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CONCLUDING REMARKS Some thoughts on future research 1 Frank J. Fabozzi Professor of Finance, EDHEC Business School Member, EDHEC-Risk Institute I benefitted from discussions with several individuals in the asset management industry in preparing these remarks EDHEC-Princeton Conference New-York City, April 3rd, 2013
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CONCLUDING REMARKSSome thoughts on future research

1

Frank J. Fabozzi

Professor of Finance, EDHEC Business SchoolMember, EDHEC-Risk Institute

I benefitted from discussions with several individuals in the asset management industry in preparing these remarks

EDHEC-Princeton ConferenceNew-York City, April 3rd, 2013

FUTURE OF FINANCE: CFA INSTITUTE PROJECT

Recent project :“a long-term global effort to shape a trustworthy, forward-thinking

financial industry that better serves society.”

Advisory Council Chair John Kay an economist who is both a professor of finance (LSE) and a Financial Times columnist --a critic of how economics is taught

He stated: “This project is designed to engage professionals and investors in

and outside of finance to help solve problems with the global financial system. “

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FUTURE OF FINANCE: CFA INSTITUTE PROJECT

Six primary topics of interest including

1.putting investors first; 2. safeguarding the system3. retirement security;4. financial knowledge5. regulation and enforcement6. transparency and fairness.

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1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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WHAT DO YOU KNOW ABOUT THESE “VENTURE CAPITAL FIRMS” (ALTERNATIVE ASSETS)

•BURFORD CAPITAL •JURIDICA CAPITAL MANAGEMENT•BENTHAM CAPITAL•BLACKROBE CAPITAL•FULBROOK MANAGEMENT•PARABELLUM CAPITAL

ARE THESE FIRMS IN A GROWTH BUSINESS?

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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HERE IS WHAT THEY DO:THEY ARE LITIGATION FINANCING FIRMS.

LITIGATION FINANCE ACCORDING TO BURFORD CAPITAL:

“The term litigation finance generally refers to any transaction where the value of a litigation claim is used to obtain financing. In its simplest form –so-called litigation funding – a provider of finance covers the expenses of bringing a legal proceeding in exchange for a return tied to the outcome of the case (such as a portion of damages).

Litigation finance unlocks the often-substantial value buried in unresolved litigation claims, and creates a new asset class out of disputes, which were historically the largest assets on the corporate balance sheet without financing options.”

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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SHORT PERFORMANCE HISTORY:

•BURFORD $300 MILLION AUM: TENFOLD RISE IN PROFIT IN 2011 IN SECOND FULL YEAR OF OPERATION

•JURIDICA CAPITAL MANAGEMENT $200 AUM: SEVENFOLD RISE IN 2011 PROFIT

WHO ARE THE INVESTORS? MAJOR INSTITUTIONAL INVESTORS

DEPSITE THE DESCRIPTION, NOT INTENDED TO PITCH THIS AS AN ALTERNATIVE ASSET CLASS

RATHER TO BE AWARE OF HOW WELL FUNDED LITIGATION AGAINST ASSET MANAGEMENT FIRMS BROUGHT BY CLIENTS WILL BE IN THE FUTURE

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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VOLATILE MARKETS HAVE CALLED FOR GREATER GOVERNNANCE OVERSIGHTS AT ASSET MANAGEMENT FIRMS

NOT JUST MARKET-DRIVEN BUT RESULT OF SEC REGULATION (CLOSER SEC SCRUTINY)

THIS HAS MEANT GREATER SCRUTINY OF•RISK MANAGEMENT SYSTEMS•COMPLIANCE AND CONTROLS

CLIENTS AND REGULATORS WANT GREATER TRANSPARENCY AND ARE EXPECTING GREATER ACCOUNTABILITY BY DIRECTORS, AUDIT COMMITTEES, AND FIRM EXECUTIVES

MUCH MORE THOUGHT IN ASSET MANAGEMENT FIRMS MUST NOW BE GIVEN TO ORGANIZATIONAL STRUCTURE, AND GREATER EXPERTISE REQUIRED BY DIRECTORS/TRUSTEES

SEC HAS CREATED A SPECIALIZED UNIT TO INVESTIGATE ISSUES SUCH AS COMPLIANCE. SEC WANTS A ROBUST GOVERNNANCE PROCESS AND COMPLIANCE PROGRAM THAT MUST BE RIGOROUSLY TESTED.

