Attribution Analysis An integral part of the investment management program Simon Willcox Paul D’Ouville

Presentation Overview A comprehensive suite for asset servicing Plan Sponsors to asset managers The attribution and data evolution A generational model A generational range of issues The asset class / market evolution The ‘simplicity’ of Equities versus the realities of Fixed Income Desire for stock level analysis Linking performance attribution and risk attribution From performance Attribution to risk adjusted performance attribution Northern Trust’s development approach The core client requirements of an effective attribution toolkit Asset Owner versus Asset Manager needs Current trends, future needs

A Comprehensive Suite for Asset Servicing What has been the return on our assets? Performance measurement (return, excess return, attribution) By Manager By consolidation (e.g. total plan / all passive portfolios / all active portfolios) By asset class / region / country / sector / stock Why have the assets performed that way? Attribution Analysis Asset Managers Has asset owner received expected performance, ‘true to label’ validation How has each investment desk performed, consistency and validation of investment process, where to spend time on process Have the desks interacted effectively (currency management) Asset Owners how have their decisions impacted performance, asset v liability monitoring

A Comprehensive Suite for Asset Servicing Asset owners and managers have a fiduciary responsibility to monitor their investments. What analysis is required to enable them to do this? Was this within our investment guidelines? Compliance / Risk Monitoring External investment restrictions (legal/regulatory). Internal investment restrictions – placed on individual managers to limit overall plan risk What risks did we take along the way and what type of risks lay ahead? Risk Analysis Ex-Post – Have we taken too much risk, or too little Ex-Ante – Is our current risk exposure in line with our investment requirements

Attribution Objectives Each user may have a different purpose and level of understanding, but the output must be understandable and useful to all parties. Meets its purpose Maps to client’s objectives and fund managers’ investment process Accurate and timely delivery Easily interpreted By clients with supplemental and meaningful commentary from fund managers By fund managers / marketing and sales By third parties /consultants receiving data from multiple sources An aid to future investment decisions Complementary to in-house risk models and other front office systems Supports previous ex-ante analysis and asset / liability modelling Automated Scalable Flexible

Northern Trust’s Approach to Supporting Clients’ Needs A full suite of attribution capabilities is a “must have” for all of clients from a precise methodology through to timely and meaningful reporting Methodology and formulae Needed “returns based” approach to compliment existing excess return driven reporting Preferred industry standard methodology but wanted integration into infrastructure Algorithms programmed directly into core platform Delivery and Frequency Daily service essential for asset managers – quantitative analysis and speedy turn around Monthly / quarterly service to compliment daily information – qualitative analysis with commentary Solution – on line reporting via Northern Trust Passport Review of data integrity – “refining the process” Daily delivery can pinpoint implementation issues prior to month end Investment goals / processes can be reviewed more frequently Solution – daily performance, available daily Integration in client reporting across segments Headline numbers and impacts needed to be highlighted in client reporting Solution – design and build client reporting blocs, marrying numbers with analysis

The Data Evolution The development of the servicing of program management has been an evolutionary process and can be represented by five key generations. Delivery implications within a Generational Model of performance delivery: Performance Measurement High Level Performance Measurement Detailed Attribution High Level Attribution Detailed Risk Other Ex Ante Generation 1 Figures Production Quarterly  Generation 2 Added Value Monthly Generation 3 Global Support GIPS requirements included Monthly with more detail Quarterly with more detail Generation 4 Focused Cost Centre More detail needed Weekly / daily Weekly / daily with more detail Weekly / daily with more proof of controls Generation 5 Integrated Feedback More interpretation, and link with attribution / risk Weekly / daily -more interpretation than production More detail More frequency Data intensity for all models Cost of delivery Performance and Risk 1990 - 94 1994 - 98 1998 - 2001 2001 - 03 2003 - now Source: Investit Intelligence ‘Outsourced Performance Measurement for Investment Managers’

Demands on Attribution Models Through ‘Diversification’ Portfolio holdings and prices D A T I N E G R Y Contribution Portfolio, benchmark, broad assets, universes Policy / Balanced Portfolio, benchmark, broad assets to stock level Equities Portfolio, benchmark, sensitivity to characteristics Fixed Income

The Asset Class and Market Evolution Profile of markets are / have changed Peer groups versus custom benchmarks – move to custom allows for more frequent attribution reporting (UK move from 75% peer group to less than 10% in last 5 years) Peer group comparison more relevant in the U.S. with large markets and similar mandates Equities v Fixed Income v Alternatives Liability matching pressures have seen a move towards fixed income Use of alternative assets is growing significantly Increased use of OTC’s – independent models required to derive characteristics Regulatory Requirements Global Investment Standards are limited with respect to attribution Difficult to point to any one “correct” approach although many are universally standard (eg: stock level equity attribution) Risk awareness Attribution is another useful tool for identifying risk within a policy / mandate

Understanding the Inputs to Attribution Analysis Increased analysis => Increased need for data integrity => Increased focus Policy No flows Manager Flows? Country / currency More flows Sector Classifications Stock Synthetic trades Corporate actions and flows between sectors Start weights Average weights Many different flavours in FI (eg: maturity bands) Increased complexity with frequency

The Process Needs to be Seemless A true end to end mechanism is essential such that transactional and accounting data flow through to attribution results with no need for human intervention 7. Apply formulae and deliver results 1. Accounting Data 6. Index data Sources and mapping Data flow, Understanding dependencies 2. Portfolio holdings and transactions 5. Application of Classification Schemes to produce returns 3. Positional and transaction code mapping 4. Performance calculation Engine

Performance Attribution Sample Output (Total Fund) Total Fund attribution is a tool to quantify the impact of strategic investment decisions and implementation decisions.

