
Dec-97
60%
Dec-99
Jun-96
Dec-96
80%
Jun-99
Jun-95
Dec-95
100%
Dec-98
Jun-98
Dec-97
Jun-97
Dec-96
Jun-96
Dec-95
Jun-95
Dec-94
Jun-94
Jun-94
-20%
Dec-94
0%
Sell USD Short………Hedge 100%
Sell USD Short………Hedge 100%
Allocation Results
USD/EUR HEDGE POSITION
100%
80%
60%
40%
20%
-40%
-60%
-80%
-100%
USD/GBP HEDGE POSITION
100%
80%
60%
40%
20%
-40%
-60%
-100%
-80%
26