1.INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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THE SEC’S NATIONAL EXAMINATION PROGRAM (“NEP”) [OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS] PUBLISHED ITS “EXAMINATION OF PRIORITIES FOR 2013] IN FEBURARY 2013

FOLLOWING FROM THAT REPORT:

“Corporate Governance and Enterprise Risk Management. The NEP will continue to meet with senior management and boards of entities registered with the Commission and their affiliates to discuss enterprise risk, and in particular, how a firm govern and manage financial, legal, compliance, operational, and reputational risks. This initiative is designed to: (i) understand firms’ approach to enterprise risk management; (ii) evaluate firms’ tone at the top; and (iii) initiate a dialogue on key risks and regulatory requirements. This effort provides the NEP with an opportunity to assess overall risk management at certain registrants through discussions with independent board members, senior management, internal audit, key risk and control functions, and leaders of business lines. It is also designed to better inform our examinations of such firms, as well as other registrants. The staff will also continue to engage in “discovery” reviews to inform both examination policy and rulemaking efforts and joint monitoring efforts with other regulators. For example, the Commission has joined the Federal Reserve in monitoring reform of tri-party repurchase agreements and practices. In addition, last fall Hurricane Sandy brought to light certain gaps in some registrants’ business continuity plans. The staff is identifying the overall impact of the hurricane on certain entities’ operations, including the obstacles they confronted when implementing their business continuity plans.”

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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A KEY PHRASE IN THE QUOTE IS “TONE AT THE TOP”. AS STATED IN THE PUBLICATION: “Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination. The staff will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.”

•ALSO RELATED TO GOVERNANCE ARE CONFLICTS OF INTEREST RELATED TO (1) COMPENATION ARRANGEMENTS AND (2) ALLOCATION OF INVESTMENT OPPORTUNITIES

•TECHNOLOGY: THE ENTIRE GOVERNANCE PROCESS REQUIRES TECHNOLOGY AT NOT THE FRONT END BUT THE BACK END. HENCE ANOTHER AREA OF EXAMINATION IS ON TECHNOLOGYTHIS BECOMES PARTICULARLY IMPORTANT WHEN AN ASSET MANAGEMENT FIRM HAS CLIENTS IN MULTIPLE JURISDICATIONS, PARTICULARLY WITH RESPECT TO TAX REPORTING

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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SAME PROBLEMS IN EUROPEAN OPERATIONS

THE EUROPEAN COMMISSION REGULATIONS DEALINGS WITH GOVERNANCE FOR FINANCIAL INSTITUTIONS.

FOCUS INCLUDES •RISK MANAGEMENT, • POTENTIAL CONFLICTS OF INTEREST • EXTERNAL AUDITORS•BOARD RESPONSIBILITIES•COMPENSATION

1. INVESTMENT RISK GOVERNANCE AND FIDUCIARY OVERSIGHT

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THE BOTTOM LINE: REQUIREMENTS FOR SATISFYING REGULATORY REQUIREMENTS WILL BE COSTLY

ESTIMATES OF THESE COSTS ARE NEEDED

ONE MIGHT EXPECT THAT THESE COSTS CAN BE REDUCED ON PER ASSET BASIS AS FIRMS GROW. HOWEVER, AS FIRMS GROW INTRODUCING NEW COMPLEX PRODUCTS AND CUSTOMIZED SOLUTIONS, THE RISK OF CONFLICTS OF INTEREST INCREASE AND THE COST OF MONITORING MAY NOT BE LINEAR.

WHILE BUSINESS MODELS OF ASSET MANAGEMENT FIRMS SEEK TO DRIVE DOWN COSTS TO REDUCE FEES AND STILL REALIZE TARGET PROFIT MARGINS, A STUDY OF REGULATORY COSTS ARE NEEDED. WILL THE NET IMPACT INCREASE MANAGEMENT FEES?

