601 INVESTMENT RISK
REPORTING
NEW REPORT: ACTIVE EQUITY RISK
Committee on Investments /
Investment Advisory Committee
August 17, 2004
RISK QUESTIONS
‹What are the components of portfolio
total risk and active risk?
„ How do they compare to the policy
benchmark?
‹How much, at the margin, does each risk
exposure contribute to portfolio risk?
„ Is the risk contribution proportional to
expectations for return?
‹How does active performance over the
last quarter relate to the risks taken?
„ Over time, is there evidence of skill (positive risk
adjusted performance)?
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REPORTING RISK AND RETURN
‹ Goal of Treasurer’s report to Committee
„ What returns were achieved
„ What risks were taken to earn the returns
„ Are risks intentional and within appropriate bounds
‹ Risk includes
„ Portfolio characteristics
„ Performance attribution
„ Sector / country / quality exposures
‹ Risk also includes
„ Measures of volatility
„ Contribution of sector / portfolio risk to total
„ Measures of sensitivity (which factors have the most
impact on total risk)
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RISK MODELS
‹Treasurer is now implementing holdingsbased factor models for forecasting equity
and bond risk
‹Same model as previously used for
analyzing internal equity strategy
‹Similar in concept to returns based models
presented in Q1 2004 report, however
„ More granular forecasts to aid in decision
making (manager allocation)
„ More responsiveness to current market
conditions
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REPORT CONTENTS
‹ Portfolio characteristics
‹ Risk measures and risk decomposition
‹ Underlying risk factor exposures
„ Industry factors
„ Style factors
‹ Performance attribution based on risk factors
Active US Equity includes the 25% of total US Equity which is or will be
managed actively; as of 6-30-04, it includes a portfolio managed
passively against the Russell 1000 tobacco free index and nine
actively managed small capitalization US equity portfolios
managed against various small cap style benchmarks
Overall benchmark for Active US Equity is the Russell 3000 Tobacco
Free
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RISK MEASURES
‹ Measures of risk are estimates of volatility, and show the
amount by which asset values could increase or decrease
over a given time period
‹ Portfolio risk measures are based on the volatility of each
security, the size of each position, and the degree to which
security prices move together
‹ Units of risk are standard deviation of returns, annualized
„ Range around expected return in which the actual one-year
return should fall in roughly two of every three years
‹ Beta is a measure of the overall degree of market exposure
„ A beta of 1.0 is neutral or very similar to the benchmark
‹ Both total and active risk may be decomposed into a
common factor (systematic) portion and portion due to
security selection.
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PORTFOLIO CHARACTERISTICS
PORTFOLIO CHARACTERISTICS VS BENCHMARK
UCRP
1.5
22.2
3.9
83.2
1.0
$68.45 bn
1,972
Dividend Yield
Price - Earnings Ratio (historical)
Price - Book Ratio
Debt - Equity Ratio
Fundamental Beta
Market Capitalization (Cap Wtd)
Number of Holdings
RUSSELL 3000
1.6
22.5
4.0
84.6
1.0
$74.6bn
3,000
‹ The aggregate active portfolio is currently structured very
similar to the benchmark
‹ Weighted security characteristics such as dividend yield, P/E,
P/B have historically been successful in explaining crosssectional stock volatility, and are used in the development of
factor based risk models
‹ Average market capitalization is slightly smaller than the
benchmark, reflecting the active small cap strategies
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RISK DECOMPOSITION
RISK MEASURES / DECOMPOSITION (Qtr End)
Common Factor
Style Factors
Industries
Factor Interaction
Asset Selection
Total
Benchmark
Beta
TOTAL RISK
Risk
Contrib
%Std dev
%Total
14.37
99
1.06
1
14.18
97
N/A
2
1.22
1
14.43
100
14.50
0.99
ACTIVE RISK
Risk
Contrib
%Std dev
%Active
0.76
90
0.73
83
