Risk Tolerance and Strategic Asset Management Pedro Gonzalez Cerrud PhD,CPA, CFP, CFA INVESCO Institutional Puerto Rico

1. Risk Tolerance and Strategic Asset ManagementPedro Gonzalez Cerrud PhD,CPA, CFP, CFAINVESCO InstitutionalPuerto RicoNov. 15, 2002

2. Topics • Importance of Risk Tolerance in the Investment Process • Budgeting for Risk Tolerance • Risk Budget • Risk Budget and top down and bottom up investment decisions • A Real World Example

3. Importance of Risk Tolerance in the Investment Process • Definition of risks • Volatility • Losses • Unknown • Expected Utility of Investors: • Increases with expected returns • Decreases with volatility of returns

4. Importance of Risk Tolerance in the Investment Process • The lower the risk tolerance more sensitive is the investor to the volatility of returns • Ultimate objective of any investment program should be: • Maximum returns per unit of risk • Both expected returns and risk tolerance of investors are dynamic variables • Change in factor affecting expected returns are faster than those impacting the level of risk tolerance

5. Budgeting for Risk Tolerance • Risk Budget • “Subset of understanding the client’s risk appetite” • “Is a way of taking a finite risk resource, and deciding how best to allocate it” • “Use of tracking error to set the downside risk” • “A method to identify, quantify and monitor the value at risk of the portfolio”

6. Budgeting for Risk Tolerance Top Down Risk Budget: A Global Approach Alpha Diversification, Max Information Ratio Benchmarks, Target alphas, Tracking Errors Liability Structure

7. Budgeting for Risk Tolerance Bottom-Up Risk Budget: A Global Approach Information Ratios per Asset Class/Style on a Global Basis Historical Relationshipamong asset classes Alpha Correlation of Asset Classes/Styles

8. A Real World Example

9. The Plan Sponsors Dilemma Every Investor’s Goal:“To build a successful multi-asset, multi-manager structure.” Definition of Success:“To build wealth by maximizing returns with minimum risk” • The Multi-Asset Problem: • Alpha’s are perishable • Style and asset class cycles can be very long • Lower return environment expected in the future

10. Why Global Asset Allocation? Solution for Multi-Asset Investing: • Create a risk habitat that seeks to enhance & preserve alpha • Two sources of alpha allows one to strive for higher returns • Valuation and Dynamic approach to investing • Model cyclical and secular forces of relative return • Quantitative and Fundamental investment platform • The path to higher returns is through the eye of risk management • Build bottom-up risk budget (understand alpha cycles) • Build top-down risk budget (understand asset class cycles) • Overall risk budget that targets realistic goals and objectives

11. Over 50 sources of top-down alpha Top-Down Active Asset Allocation Strategies Two Sources of Alpha • Returns are additive, risks are not • Create the optimal risk habitat • Solve for an information ratio of 1.0 • Higher probability of achieving 300 bps alpha with 300 bps tracking error Top-Down Bottom-Up Bottom-Up Active Security Selection Strategies 15 Bottom-up managers

12. Asset Allocation Philosophy • Beliefs • Inefficiencies across asset classes are meaningful enough and powerful enough to prompt us to capture them in an active mode. • A disciplined, systematic approach (grounded in financial theory and devoid of human emotion) can provide incremental value-added. • Philosophy • We believe that to consistently add value from a top-down perspective, an investment approach needs to combine information from long-run valuation measures with insights about the near-term investment environment.

13. Asset Allocation Process Step One Step Two Step Three Step Four Step Five Identify the Key Cyclical and Secular Drivers Valuation and Dynamic approach to determine the relative return signal • Build a top-down risk budget: • Asset Classes • Countries • Currencies Build a bottom-up risk budget Complete risk budget for the total portfolio

14. Domestic vs. International: Economic Fundamentals • The primary driver of US vs. non-US equities is relative earnings. The magnitude of relative earnings is determined by the investment cycle. Relative Cash Earnings vs. Relative Market Price US vs. International

15. Understanding Asset Class Cycles US/Non-US Relative Return US vs. International and G7 Nominal Growth Indicator Cyclical Drivers • US Equity Market is a Stable Grower • Outperforms during Global Weakness • Under performs during Global Strength 12 Mo Change in US vs. Intl (%) G7 Nominal Growth (Inverted %) US vs. International and Change in Relative Investment Secular Drivers • Relative earnings determines relative performance • Magnitude of relative earnings is determined by the investment cycle Relative Capital Spending Growth US vs. International

16. Non-US vs. US Equities: Valuation • US Equities tend to get overvalued against non-US equities following periods of strong relative growth and investment. Relative Valuation: US vs. Developed Non-US

