5 - 0 second investment course – november 2005 topic five: portfolio optimization: case studies
TRANSCRIPT
5 - 1
Second Investment Course – November 2005
Topic Five:
Portfolio Optimization: Case Studies
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Portfolio Optimization Example #1: 2003 Texas Teachers’ Retirement System
Background: Texas Teachers’ Retirement System (TRS) is a public defined-benefit pension fund dedicated to delivering retirement benefits and related services for more than 1,000,000 public education employees and their annuitants in the state of Texas. It currently has more than USD 90 billion of assets under management.
Investment Problem: The Board of Trustees at TRS faces a typical “asset-liability” management problem in that they must invest so as to simultaneously satisfy the income needs of current retirees and beneficiaries as well as provide sufficient asset growth to provide for future funding needs. The system is currently underfunded relative to actuarial liabilities, largely due to the fact that contributions from the state legislature have not kept pace with needs.
Portfolio Optimization Application: Mean-variance optimization approach across multiple asset classes, including U.S. equity, non-U.S. equity, fixed-income, private equity, “strategically traded” (i.e., hedge funds), and real estate.
Miscellaneous Issues:- Ennis Knupp Associates in the main economic consultant to the TRS Board- TRS is required by state law to revisit strategic allocation process every 3-5 years
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TRS: Initial Strategic Allocation & Comparable Portfolios
Current
TRS
Higher Equity
Allocation
Higher Real
Estate and Emerging
Debt Allocation
Average Large Public Fund
(TUCS)
Average State Public Fund Over $5 Billion
(Greenwich)
Average State
Public Fund
Over $1 Billion
(Russell Mellon)
U.S. Stock 52.5% 53% 51% 44% 42% Non-U.S. Stock
13 17.5 16.5 57% 12 17
Real Estate
0 0 3 4 4 5
Private Equity
3 3 3 4 3 5
Hedge Funds
1.5 1.5 1.5 -- <1 0
Total Equity
70% 75% 75% 65% 63% 69%
Bonds 29.5% 25% 25% 30% 33% 30% Cash 0.5 -- -- 3 1 1 Total Bonds
30% 25% 25% 33% 34% 31%
Other -- -- -- 1% 3% --
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Texas Teachers’ Retirement System: Optimization Process Overview
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TRS: Steps in the Process
Establish assumptions and simulate key economic variables Inflation (price and wage) Interest rates Asset class returns, volatility and correlations
Use simulations to develop plan financial results over forecast period
Summarize and graph results Trends Range and distribution of results (i.e. uncertainty or risk)
Test impact of alternative equity allocation targets
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TRS: Unfunded Status
A contribution from the State of Texas of about (12% x Pay) would be required to fund the normal cost plus amortize a $22 billion unfunded actuarial liability over 30 years
Actuarial liability 89,323$ MM 95,000$ MM
Actuarial value of assets 86,035$ MM 87,000$ MM Unfunded = $22 bn
Market value of assets * 71,696$ MM 73,000$ MM
Funded ratio -- actuarial value 96% 92%
Funded ratio -- market value 80% 77%
9/1/2002Projected 9/1/2003
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TRS: Economic Assumptions for the Forecast
Each forecast reflects a specific scenario for future rates of inflation, wage increases, bond yields and asset class returns
These variables will be different than the actuarial assumptions, thus producing “actuarial gains or losses” that are recognized in the forecast results – just as happens in each year’s actuarial valuation results
For the baseline forecast, best estimate assumptions are used
For simulation runs, the model produces 500 different scenarios with year-to-year fluctuations in each economic variable – but the average result across all 500 scenarios will closely match the best estimate assumptions from the baseline forecast
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TRS: Example of Simulation-Based Forecasting Process
2.65%
3.65%
4.30%
0%
1%
2%
3%
4%
5%
6%
7%
8%
WageInflation**
10-yr.BondYield
Price Inflation*
* Compound average price inflation over 15 years is 3.00%.** Compound average wage inflation over 15 years is 4.00%. A merit/promotional increase is added to wage inflation to get the total salary increase rate.
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TRS: Asset Class Mix and Assumptions
Target Alloc.
