INVESTMENT RISKMEASUREMENT AND
REPORTINGCommittee on Investments /
Investment Advisory CommitteeJanuary 7, 2003
Page 1January 7, 2003 Regents COI / IAC Meeting
CONTENTS
Introduction to Investment RiskIntroduction to Investment RiskOrganizationRisk PolicyMeasuring RiskPreliminary ResultsNext Steps
Page 2January 7, 2003 Regents COI / IAC Meeting
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
Page 3January 7, 2003 Regents COI / IAC Meeting
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
Page 4January 7, 2003 Regents COI / IAC Meeting
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
Page 5January 7, 2003 Regents COI / IAC Meeting
CONTENTS
Introduction to Investment RiskOrganization Organization Risk PolicyMeasuring RiskPreliminary ResultsNext Steps
Page 6January 7, 2003 Regents COI / IAC Meeting
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
Page 7January 7, 2003 Regents COI / IAC Meeting
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
Page 8January 7, 2003 Regents COI / IAC Meeting
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
Page 9January 7, 2003 Regents COI / IAC Meeting
CONTENTS
Introduction to Investment RiskOrganizationRisk PolicyRisk PolicyMeasuring RiskPreliminary ResultsNext Steps
Page 10January 7, 2003 Regents COI / IAC Meeting
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
Page 11January 7, 2003 Regents COI / IAC Meeting
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
Page 12January 7, 2003 Regents COI / IAC Meeting
CONTENTS
Introduction to Investment RiskOrganizationRisk PolicyMeasuring RiskMeasuring RiskPreliminary ResultsNext Steps
Page 13January 7, 2003 Regents COI / IAC Meeting
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
Page 14January 7, 2003 Regents COI / IAC Meeting
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
Page 15January 7, 2003 Regents COI / IAC Meeting
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
Page 16January 7, 2003 Regents COI / IAC Meeting
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
Page 17January 7, 2003 Regents COI / IAC Meeting
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
Page 18January 7, 2003 Regents COI / IAC Meeting
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)
Page 19January 7, 2003 Regents COI / IAC Meeting
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 $)
Page 20January 7, 2003 Regents COI / IAC Meeting
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
Page 21January 7, 2003 Regents COI / IAC Meeting
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
Page 22January 7, 2003 Regents COI / IAC Meeting
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
Page 23January 7, 2003 Regents COI / IAC Meeting
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
Page 24January 7, 2003 Regents COI / IAC Meeting
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
Page 25January 7, 2003 Regents COI / IAC Meeting
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)
Page 26January 7, 2003 Regents COI / IAC Meeting
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”)
Page 27January 7, 2003 Regents COI / IAC Meeting
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)
Page 28January 7, 2003 Regents COI / IAC Meeting
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
Page 29January 7, 2003 Regents COI / IAC Meeting
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
Page 30January 7, 2003 Regents COI / IAC Meeting
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
Internal Equity Internal Bonds
Page 31January 7, 2003 Regents COI / IAC Meeting
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
Internal Equity Internal Bonds
“Information Ratio” = Active return (above benchmark) ÷ active risk
Page 32January 7, 2003 Regents COI / IAC Meeting
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
Page 33January 7, 2003 Regents COI / IAC Meeting
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
Page 34January 7, 2003 Regents COI / IAC Meeting
CONTENTS
Introduction to Investment RiskOrganizationRisk PolicyMeasuring RiskPreliminary ResultsNext StepsNext Steps
Page 35January 7, 2003 Regents COI / IAC Meeting
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