17. Non-US vs. US Equities: Dynamics • In the near-term, the US tends to outperform when: • Relative earnings expectations favor US companies, • US liquidity is more abundant than non-US liquidity Relative Liquidity High; US Outperforms Global Growth Low; US Outperforms Relative Liquidity (%) Relative Returns (%) Global Growth (%) Relative Returns (%) Relative Liquidity Low; Non-US Outperforms Global Growth High; Non-US Outperforms

18. 80% -30% 60% Rel Index 12m Chg -20% d12 Invent / Sales 40% -10% 20% Chg in Inventory / Sales Ratio 0% 0% -20% 10% -40% 20% -60% -80% 30% 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 03 Asset Allocation – Country Example Japan vs. World: Relative Index and Market Share Proxy Valuation • Shifts in global market share lead relative price performance • Japan tends to gain share within global economic up-turns and lose within down-turns • This measure, combined with other valuation measures, suggests that Japan is still reasonably valued despite out-performance year-to-date Dynamics • Like most of Asia, Japan outperforms the rest of the world at the beginning of the economic cycle • One of the leading indicators of the economic cycle is the Inventory/Sales ratio – low readings imply strong potential in the global economy • The Inventory/Sales ratio is currently very low (inverted at left); Japan should outperform. Other cyclical indicators confirm this message Japan vs. World: Relative Index and Inventory/Sales Ratio 12m Chg in Relative Index

19. Principles of Risk Management Goal: • Deliver the best possible return within acceptable total and active risk budgets. Properties of Risk: • Definition: On a stand alone basis, risk is the decay of compound returns. • Diversification: Returns are additive, but risk is not. In a portfolio, risks can be diversified allowing the return of whole to exceed the sum of the returns of its parts. • Universal Nature: Applicable in active or passive context, across asset classes, markets, securities, top-down alpha sources and bottom-up alpha sources.

20. Top-Down Risk Management: Alpha Diversification Alpha diversification delivers superior top-down information ratio.

21. Bottom-Up Risk Budget: Alpha Modeling Chart 1:Large Cap Core’s Alpha Correlation to Growth & Value Chart 2:Small Cap Core’s Alpha Correlation to Growth & Value Chart 3: Large Cap Core: Trend Deviation: Relative Strength vs. Benchmark

22. Bottom-Up Risk Budgeting: Alpha Diversification Trailing 24-month Excess Returns

23. Bottom-Up Risk Budget: Striving for Higher Returns Trailing 24-month Excess Returns Correlation Coefficient

24. Allocation: ExcessReturn: TError: Alpha Correlations: 1 2 3 4 1 Core 10.0% 2.00% 3.00% 2 Large Value 17.5% 2.00% 3.00% 0.20 3 Large Growth 12.5% 2.00% 3.00% 0.15 0.65 4 Mid Cap Core 2.5% 2.33% 3.50% 0.10 0.10 0.00 5 Small 2.5% 2.67% 4.00% 0.45 0.10 0.00 0.45 Total: 45.0% US Equity Portfolio: Excess Return 2.08% Tracking Error 2.14% Bottom-Up Risk Budget: Striving for Higher Return Information Ratio 0.97 Alpha diversification delivers superior bottom-up information ratio.

25. Global Asset Allocation Risk Budget The risk budget is constantly monitored by each top-down and bottom-up alpha source. Average Target Tracking Information Portfolio Implementation Target Alpha Error Ratio U.S. Equity Large Cap Value 2.00 3.00 0.66 U.S. Equity Large Cap Growth 2.00 3.00 0.66 U.S. Equity Large Cap Core 2.00 3.00 0.66 U.S. Equity Mid Cap Core 2.25 3.50 0.62 U.S. Equity Small Cap Core 2.75 4.25 0.62 International Developed Equity 3.50 7.00 0.50 International Developed Equity Small Cap 5.00 10.00 0.50 Emerging Equity 4.00 8.00 0.50 U.S. Bonds 0.75 1.50 0.50 High Yield Bonds 1.00 2.00 0.50 International Developed Bonds 1.75 3.50 0.50 Emerging Bonds 4.50 9.00 0.50 Cash 0.20 0.10 0.50 Total From Portfolio Implementation 2.06 2.03 1.03 Total From Asset Allocation 0.95 1.90 0.50 Grand Total 3.03 2.78 1.09 All tracking error estimates are based on 3-year time horizon.

26. Conclusions R eturns are volatile I nvestment objectives defined as liabilities S ensitivity to changes in market and risk parameters K nowledge of long term and cyclical trends in the market T ake into consideration risk appetite O ptimal distribution of assets to maximize returns L ink of risk appetite and optimal assets E xpressed in a risk adjusted format R isk Budget to quantify and monitor risk A sset allocation based on alpha trends N umber and types of assets change based on sensitivity to volatility C onstant monitoring of sources of alpha and their risk characteristics E motions of investors taken into consideration