Expected Annual Return
Standard Deviation
Fixed income + short term 30.0% 4.65% 7.7%
Equity-type assets:U.S. equity 52.4% 8.45% 16.7%Non-US equity 13.1% 8.45% 18.7%Private equity 3.0% 11.45% 31.2%Strategically traded 1.5% 5.78% 8.2%
Subtotal 70.0% 8.52% 16.4%
Total portfolio -- gross return 7.36% 12.3%
Less investment expenses (passive) 0.00%Less "volatility drag" -0.58%
15-yr. compound return, net of expenses 6.78%
Less average inflation impact 3.06%
Compound real return, net of expenses 3.72%
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TRS: Gross Return Simulations with Different Equity Levels in Portfolio
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Target Equity %
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
100% Fixed
100% Equity0% Equity
30% Fixed 0% Fixed
70% Equity
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Target Equity %
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
4.65% 7.36%8.52%
100% Equity0% Equity 70% Equity
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TRS: Forecast Results With Full Simulation
Six different sets of results, based on two key variables Three different rates of employer contribution (as % of pay)
6% (current) 10% (constitutional max) 14% (approximate rate for 30-year amortization of UAL, plus a 2% cushion)
Two different assumptions for ad hoc benefit increases to retirees No ad hoc increases Increases to match CPI each year
Funded ratio results = actuarial value of assets / actuarial value of liabilities Based on current actuarial assumptions in almost all scenarios Only in some of the scenarios where market interest rates move to (and
stay at) extreme levels do we assume that changes in the actuarial assumptions would be made
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Question: How Much Equity to Include in the TRS Portfolio?
First analysis is for the result set that puts the lowest emphasis on the need for high equity returns to maintain funded status:
Assume contributions are at 14% of pay Assume no ad hoc increases for retirees
Look at distribution of final (year 15) funded position and the contribution required to fund it
Final unfunded liability = final actuarial liability minus final market value of assets Calculate the additional contribution (% pay) that would be required over the 15 year
forecast period to fully fund the final unfunded liability – call this the “full funding cost add-on”
Put no weight on any final surplus assets (i.e. the required contribution above is never less than zero)
Repeat for various equity allocation targets
Perform risk / reward analysis Reward = average of all 500 simulated scenarios Risk = average of the worst 100 simulated scenarios Plot the changes in risk and reward measures vs. current policy
Repeat analysis using a result set that puts more emphasis on the need for high equity returns to maintain funded status (10% contributions & full ad hocs)
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Example of Simulation Analysis on Final Funded Ratio: 14% Contributions & No Ad Hocs
Equity % 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Percentile values:
5% 56% 55% 56% 55% 54% 52% 50% 49% 48% 47% 45% 43% 41% 39% 37% 36%25% 66% 67% 70% 70% 70% 71% 71% 71% 70% 70% 69% 69% 69% 69% 68% 66%50% 75% 77% 82% 83% 85% 86% 87% 88% 90% 91% 92% 92% 93% 94% 94% 95%75% 85% 88% 95% 99% 102% 106% 109% 113% 117% 121% 125% 129% 133% 136% 140% 145%95% 99% 105% 117% 124% 133% 142% 150% 161% 172% 183% 195% 207% 218% 229% 243% 258%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
110%
120%
130%
140%
150%
160%
170%
180%
190%
200%
210%
220%
230%
240%
250%
260%
25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Equity %
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
110%
120%
130%
140%
150%
160%
170%
180%
190%
200%
210%
220%
230%
240%
250%
260%
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-0.50%
-0.25%
0.00%
0.25%
0.50%
-1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5%
More risk
Lo
we
r c
os
t
Hig
he
r c
os
t
Benchmark ( = current mix)
Change in cost relative to “benchmark” values
Less risk
Avg. Risk Increase (% Pay)(Worst 100 scenarios)
Av
g.
Co
st
Sa
vin
gs
(%
Pa
y)
(All
50
0 s
ce
na
rio
s)
TRS: Notion of Risk-Reward Analysis
2.19
5 - 15
-0.50%
-0.25%
0.00%
0.25%
0.50%
-1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5%
Benchmark ( = current 70%)
Avg. Risk Increase (% Pay)(Worst 100 scenarios)
Av
g.
Co
st
Sa
vin
gs
(%
Pa
y)
(All
50
0 s
ce
na
rio
s)
TRS: Risk-Reward Analysis for Different Equity Levels
2.20
80%
90%
60%
50%
40%
Conclusion: Based on this analysis, a reduction in the equity allocation to as low as 40% could be justified. At 60% equity, risk is reduced, but the average cost remains essentially unchanged.
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TRS: Mean-Variance Optimization Inputs and Results
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Texas Teachers’ Retirement System (cont.)
