Benchmarks, Risk and Performance Economic & Accounting Perspectives

1. SEACEN Conference December 4-7, 2007 Siem Reap, Cambodia Benchmarks, Risk and PerformanceEconomic & Accounting Perspectives Nilakanta Venky Venkatesh, CFA Principal Financial Officer Sovereign Investments Partnerships World Bank Treasury nvenkatesh@worldbank.org Richard V. Williams, CFA Senior Financial Officer Sovereign Investments Partnerships World Bank Treasury rwilliams1@worldbank.org

2. This presentation will cover: • Brief review of reserves management objectives, tranching and SAA; • Why we need benchmarks; • Characteristics and examples of good benchmarks; • Basics of performance measurement and attribution; • Why and how we look at performance in the context of risk; • How we reconcile the economic and accounting perspectives;

3. Reserves Management Objectives • Provision of Liquidity • Daily, Monthly, Annual • Safety - Capital Preservation • No negative return over the investment horizon • Income Generation • Return objective

4. Portfolio Tranching Characteristics Parameters Tranche • Handle Daily Cash Flow needs • One month horizon Working Capital • Liquid assets • Available to replenish WC or for other draw down requirements • Sensitive to volatility of returns Liquidity Tranche • Liquidity less of a concern • Low probability of draw down • Less sensitive to volatility of returns Investment Tranche

5. The Board focuses on the role of foreign reserves in the overall central bank mandate Investment Policy SAA reflects the central bank’s overall risk tolerance and investment objectives Investment Strategy Investment benchmarks represent operationalized optimal SAA Benchmark Follows from the SAA Process

6. Risk Adhere to risk constraints (Market/Credit Risk) Provide a passive (no-risk) portfolio management strategy Return Specify return expectation Measure effectiveness of active management Appropriate Benchmarks for Reserves Management Should embody the risk and return preferences of the Board

7. What Is a “Good” Benchmark? • Adheres to risk constraints specified in SAA • Feasible  easily implemented with no impact on market prices • Passive  rules need to be established to address portfolio evolution • Transparent  characteristics and constituents are publicly available

8. Is This a “Good” Benchmark? 1. Policy allows 60% of the portfolio to be placed with banks • Benchmark: fed funds rate • Not feasible given limits on bank deposits 2. Policy sets currency mix of 50% USD, 25% Euro, 25% JPY • Benchmark: 100% USD as management is bullish on the $ • Violates policy currency limits

9. Benchmarks for Portfolio Tranches Benchmark Characteristics Tranche • Short-term Money Market Instruments • Zero probability of negative return Working Capital • Money Market Inst., Govt. Bonds • Short-medium duration • Low expected volatility of returns Liquidity Tranche • Govt. Bonds, Credit products, MBS • Longer duration • Higher volatility of returns • Higher expected return Investment Tranche

10. Internal Pros: Can provide an optimal passive strategy and conform to portfolio specifications Cons: Major system and resource commitment Not independent, can be manipulated Difficult to compare performance with peers Internal vs. External Benchmarks External Pros: • Credible, independent yardstick • Minimal systems requirements • Can be combined to create a tailored benchmark Cons: • May not be an optimal passive strategy • Could be difficult to replicate, particularly for small portfolios

11. Benchmark and Index • An index generally consists of a group of securities, based on certain objective criteria. • An Index can be either internal or external • Internal: maintained in-house • External: market indices, maintained by independent index providers • A benchmark can be composed of one or more indices.

12. Features of a Good Index • Universe is well-defined • Securities are investable • Daily performance is available • Current characteristics are available • Historical information is available • Investment style is defined • Risk profile is well-defined • Benchmark is specified in advance • Low turnover 1/ Bailey, J. “Are Manager Universes Acceptable Performance Benchmarks?”, Jnl. Of Portf Mgmt, 1992.

