OPTICS – Advanced Portfolio Construction System*

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* Adopted by CalPERS to assist with managing risk across its hedge fund and equity programs.

Liability funding has generally been based on the view that while market behaviour is largely unpredictable, there is a reliably positive relationship between expected return and risk. As a result, many funding programmes have adopted a policy of retaining a more or less static allocation across a range of asset classes, beginning with traditional assets and extending the programme to bring in additional sources of uncorrelated return. Hedge fund ‘alpha’ has been seen as one such source, and as a result hedge funds have become an established part of many institutional portfolios.

The events of 2008 have led many investors to question the world-view that underpins this approach to funding. When equities crashed, hitherto uncorrelated hedge funds also failed, precisely when they were needed most. For correlation, just as for performance, the past turned out to be an inadequate guide to the future. And that has profound implications for risk management.

Once we accept that correlations can change, the question of how best to manage risk shifts from being a matter of finding uncorrelated assets – to understanding the specific circumstances in which an investment programme might fail. We might express it as shifting the focus towards understanding the dynamics of correlation, but it is more accurate to say that correlation, other than in the broad sense of return similarity, is not the critical determinant of diversification. It is easy to find examples of assets with no statistical correlation that fail to diversify each other.

We believe that an effective investment programme must deal with market conditions as they really are, and not follow the prescriptions of idealised and simplistic theoretical models that entirely fail to capture the periodic upheavals and occasional violence of real market moves. A pragmatic approach to risk management must start from a real-world understanding of the behaviour of the assets that make up the programme, across the range of conditions the portfolio might encounter. Hedge funds, as a case in point, are not a new asset class; they are adaptive strategies, that in some circumstances may be profoundly affected by market events. Their value derives mainly from their ability to adapt to new conditions, so if they are to be included in an investment programme, we must understand the nature and scope of their response to change.

This is why we created OPTICS – an advanced risk management and portfolio construction system that gives professional investors the ability to build a totally customised portfolio to meet their specific requirements in terms of risk, return and other investment preferences, taking account of the range of market conditions the portfolio may encounter.

Introduction

“OPTICS features a powerful

range of analytics that can

evaluate an investor’s entire

portfolio in relation to its

objectives. We can assess the

likelihood that a portfolio will

perform in both positive and

difficult environments, and

then work with you to design an effective portfolio

that can integrate hedge funds alongside your current

investments in a way that best meets your needs.”

Nick Macleod Investment Solutions

OPTICS - key points:

• Creates customised portfolios to meet specified objectives across a range of market environments

• Handles conventional assets and alternatives

• Integrates specialised (qualitative) hedge fund knowledge

• Focuses on forward-looking estimates, not past returns

• Fully transparent construction process

• Allows active client participation at every stage

Dynamic Markets: Environmental Shift

Cum

ulat

ive

Ret

urn

Building portfolios for the Real World

Many funding schemes operated by insurance companies and pension funds rely on the assumption that investments will achieve known ‘long run average rates of return’ over the life of the investment programme. In effect, they employ time as the primary means of risk management.

We believe this view seriously underestimates the dynamic nature of financial markets.

Changes in market conditions are not mere fluctuations in a stable long-run return distribution; they are genuine shifts in the environment whose persistence can disrupt convergence towards long-term average returns and lead to serious funding issues.

In our view, relying on the long run (and thereby failing to acknowledge the reality of shifts in the economic and financial environment) is not an effective way of managing the risk associated with a liability funding programme. To succeed, you need to manage risk in the near-term, and think about return in the long-term - not the other way around.

We think the way forward for many investment programmes lies in ‘risk-managed’ assets. When we say ‘risk-managed’ assets, we mean investments (such as certain hedge funds) that can adapt to changes in market environment.

While it is extremely difficult to predict a change in the market environment, it is certainly possible to build hedge fund portfolios that can adapt to the range of market conditions they may encounter over an extended funding period. And since changes in the environment tend to be persistent, it is possible to detect changes and react to them in time to control losses.

The OPTICS system recognises this and takes a pragmatic “real world” approach to portfolio and risk management, reflecting the way that experience tells us markets do behave, rather than merely how they should behave. It provides a framework within which investment professionals can deploy their expertise without invoking theories of investor behaviour, without requiring specialist mathematical knowledge, and without relying on statistical measures drawn from the past.

“The cosy theoretical

world in which average

returns converge convincingly on their long-term

values over a 10 to 30 year funding period is an

illusion. Instead, the real world is much more dynamic

where the long term is composed of a sequence of

distinct and persistent short-term environments.”

