Governance, Transparency and Good Portfolio Management with Internet-based Tools

1. Governance, Transparency and Good Portfolio Management with Internet-based Tools Dr. Arun Muralidhar www.mcubeit.com

2. Outline • Keys to Effective Portfolio Management: 5 Key Steps • Good Process Overcomes Challenges in Managing Funds • Technology Challenges: Where Web Applications Help • Using Web-based Technologies Effectively – Demo • Structuring portfolios; understanding risks; converting risks into higher returns; using attribution to improve decisions • Using the Internet to Empower Investors • Summary and Conclusions

3. Who Benefits from This Presentation? • Country pension funds • Central banks • Funds-for-the-future (e.g., funds to preserve wealth from the extraction and sale of commodities) • Liability management organizations IT Departments: Help make front and middle office effective

4. 1. Key to Success – Effective Decisions Set Objectives Determine Benchmark Outperform Benchmark Evaluate Performance Measure Risk Annual Monthly Monthly Daily • Goodmanagement = must make many decisions well • Must make these decisions in an informed manner • Process, transparency and governance are critical • Challenge: Can technology integrate front & back office?

5. Asset- Liability Risk Manager/ Active Risk Tactical & Benchmark Risk Responsibility Board of Governors Internal Staff Outside Managers Responsibility Monitor Annually Daily/Monthly Monthly Decision Frequency Manage Strategic Decisions – Need Good Reporting Effective Investment Decisions – Need IT Support How to Manage the Risk Manager Selection Decisions – Good Reporting 1. Many Share Responsibility for a Fund Need good technology to track and manage all decisions

6. Asset Allocation Sector/ Regional Style Selection Manager Selection 1. Portfolio =Many Decisions P o r t f o l i o Bonds = 40% Cash/ Currency = 20% Equity = 40% By Market (Local, US etc.) By Market (Local, US, Euro) Bank 1 for Deposits Bank 2 for Deposits Large Stocks/ Small Stocks Govt./Agency etc. Mgr D Mgr E Mgr F Mgr A Mgr B Mgr C

7. 2. Challenges in Managing Portfolios • Manage ongoing cash inflows and outflows • Evaluate and implement rebalancing strategies • Manager selection and allocations • Asset, country, style, sector or currency allocation A portfolio is very dynamic – impacted daily. Each decision can be a source of return or, if badly managed, can reduce returns

8. 2. Challenges in Public Entities • Resource constrained: financial (budget) and staffing • “In public eye”: decisions are reviewed publicly • Need to demonstrate that decisions not political; need to show financial impact of political constraints • Good governance and transparency critical Challenge: Can technology empower staff, to raise return and lower risk while maintaining control?

9. 3. Current Technology Challenges • SILO SYSTEMS – Narrow Applicability: • Focus on only one asset (stocks/bonds) or one aspect (e.g., risk or performance measurement; trading) • Multiple systems; high cost to integrate/maintain • Required extensive training and client IT backup • Not designed by people who managed funds Senior managers are at risk – not knowing what is impacting the fund or how to correct it

10. 3. Current Technology Challenges • EXCEL based models are often used to make investment decisions, which from a technology perspective pose serious challenges: • EXCEL models prone to error (not transparent) • Key man risk (if staff leaves); create large teams as insurance • Difficult to share ideas/analyses across organization • Managers are at risk if the models have errors Alternative technology must be transparent, robust, inexpensive and easy to use!

11. 3. Web/ASP Model Overcomes Problems • Enterprise system can be implemented at low cost • Easy to use and can customize their overall fund • Support all asset areas in one technology • Link portfolio management, risk and performance in one system/framework: transparent, flexible, quick • Data management can be simplified Senior managers are empowered – access results from their desktop (intranet or internet)

12. 4. Using Web-based Technologies Effectively A Case Study: Integrated system that allows user to follow specific process steps: • Specify a clear investment process (i.e., who makes what decisions at what level of the fund) = GOVERNANCE • Understand all the risks taken by the fund = GOVERNANCE • Model decisions in a TRANSPARENT way (i.e., simple so that anyone can understand/evaluate) • Attribute performance to improve decisions Governance, process & transparency = better returns