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Texas Teachers’ Retirement System (cont.)
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Portfolio Optimization Example #2: 2004 Chilean Pension System (Source: Fidelity Investments)
Background: System of private pension accounts since 1980. Beneficiaries select among several different investment managers (i.e., AFPs), which in turn over five different asset allocation alternatives. Constraints exist as to how much non-CLP investment can occur and what form the foreign investments must take.
Investment Problem: What are the optimal strategic asset allocations for the Chilean pension funds?
Portfolio Optimization Application: Augmented mean-variance optimization using three Chilean asset classes (stocks, bonds, cash) and four foreign asset classes (U.S. stocks, U.S. bonds, Developed Non-U.S. stocks, Developed Non-U.S. bonds)
Miscellaneous Issue: Optimization process uses the “Resampled Frontier” approach to reduce estimation error problems
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Two Approaches to the Chilean Pension Investment Problem
Defined Benefit (DB)- Immunize the future liability stream (or manage the surplus)
- All individuals treated identically within the overall plan
Defined Contribution (DC)- Maximize wealth at retirement subject to risk
- Provide efficient portfolios in absolute return/risk space
- Individuals select risk/return profile based on preferences
Analysis requires: - Long-term expected asset class returns
- Asset class covariances
- Appropriate portfolio construction
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Chile: Base Case Assumptions
Chile Stock
Chile Bond
Chile Cash
Developed Stock
Developed Bond US Stock US Bond
Risk Premium 7.19% 2.65% 0.00% 4.89% 1.66% 5.83% 1.41%
Real Cash Return 0.60% 0.60% 0.60% 0.60% 0.60% 0.60% 0.60%
Expected Real Return 7.79% 3.25% 0.60% 5.49% 1.66% 6.43% 2.01%
Volatility 25.02% 6.75% 1.50% 12.57% 3.33% 14.75% 5.05%
Base Case Assumptions:
-Expected real returns based on 1954 – 2003 risk premiums
-Real returns for developed market stocks and bonds areGDP-weighted excluding US (equally-weighted returns for stocks and bonds are 5.73% and 1.39%, respectively)
- Chilean risk-premium volatility estimates exclude the period 1/72 – 12/75
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Chile: Base Case Assumptions (cont.)
Chile Stock
Chile Bond
Chile Cash
Developed Stock
Developed Bond US Stock US Bond
Domestic Stocks 100.00% 21.85% 13.51% 35.28% -20.91% 38.78% -23.13%Domestic Bonds 100.00% 31.04% 2.71% -0.98% -1.39% 2.37%Domestic Cash 100.00% 1.79% 10.31% 6.27% 3.77%DM Stocks 100.00% 26.01% 71.23% 11.06%DM Bonds 100.00% 7.54% 73.19%US Stocks 100.00% 16.56%US Bonds 100.00%
- Correlation matrix is based on real returns from the period 1/93 – 6/03 using Chilean inflation and based in Chilean pesos
- Real returns for developed market stocks and bonds areGDP-weighted excluding US
5 - 23
Chile: Notion of a Resampled Efficient Frontier
Problems with traditional mean-variance optimization
Rare events such as unusually low or high returns greatly affect the result of the optimization (maximizing sampling error)
Length of data series is crucial -- the longer the forecasting period, the longer data series are required
“Optimal” efficient frontier may not be optimal and should not be used to make all asset allocation decisions
6%
7%
8%
9%
10%
11%
12%
2% 3% 4% 5% 6% 7% 8% 9% 10%
Annual Volatility (%)
An
nu
al R
etu
rn (
%)
5 - 24
Chile: Notion of a Resampled Efficient Frontier (cont.)
Created by Richard Michaud, resampling is a Monte Carlo technique for estimating the inputs of a mean-variance efficient frontier that results in well-diversified portfolios.
Concept of a Resampled Efficient Frontier:- Take a random sample of observation from a universe of asset class
returns (e.g., 30 of 60 months) and calculate the efficient frontier- Divide this efficient frontier into 20 regions by risk or expected return
and look at the median allocation in each of these regions- Repeat these steps for a new sampling of the asset class return
universe- Generate a large collection of efficient frontiers by repeated sampling of
the return universe (e.g., 500-1000 trials)- Average all of the “regional” allocations across the collection of
optimization trials – this is the resampled efficient frontier
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Chile: Notion of a Resampled Efficient Frontier (cont.)