Nick Macleod Investment Solutions

Guiding principles:

• Failure to take account of market dynamics leads to systematic and serious underestimation of risk

• Low correlation between investments does not guarantee effective diversification

• Reliance on long run averages can lead to failure in the near term

Dynamic markets: Environmental shift

0

0.5

-0.95 -0.65 -0.35 -0.05 0.25 0.55 0.85

1

1.5

2.5

1.5

2

2.5

3

Environment A

Environment B

Long-run average

Source: Bloomberg, Ermitage

OPTICS portfolio inputs

In contrast with many commercial systems (and in house tools) which place great emphasis on historical statistics, OPTICS is driven by a rational forward-looking return forecast structure.

The process begins by agreeing each portfolio’s objectives, in terms of:

• Risk-return profile

• Geographic specialisation

• Concentration on / or avoidance of certain strategies

• Other constraints and preferences (e.g. manager liquidity etc)

OPTICS accesses our complete knowledge base:

• Our proprietary database (‘LEWIS’) covers over 5400 hedge funds, includes meeting notes on 2500 funds, and comprehensive reports on over 80 approved funds.

• Analysts’ direct and detailed knowledge of managers and strategies, obtained through face-to-face meetings, regular telephone conversations etc.

• Macro-economic outlook across a range of environments, driven by bottom-up manager / analyst insights, coupled with a broader top-down perspective.

• Overall Hedge Fund strategy forecasts (reflecting macro-economic outlook).

• Individual Hedge Fund forecasts

OPTICS incorporates proprietary statistical software specifically designed to accommodate the special features of hedge funds and to distinguish between significant and non-significant features of past performance.

Advanced proprietary algorithms within OPTICS use the forecasts to identify portfolios with a high probability of meeting the client’s stated return objectives across a range of plausible market environments.

Forecast driven approach for each fund and market factor across multiple scenarios.

Initial Portfolio to Final Portfolio

Once we have confirmed the portfolio objectives with the client, we begin by specifying a range of plausible economic environments that we expect the portfolio to be able to cope with. The main stages in this process are:

• Assessing the range of market conditions the portfolio may encounter.

• Boiling them down to a small number of model scenarios.

• Expressing the scenarios in terms of return to various market factors.

• Modelling the behaviour of the candidate funds in each environment, thereby creating a forecast for each fund in each scenario.

• Translating the individual fund forecasts into portfolios that have a high probability of achieving their objectives in each of the scenarios, without taking on undue risk, taking proper account of limitations on liquidity, etc.

Our model scenarios currently range from double dip, through low growth to full-blown recovery. The scenarios are expressed in terms of returns to influential market and strategy factors. A difficult environment for equities, for example, might be expressed as an expected annualised return for MSCI World of -20%, accompanied by 25% annualised volatility.

The next step is to create forecasts for individual funds in each of the scenarios. The forecasts reflect each fund’s degree of dependence on whatever factors influence their returns in each environment coupled with an assessment of their ability to add an idiosyncratic return.

Once we have forecasts for each fund in each scenario, we translate them into portfolios that have a high probability of meeting specified objectives across the whole range of model environments. The first step uses proprietary algorithms to create a suitable portfolio structure; that portfolio, referred to as the Initial Portfolio, is then modified to take account of practical considerations and other factors that lie outside the model inputs. These can include simplification of portfolio structure, stress-testing in alternative scenarios, recognition of particular circumstances at individual funds, and so on. Each step in the transition from the Initial Portfolio to the Final Portfolio is fully documented.

Once we have agreed the Final Portfolio, the forecasts for each constituent fund serve as real-world benchmarks for performance. In other words, we know exactly what each fund’s role in the portfolio is, and as a result we are quick to spot when a fund is not performing to expectations, even when the overall portfolio is. This greatly simplifies and clarifies portfolio monitoring and risk management.

Each stage of the process is entirely transparent and reviewed each month to ensure that the underlying funds are performing according to expectations, that position sizes remain within set limits, and that portfolio structure is consistent with objectives.

1 2 3 4

OPTICS summary

For investors who allocate over $50m to hedge funds, our advanced OPTICS system provides the opportunity to:

a) Evaluate an existing portfolio in terms of its ability to meet objectives

b) Create a customised portfolio of hedge funds to meet your specific requirements with respect to risk, return and other specified constraints and preferences.

c) Ensure an effective fit with your pre-existing range of investments and overall portfolio objectives.

