Steven Hartt, CAIA Senior Vice President Meketa Investment Group May 21, 2013 NCPERS 2013 Annual Conference Alternative Investments: Measuring the Risks
Steven Hartt, CAIA
Senior Vice President
Meketa Investment Group
May 21, 2013 NCPERS 2013 Annual Conference
Alternative Investments:
Measuring the Risks
What are Alternative Investments?
Why is it Important for Trustees to Understand Alternatives?
How are Alternatives Similar to Traditional Investments?
Why Invest in Alternatives?
What are the Risks with Alternative Investments?
Summary
Agenda
What are Alternative Investments?
Something other than US stocks, bonds and cash
Anything you don’t understand
Something that sounds risky or makes you
uncomfortable
Something you never heard of before
Anything outside your mainstream thinking
What is an Alternative?
1975: Mortgage backed bonds (e.g., Fannie Mae)
1985: European and Japanese stocks
1990: High yield bonds
1995: Emerging markets (e.g., China)
2000: Treasury Inflation Protected Securities (TIPS)
Today’s Alternatives Can Become
Tomorrow’s Mainstream
Private Equity
Infrastructure
Real Estate
Commodities
Hedge Funds
What is Considered an Alternative in 2013?
Why is it Important for Trustees
to Understand Alternatives?
The return for a “standard” investment portfolio
has declined dramatically over the past decade.
This Used to be Easier
Current = 4.6%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Oct-91 Jan-94 Apr-96 Jul-98 Oct-00 Jan-03 Apr-05 Jul-07 Oct-09
65% Stock / 35% Bond 10-Year Rolling ReturnAverage
20-year average = 10.4%
Sep-11
Stocks remain relatively expensive…
Current Investment Challenges
0
5
10
15
20
25
30
35
40
45
50
1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 2015
Year
No
rmalized
Pri
ce-E
arn
ings
Rati
o
+ 1 Std. Dev.
Average
-1 Std. Dev.
Source: Shiller, Global Financial Data, S&P 500, Meketa Investment Group
Bond yields remain near historic lows…
A traditional portfolio of stocks and bonds will not get your 7.5%!
Current Investment Challenges
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
1900 1915 1930 1945 1960 1975 1990 2005
Year
10-Y
ear
Tre
asu
ry Y
ield
How are Alternatives Similar
to Traditional Investments?
Alternatives have many of the Same
Characteristics as Traditional Investments
Alternatives are exposed to many of the same
risks as traditional investments
Characteristics of Traditional and Alternatives
Traditional Alternatives
Stocks Public Equity Private Equity
Bonds Bonds Private Debt
Real Estate REITs Private Real Estate
Infrastructure Utility Stocks Private Infrastructure
Commodities & Natural Resources Natural Resources Stocks Commodities
Why Invest in Alternatives?
Chance to participate in new opportunities
A higher expected return for giving up some liquidity
Greater alpha potential
Ability to moderate risks associated with ordinary
stocks and bonds
Diversification benefits
What Can Alternatives Offer?
Historical Private Equity Returns
What have been the returns?
Source: Thomson Reuters. All Regions all Styles
As of December 31, 2012
1
Year
10
Years
20
Years
Upper Quartile 22.8% 20.3% 33.0%
Median 12.6% 11.3% 11.1%
S&P 500 Index 16.0% 7.1% 8.2%
Over the last twenty years, Median Private Equity has returned
11.1% annually, while Upper Quartile has returned 33.0%
This compares to 8.2% for the S&P 500 Index
What are the Risks with Alternative
Investments?