Resampling provides a more realistic and reliable risk/return structure
Robust estimate of underlying distributions
While the weights on the actual frontier change erratically, the resampled weights are evenly distributed along the points on the efficient frontier
With the actual efficient frontier, a marginal change in risk or return can bring about a dramatic change in the optimal allocation. With the resampled frontier, the changes in weights are always smooth
Potential shortcomings of resampling:
Lack of theory (i.e., no reason why resampled portfolios will be optimal)
No framework for incorporating tactical views
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Chile: Traditional vs. Resampled Efficient Frontier
Asset Weights along Traditional FrontierScenario 1
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Points along Traditional Effi cient Frontier
Asset 4
Asset 3
Asset 2
Asset 1
Asset Weights along Resampled Frontier
Scenario 1
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Points along Resampled Effi cient Frontier
Asset 4
Asset 3
Asset 2
Asset 1
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Chile: Base Case Unconstrained Resampled Frontier
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Chile: Base Case Unconstrained Resampled Frontier (cont.)
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Chile: Base Case Unconstrained Resampled Frontier (cont.)
Unconstrained Frontier:
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Chile: Modifying the Unconstrained Optimization
Fund A Fund B Fund C Fund D Fund EChile Stock 60% 50% 30% 15% 0%Chile Bond 40% 40% 50% 70% 80%Chile Cash 40% 40% 50% 70% 80%
All Foreign Investments 30% 30% 30% 30% 30%Min Total Equity 40% 25% 15% 5% 0%Max Total Equity 80% 60% 40% 20% 0%
Constraint Set:
5 - 31
Chile: Modifying the Unconstrained Optimization (cont.)
Constrained Frontier for Fund A:
Point on EF
Chile Stock
Chile Bond
Chile Cash
Developed Stock
Developed Bond US Stock US Bond
Expected Return Volatility
1 10.0% 20.0% 40.0% 24.2% 0.0% 5.8% 0.0% 3.37 5.65 2 10.6% 21.0% 38.4% 22.3% 0.2% 7.2% 0.3% 3.43 5.73 3 11.3% 22.4% 36.3% 20.7% 0.5% 8.2% 0.6% 3.51 5.85 4 12.1% 23.8% 34.1% 19.3% 0.7% 9.0% 0.9% 3.59 6.00 5 13.2% 24.9% 32.1% 18.0% 0.9% 9.6% 1.3% 3.68 6.18 6 14.4% 25.7% 30.2% 16.9% 1.1% 10.0% 1.7% 3.76 6.38 7 15.7% 26.3% 28.3% 15.9% 1.4% 10.3% 2.0% 3.85 6.62 8 17.2% 26.9% 26.4% 15.0% 1.6% 10.6% 2.3% 3.95 6.89 9 18.7% 27.2% 24.5% 14.2% 1.9% 10.9% 2.6% 4.05 7.19
10 20.3% 27.5% 22.7% 13.5% 2.1% 11.0% 2.8% 4.16 7.51 11 22.1% 27.7% 20.9% 13.0% 2.3% 11.1% 3.0% 4.27 7.86 12 23.9% 27.8% 19.3% 12.4% 2.4% 11.1% 3.2% 4.38 8.23 13 25.8% 27.8% 17.8% 11.9% 2.3% 11.2% 3.3% 4.49 8.63 14 27.8% 27.6% 16.4% 11.4% 2.3% 11.3% 3.2% 4.61 9.06 15 29.9% 27.2% 15.3% 10.9% 2.1% 11.4% 3.2% 4.74 9.53 16 32.3% 26.7% 14.1% 10.5% 2.0% 11.5% 3.1% 4.87 10.04 17 34.8% 25.9% 12.9% 10.1% 1.8% 11.5% 2.9% 5.01 10.61 18 37.6% 25.1% 11.6% 9.6% 1.7% 11.6% 2.8% 5.17 11.23 19 40.9% 24.2% 10.3% 8.8% 1.4% 11.6% 2.7% 5.34 11.97 20 45.6% 23.0% 8.0% 7.9% 1.2% 12.2% 2.2% 5.63 13.08
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Chile: Comparing Optimal Allocations Across Constraints
Chile Stock
Chile Bond
Chile Cash
Developed Stock
Developed Bond
US Stock
US Bond
Expected Return Volatility
Unconstrained 42.8% 11.2% 0.0% 15.2% 1.6% 26.0% 3.2% 6.3% 13.9%Fund A 45.6% 23.0% 8.0% 7.9% 1.2% 12.2% 2.2% 5.6% 13.1%Fund B 35.5% 32.2% 10.1% 6.1% 1.7% 11.1% 3.3% 5.0% 10.6%Fund C 18.6% 40.3% 15.7% 6.0% 2.5% 10.7% 6.2% 4.0% 6.9%Fund D 6.5% 54.9% 14.5% 4.9% 5.4% 6.7% 7.1% 3.3% 4.9%Fund E 0.0% 63.8% 15.3% 0.0% 7.4% 0.0% 13.5% 2.6% 4.5%
Asset Allocations of Various Funds Using Point 20 on Unconstrained Frontier:
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Chile: Comparing Optimal Allocations Across Constraints (cont.)