Performance Attribution Sample Output (Sector Equity) Sector level attribution is useful for all types of funds, even tracker funds as per this example, to highlight to the manager where extra return is being generated. Was it deliberate?

Performance Attribution Sample Output (Stock Level Equity) Stock level attribution is useful to pinpoint where good stocks were chosen and just as importantly which poor performing stocks were avoided.

What Is Fixed Income Attribution Analysis? Returns-based attribution model Flexibility to calculate attribution results based on client specific mandate types (eg: Govs. Vs, Corporates)

Equity and Balanced vs. Fixed Income Attribution Should different attribution methodologies exist between equity vs. fixed income strategies? Similarities Both are returns based (portfolio vs. benchmark) and look to decompose the excess return into the conscious decisions of the investment process Top Down approach Both look at the impact of investing in specific markets or assets and choice of stocks within the market / category Differences Fixed Income portfolios tend to have a greater degree of currency management within the fund which needs to be measured independently (passive versus active) Fixed Income models are more risk orientated with the use of duration to measure interest rate sensitivity Excess returns tend to be smaller, so results in fixed income are much more sensitive to price and characteristic differences

Understanding the Effects If interest rates fall, then the returns are positive so overweight duration in rising markets is good and underweight duration is bad Duration Positive / negative impact on excess return from a parallel shift in the yield curve Yield Curve Positioning Positive / negative impact on excess return from a change in shape in the yield curve Sector / Country Yield spread movements between Gov. and Non Gov. Bonds or currencies of issue Bond Specific Did we pick good performing bonds along the yield curve? Was credit part of the benchmark? Currency Did we pick good or poor performing currencies ?

Understanding the Data Requirements Portfolio and index (as per the classification scheme) Market Value (income accrued versus received) Effective duration (allows for options on bonds) Effective maturity bands for classification purposes (callable bonds) Currency of Issue rather than country of risk Credit rating – official versus implied Sector classification (Government / Corporate etc)

Considerations for fixed income attribution - General Different interpretation of added value Yield spread versus total return Buy & hold versus transaction based Arithmetic versus geometric Data integrity and consistency Security characteristics Greater variety of benchmark schema’s/definitions Front office systems to back office analysis and reporting Index data requirements – cost, distribution and formatting Greater complexity with derivatives Greater portfolio turnover Greater complexity transitioning historical information

Performance Attribution Sample Output (Fixed Income) Fixed Income Attribution highlights the impacts of effective positions (duration adjusted weights)

Risk Attribution / Risk Adjusted Performance Attribution Decomposition of ex post and ex ante measures into meaningful factors Ex ante risk attribution normally built from multi factor model approach Ex post risk adjusted performance attribution can be built from statistics such as tracking error / information ratio decomposition Ex Post Risk Attribution Based on standard deviation of active returns Attribution built from asset volatility and correlation to tracking error (but using traditional performance definitions of selection and allocation) Selection impact built from asset weight times active return volatility in asset Allocation impact built from size of asset active weight times active return volatility in asset relative to overall benchmark. Ex Post Risk Adjusted Performance Attribution Information Ratio useful (active return / tracking error) Use of ‘risk weights’ rather than investment weights – how much of risk budget has been spent on asset

Risk Attribution / Risk Adjusted Performance Attribution Sample UK Equity – 1 Year Attribution Results

Strategic Approach to Attribution Developments Full integration within infrastructure remains crucial Analysis is embedded within Northern Trust infrastructure Important to ensure that data updates at source flow efficiently through to end analysis and attribution Industry leading professionals researching new methodologies and approaches Active participation in external performance conferences Close ties with performance professionals in the industry Continued investment in capital expenditure Senior management continue to comit resources to analysis and decision support capabilities Displined approach to development, testing and implementation Staying on current with new investment approaches Working with clients and asset managers to ensure new investment strategies are captured within performance Strategic alliances to deliver industry leading capabilities

Recent Developments Around Attribution Daily relative attribution capability through Passport (Fundamentals) Equity (regional, country, sector and stock level) Popular with investment management community Daily indexes information from all major index vendors Specialist benchmark team negotiating and managing index vendor relationships Daily benchmark building functionality Benchmarks feeding attribution can be built daily and rebalanced monthly Strategic alliances with third party index and characteristic providers

Current Trends, Future Needs Absolute / Hedge Funds Some strategies do not lend themselves to relative attribution decomposition Contribution analysis is the start …but do need in-depth knowledge of investment decisions (e.g. – pairing) Derivatives – greater complexity and evolution of purpose Attribution ‘methodologies’ have existed for significant periods of time Treatment of ETD v OTC’s But again, need in-depth knowledge of investment decisions to ensure attribution reflective of investment process Active vs. passive currency management Need to strip out forward contracts between passive and active decisions Need to allocate cost of hedging to appropriate investment desk Separate measurement of currency overlay programs LDI A valuation process – decomposition of asset value versus liability value Non published benchmarks – derived from asset exposure Characteristics enhancements and custom indexes development

Thank You Simon Willcox Paul D’Ouville