A Primer on Overlays

www.mcubeit.com Dr. Arun Muralidhar

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Arun Muralidhar - BioArun Muralidhar - Bio

Chairman of Mcube Investment Technologies, LLC and Managing Director at FX Concepts, Inc.

Head of Investment Research and Member of Investment Management Committee, World Bank Investment Department, 1995-1999

Derivatives and Liability Management, World Bank Funding Department, 1992-1995

Managing Director and Head of Currency Research, JPMIM, 1999-2001

BA, Wabash College (1988); PhD, MIT Sloan (1992)

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Agenda

Overlays – TAA or Currency

Underused by most funds

Internal versus External

Capability, fees and product offerings

New paradigm: alpha from good decisions

AlphaEngineTM: empower clients to make better decisions

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Case for Overlays Markets are inefficient – currency is best

example

Low correlations across assets - “informed decision making” will be profitable

Can be implemented with little cash (derivatives)

An excellent source of uncorrelated alpha

Sophisticated Clients can Implement at Low Cost

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TAA Case Study: Many Possible TAA Case Study: Many Possible IdeasIdeas

EAFE20%

Total Portfolio

US Equity50%

Cash5%

US Fixed Income 25%

Decisions to be made on allocation between asset classes:

Domestic vs International Equities (Stock-Stock)

Domestic Equities vs Domestic Bonds (Stock-Bonds)

Domestic Bonds vs Cash (Bonds-Cash)

Assume Asset Limits of +/- 5% from Benchmark Weight

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Simple/Intuitive Rules Tested

Rule Rule DescriptionCash vs. Bonds, based on Gold

Duration choice based on price of gold. If the spot price of gold is higher than it was a year ago, overweight cash, otherwise overweight bonds

Stocks vs Bonds: Halloween Effect

Stocks tend to underperform bonds between June and Sept - apparently works in 16 out of 18 stock markets, so underweight stocks during this period

Stocks vs Bonds: Inflation/Growth

Equities undervalued when inflation rises (Modigliani-Cohn insight); equities favored when industrial production is increasing

Market Volatility Low equity volatility in a rising stock environment is bullish for equities.Oil and Economy Rising oil prices affect the economy and tend to depress equities.P/E Ratio Rule Value rule for equity (vs FI) using the S&P 500 P/EFed Model When equity yield is higher than treasury yield then buy equity, else

sell equityUnemployment Rate Buy stocks when the unemployment rate is falling (good for economy)US/EAFE: LIBOR Rates Overweight equity market with the stronger currency (higher interest

rate)US/EAFE: Favor Underperformer

Overweight equity market which has underperformed over past year (i.e., buy the laggard)

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Rule Performance (1998-2004)

Rule

Excess Annualized

ReturnInformation

RatioConfidence

in SkillSuccess Ratio

Ratio Good /Bad Risk

Max Drawdown

Cash vs. Bonds, based on Gold 0.04% 0.20 68.8% 56.4% 1.30 -0.44%

Halloween Effect 0.98% 0.88 98.0% 63.8% 1.42 -1.58%

Inflation/ Growth 0.50% 0.57 93.1% 79.7% 1.07 -1.31%

Market Volatility 0.12% 0.11 67.8% 56.4% 1.41 -2.74%

Oil and Economy 0.45% 0.57 91.6% 70.5% 1.16 -0.84%

P/ E Ratio Rule 0.17% 0.39 87.1% 50.0% 2.12 -0.80%

Fed Model 0.47% 0.50 91.8% 61.5% 1.43 -2.17%

Unemployment Rate 0.51% 0.61 94.1% 59.0% 0.99 -1.11%

US/ EAFE: LIBOR Rates 0.17% 0.43 84.7% 55.1% 1.07 -0.71%

US/ EAFE: Favor Underperformer 0.53% 0.95 99.3% 64.1% 1.33 -1.07%

Monthly Decisions – No Transactions Costs

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Strategies (Mix of Rules) Tested

Strategy Name Strategy DescriptionRebalancing I Quarterly Rebalancing to Benchmark WeightsRebalancing II Rebalance to Benchmark Weights when Range of +/-5%

BreachedCombination of Rules:

Strategy 1

6 Best Excess Annualized Returns () and Information Ratios – Cash vs Bonds, Halloween Effect, Inflation/Growth, Unemployment Rate, Fed Model, US/EAFE: Favor Underperformer (all equally weighted)

Combination of Rules:

Strategy 2

6 Lowest Annualized Standard Deviation (Risk) - Cash vs Bonds, Oil and Economy, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted)

Combination of Rules:

Strategy 3

3 Highest and 3 Lowest Risk - Cash vs Bonds, Halloween Effect, P/E Ratio, Unemployment Rate, US/EAFE: LIBOR Rates, US/EAFE: Favor Underperformer (all equally weighted)

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Strategy Performance (1998-2004)