Asset Allocations of Various Funds Using Point 15 on Unconstrained Frontier:
Chile Stock
Chile Bond
Chile Cash
Developed Stock
Developed Bond
US Stock
US Bond
Expected Return Volatility
Unconstrained 18.1% 20.6% 2.9% 19.4% 9.2% 18.6% 11.3% 4.7% 8.1%Fund A 29.9% 27.2% 15.3% 10.9% 2.1% 11.4% 3.2% 4.7% 9.5%Fund B 19.5% 31.6% 20.3% 9.4% 2.2% 12.1% 4.8% 4.1% 7.2%Fund C 9.0% 34.4% 28.5% 7.2% 3.6% 9.4% 7.9% 3.2% 4.7%Fund D 3.7% 30.3% 38.6% 5.6% 8.3% 5.6% 8.0% 2.5% 3.3%Fund E 0.0% 40.7% 35.0% 0.0% 11.4% 0.0% 13.0% 2.0% 3.1%
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Portfolio Optimization Example #3: 2005 University of Texas Investment Management Company
Background: The University of Texas Investment Management Company (UTIMCO) is a private company whose only client is the public endowment fund holding the assets of the University of Texas and Texas A&M University Systems. It currently has about USD 16 billion under management.
Investment Problem: The Board of Directors of UTIMCO faces a multi-dimensional investment problem that involves both short- and intermediate-term funding needs for the various campuses in the UT and A&M systems as well as long-term growth goals. Although UT is a public university, the UTIMCO staff feels that it must produce investment returns that are comparable to the endowments of Harvard and Yale Universities.
Portfolio Optimization Application: Mean-downside risk optimization approach across multiple asset classes, including U.S. equity, non-U.S. equity, fixed-income, private equity, hedge funds, and real estate.
Miscellaneous Issues: - The downside risk threshold is the funding rate that is projected by the System’s
Board of Regents, which consists of politically appointed members.- Cambridge Associates is the primary economic consultant to the UTIMCO Board
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UTIMCO: Initial Asset Allocation and Issues to Address
May, 2005 35
Benchmark for Developed International and Emerging Markets
Target and Upper Limit Identical in Hedge Funds
Target and Upper Limit Identical in Private Equity
Target and Lower Limit Identical in Fixed Income
Remove REITS From US Equity Category
Remove TIPS From Fixed Income Category
Reinstate Inflation Hedge Category
Liquidity Policy is Inconsistent With Asset Allocation Policy
Asset Category Policy Target Policy Range Benchmarks
U S Equities (Includes REITs) 25.0 15 to 45Combination benchmark: 80% Russell 3000 Index plus 20% Wilshire Associates Real Estate Securities Index
Traditional US Equities 20.0 15 to 45 Russell 3000 Index REITs 5.0 0 to 10 Dow Jones Wilshire Real Estate Securities IndexGlobal ex US Equities MSCI All Country World Index ex USNon-US Developed Equity 10.0 5 to 15Emerging Markets Equity 7.0 0 to 10 Total Equity 42.0 20 to 60
Equity Hedge Funds 10.0 5 to 15 90 day T-Bills + 4%Absolute Return Hedge Funds 15.0 10 to 20 90 day T-Bills + 3% Total Hedge Funds 25.0 15 to 25
Venture Capital 6.0 0 to 10Private Equity 9.0 5 to 15 Total Private Capital 15.0 5 to 15 Venture Economics Periodic IRR indexCommodities 3.0 0 to 10 GSCI minus 1%
Fixed Income (Includes TIPS) 15.0 10 to 30Combination benchmark: 66.7% Lehman Brothers Aggregate Bond Index plus 33.3% Lehman Brothers TIPS Index
Traditional Fixed Income 10.0 10 to 30 Lehman Brothers Aggregate Bond Index TIPS 5.0 0 to 10 Lehman Brothers US TIPS IndexCash 0.0 0 to 5 90 day T-Bills
Percent of Portfolio (%)
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UTIMCO: How Competitive is the Current Allocation Policy?