OPTICS designed bespoke portfolios offer many potential benefits:

• Risk-managed performance across a range of market conditions – We build portfolios across multiple market scenarios, allowing for the fact that markets may change course, sometimes dramatically and often unexpectedly.

• Control – Clients dictate the investment mandate in terms of included or excluded strategies, liquidity, risk/return targets, etc. This is particularly helpful if the portfolio is used as an ‘adaptive’ mandate to help achieve long term objectives, without having to accommodate other shareholders (as required with co-mingled funds).

• Transparency – Our ‘glass box’ approach means that clients have access to our comprehensive qualitative and operational due diligence research which provides greater peace of mind in terms of risk management.

• Custody – Solutions can be delivered through a wide range of legal vehicles such as LLP’s, managed accounts and offshore funds. Clients specify the structure, with no other external shareholders.

• Customised reporting – OPTICS provides a clear, repeatable, disciplined and transparent portfolio decision making framework based on consistency between beliefs, objectives and actions. It establishes a basis for proper accountability to Boards of Trustees and similar bodies.

• Partnership culture – Direct access to our investment seniors.

Examples of requested objectives

European Multi Strategy portfolio Designed for Pension Fund

• Beta: < 25% to MSCI Europe

• Volatility target: < 50% MSCI AC Europe Index

• Return target: Merrill Lynch 1 Year Treasury Note +5%

CTA Portfolio Designed for Family Office

• Return target: 15 – 20%

• Strategy: Commodity Trading Advisors

• Constraints: High concentration (< 7 managers)

Global Market Neutral Portfolio Designed for Pension Fund

• Return target: Eurobor +3% to 5%

• Volatility target: 4% to 6%

• Constraints: c25 managers, 5 year min. track record

Global Long Volatility Portfolio Designed for Pension Fund

• Return target: +12% to 15% in volatile period (cash otherwise)

• Strategy: Managers that perform when volatility spikes

• Constraints: No meaningful correlation with MSCI World

Contact us

Ermitage Asset Management Jersey Limited (“EAMJL”; “Ermitage”) is registered

with the Jersey Financial Services Commission for the conduct of investment

business and fund services business and with the U.S. Securities and Exchange

Commission as an investment adviser. Ermitage UK Limited is authorised by the

Financial Services Authority. Ermitage is a wholly owned subsidiary of Nexar

Capital Group SCA (“Nexar Capital Group”). Other subsidiaries in the Nexar Capital

Group include: (i) Nexar Capital S.A.S., approved by the Autorité des Marchés

Financiers (AMF) for managing single strategy funds; (ii) Nexar Capital LLC,

registered with the Securities and Exchange Commission (SEC) as an Investment

Advisor; (iii) Nexar Trading LLC, registered with the Commodity Futures Trading

Commission (CFTC) as a Commodity Trading Advisor; (iv) AAAm S.A., authorized

by the AMF for managing funds of funds; and (v) Nexar Fund Management

(Ireland) Limited, authorized as a Non-UCITS management company by the

Central Bank of Ireland. Ermitage has issued this publication which is for private

circulation only, is published solely for information purposes and does not

constitute an offer to sell or an invitation to buy any of the securities or funds

mentioned herein. This document is only intended for distribution to persons

permitted to receive it by s.238 of the Financial Services and Markets Act 2000

(the “Act”) or by applicable legislation in other relevant jurisdictions. None of the

funds described herein are regulated under the Act, and for such funds protections

provided by the UK regulatory system do not apply, nor are the benefits available

under the Financial Services Compensation Scheme. Ermitage has relied on

external information providers and/or included estimates in the report and accepts

no responsibility for its accuracy, nor the reasonableness of the conclusions based

upon such information. The contents of this document are subject to change

without prior notification. Past performance is not a guarantee of future

performance. The price of units or shares can go down as well as up and may be

affected by changes in rates of exchange. An investor may not receive back the

amount invested.

Lindsay Bateman | lbateman@ermitagegroup.comExecutive Director – Business Development | +44 (0)1534 615 544

Antoine Prudent | antoine.prudent@nexarcap.com Global Head of Product & Business Development | +33 (0) 1 75 77 80 90

Ermitage Asset Management Jersey Limited 47 The Esplanade, St Helier, Jersey, Channel Islands JE1 9LB | +44 (0) 1534 615500

Nexar Capital Group 127 Avenue des Champs Elysées, 75008 Paris, France | +33 (0) 1 75 77 18 30

info@ermitagegroup.com | NexarEUInvestorServices@nexarcap.com | www.ermitagegroup.com