Common Issues with Alternatives
Issue Consideration
Lower level of liquidity or illiquid Subject to redemption terms (if any at all)
Limited/no market for investor’s interest
Lower level of transparency into
underlying assets
Specific assets often not identified at the time of investment
Limited/no ability to control the assets in the portfolio
Some managers utilize leverage and/or derivatives
Hard to value Many assets are not publicly traded and are subject to
appraisal based valuation techniques
No clear benchmarks
Best managers are critical
to success
Spread between top performing and median managers
is wide
Common Issues with Alternatives
Issue Consideration
Higher fees Managers typically charge both management fees
(1% - 2%) and performance fees (20% +)
Lumpy cash flows Investments may have unpredictable capital call and return
patterns
Self liquidating structures require reinvestment in order to
maintain target allocation
Administrative burden Alternative investments often require monitoring, accounting
and tax specialists
Potential headline risk Limited ability to exit manager in case of investment or
other issue
Summary
Investing in Alternatives
The Eight Golden Rules
Understand it first
Adopt a well-considered long-term strategy
Take your time to get invested
Avoid fads
Plan for the necessary illiquidity
Avoid unnecessary pyramided costs
Use the right professionals
Diversify, diversify, diversify
Summary
BOSTON MIAMI SAN DIEGO
100 Lowder Brook Drive
Suite 1100
Westwood, MA 02090
Telephone Number: (781) 471-3500
Fax Number: (781) 471-3411
1001 Brickell Bay Drive
Suite 2000
Miami, FL 33131
Telephone Number: (305) 341-2900
Fax Number: (305) 341-2142
5796 Armada Drive
Suite 110
Carlsbad, CA 92008
Telephone Number: (760) 795-3450
Fax Number: (760) 795-3445
Contact Information
M E K E T A I N V E S T M E N T G R O U P
www.meketagroup.com
1
Alternative Investments: Measuring the Risks
Matt Appel, CFA – Vice President
State Street Global Exchange – Analytics
May 21, 2013
2
Agenda
• Introduction
• Alternative Investments
– Trends
– Importance
• What are the Risks
– Quantitative
• Hedge Funds
• Private Equity & Real Estate
• Risk Measurement and Solutions
• Assimilating Risks into Total Portfolios
• Trends in Alts
3
State Street Global Exchange
State Street Bank &Trust
State
Street
Global
Markets
State
Street
Global
Services
State
Street
Global
Advisors
State
Street
Global
Exchange
• State Street Global Exchange (SSGX) is a global provider of advisory, analytics, investment, information, and
electronic trading solutions.
• SSGX is committed to providing value to the front office in the same way State Street has and continues to do in the
middle and back office.
• SSGX leverages State Street’s unique data sets and industry-leading technology platforms to provide information
products, software, and services across all asset classes and buy-side industry segments.
4
State Street Global Exchange - Analytics
State Street Global Exchange
Information
Solutions
Research &
Advisory
Analytics • Independent
valuation
• “What-if”
performance
attribution
• Risk/Return
Optimization
• Analytics for
regulatory risk
• Structured
investment
products
Trading &
Clearing
Solutions
Software
Solutions
5
Full Service Risk Solution for Institutional Clients
• We have been in existence since 2001
– for 11+ years
• Extensive history with derivatives
and alternative investments
• Grown from servicing only HFs to
servicing all of the State Streets clients
• More than $1.5 trillion across ALL asset
classes including private markets
History
Staff
• Global Staff consists of 90+ people
dedicated to risk services
– Client Support
– Development
– Risk Advisory
– Financial Engineering
– Research
– Business Development
– Administration
Assets Serviced
17
19
Public
Corporate
Global Pension Fund Clients
• 36 Pension Fund Clients
• Over 125 Clients Globally
6
Public Pension Funds Increase Allocation to Alternative Investments
• State pension systems shifted 10% of their
assets from public equities to alternatives
over the five years ending June 30, 2011
• Alternatives now average 20% of total
state fund assets
• Private equity and real estate allocations
were the primary driver behind the better
performing state funds
• Median allocation to alternatives by
public plans with assets >$1B was 15.07%
as of June 30, 2012, up from 1.81% as of
June 30, 2003
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1-Jan-03 1-Jan-11
Public Pension Plan Portfolio Allocation
2003 v. 2011
Other
Alternatives
Fixed Income
Equities
Sources: Pension & Investment and Cliffwater Inc.