May, 2005 36
UT System Policy Allocation Weights Versus Other Endowment Categories Actual Allocations
(6.3
)
3.8 6.
4
0.0
(1.3
)
(2.6
)
(18.
5)
13.5
9.8
1.8
(4.2
)
(2.4
)
(9.8
)
7.0 7.9
0.6
(3.0
)
(2.7
)
7.0
(0.7
)
(4.8
)
(3.3
)
2.9
(1.1
)
1.6
1.0 2.
4
(1.2
)
(2.2
)
(1.6
)
(25.0)
(20.0)
(15.0)
(10.0)
(5.0)
0.0
5.0
10.0
15.0
20.0
Equity Hedge Funds Private Capital Real Estate Fixed Income Cash
UT
Syst
em W
eigh
t min
us O
ther
Wei
ght (
%)
Endowments Larger Than $1 billion Public Endowments Independent Endowments 10 Most Successful Cambridge 20
UT Weight Larger
UT Weight Smaller
Source: 2004 NACUBO Endowment Study, Cambridge Associates
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UTIMCO: Recent Performance Relative to Large Endowment Peers
May, 2005 37
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UTIMCO: Inputs for the Asset – Obligation Optimization Process
March, 2005 16
The Asset – Obligation Optimization Process Requires the Following Assumptions:
Expected Returns
Expected Risk and Risk Profile
Correlations Between Expected Returns Across Asset Categories
The Minimum Acceptable Return (or MAR)
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UTIMCO: Developing Return Assumptions Through the Risk Premium Approach
March, 2005 18
T bills
Real Interest
Rate
Inflation
Term Premium
Credit Risk
Premium
T notes
CorpBonds
USEquities
Equity Risk
Premium
3.00%
1.00%
1.40%
1.25%
1.5% to 2.0%
4.00%
5.40%6.65%
8.15%to
8.65%T bills
Real Interest
Rate
Real Interest
Rate
InflationInflation
Term Premium
Term Premium
Credit Risk
Premium
Credit Risk
Premium
T notes
CorpBonds
USEquities
Equity Risk
Premium
Equity Risk
Premium
3.00%
1.00%
1.40%
1.25%
1.5% to 2.0%
4.00%
5.40%6.65%
8.15%to
8.65%
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UTIMCO: Developing Return Assumptions by Building Economic Return Components
March, 2005 19
ProjectionsThe
"Golden Years"
The Bubble Years
The Bubble Bursts
Next 15 Years
1950 to 1995
1996 to 1999
2000 to 2002
2004 to 2019
Capital Appreciation: (all numbers annual % change)Inflation 4.2 2.2 2.1 3.0Real Earnings Growth 3.1 5.1 (7.7) 4.0Change in Valuation (P/E ratio) 1.5 18.1 (10.3) (0.5) Total Capital Appreciation 8.8 25.4 (15.9) 6.5
Yield:Dividend Yield 4.3 2.2 1.6 1.8
Total Return 13.1 27.6 (14.3) 8.3
History
Total Return = Capital Appreciation + Yield
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UTIMCO: Notion of Potential Value Added (PVA)
23
Potential Value-Added (PVA) is the opportunity to increase returns beyond those generally available in an asset class through active management,
PVA takes two forms: PVA by an active manager is the result of effective security selection
usually based on extensive research and analysis skills, PVA by staff can result from a wide range of sources including skill in
manager selection, term negotiations, manager monitoring, responses to periodic special opportunities in the markets, and risk control.
The objective at UTIMCO is to focus on high PVA opportunities, developing or purchasing the skills necessary to earn attractive returns.