0.25
10
N/A
(2)
0.25
10
0.80
100
‹ Shown above are measures of portfolio and benchmark risk, which
are very similar
‹ The majority of total risk is attributed to industry exposures
„ Only a small amount comes from style factors or asset selection
‹ Most of active risk though is attributed to style exposures different
from the benchmark (see below)
„ Industries and asset selection have a small contribution
‹ Active risk (tracking error) is very low (80 bp), due to the large
component of passively managed funds
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PERFORMANCE ATTRIBUTION
PERFORMANCE ATTRIBUTION (one quarter) (3)
Return
Risk
Total Portfolio
1.21
14.03
Benchmark
1.45
14.10
(0.25)
0.86
Active
Common Factor
0.03
Style Factors
0.01
0.79
Industries
0.02
0.17
Asset Selection
(0.28)
0.23
Market Timing
0.01
0.29
Trading
-
N/A
0.09
‹ Performance relative to a benchmark can be explained as follows:
„ Risk exposures different from the benchmark
„ Performance of those risk factors during the period
‹ Most of the underperformance was attributed to asset selection, not
common factors
„ Two thirds of asset selection return came from over-weighted assets, onethird from under-weighted assets
‹ Risk column in performance attribution refers to variability of each
component of earnings over that quarter
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STYLE EXPOSURES AND RISK
‹ The graph shows portfolio and
benchmark exposure to each style
factor, measured in standard
deviation
Currency (0.000)
Earnings Var. (0.000)
Earnings Yield (-0.005)
Growth (0.005)
„ Note on magnitude: as a rule of
thumb, style exposures < 0.20 are not
considered significant
Leverage (0.000)
Momentum (-0.001)
Size(NEU) (-0.005)
Size (0.004)
Size (NL) (0.007)
Trading (0.014)
Value (0.000)
Volatility (0.050)
Yield (-0.004)
MCTR in
parentheses
-0.30 -0.25 -0.20 -0.15 -0.10 -0.05
0.00
Portfolio
Active
Benchmark
0.05
RISK MEASURES / DECOMPOSITION (Qtr End) (2)
TOTAL RISK
ACTIVE RISK
Risk
Contrib
Risk
Contrib
%Std dev
%Total
%Std dev
%Active
Common Factor
14.37
99
0.76
90
Style Factors
1.06
1
0.73
83
14.18
97
0.25
10
Industries
Factor Interaction
N/A
2
N/A
(2)
1.22
1
0.25
10
Total
14.43
100
0.80
100
Benchmark
14.50
Asset Selection
Beta
Aug 17, 2004
0.10
‹ The active bars show the difference
between portfolio and benchmark
exposure
‹ The aggregate of all exposures,
weighted by the volatility and
covariances among the risk factors,
yields the total volatility attributed to
style
‹ Only the Size and Size NL (non
linearity) factors are significant, and
are indicative of the tilt toward
smaller cap stocks
„ together they account for a large
portion of the active risk
‹ MCTR, or Marginal Contribution to
Total Risk, is a risk sensitivity measure
(see below for explanation)
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SECTOR EXPOSURES AND RISK
Basic Mat'ls (0.15)
Cnsmr Cyc. (0.15)
Cnsmr Non-cyc. (0.12)
Cnsmr Serv. (0.14)
Comm Serv. (0.14)
Energy (0.12)
Financial (0.15)
Health Care (0.12)
Industrials (0.15)
Technology (0.18)
Telecom (0.14)
Transport (0.14)
Utility (0.11)
Cash (0.00)
-5
0
5
10
Portfolio
15
Benchmark
20
25
Active
RISK MEASURES / DECOMPOSITION (Qtr End) (2)
TOTAL RISK
Common Factor
Style Factors
Industries
Factor Interaction
ACTIVE RISK
Risk
Contrib
Risk
Contrib
%Std dev
%Total
%Std dev
%Active
14.37
99
0.76
90
1.06
1
0.73
83
14.18
97
0.25
10
N/A
2
N/A
(2)
1.22
1
0.25
10
Total
14.43
100
0.80
100
Benchmark
14.50
Asset Selection
Beta
Aug 17, 2004
‹ The graph shows portfolio and
benchmark exposure to each
industry group factor, measured in
percent (adds to 100)
‹ The active bars show the
difference between portfolio and
benchmark exposure
‹ The aggregate of all exposures,
weighted by the volatility and
covariances among the risk
factors, yields the total volatility
attributed to industries
‹ There are no significant active
industry exposures, indicating a
well diversified portfolio; this
explains the small contribution to
active industry risk
‹ MCTR, or Marginal Contribution to
Total Risk, is a risk sensitivity
measure (see below for
explanation)