GIVEN THESE COST DRIVERS, HOW DOES THIS IMPACT THE ISSUE OF ECONOMIES OF SCALE AND SCOPE IN ASSET MANAGEMENT (40 ACT FUNDS WITH 15(C) ANNUAL REVIEWS)

2. LIQUIDITY

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RESEARCH NEEDED ON THE MARKET VALUE OF LIQUIDITY AND LIQUIDITY RISK FOR DIFFERENT ASSET CLASSES

• HOW SHOULD IT BE MEASURED?Bid/ask spreadMarket depthMarket impact/pricing spilloversTime required to complete an order

•HOW DO THE ALTERNATIVE MEASURES PERFORM?Data limitationsBarclays Liquidity Cost Scores (LCS) in bond area

•WHAT ARE THE DRIVERS?Market sentimentCapital liquidity intensity of market makingAvailability/cost of hedging with derivatives if availableRegulatory changes such as (1) the closing of prop trading desks (Volcker rule) and (2) potential impact of any regulations covering high frequency trading.

2. LIQUIDITY

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•HOW DOES ONE MEASURE THE SHOCKS TO LIQUIDITY?

Historical experiencesCorrelations with other shocks (e.g. to spreads)Fire sales during crisis periodsCorrelation between asset classes

•HOW DOES LIQUIDITY RISK GET INCORPORATED INTO PORTFOLIO MODELS?

Example: Barclays has shown how to incorporate LCS into a tail-risk model such as VaR.

2. LIQUIDITY

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•VALUE OF LIQUIDITY/CORRELATION WITH EVENTS "OUTSIDE" THE PORTFOLIO

E.g.: liquidity is more valuable during periods of high redemptions/outflows

Part of the "alpha" contained in the return for illiquid assets such as alternative assets is a premium for accepting liquidity risk.

Example of research in fixed income markets: Fontaine and Garcia (“Bond Liquidity Premia” in RFS) – Tracking the linkages of funding liquidity to the shadow banking sector, a large non-bank component of the financial intermediation system that relies heavily on short-term funding to finance long-lived illiquid assets, they document the price-quantity relationship between the value of liquidity and the quantity of funding liquidity supplied by shadow banks.

3. Portfolio Management and Strategies

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BENCHMARK SELECTION

• RECOGNITION OF NEED TO WORK WITH CLIENTS TO DETERMINE A SUITABLE BENCHMARK AND THAT THE STANDARD MARKET BENCHMARKS DO NOT ACCOMPLISH INVESTMENT OBJECTIVES

• CREATION OF MORE EFFICIENT BENCHMARKS AND THE NEED FOR CUSTOMIZATION OF BENCHMARKS

E.g. Smart Beta

•CREATION OF CUSTOMIZED LIABILITY-BASED BENCHMARKS

•EXPANDING THE NOTION OF CUSTOMIZED BENCHMARKS TO INCLUDE A FIRM/ENTITY PERSPECTIVE

E.G. DEFINED BENEFITS PLANS MINIMIZING EXPOSURE TO OWN INDUSTRY RISKS

E.G. PBGC CREATING BENCHMARKS TO AVOID EMBEDDED RISK OF INDUSTRIES/SECTORS AND USE OF DERIVATIVE PRODUCTS TO ALTER INDUSTRY EXPOSURE

3. Portfolio Management and Strategies

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ALTERNATIVE RISK AND RISK/REWARD MEASURES

• TRADITIONAL PORTFOLIO THEORY FOCUSES ON RISK MEASURES IN TERMS OF VOLATILITY AND RISK/REWARD MEASURES SHARPE/INFORMATION RATIOS

•GREATER RECOGNITION OF THE NEED TO IMPROVE RISK MEASURES

•REGULATORS HAVE SUGGESTED VaR (VALUE AT RISK) BUT ITS LIMITATIONS ARE WELL KNOWN

•FOCUS ON TAIL RISK AND INCORPORATION OF TAIL RISK ANALYTICS INTO CURRENT REPORTING SYSTEMS AND MODELS

3. Portfolio Management and Strategies

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TAIL RISK (E.G. FINANCIAL CRISIS, EURO AREA COLLAPSE, WAR IN MIDDLE EAST, REGIME CHANGE IN CHINA) WILL BE A MAJOR THEME IN FUTURE RESEARCH

THERE IS A BODY OF LITERATURE THAT CAN BE DRAWN UPON: EXTREME VALUE THEORY

BEYOND JUST MEASUREMENT THERE WILL BE ISSUES SUCH AS

•WHAT ARE TAILS RISKS REALLY WORTH?