March, 2005
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UTIMCO: Measuring PVA Across Asset Classes
24
High value-added spread equals high PVA, PVA spreads measure the opportunity for value-added Realistic assumptions on future value-added spreads are the basis for
PVA projections A realistic evaluation of staff and external manager skills leads to an
estimated “Capture Ratio” that defines the portion of the total value-added spreads we expect to earn in excess returns
Differences in Returns (%)
U.S. Equities
U.S. Fixed
Income
Int'l Equities
Real Estate
Int'l Fixed
Income
Small Cap U.S. Equity
Venture Capital
Hedge Funds
Private Equity
Selection Reward 1.10 1.10 1.20 2.10 2.90 5.63 9.00 9.50 10.60
Selection Penalty (0.60) (1.00) (0.90) (1.90) (1.90) (6.10) (7.50) (8.90) (12.10)
Value-Added Spread 1.70 2.10 2.10 4.00 4.80 11.73 16.50 18.40 22.70
Selection Reward = First Quartile Return minus Median ReturnSelection Penalty = Third Quartile Return minus Median ReturnValue Added Spread = First Quartile Return minus Third Quartile Return
All data from 1980 - 1997; Source: PIPER, Cambridge Associates, Venture Economics, Institutional Property Consultants
March, 2005
5 - 43
UTIMCO: Efficient Frontier With PVA
5 - 44
UTIMCO: Recommended 2005 Return and Risk Assumptions With PVA
May, 2005 44
Risk & Return Assumptions Summary: PVA Assumptions:
Data ItemConsultant Average
HistoricalUTIMCO
2003UTIMCO
2005
▪ 75th Pct PVA ▪ 25th Pct PVA
V/A Spread
Capture Ratio
▪ Exp PVA ▪ Std Dev
UTIMCO 2003 with
PVA
UTIMCO 2005 with
PVA
US Equity Nominal Returns 8.85% 11.53% 8.50% 8.50% 2.50% 35% 0.88% 9.13% 9.38% Real Returns 6.37% 6.86% 5.50% 5.50% -2.50% 6.13% 6.38% Std Deviation 16.44% 15.82% 17.00% 17.00% 5.00% 3.71% 17.40% 17.40%
Non-US Developed Equity Nominal Returns 8.85% 11.86% 8.50% 8.50% 3.00% 35% 1.05% 9.25% 9.55% Real Returns 6.38% 7.19% 5.50% 5.50% -3.00% 6.25% 6.55% Std Deviation 17.48% 16.77% 19.00% 19.00% 6.00% 4.45% 19.51% 19.51%
Emerging Markets Equity Nominal Returns 10.34% 15.04% 11.00% 10.50% 10.00% 25% 2.50% 12.50% 13.00% Real Returns 7.86% 10.36% 8.00% 7.00% -10.00% 9.50% 10.00% Std Deviation 24.80% 23.25% 26.00% 26.00% 20.00% 14.83% 29.93% 29.93%
Absolute Return Hedge Funds Nominal Returns 6.91% 10.79% 7.00% 7.00% 4.00% 25% 1.00% 8.00% 8.00% Real Returns 4.42% 6.12% 4.00% 4.00% -4.00% 5.00% 5.00% Std Deviation 6.49% 6.15% 7.50% 7.50% 8.00% 5.93% 9.56% 9.56%
Equity Hedge Funds Nominal Returns 8.46% 10.48% 8.00% 8.00% 5.00% 25% 1.25% 9.25% 9.25% Real Returns 5.97% 5.81% 5.00% 5.00% -5.00% 6.25% 6.25% Std Deviation 8.37% 8.16% 11.00% 10.00% 10.00% 7.41% 13.26% 12.45%
Venture Capital Nominal Returns 14.24% 15.16% 14.00% 14.00% 15.00% 15% 2.25% 16.25% 16.25% Real Returns 11.57% 10.49% 11.00% 11.00% -15.00% 13.25% 13.25% Std Deviation 31.63% 18.78% 30.00% 30.00% 30.00% 22.24% 37.34% 37.34%
5 - 45
UTIMCO: Recommended 2005 Return and Risk Assumptions With PVA (cont.)
