A Better Way to Assess Global Risk

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A Better Wayto Assess Global Risk Return

• Ronnee Ades
• Senior Director, Institutional Markets

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AGENDA

• Risk Management
• Index Methodology
• Market Representation
• Market Segmentation
• Conclusions

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Risk Management
Trustees
Investment Strategy Decision Making
Money Managers

• Consultants

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Risk Management

• Pension Plans 1 ObjectiveMeet Funding
  Obligations
• Pension Plans 1 ProblemProjected Payments Out
  gt Projected Payments In

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Risk Management

• The Plan Sponsors Responsibility to Meet Funding
  Obligations involves the process of Risk
  Management.
• The overall goal of the risk management process
  should be an investment fund having well
  understood and desirable risk and return
  characteristics.

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Risk Management

• BUT what is risk?
• The definition of risk is variability of return.
• For the Pension Plan it is commonly the
  percentage change in assets over 1 Qtr., 1 year.

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Risk ManagementDeveloping an Investment Strategy

• Investment strategies behave differently relative
  to the chosen definitions of risk and return.
• The First step in the process requires
  assumptions about asset class behavior.
• Then you choose your Plans investment strategy
  (policy portfolio) having what you judge to be
  the optimal risk versus return trade off.
• Then you choose managers to implement the
  strategy.
• You may use passively managed index funds and/or
  add what may be termed implementation risk and
  hire active managers.

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Risk Management

• Benchmarks are used in the process as
• Proxies for Asset Class behavior
• Targets for Investment Return in passive
  portfolios
• Performance benchmarks for the active managers
  and also, their universe for stock selection

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Index Methodology

• Knowing the construction parameters (methodology)
  of the popular benchmarks is critical to
  assessing the best choice for your Plan.
• Criteria for a good benchmark
• Rules-based transparent
• Market representation
• Market segmentation

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Index MethodologyMarket Representation

• Typical Investment Strategy Starts With a
• 60/40 Asset Allocation

FixedIncome40
Equities60
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Index MethodologyMarket Representation

• Actual Investing is Typically in Market Segments

FixedIncome40
Large Cap35
Alternative Investments5
Small Cap10
InternationalEquity10
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Index MethodologyRules Based

• Rules-based indexes
• Objective selection
• Review frequency are usually scheduled
• Examples Dow Jones Wilshire 5000, Russell 2000

• Committee-based indexes
• Subjective selection
• Review frequency is usually as needed
• Examples Dow Jones Industrial Average, SP 500

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Index MethodologyRules Based

• Rulesbased and Representative
• David Blitzer from SP on CNBCs Squawk on the
  Street
• we were slightly underweight technology
  throughout most of the tech boom specifically
  because we look for companies that have at least
  a year of solid profit.
• stood us in very good stead
• Good stead versus what? the market?
• Underweight versus what? the market?

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Index MethodologyMarket Representation

• Evolution of US Stock Market Benchmarks

• In the 1970s there was the SP 500
• Then in the 1990s there was the Russell 3000
• And now there is the Dow Jones Wilshire 5000

DJW 5000
Wilshire 5000
Russell 3000
SP 500
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Index MethodologyMarket Representation

• The SP 500 components are selected by committee,
  in private.
• The DJW 5000 is rules based and those rules are
  transparent.
• The SP 500 components are not the 500 biggest
  stocks. In fact, after the top 350, they scatter
  down to nearly the 2000 rank within the DJW 5000.

DJ Wilshire 5000
SP 500

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Index MethodologyMarket Representation

• Evolution of Global Stock Market Benchmarks

• In 1969 there was the MSCI EAFE
• Then in 1987 there was the MSCI All-Country World
  Index
• Then in 1993 the FTSE World Index started
• And now there is the Dow Jones Global Total
  Market Index

Today
DJWG 12000
1993
FTSE 7900
1987
ACWI 2600
1969
EAFE 1140
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Investable Universe

• Number of Countries Covered

Depth of Coverage within the Counties
World INDEX B
World INDEX A
Investable Universe
Investable Universe
50 Countries
40 Countries
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Index MethodologyMarket Segmentation

• Segmentation is a extension of Representation
  How is the broad market sliced?
• Industry Groups/Sectors
• Size Segments
• Style Segments

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Index MethodologyMarket Segmentation