1.81% 15.07%
7
What are the Risks?
1. Lose Money
2. Liquidity – can’t get your money out when you need it
3. Over invested in certain exposures
4. Don’t make expected return
8
How do I get the Information to Model?
1. Transparency Services
2. Proxy
3. Open Protocol
4. Regulation & Industry Standard Reporting
9
Transparency
• Execution of non-disclosure agreements to protect confidential information
• Monthly aggregation of hedge fund positions from:
– Fund administrators
– Fund prime brokers
– Fund custodians
– Funds themselves
• Position verification, cleanse, and augmentation with market data each reporting period
• Independently calculated position pricing
• Exposure reporting, including standardized and client-driven tags attributed to each
position, enabling high flexibility
• Full range of position-based analytics including stress testing, VaR analysis, risk
decomposition, sensitivities and what-if analysis
Today, more than ever, hedge fund investors are seeking ways to better measure and
understand the dynamics and risks in their alternative investments.
10
Proxy – What Information Do you Need
1. Exposures
2. Return Streams
3. Indices
4. Blended Proxies
11
Open Protocol
Regulatory Reform and Strong Investor Pressure has Necessitated Standard Risk Reporting
Procedures for Alternative Investments
Source: www.theopenprotocol.org
1
THE WORKING GROUP – responsible for developing the first draft of Open Protocol reports for
consultation by a wider audience as well as ongoing maintenance and development of the protocols
Alongside Albourne Partners, State Street was a champion in the working group and continues to be
actively involved in the Open Protocol initiative.
Reasons for Open Protocol Reporting
2 The UK Financial Authority
recognized reporting
inconsistencies as it discussed
assembling its first template to
capture capital market risk in 2008.
Where investors were able to see
transparency into their hedge fund
investments, it was complicated to
view and monitor risk due to:
• Multiple sources of data
• Inconsistent calculation
methods
• Different reporting formats
Post US financial crisis, there was a
growing demand from institutional
investors for standardized risk
reporting to ensure consistency of
data to better aggregate risk
information.
3
12
What is Open Protocol?
• Open Protocol brings together
three types of information
– State Street uniquely provides
counterparty and investor information
• Predefined levels of granularity
allow managers to provide consistent
information without compromising
the trade in the market
Completed in August 2011, the Open Protocol Template Provides Your Investors With a
Consistent Level(s) of Hedge Fund Transparency
Granularity Mandatory Example
(Sector Exposure)
Grade
I Low
Yes, for all
metrics
• Materials
• Industry
Grade
II* Medium
Manager /
Client Discretion
• Materials
– Chemicals
Grade
III* High
Manager /
Client Discretion
• Materials
– Chemicals
• Diversified
• Chemicals
2. Investor
Information (10%)
3. Risk
Information (80%)
1. Counterparty
Information (10%)
* In development
13
Who Does OP Benefit? Open Protocol Benefits Hedge Fund Managers, Institutional Investors and Regulators
• Transparency of asset classes traded (not trading strategy) makes hedge funds more attractive
investments for institutional investors (no more “black box” investing)
• The standard reporting template is flexible, easy to implement and comprehensive
• Aggregate reports will minimize managers’ and investors’ investment in additional technology
and resources
Benefits
Beneficiaries
Hedge Fund
Managers
Institutional
Investors Regulators
1. Fund Transparency X X X
2. Standardized Reporting Procedure X X X
3. Decreased Reporting Costs X X
14
3. Regulatory and Industry Standard Risk Reporting
Regulatory Reporting Industry Standard
Reporting
SEC
Form PF
CFTC
Form CPO-PQR UCITS IV AIFMD Solvency II Open Protocol
A rule that
requires private
fund advisors to
report regulatory
assets under
management to
the FSOC.
These
requirements are
intended to
provide risk
exposure
statistics
regarding the
type and size of
assets held by
private firms.