13. External Index Providers • Some of the Major Index Providers • Merrill Lynch • Lehman Brothers • Citi • JP Morgan …… • Each index provider covers a broad spectrum of the fixed income markets

14. Lehman Coverage

15. Citigroup Coverage

16. Merrill Lynch Coverage

17. Merrill Lynch Indices on Bloomberg

18. Benchmark Design flows from the SAA Strategic Asset Allocation Investment benchmark (1B USDeq.) USD 600M USD 60 : 40 USD: EUR Allocations UST 1-3 200 UST 3-5 100 AAA US. Agencies 1-3 200 AAA US. Agencies 3-5 100 Credit Allocation (ABS/Agencies) 50% of total portfolio EUR 400M EUR EMU Government 1-3 110 EMU Government 3-5 90 EMU Sov/Agcy/Supras 1-3 100 EMU Sov/Agcy/Supras 3-5 100 2 years Duration Target Assuming 1 EUR = 1 USD

19. Why measure performance?

20. What is Performance Measurement? • In Absolute Terms: Rate of return of the portfolio • In Relative Terms: Excess return relative to a benchmark

21. Dollar-Weighted Return vs. Time-Weighted Return • Dollar-Weighted Return • is used to evaluate the performance of a portfolio from the sponsor’s point of view • Time-Weighted Return • is used to evaluate the investment manager’s decisions excluding the effects of the sponsor’s cash flows • Hybrid (both) • is used to understand the effects of strategic asset allocation decisions, when cash flows that are the part of strategic decisions are accounted for and those that are not do not influence the measured rate of return

22. Cons • Clouds the effect of the • investment managers: • intervening cash flows • strongly influence the • calculation of return • Pros • Easy to understand • Gives the true rate of • return from the owner of • the fund perspective Dollar-Weighted Return (IRR) • Dollar- Weighted return is the internal rate of return r that equates the initial contribution of funds and the cash flows that occur along the way with the ending value of the fund:

23. Time-Weighted Return • Time - Weighted return is theweighted average of the rates of return for each period and equals the geometric mean if all periods are of equal length

24. Dollar-Weighted and Time-Weighted Returns, example • All unrealized gains are assumed to be reinvested • Time-weighted returns are the same (8%) for Barry and Samantha • According to dollar-weighted returns, Barry experienced a loss while Samantha had the same returns as the time-weighted return • Samantha had the same dollar & time weighted returns since she had no external cash flows in years 2 or 3

25. Cash Flows: Which ones affect performance? • External Cash Flows : Contributions into or withdrawals from the portfolio - important factor to consider for accurate performance measurement • Internal Cash Flows : Cash flows associated with purchases, sales, and coupon payments are within the portfolio - do not affect performance measurement

26. Cash Flows: Should external cash flows affect the rate of return? • No, if the objective is to measure the performance of the investment manager. • Because, the cash flows are at the discretion of the investors – the investment manager has no control over the timing or size of the cash flows. • Need a performance measure that negates the effect of these cash flows.

27. Total Return Total return is the proper measure of the results of investment management where MTMIncome = Change in market value + Interest MVEND = Ending Market Value MVBEG = Beginning Market Value

28. Total Rate of Return: Example Par value = $1,000,000 Date Clean Price Acc. Int. Dirty Price Dirty MV($) 8/31/07 98-28 (=98.875) 0.9171 99.7921 997,921 9/30/07 98-12 (=98.375) 1.1719 99.5469 995,469 Monthly Return: (MV Ending – MV Beginning)/ MV Beginning = (995,469 – 997,921 ) / 997,921 = - 0.25 % Note: Return consists of change in both accrued interest and price

29. Total Rate of Return: Example (With External Cash Flow) Date Clean Price Acc. Int. Dirty Price Dirty MV($) 8/31/07 98-28 (=98.875) 0.9171 99.7921 997,921 9/30/07 98-12 (=98.375) 1.1719 99.5469 995,469 External Cash Flow on 9/30/05 (EOD) : 1,000,000 Monthly Return: (MV Ending – MV Beginning)/ MV Beginning = (1995,469 – 997,921 ) / 997,921 = 99.96 % !!!!!! (Instead of –0.25%)

30. Total Rate of Return: Example (With External Cash Flow) Adjust for the external flow Monthly Return= (MV Ending – MV Beginning – External Flow) MV Beginning = (1,995,469 – 997,921 – 1,000,000) / 997,921 = –0.25% (which is what we had without the external flow)

31. Total Rate of Return: Example (With External Cash Flow) Date Clean Price Acc. Int. Dirty Price Dirty MV($) 8/31/05 98-28 (=98.875) 0.9171 99.7921 997,921 9/30/05 98-12 (=98.375) 1.1719 99.5469 995,469 External Cash Flow on 9/30/05 (EOD) : 1,000,000 Monthly Return= (MV Ending – MV Beginning – External Flow) MV Beginning = (1,995,469 – 997,921 – 1,000,000) / 997,921 = –0.25% (which is what we had without the external flow)