• Market Size Distinctions

DOW JONES GLOBAL TOTAL MARKET INDEX
DOW JONES WILSHIRE
Small-Cap 1,750 Stocks
Micro-Cap 2,500 Stocks
Large-Cap 750 Stocks
US 5000
World ExUS 7000
Small-Cap 2,000 Stocks
RUSSELL
Large-Cap 1,000 Stocks
Micro-Cap 2,000 Stocks
SP
Large-Cap 500 Stocks
Small-Cap 600 Stocks
Mid-Cap 400 Stocks
Micro-Cap 0 Stocks
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Index MethodologyMarket Segmentation
YEARLY TOTAL RETURN PERFORMANCE
Index
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
DJ Wilshire 5000
6.34
12.62
31.64
-20.86
-10.97
-10.89
23.56
23.43
31.29
21.21
36.45
28.59
32.97
22.52
37.61
DJ Wilshire U.S.Large-Cap Index
6.38
11.65
28.89
-21.07
-12.96
-10.50
21.93
28.59
32.97
22.52
37.61
7.37
19.46
-9.08
DJ Wilshire U.S.Small-Cap Index
7.37
19.46
49.02
-18.98
3.13
-9.08
29.25
1.35
24.87
17.38
31.07
83.20
-8.71
24.31
40.99
DJ Wilshire U.S.Micro-Cap Index
1.21
17.18
83.20
-8.71
24.31
-18.29
40.99
5.95
22.02
17.81
36.42
Shaded values indicate top-performing segments.
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Index MethodologyMarket Segmentation
YEARLY TOTAL RETURN PERFORMANCE
Index
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
DJ Wilshire Global
?
?
?
?
?
DJ Wilshire GlobalLarge-Cap Index
?
?
?
?
?
DJ Wilshire GlobalSmall-Cap Index
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Market SegmentationStyle Methodology
Distinctions

• Factors used for Mapping Stocks into Growth and
  Value Segments

DOW JONES WILSHIRE
RUSSELL
SPciti
Historical Trailing Revenue Growth Trailing
Earnings Growth
Current Price-to-Book Ratio Dividend Yield
Projected Projected Earnings Growth Projected
Price-to-Earnings Ratio
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Index MethodologyMarket Segmentation

• Style Distinctions

DOW JONES WILSHIRE
Micro-caps
Large Cap Growth
Small Cap Growth
Small Cap Value
Large Cap Value
RUSSELL
Micro-caps
Large Cap Growth
Small Cap Growth
Large Cap Value
Small Cap Value
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Index Methodology

• We know that the Benchmarks are different SP
  500 vs. DJW 5000
• Over a 10 year period we can reasonably expect
  the returns will be significantly different
• 55 probability the 1 year return difference
  exceeds 1.5
• 55 probability the 3 year return difference
  exceeds 1.0
• 40 probability the 5 year return difference
  exceeds 1.0
• 20 probability the 10 year return difference
  exceeds 1.0
• Impact on 50 million _at_ 1 (100bps) 500,000
• It does matter in the long run it does make a
  difference!

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Comparative Index Returns, Major US Index
FamiliesAs of December 31,2005
Large

• Compare Broad Market Managers to the Broad Market
  Benchmarks
• Should your Plan pay for BETA?
• Should a manager who had 5.75 return be given a
  performance bonus or potentially fired?

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Comparative Index Returns, Major US Index
FamiliesAs of December 31,2005
Small

• Compare Small-Cap Market Managers to the
  Small-Cap Benchmarks
• Should your Plan pay for BETA?
• Should a manager who had 5.75 return be given a
  performance bonus or potentially fired?

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Index Methodology

• Using indexes from multiple providers has serious
  implications for your investment strategy.
• What happens when you dont use one consistent
  index methodology?

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MethodologyMultiple Vendor DilemmaAn Example

• SP 500 SP Mid Cap 400 Russell 2000
• Missing 250 names from the universe of 3000
• Over 130 of top 750 stocks missing
• Double count 140 stocks with median market cap
  over 1 Billion
• Missing micro cap

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MethodologyMultiple Vendor DilemmaAn Example

• Some Missing Companies
• Amazon.com
• Directv Group
• Fox Entertainment Group
• Genentech
• Kraft Foods

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MethodologyMultiple Vendor DilemmaAn Example

• Double Counted Companies
• Callaway Golf
• Calpine
• Cooper Tire Rubber
• Delta Air Line
• Goodyear Tire Rubber

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MethodologyMultiple Vendor DilemmaThe Point (on
a global scale)

• SP 500 Russell 2000 MSCI EAFE
• Gaps
• Overlaps

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Conclusions The Process Begins and Ends with the
Investors
Trustees
TRUSTEES
Consultants
Money Managers
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ConclusionsWhat Every Trustee Should Know

• Benchmarks should be rules-based and transparent
• Objective Selection
• Scheduled Reviews

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ConclusionsWhat Every Trustee Should Know

• The benchmark selected should provide the
  relevant opportunity set of stock market returns.
  

Today
DJW 5000
Russell 3000
1990s
1970s
SP 500
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ConclusionsWhat Every Trustee Should Know

• Risk management in the global space requires
• Rules Based Indexes
• Consistent Methodology

• Greater explanatory power (of Benchmark Mismatch,
  Asset Class Misfit, Alpha) can be obtained by
  using an index family with

Discrete market size segments that add up to
the total market
FixedIncome
Large Cap
Growth
Value

• Size and Style (growth/value) segmentation
  matters.

Exclusive style segments with an emphasis on
purity
Growth
Value
Alternative Investments
Small Cap
International Equity (Ex-US)
MicroCap
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Conclusions

• Not all Benchmarks are the same
• Dont make the Benchmark decision lightly
• Seek information from the index provider
• Dow Jones Wilshire A Better Way to Assess Risk
  Return

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