A rule designed
to provide
information
about
operations and
strategies of
commodity
pools in order
to establish a
baseline picture
of potential
systemic risk in
the industry
The Committee of
European Securities
Regulators (CESR)
requires
Undertakings for
Collective
Investments in
Transferable
Securities (UCITS)
funds to employ a
risk management
framework that
monitors and
measures the risk of
their holdings and
contribution to
overall portfolio risk
at any time.
A regulatory directive
whose primary
objective is to provide
common rules for the
authorization and
supervision of
alternative
investment fund
managers (AIFM).
All managers of AIFs
operating in the EU,
providing investment
management
services to non-
UCITS, irrespective
of legal form or
domicile, are subject
to transparency
requirements.
An EU directive that
codifies and
harmonizes the EU
insurance
regulation regarding
the amount of
capital that EU
insurance
companies must
hold to reduce the
risk of insolvency
An 11-tab
spreadsheet
report that
standardizes
reporting
procedures for
the collection,
collation and
conveyance of
hedge fund risk
information.
US-domiciled EU-domiciled Both
15
Losing Money
• Value at Risk (VaR)
• Drop Down Risk
• Sensitivities
• Stress Scenarios
16
Liquidity
• Legal Terms
• Gates
• Lock-ups
• Fees
17
Exposures
• Currencies
• Countries
• Sector
• Counterparties
• Issuers
18
Stress Scenarios
• Custom
• Historic
• Economic
(2.97%)(2.80%)
(7.20%)
3.64%
0.36%
4.10%
1.18%
(6.55%)
(3.53%)
(4.32%)
(8%)
(6%)
(4%)
(2%)
0%
2%
4%
6%
9/11 Attack - 5
Day
Asian Crisis
97-98 - 5 day
Bond Crash:
Feb 94 - May94
Emerging
Markets Rally:Jan 99 - May
99
Fed
Tightening:April - June 99
IR
Steepening:Sept 98 - Nov
98
Nadaq Rally:
Nov 99 - Jan00
Nasdaq
Correction:July 98 - Aug
98
Russian Crisis
- 5 Day
Government
Intervention
Fixed Income Domestic Equity Alternative Investments International Equity Total
19
Investment Vehicles to Mitigate Hedge Fund Risk
• Hedge Fund of Funds
• Commingled Funds
• Separate Accounts
• Funds of One
• 1940 Act Funds (Registered Products)
20
Liquid Alternative Strategies
1. Fidelity/Arden
2. Blackstone
3. KKR
4. Goldman
5. ARIA
1. Franklin Templeton / K2
2. NYLIM / Private
Advisors
3. Legg Mason / Permal
Liquid Products
Traditional and Hedge FOF
21
ARIA – Alternative Road Investment Advisors
• Registered 1940 Act Mutual Fund
• Access to Veteran Hedge Fund Managers
• Single 1.97% Fee
• (No performance fees or multiple layers of fees)
• Daily Liquidity
• Real-Time Transparency
• Multiple Hedge Fund Subadvisers & Strategies
• Endowment Asset Allocation Model
• Uncorrelated Return Stream Versus Broad Market Indices
• Downside Risk Protection
• Absolute Return Stream
• Long Term Capital Appreciation
22
Private Equity & Real Estate Investments
1. Liquidity
2. Exposure
3. Volatility
4. Opportunity Costs
23 23
PE Market parameter and assumption:
Parameter Description Possibility Lower End Upper End
1 Robust 13.4% 1sd 1.96sd
2 Sound 15.0% 0.5sd 1sd
3 Neutral 38.2% -0.5sd 0.5sd
4 Slow 15.0% -1sd -0.5sd
5 Weak 13.4% -1.96sd -1sd
Total: 95.0%
PE Market Parameter is served
as a Probability Density
Function, which generates a
random process from its
observed behavior during a
finite period of time, within
user defined range.