•ARE THERE WAYS TO MITIGATE TAIL RISK?

•HOW DO TAIL RISKS FIT INTO AN ASSET ALLOCATION FRAMEWORK?

•HOW CAN ONE QUANTIFY THE IMPACT OF TAIL RISK SCENARIOS: SCENARIO SPECIFICATION?

•IS THERE A USEFUL DISTINCTION BETWEEN LOW-PROBABILITY TAIL SCENARIOS (E.G. WAR) VERSUS UNANTICIPATED-BUT-INEVITABLE SCENARIOS (E.G. BUBBLE BURSTING)?

•WHAT HAPPENS TO CORRELATIONS IN A TAIL RISK SCENARIO?

3. Portfolio Management and Strategies

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PERFORMANCE EVALUATION

• LINKED TO ISSUE OF BENCHMARKS

•HOW USEFUL ARE THE TRADITIONAL SINGLE MEASURES SUCH AS SHARPE RATIO AND INFORMATION RATIO IN ASSESSING PERFORMANCE

•INCREASED EMPHASIS ON RETURN ATTRIBUTION MODELS

•BETTER MODELS THAT TAKE INTO ACCOUNT THE USE OF DERIVATIVES TO EVALUATE, FOR EXAMPLE, OPTION STRATEGIES

•BETTER MODELS FOR EVALUATING PERFORMANCE OF SPECIFIC ALTERNATIVE ASSETS SUCH AS HEDGE FUND (E.G., GARCIA PAPER ON ROBUST ASSESSMENT OF HEDGE FUND PERFORMANCE)

•SHOULD THERE BE STANDARDIZED PRESENTATIONS OF RETURN ATTRIBUTION PERFORMANCE BEYOND THE CFA/AMIR GLOBAL INVESTMENT PERFORMANCE STANDARDS (GIPS) TO ALLOW A BETTER MEASURE OF PERFORMANCE THAN CURRENT PRACTICE OF USING PEER GROUPS?

3. Portfolio Management and Strategies

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ASSET ALLOCATION PARADIGMS

FURTHER TESTING OF ASSET ALLOCATION MODELS THAT HAVE BEEN PROPOSED:

•Traditional asset-based approach versus risk-based approach

•And relative performance of risk-based approachesRisk parity approach versus risk-factor (risk-premia) approach versus Factor-risk parity

FURTHER RESEARCH ATTACKING THE 60-40 APPROACH AND ITS LIMITATIONS

IMPROVING MODELING USING ROBUST PORTFOLIO OPTIMIZATION AND THE RISK ATTRIBUTES OF PORTFOLIOS CONSTRUCTED WITH SUCH MODELS

EDUCATION, EDUCATION, EDUCATION

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INVESTORS

NAÏVE TO THINK THAT INVESTORS WILL UNDERSTAND INVESTMENT ATTRIBUTES AND STRATEGY RISK WITHOUT AN EDUCATIONAL FOUNDATION.

HIGH SCHOOL: FUNDAMENTAL PRINCIPLES OF MONEY MANAGEMENT SHOULD BEGIN AT THE HIGH SCHOOL LEVEL TAUGHT BY QUALIFIED TEACHERS

•PUSH NEEDED BY INDUSTRY FOR SUCH CLASSES. INDUSTRY CAN HELP BY PRODUCING ON-LINE TEXTBOOK MATERIAL

COLLEGE: COURSE ON PERSONAL FINANCE WHICH WAS AT ONE TIME PART OF FINANCE CURRICULUM SHOULD BE REQUIRED. NO ARM TWISTING, JUST A SMART MOVE

EDUCATION, EDUCATION, EDUCATION

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DIRECTORS/TRUSTEES

HIGH LEVEL OF SCREENING FOR DIRECTORS AND TRUSTEES BY SPECIALIZED HEADHUNTING FIRMS

YET, FOR THOSE HIGHLY CAPABLE INDIVIDUALS NOT TRAINED IN FINANCIAL MARKETS AND ASSET MANAGEMENT, THERE ARE CONCEPTS AND MARKET MECHANISMS THAT MUST BE TAUGHT

BOARDS UNFAMILIAR WITH FINANCIAL PRODUCTS AND RISK MANAGEMENT OFTEN GET SWAYED BY THE POPULAR PRESS


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