32. Linking Returns Suppose we have the returns for month 1 (0.5%) and month 2 (-0.22%). How do we get the cumulative return for the two month period? • Usegeometric linking to calculate returns over multiple periods. Total Return = (1 + Rt) * (1 + Rt+1) *…..* (1 + Rn) – 1 For our example, R= [(1+0.5%)(1-0.22%)] -1=0.28%

33. Performance • Total Return of the portfolio minus Total Return of the benchmark • Measured in terms of basis points

34. Goals of Performance Attribution: • Explain source of excess returns of a portfolio • Attribute value added of a portfolio relative to benchmark over a time period to different risk views and actions taken in building a portfolio • Provide an independent analytic tool for analyzing a portfolio’s profile and returns

35. Stages of Active Investment Process: Stage 1:Assess economic environment and generate views Stage 2:Proceed with portfolio investment strategy Overall PerformanceHow well portfolio did against benchmark? Performance Attributionwhat factors contributed to outperformance? Performance Contributionwhich sectors contributed to outperformance? Stage 3:Review investment strategy as needed

36. Factor Model • Computes ex-post performance returns arising from exposure to risk factors: • Interest rate exposure • Credit exposure • Embedded optionality • Currency exposure • Provides ease of comparison of ex-ante risk position to ex-post performance: • Making it easier to explain performance • Works as a tool to back-test risk measurement • Models yield curve changes for each portfolio based on its positioning along the curve

37. Allocation Model • Computes ex-post excess returns by asking two questions: • Allocation effect: if portfolio earned within each market segment the same as the benchmark, how much would it differ from the benchmark in terms of performance? • Selection effect: how much extra return is attributable to the difference in returns within each segment? • Model works by placing each security into n-dimensional grids or “buckets” that reflect allocation decisions of the portfolio manager

38. Looking at Performance & Expected Performance in the Context of Risk • Different ways of looking at risk • Why should you look at performance in the context of risk? • Risk adjusted performance measures • Comparing different portfolios/ managers • Estimating future expected returns based on risk profile

39. Risk can be viewed in two ways • Potential for incurring losses • Shortfall probability • Value at Risk • Variability of returns • May want a minimum return • Concerned about underperforming the benchmark

40. Why look at risk when evaluating performance? Which portfolio would you prefer?

41. Portfolios with different levels of Return and Risk High Return and High Risk Versus Low Return and Low Risk • How would you decide which portfolio was better? • Need to adjust returns for the risks involved

42. Risk Adjusted Performance Sharpe Ratio = Average Return – Risk-Free Rate Std Dev(Portfolio Returns) • Uses standard deviation as a measure of risk to adjust return • Risk-Free rate could be O/N cash or T-Bill rate

43. Uses and limitations of Sharpe Ratio • Objective function in mean-variance optimization – used in SAA process • t-statistic to test the hypothesis that the return on the portfolio is >= to the risk-free return • Constant “Risk-free” rate not very relevant when evaluating portfolios versus a benchmark Higher probability that portfolio return will exceed risk-free return Higher Sharpe Ratio

44. Performance vs. Benchmark • Excess return (Alpha) • Tracking Error (ex-post or ex-ante) • Standard Deviation of Excess Returns

45. Alpha and Tracking Error Tracking Error Alpha Relative VaR

46. Risk Adjusted PerformanceVs. Benchmark Information Ratio = Excess Return Tracking Error • Measures how well one was rewarded for each incremental unit of risk • Useful for comparing different portfolios managed against the same benchmark

47. Comparing Portfolios Based on Information Ratio Which portfolio performed better?

48. Interpreting Information Ratios • Valuable tool in evaluating managers’ ability to add incremental value relative to incremental risk • A relatively stable IR (as viewed on a rolling basis over an extended period) can indicate consistent ability (or inability) to efficiently add return • Difficult to interpret when alpha is negative • Return history needs to be long enough to generate statistical confidence

49. Key Messages so far • Benchmark should embody the institution’s risk and return preferences • Benchmark should provide a passive strategy and an independent source for comparing the portfolio return • Time-weighted total return is the correct measure of portfolio return/performance • Risk adjusted performance measures help in comparing portfolios/managers with different returns and risks

50. Reconciling the Accounting and Economic Perspectives