For example, based on SSPEI
database observations, first year
Buyout Fund on average drawdown
16% of commitment in year 1 with 6%
Standard Deviation.
Parameter Lower
bound
Upper
bound
1 4% 10%
2 10% 13%
3 13% 19%
4 19% 22%
5 22% 28%
24 24
PESM provides a range of possible outcomes
Simulation: Percentile Distribution
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0% 10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Simulation: Histogram
0
10
20
30
40
50
60
70
-0.7
%0.3
%1.3
%2.3
%3.3
%4.3
%5.3
%6.3
%7.3
%8.3
%9.3
%
25
Sample of Simulation Result: Year 2013 to 2021
PE Market Barometer (CF Projection Parameters): 3, Neutral
T0 T1 T2 T3 T4 T5 T6 T7 T8 T9
Contribution (253.3) (316.1) (361.0) (414.9) (428.2) (446.1) (459.9) (485.6) (504.4) (419.7)
Buyout (147.2) (203.1) (252.8) (284.6) (294.9) (309.5) (322.7) (343.9) (365.0) (311.9)
Venture Capital (16.1) (21.7) (27.0) (29.6) (37.5) (36.9) (37.2) (42.0) (39.5) (34.5)
Debt Related (90.0) (91.3) (81.1) (100.7) (95.9) (99.7) (100.0) (99.6) (99.9) (73.2)
Distribution 254.6 247.0 251.2 255.5 295.5 356.4 426.9 462.8 493.1 511.3
Buyout 160.6 156.3 131.5 133.0 170.5 235.4 306.5 355.0 380.9 394.9
Venture Capital 7.2 2.2 4.0 6.8 9.9 14.5 16.3 17.8 20.2 25.9
Debt Related 86.9 88.4 115.6 115.6 115.2 106.4 104.2 90.1 92.0 90.5
Net Cash Flow 1.3 (69.2) (109.8) (159.4) (132.7) (89.8) (33.0) (22.8) (11.2) 91.6
Buyout 13.4 (46.8) (121.3) (151.5) (124.4) (74.1) (16.2) 11.0 15.9 83.0
Venture Capital (8.9) (19.5) (23.0) (22.8) (27.6) (22.4) (20.9) (24.2) (19.3) (8.6)
Debt Related (3.2) (2.9) 34.5 14.9 19.3 6.7 4.1 (9.6) (7.9) 17.2
Fair Marktet Value 1,130.4 1,278.2 1,423.9 1,606.3 1,773.0 1,908.9 2,055.9 2,196.5 2,338.4 2,324.4
Buyout 649.7 748.8 892.2 1,060.9 1,219.9 1,347.8 1,476.6 1,599.0 1,712.9 1,715.1
Venture Capital 41.2 52.3 70.8 91.0 113.0 136.8 162.9 187.8 208.9 216.4
Debt Related 439.5 477.1 460.8 454.5 440.2 424.2 416.4 409.7 416.6 392.9
T0 T1 T2 T3 T4 T5 T6 T7 T8 T9
Ending AUM Value 18,503 21,278 24,470 28,141 30,955 34,050 37,455 41,201 45,321 49,853
Ending PE Allocation % 6.11% 6.01% 5.82% 5.71% 5.73% 5.61% 5.49% 5.33% 5.16% 4.66%
26
Private Equity & Real Estate Exposures
1. Country
2. Currency
3. Sector
4. Industry
5. Leverage
6. Vintage
27
Volatility & Opportunity
1. Proxy
2. Funds
3. Portfolio Companies
4. Leverage
5. PME
28
Stress Scenarios Transparency
Oversight, Analysis and Actionable Information
Exposures Tracking Error
(2.97%)(2.80%)
(7.20%)
3.64%
0.36%
4.10%
1.18%
(6.55%)
(3.53%)
(4.32%)
(8%)
(6%)
(4%)
(2%)
0%
2%
4%
6%
9/11 Attack - 5
Day
Asian Crisis
97-98 - 5 day
Bond Crash:
Feb 94 - May94
Emerging
Markets Rally:Jan 99 - May
99
Fed
Tightening:April - June 99
IR
Steepening:Sept 98 - Nov
98
Nadaq Rally:
Nov 99 - Jan00
Nasdaq
Correction:July 98 - Aug
98
Russian Crisis
- 5 Day
Government