Informed decisions significantly outperform rebalancing

Rule diversification enhances information ratios

Strategy

Excess Annualized

ReturnInformation

RatioConfidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

Rebalancing I - Quarterly -0.22% -0.87 NM 29.5% 1.26 -1.50%Rebalancing II - Range of 5% -0.42% -1.11 NM 33.3% 0.96 -2.74%

Strategy 1 (highest 6 Excess Returns/IR) 0.44% 1.29 99.97% 64.1% 2.11 -0.21%Strategy 2 (lowest 6 risk) 0.32% 1.20 99.90% 61.5% 1.54 -0.28%Strategy 3 (Highest 3 Excess, lowest 3 Risk) 0.36% 1.42 99.99% 57.7% 2.09 -0.20%

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Historical Allocations to Asset Classes

Strategy 1

Strategy 2

Strategy 3 All

strategies have same rule/allocati

on

Strategies 2 & 3 have

same rules/allocat

ion

US Equity

45%

50%

55%

Fixed Income

20%

25%

30%

Jan-

98

Jul-9

8

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Intl Equity

15%

20%

25%

Cash

0%

5%

10%

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Currency Case Study: Easy Currency Case Study: Easy AlphaAlpha

JPY (30%)

Currency Portfolio

GBP (20%)EUR (50%)

Three rules make money: Trend, Carry/Yield and Options

Work in Divergent, Convergent and Sideways Markets, respectively

Potential to add in other currencies and make more complex

Rules will, by construct, have high tracking error: +100%/-100%

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Simple Rules Work (1994-2004)

Trend – if 25 day moving average > 65 days moving average, BUY, else SELL

Carry – SELL currency with low interest rate

Yield – SELL currency with steep yield curve

Options – Are overpriced, SELL

Not highly correlated – good diversification

Need Not Pay Active Fees for Simple Rules

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Performance of JPY Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c)

moving average

USD/JPY Strategy = 40% Yield curve and Carry, 20% MA

Diversification improves information ratio, skill, & drawdown

Strategy/ Rules

Annualized Return

Annualized Std Deviation

Information Ratio

Cumulative Return

Confidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

USD/JPY Strategy 4.59% 8.56% 0.5365 57.45% 94.17% 52.86% 0.9103 -20.45% USD/JPY Yield Curve 4.54% 11.59% 0.3919 56.68% 85.59% 53.43% 0.8564 -26.21% USD/JPY Carry 4.33% 11.59% 0.3741 53.57% 84.26% 52.37% 0.8613 -26.21% USD/JPY MA 20-65 3.62% 11.59% 0.3121 43.22% 79.05% 51.12% 1.06 -20.51%

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Performance of EUR Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c)

moving average

USD/EUR Strategy = 40% Yield curve and Carry, 20% MA

Trend model losses are meaningful; but moderate lower drawdown and worst single performance of the strategy

Strategy/ Rules

Annualized Return

Annualized Std Deviation

Information Ratio

Cumulative Return

Confidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

USD/EUR Strategy 3.79% 5.09% 0.7444 45.69% 98.89% 55.21% 0.9793 -7.78% USD/EUR Yield Curve 5.20% 6.26% 0.8301 40.10% 98.42% 82.95% 0.8599 -8.08% USD/EUR Carry 8.48% 9.71% 0.8729 127.66% 99.56% 55.21% 0.8997 -13.07% USD/EUR MA 20-65 -5.22% 9.72% -0.5372 -41.86% 3.13% 46.68% 1.1392 -49.12%

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Can Be a Consistent Alpha Source

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Internal versus External

Internal

May require use of derivatives (not critical as portfolio drift/rebalancing is an active decision)

Can keep costs down; better control

External

Some strategies better suited – Options

Less career risk; long record of having added alpha

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AlphaEngineTM: Empower Clients Brings state-of-the-art management to pension

funds

Easy to use: Clients generate ideas – software does work

Test strategies in a few minutes

Client can customize to their structure and objectives

No consulting!! Client can make all decisions better

Very transparent: See impact of all decisions on individual asset class or entire fund (easy to read)

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Summary

Many (explicit and implicit) decisions in a portfolio

Each is an opportunity for alpha/risk management

Overlays can help manage these risks for return

Good governance: cost/return impact of every decision

Must aggregate impact of all decisions on portfolio

AlphaEngineTM: adopt best practices quickly and easily

AppendixAppendix

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Fund ResponsibilitiesAsset-Liabilit

yRisk

Tactical & Benchmark

Risk

Manager/ActiveRisk

Responsibility

Monitor

Manage

Trustees Internal Staff Managers

Annually Daily/Monthly Monthly

Strategic Allocations & Funding

Policy

Asset, Sector, Style and Currency

Allocations

ManagerSelection and

Allocation

Responsibility

Decision Frequency

How to Manage the

Risk

Staff are Making Many Decisions (Implicitly) Periodically

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Effective Decision Making Low asset correlations allow “informed decision making”

