18 September 2003 Joeri van Alphen Lodewijk van Pol Modelling Active Management AFIR 2003, Maastricht

2 Agenda Introduction The model Example Application to manager structure Conclusion

3 Absolute versus relative risk

4 Active return matters An additional 1% return saves an average pension fund about 6% contribution of payroll In a low return environment, additional return from active management becomes more important

5 Model Active return normally distributed with expectation  and standard deviation TE Portfolio return R p = R b +  Portfolio risk: standard deviation of benchmark (  b ) tracking error (TE) correlation between R b and 

6 Impact of TE and correlation on portfolio standard deviation

7 Some real-life examples

8 Two “active” asset mixes

9 Two “active” asset mixes compared with 50/50-benchmark and 40/60-mix

10 Two “active” asset mixes compared with 50/50-benchmark and 40/60-mix More efficient manager structure

11 What is manager structuring? How can the strategic investment allocation best be implemented taking into account the efficiency of markets, the capabilities of investment managers and the costs of investment management?

12 The Investment process Pension funds Follow upSearch & selectionImplementationALM study ISSUES TO CONSIDER SERIES OF DECISIONS PRE-DEFINED CRITERIA USED FOR SELECTION /REVIEW ISSUES TO CONSIDER financial strength Nature of Fund's liabilities and Legislative issues, Accounting The risk tolerances of sponsoring organisation Specific Issues of relevance to the Fiduciaries Transition Management Investment guidelines Statement of Investment Policy Custody Active versus passive investment management Specialist or balanced mandates Multiple versus single manager structures Organizational criteria (stability, commitment) Process related criteria (research, risk management) Product related criteria (performance, fees) Determine Investment Objective / Set Asset Allocation Strategy Determine Investment Management Structure Review / Appoint Investment Manager(s) Implement & Document Changes Monitoring & Evaluation

13 Why is it important? ALM studyImplementation n RiskBenchmark+ n ReturnBenchmark+/- (?) n Costs= zero!+ n Implementation affects Assumptions of the ALM study n Manager structuring is focussed on controlling this process n Possibly to enhance return and diversify risk

14 Concepts & Approach Three basic questions Active versus passive investment management Balanced versus specialist investment management Multi versus single investment management

15 Active versus passive Investment Management Three issues (in)Efficiency of markets  Potential of positive alpha and information ratio  Need to reduce risk Costs  Transaction costs  Management fees Diversification  Low correlation of Alpha with benchmark  Volatility of (active) portfolio is not sum of passive + TE

16 Active versus passive: a variety of degrees of activity

17 Active versus passive Investment Management Transaction costs: equities

18 Active versus passive Investment Management Management fees: global equities

19 Balanced versus specialist Investment Management Pros and cons of specialization +/+ of specialization Select capability out of larger universe Diversity of Investment styles Greater flexibility in appointment -/- of specialization Higher fees More complex communication TAA will require additional solutions >> consistency problem Extra costs for Monitoring & Evaluation, appointment

20 Summary & Conclusions Manager structuring has impact on ALM assumptions All pension funds have to decide on:  Active versus passive  Balanced versus specialist  Multiple versus single Modeling and quantification is possible, but… Make careful assumptions! In active equity investment management, style diversification appears attractive