Intervention
International Equity Alternative Investments Domestic Equity Fixed Income Total
Industry R ankings
R elat ive W eight A bso lut e W eight R isk T racking
Pharmaceut icals B io t echno logy & Lif e Sciences 2.3% Sof t ware & Services 11.5% Energy -1.1% Pharmaceut icals B io t echno logy & 0.4%
Sof t ware & Services 1.9% Pharmaceut icals B io t echno logy & Lif e 10.1% D iversif ied F inancials -0.8% Sof t ware & Services 0.3%
M edia 1.4% Energy 9.1% Sof t ware & Services -0.7% Techno logy Hardware & 0.3%
C onsumer Services 1.1% Techno logy Hardware & Equipment 7.6% C ap it al Goods -0.7% Semiconduct ors & Semiconduct or 0.3%
R et ail ing 0.8% C ap it al Goods 7.2% Pharmaceut icals B io t echno logy & Lif e -0.5% C onsumer Services 0.2%
C ap it al Goods -0.9% U t il it ies 1.6%
Energy -1.1% Househo ld & Personal Product s 1.2%
Telecommunicat ion Services -1.2% R eal Est at e 1.2%
U t il it ies -2.0% A ut omob iles & C omponent s 0.8%
R eal Est at e -2.4% C ommercial Services & Supp lies 0.4%
Issuer R ankings
R elat ive W eight A bso lut e W eight
M IC R OSOFT C OR P 0.9% A PPLE IN C 3.2%
T IM E W A R N ER IN C 0.8% M IC R OSOFT C OR P 2.3%
N A TION A L OILW ELL V A R C O IN C 0.7% GOOGLE IN C 1.6%
C OM C A ST C OR P 0.7% EX X ON M OB IL C OR P 1.3%
FED EX C OR P 0.6% PF IZER IN C 1.3%
A PPLE IN C -0.8%
V ER IZON C OM M U N IC A T ION S IN C -0.8%
IN TER N A TION A L B U SIN ESS M A C HIN ES C OR P -0.9%
A T&T IN C -1.0%
EX X ON M OB IL C OR P -1.4%
• Mid cap
overweights vs.
Large Cap
• Energy, Financial,
and Software &
Services are largest
contributors to risk
• 4 out of top 5
relative under
weighted securities
stay constant from
prior qtr with
rankings changed; 3
out of top 5 relative
over weighted
securities remain
constant from
prior qtr with
rankings changed
0%5%
10%15%20%25%
Allocation By Risk
Allocation
Risk
45%
18%
14%
11%
12%
Risk Contribution by Market Cap
Large
Med/Lrg
Med/Small
Medium
Smal l
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
Allocation by Market Cap
Actual BM
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Allocation by Sector
Actual
BM
COMPLETE TRANSPARENCY INTO ALL ASSET CLASSES
Hedge Funds – position level information assimilated with rest of
your assets
Private Equity – portfolio company proxy capturing exposures
and volatility
Real Estate - portfolio company proxy capturing exposures and
volatility
Co-mingled – integration of all positions with rest of portfolio
-10.9%-10.3% -10.5% -10.4% -10.4% -10.6%
-10.1% -10.0% -10.1%-9.4% -9.4% -9.7%
-10.4%-9.7% -9.9% -9.6% -9.6%
-10.2% -9.9% -9.8% -9.8%-9.4% -9.4% -9.5%
-14.0%
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
10/11 11/11 12/11 01/12 02/12 03/12 04/12 05/12 06/12 07/12 08/12 09/12
Monthly Risk 95% VaR
TOTAL ASRS FUND POLICY BENCHMARK