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El Segundo, California 90245

310.297.1777 tel 310.297.0878 fax

www.wurts.com

Case Study – Alaska Permanent Fund Asset Allocation to Risk Allocation

October 2011

Jeffrey C. Scott, CFA Chief Investment Officer

P R O B L E M : M E A N - V A R I A N C E O P T I M I Z A T I O N

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Diversification?

Company Exposure Risk

Home Country Bias

Growth & Prosperity Economic Environment

Geography

Risk and Return Contribution

P R O B L E M

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Fat Left Tail Distribution

Normal Distribution

Markets exhibit larger drawdowns with greater frequency than normal distribution would suggest.

H O W D I D W E G O F R O M M O V E F R O M A S S E T A L L O C A T I O N T O R I S K A L L O C A T I O N ?

Education • Risk • Risk allocation • Recruited help

Governance • Principles • Philosophy • Policies

Implementation • Portfolio construction • Active risk budgeting • Oversight and

communication

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Model

Principal

Investment Income

Active Risk

Leverage

Commitment

Concentration

Liquidity Volatility

Real Estate

Interest Rate

Political

Credit

Company

Deflation Inflation

Spending Rule

Counterparty

Business Partner

Peer

Country

Currency

Turnover

Pricing

Asset Allocation

Refinancing

Headline Risk

Operational

Staff

Fiduciary

Sample List

Margin

Liabilities

T H E W O R L D O F R I S K S

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Derivatives

Culture

Alignment of Risk &

Objectives

Defining Boundaries

Communication Tool

Risk Response

Seizing Opportunities

Deployment of Capital

Not a System!

§  Risk is NOT just the standard deviation of returns!

§  Risk is first and foremost the risk of losing principal. At what point is the drawdown too deep?

§  Risk is failing to meet the

demands of the organization.

§  Risk is an unexpected negative event.

W H A T I S R I S K M A N A G E M E N T ?

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Passive Information reporting on aggregate risk

Defensive Controlling risk through limits

Active Managing risk through capital allocation

A P P L I C A T I O N S F O R R I S K M A N A G E M E N T

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A S S E T S C O N T A I N M U L T I P L E R I S K F A C T O R S

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Bonds for Safety? NOTE: Not all are created equal

Rates

Domestic

International

Emerging Markets

Curve

Duration

Liquidity

Country

Credit

Investment Grade

High Yield

Emerging Markets

Private

Curve

Duration

Liquidity

Country

Sector

Equity

Domestic

International

Emerging Markets

Private

Country

Value

Momentum

Sector

Size

Inflation

TIPS

Commodities

Private

Country

Curve

Duration

Liquidity

Currency

Developed

Emerging Market

Country

Carry

Primary Risk Factors

Secondary Risk Factors

Tertiary Risk Factors

R I S K F A C T O R B U I L D I N G B L O C K S

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A C T I V E R I S K B U D G E T I N G

Size §  Fear of regret vs fear of losing money §  Peer risk §  Reputational risk/career risk

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Superior Portfolio Construction

“True” Diversification § Risk factors § Geography § Manager § Economic sensitivity § Return contribution

Active Risk Budgeting

Managers with sound risk management philosophy Diversification of alpha risk factors

Tail Risk Hedging Opportunistically purchase relative inexpensive insurance Actively harvest gains

Who has the proven skill? §  Board §  Staff §  External Managers

Monitor & Oversee

Mission & Philosophy

Delegation of Authority

Policies •  Spending •  Asset Allocation •  Management •  Manager •  Compensation etc.

Education

Communication

Corrective Action

S O U N D G O V E R N A N C E I S T H E K E Y

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I N V E S T M E N T P R I N C I P L E S

Principles

Valuation

Risk

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Diversification

Security Selection

Manager Selection

Active Risk Budgeting

Risk Allocation

Risk Framework

I N V E S T M E N T P H I L O S O P H Y

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In the past… The Board focused on implementation, e.g. manager selection and termination

Today… The focus is on governance, risk tolerances, policies, processes and oversight

P O R T F O L I O C O N S T R U C T I O N

Diversification

• Economic sensitivity • Risk factors • Geography • Return contribution

Active Risk Budgeting

• Valuation assessment • Risk factor tilts • Opportunistic tail risk hedging • Manager allocations

Risk Assessment • Scenario • Stress • Relative risks

Implementation

• Smart cost-effective allocation to beta exposures

• Judicious allocation to alpha sources

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I M P L E M E N T A T I O N

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‘Liquid’ Beta & Alpha

Illiquid Beta & Alpha

Liquid Beta & Alpha

High Fees

Moderate Fees

Hedge Funds and Real Return Managers

Real Estate Infrastructure

Timber Agriculture

Energy

Private Equity

Distressed

Debt

Bank Loans

Mezzanine Debt

Rates Credit Equity Real

Assets Currency

K E Y T A K E - A W A Y S

•  Risk is more than standard deviation of returns

Risk Culture

•  “True” diversification

Risk Allocation not Asset Allocation

•  Preservation of capital in down markets

Dynamic Allocation by Proven Professionals

• Oversight and communication; not implementation

Governance & Policy Focused Board

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