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1. abcd Active Management or the Equity Risk Premium:Place Your Bets Investment Risk Working Party Finance and investment Conference 22-24 June 2003

2. A Perfect Storm? • Market-based valuations • Weak equity markets • Greater trustee accountability • Media highlighting pension disasters

3. Increased focus on investment risk ‘The focus of consulting actuaries used to be on how to maximise the long-run investment returns of pension funds and reduce costs to the sponsoring companies. Now the emphasis has shifted to the measurement and management of short-term solvency problems and the protection of beneficiaries.’ Barry Riley, Financial News 5th May ‘The attention devoted to asset allocation decisions should fully reflect the contribution they can make to achieving the fund’s investment objective’. ‘Where they believe active management to have the potential to achieve higher returns, funds should set both targets and risk controls which reflect this, allowing sufficient freedom for genuinely active management to occur’. Recommendations of Myners report, 2000

4. Overview • Merits of strategic and active risk • Rationale for current split • Tailoring the split of risk • “Unconstrained” mandates

5. Background definitions • Investment Risk • Minimum Risk Position • Strategic/Market Risk • Active Risk

6. Market risk versus active risk • Positive equity risk premium implies risk likely to be rewarded over the long-term • Zero-sum game but… • … pension funds may have advantage in accessing “alpha” • … risk-return trade-off superior if skilful managers can be identified • Cost between 20 and 200 basis points depending on size and nature of fund (i.e. higher for long-short) • Costs of up to about 10 basis points (based on passive investing)

7. Risk return trade-off: Market risk only EXPECTED RETURN STRATEGY TOOL KIT change market risk pursue active management

8. Risk return trade-off: Typical pension fund Currently over 90% of expected total risk is spent capturing the market risk premium while less than 10% is allocated to capturing active returns EXPECTED RETURN

9. Why does market risk swamp active risk? • Lower return expectations for active risk • Diversification of active risk • Unintentionally high market risk • Regret aversion/herding • Myopic loss aversion resulting in index-hugging

10. Risk return trade-off: Optimal Split An optimal implementation of this strategy will allocate your total risk budgetbased on your expected risk-return (IR) of selected active investment strategiesand your expected risk-return (Sharpe ratio) of asset classes from your strategic asset allocation analysis EXPECTED RETURN

11. Diversification Benefits • Even small levels of alpha highly valued • A typical fund should increase active risk if believe net IR > 0.06 • Even greater benefits if multiple skilled managers can be found

12. Tailoring the split of risk • Passive investing to gain pure market exposure • Market-neutral to gain pure active exposure: • Portable alpha: • Based on proven long-only strategy • Long-short • Can efficiently gear alpha • Investor comfort?

13. Place Your Bets • If the trustees believes in active management: • Should increase active risk as proportion of total • … but regret risk high • … limited ability to gear alpha without long-short • Strong conviction needed to break away from the herd

14. Unconstrained mandates • Focus on long-term • Less turnover • Index weightings ignored • Genuine active management

15. Unconstrained mandates - grey areas • Market-neutral / Equity-based / Manager discretion? • Measure of success and risk? • Performance fees? • Activism? • Can trustees withstand significant short-term poor performance? • Another working party? To be continued…..