Identify rule ideas to allocate across asset classes

Select criteria for rule/strategy evaluation (excess return, information ratio, skill, success rate, drawdown)

Analyze rule performance, test different strategies (rule combinations) - diversification benefits not obvious

Test alternative policies versus rebalancing options

Assumed Monthly Decisions (1998-2004); No Transaction Costs

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Extensions Each decision is an opportunity for more returns/risk

management More tiers = greater diversification, efficacy = more returns

Within asset classes (Fixed Income, Equities, Currencies) Managers: Active versus passive and across managers

Leverage asset managers to generate research ideas for decisions

Rule were equally weighted; opportunity to further improve Evaluate ideas in isolation as well as part of a total portfolio

(aggregation produces results that are not obvious)

Improve fund governance, and in turn, returns and risk

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Relaxing Asset Limits to +/- 10%

Change in asset range produces higher ; other measures improve or stay within

acceptable range

Strategy

Excess Annualized

ReturnInformation

RatioConfidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

Rebalancing II - 5% Range -0.42% -1.11 NM 33.3% 0.96 -2.74%Rebalancing II - 10% Range -0.11% -0.16 31.95% 46.2% 1.60 -2.48%

Strategy 1 - 5% limit 0.44% 1.29 99.97% 64.1% 2.11 -0.21%Strategy 1 - 10% limit 0.93% 1.29 99.97% 68.0% 1.91 -0.50%

Strategy II - 5% limit 0.32% 1.20 99.90% 61.5% 1.54 -0.28%Strategy II - 10% limit 0.51% 1.16 99.85% 62.8% 1.91 -0.26%

Strategy III - 5% limit 0.36% 1.42 99.99% 57.7% 2.09 -0.20%Strategy III - 10% limit 0.75% 1.50 99.99% 66.7% 1.90 -0.44%

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Multi-tiered Alpha Aggregation

Alpha = 0.5%

Alpha = 0.5%

Alpha = 0.5%

Alpha = 1.5%

Asset allocation/ rebalancing strategy

Small CapRussell 2000

Large CapS&P500

Equity strategy – Large vs Small Cap

Manager rule to determine allocation between managers/index

Intl Equity(EAFE) 20%

Total Portfolio

US Equity50%

Cash5%

US Fixed Income 25%

Active(Manager B)

Enhanced Index(Manager A)

Passive(S&P500)

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Performance of GBP Rules/Strategies Rules Evaluated: (a) yield curve; (b) carry; (c)

moving average

USD/GBP Strategy = 40% Yield curve and Carry, 20% MA

GBP is hardest to modelStrategy/ Rules

Annualized Return

Annualized Std Deviation

Information Ratio

Cumulative Return

Confidence in Skill

Success Ratio

Ratio Good /Bad Risk

Max Drawdown

USD/GBP Strategy 1.50% 5.56% 0.2703 16.29% 77.97% 53.20% 0.9408 -17.50% USD/GBP Yield Curve 0.15% 7.80% 0.0192 1.53% 47.49% 49.53% 1.0048 -29.22% USD/GBP Carry 3.00% 7.80% 0.3847 34.85% 86.41% 53.54% 0.9758 -17.95% USD/GBP MA 20-65 0.50% 7.80% 0.0642 5.18% 53.18% 52.97% 0.8862 -29.63%

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Allocation ResultsUSD/JPY HEDGE POSITION

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

Jun-9

4

Dec-9

4

Jun-9

5

Dec-9

5

Jun-9

6

Dec-9

6

Jun-9

7

Dec-9

7

Jun-9

8

Dec-9

8

Jun-9

9

Dec-9

9

Jun-0

0

Dec-0

0

Jun-0

1

Dec-0

1

Jun-0

2

Dec-0

2

Jun-0

3

Dec-0

3

Jun-0

4

Sell

US

D S

ho

rt…

……

Hed

ge 1

00% USD/EUR HEDGE POSITION

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

Jun

-94

De

c-9

4

Jun

-95

De

c-9

5

Jun

-96

De

c-9

6

Jun

-97

De

c-9

7

Jun

-98

De

c-9

8

Jun

-99

De

c-9

9

Jun

-00

De

c-0

0

Jun

-01

De

c-0

1

Jun

-02

De

c-0

2

Jun

-03

De

c-0

3

Jun

-04

Sell

US

D S

ho

rt…

…H

ed

ge 1

00%

USD/GBP HEDGE POSITION

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

Jun-94

Dec-9

4

Jun-95

Dec-9

5

Jun-96

Dec-9

6

Jun-97

Dec-9

7

Jun-98

Dec-9

8

Jun-99

Dec-9

9

Jun-00

Dec-0

0

Jun-01

Dec-0

1

Jun-02

Dec-0

2

Jun-03

Dec-0

3

Jun-04

Sell

US

D S

ho

rt…

……

Hed

ge 1

00%