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Marginal Contribution to Total Risk (MCTR)
‹ This is the sensitivity to total portfolio risk of a small change in
the factor exposure
‹ It is measured in basis points, or 1/100 of a percent of
standard deviation
‹ E.g., a 1% increase* in exposure to the Financials (industry)
risk factor will cause portfolio risk to increase by 0.148% or 15
bp
‹ E.g., a .01 standard deviation increase* in exposure to the
Momentum (style) risk factor will cause portfolio risk to
decrease by 0.0012% or .12 bp
‹ *Calculation assumes that an increase (decrease) in asset
weights resulting in increase (decrease) in factor exposure is
offset by a decrease (increase) in cash of the same amount
‹ Also may be calculated for active risk to aid portfolio
manager in determining impact of active (benchmark
relative) decisions
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CONCLUSIONS
‹ Risk exposures are similar to the benchmark, so
active risk is low
‹ Most of the “active” portfolio is still passively
managed, until the transition to active large cap
managers later in the year
‹ The Risk Management group has established a
quantitative review and oversight process of
active managers to complement the qualitative
oversight process of the Externally Managed
Investments group
‹ A risk model is a key element in this quantitative
analysis and control process
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NOTES
‹ The benchmark for aggregate of all managers is Russell
3000 Tobacco Free
‹ Risk factor exposures and risk estimates are based on actual
holdings as of quarter end using proprietary data and
analytics from Barra, Inc.
‹ Performance covers the period 4-1-2004 to 6-30-2004 (single
quarter, cumulative, not annualized)
‹ Performance attribution is based on month end holdings
using a buy-hold methodology; thus calculated returns will
differ slightly from official performance results
‹ Style factor exposures are expressed as % Standard
Deviation (annualized)
‹ Industry exposures are expressed in terms of percent
weights
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APPENDIX: MODEL RISK FACTORS
‹ US equity risk factors measure systematic
(common) risks shared by groups of securities;
divided into two types
‹ Style factors
„ 13 factors, measuring risks such as
‹Large vs. small capitalization
‹Value vs. growth styles
‹Volatility, momentum, trading activity
‹Leverage, exposure to foreign currency
‹ Industry factors
„ 54 Industries, grouped into 13 sectors as shown on graph
„ A security can have exposure to more than one industry
„ Based on segment sales, assets, and earnings
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APPENDIX: RISK MEASUREMENT
‹ First use of a risk model is to measure risk
exposures and contributions
‹ Then compare those measures to:
„ A benchmark, some pre-assigned limits, or qualitative
understanding of the portfolio’s strategy
‹ This is an important component of the total
investment oversight process
„ Includes both qualitative and quantitative analysis
‹ The value of a quantitative risk model:
‹ Contribution of a single position or sector to total
portfolio risk depends on more than just its size
„ Depends on the volatility of that position
„ Depends on its covariance with the rest of the portfolio
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APPENDIX: RISK BUDGETING
‹ Second use of a risk model is to aid in risk budgeting:
„ Allocation of risk in proportion to expectations for return
‹ Manager will take positions different from consensus
only if she has expectation to earn excess returns
‹ Size of the active position should depend on
„ Expected out-performance
„ Degree of confidence in one’s beliefs
„ Risk it contributes to the rest of the portfolio.
‹ Risk budgeting is the process of constructing a
portfolio so that each active weight should be sized
so that, at the margin, its contribution to expected
return is proportional to its contribution to risk
‹ Application: allocation to managers within asset class
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