13. P o r t f o l i o Bonds = 40% Cash/ Currency = 20% Equity = 40% Asset Allocation By Market (Local, US etc.) By Market (Local, US, Euro) Sector/ Regional Bank 1 for Deposits Bank 2 for Deposits Large Stocks/ Small Stocks Govt./Agency etc. Style Selection Manager Selection Mgr D Mgr E Mgr F Mgr A Mgr B Mgr C Case Study: Step 1 Articulate Responsibilities/Decisions

14. Pension Fund Case Study: Step 2Use Portfolio Tree to Pinpoint Risk • Structuring risk at total fund level=1.5% (or $300 mn) • From asset allocation and style tilts (excludes managers) • From allocations to assets other than fund benchmark • Allocation decisions have historically had big drawdowns Risk= 1.5% Maximum Drawdown = -7.5% Risk = 1.5% Maximum Drawdown = -5.5% Risk = 3.2% Maximum Drawdown = -11% Risk = 1.8% Maximum Drawdown = -6.8%

15. Case Study: Step 3Ensure Decisions Generate Returns Total Portfolio Total Excess = 2% Asset allocation strategy Excess Return = 0.5% Equities Bonds Cash 1-mo LIBOR Currency + Country allocation strategy Excess Return = 0.5% Foreign bonds Local Bonds + Excess Return = 0.5% Sector allocation strategy + Government Bonds Mortgage/ Corporate Manager Excess Return = 0.5% Internal/External Managers

16. Case Study: Step 4Use Attribution to Improve Decisions Total Portfolio Total Excess = 0% Naïve Rebalancing Excess Return =- 0.5% Equities Bonds Cash 1-mo LIBOR Currency + Let Portfolio Drift Excess Return = - 0.5% Foreign bonds Local Bonds Excess Return = 0.5% Sector allocation strategy Too much focus on manager selection + Government Bonds Mortgage/ Corporate Manager Excess Return = 0.5% Internal/External Managers

17. Case Study: Step 5Portfolio Rules: Web = Transparency Example: Investment Idea:Cash vs Bonds: Apparently, the price of gold is a good indicator of whether funds should be invested in cash or higher duration assets (bonds). Rising gold prices are good for cash relative to bonds. Rule Criteria: IF ((Price of Gold Today > Price of Gold a Year Ago))          THEN Allocate more to CashELSEIF ((Price of Gold Today < Price of Gold a Year Ago))          THEN Allocate less to Cash ELSE         Do Nothing Performance Statistics: Excess Annualized Return: 0.61% Risk: 0.94% Information Ratio: 0.65 Max Drawdown: -1.24% on 3/31/1999 Success Ratio: 61.1% Confidence in Skill: 97.95% Good decisions add returns and reduce risk *Purely hypothetical example and not an investment recommendation

18. Performance Measures Benchmark          Strategy Excess Return % 6.47 9.25 2.78 Cum. Return % 36.79 55.64 18.85 Risk % 2.28 5.58 3.55 Return / Risk Ratio 2.84 1.66 0.78 Case Study: Step 6 Deliver Detailed Reports Through Web

19. 5. Mcube IT: Better Governance/Returns Through Web Applications • Boards/Senior Managers can set fund structure and monitor all decisions easily • Portfolio managers can use to make better decisions • Middle office can use to evaluate risks/performance • Web-technology for 3 Ms of Portfolio Management: “Measure”, “Monitor” and “Manage”

20. 6. Summary & Conclusions • Portfolio management = many decisions and requires many groups to coordinate (board, front office, back office, external managers) • Silo systems make it difficult and expensive to manage fund • Web (internet/intranet) can overcome challenges • Can create customized portfolio structure, analysis and reports • Can create transparency for good governance, returns and risk management • AlphaEngineTM: adopt best practices quickly and easily

21. Appendix

22. 5. Converting Ideas To Rules to Give Good Process and Add Value

23. Rule Performance (1998-2004)