May, 2005 45
Risk & Return Assumptions Summary: PVA Assumptions:
Data ItemConsultant Average
HistoricalUTIMCO
2003UTIMCO
2005
▪ 75th Pct PVA ▪ 25th Pct PVA
V/A Spread
Capture Ratio
▪ Exp PVA ▪ Std Dev
UTIMCO 2003 with
PVA
UTIMCO 2005 with
PVA
Private Equity Nominal Returns 11.85% 11.32% 11.50% 11.50% 10.00% 20% 2.00% 13.50% 13.50% Real Returns 9.38% 6.65% 8.50% 8.50% -10.00% 10.50% 10.50% Std Deviation 28.25% 9.04% 20.00% 24.00% 20.00% 14.83% 24.90% 28.21%
REITS Nominal Returns 7.89% 14.54% 7.50% 7.50% 3.00% 25% 0.75% 8.25% 8.25% Real Returns 5.41% 9.87% 4.50% 4.50% -3.00% 5.25% 5.25% Std Deviation 13.64% 14.74% 15.00% 15.00% 6.00% 4.45% 15.65% 15.65%
Commodities (Financial) Nominal Returns 6.40% 13.37% 5.00% 6.00% 3.00% 25% 0.75% 5.00% 6.75% Real Returns 3.70% 8.70% 2.00% 3.00% -3.00% 2.00% 3.75% Std Deviation 18.47% 18.43% 18.00% 18.00% 6.00% 4.45% 18.00% 18.54%
TIPS Nominal Returns 4.94% 9.07% 5.50% 5.50% 1.00% 25% 0.25% 5.50% 5.75% Real Returns 2.40% 4.39% 2.50% 2.50% -1.00% 2.50% 2.75% Std Deviation 6.00% 3.69% 6.00% 6.00% 0.00% 1.48% 6.00% 6.18%
US Fixed Income Nominal Returns 5.18% 8.80% 5.00% 5.75% 1.00% 25% 0.25% 5.25% 6.00% Real Returns 2.70% 4.13% 2.00% 2.75% -1.00% 2.25% 3.00% Std Deviation 5.34% 6.02% 6.00% 7.00% 2.00% 1.48% 6.18% 7.16%
Cash Nominal Returns 3.33% 6.43% 4.00% 4.00% 0.00% 0% 0.00% 4.00% 4.00% Real Returns 0.86% 1.75% 1.00% 1.00% 0.00% 1.00% 1.00% Std Deviation 0.88% 0.91% 1.00% 1.00% 0.00% 0.00% 1.00% 1.00%
Inflation Returns 2.48% 4.67% 3.00% 3.00% 3.00% 3.00% Std Deviation 1.25% 1.17% 2.00% 1.50%
5 - 46
UTIMCO: Risk Framework
1. Risk is asymmetric. Falling below an expected future value in an investment is a lot more important than exceeding the expected value.
2. Risk is relative. Just like the old saying that if you don’t know where you are going, any road will take you there, if there is no return objective for an investment, there can’t be any real risk. Risk must be measured relative to a desired result. Modern Portfolio Theory (MPT) uses the mean return of an asset as the desired result by default. Post-Modern Portfolio Theory (PMPT) allows us to specify the desired result, and then measures risk as the likelihood that the desired result will not be achieved.
3. Risk is investor specific. MPT holds that the risk inherent in common stocks is the same for all investors since risk is measured relative to the mean return for stocks, which is the same for all investors. That doesn’t make any sense, of course. PMPT measures risk specifically and individually for each investor by allowing the investor to set a “minimal acceptable return” (MAR) against which all asset return expectations are measured. Common stocks represent a very different level of risk to the UT System than they do to your aunt Martha.
4. Risk is multidimensional. Once again, MPT falls short because it allows only a single dimension of risk. But investors usually want to achieve several goals simultaneously, but are willing to sacrifice one goal to achieve a more important goal if necessary. PMPT and Decision Factors will allow us to deal with multidimensional goals.
5. Risk is non-linear. Most investors consider a large potential loss at a low probability of occurrence as much more risky than a smaller loss at a higher probability such that the expected losses are similar. We must be able to deal with such non-linearity in investor decision making. MPT cannot; PMPT does.
5 - 47
UTIMCO: Developing Return Correlations Assumptions
May, 2005 47
US Equities - Fixed Income
-0.20
-0.49
0.05
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
Jan-95 Jan-05Jan-00
5 - 48
UTIMCO: Developing Return Correlations Assumptions (cont.)
May, 2005 48
US Equities - Global Equities
0.850.89
0.67
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
Jan-95 Jan-05Jan-00
5 - 49
UTIMCO: Recommended Return Correlations Assumptions
May, 2005 49
US Equities Global EquitiesEmerging Markets Equities
Absolute Return Hedge
Funds
Directional Hedge Funds
Venture Capital Private Equity REITs Commodities TIPS Fixed Income Cash
US Equities 1.00
Global Equities 0.85 1.00
Emerging Markets Equities 0.80 0.80 1.00
Absolute Return Hedge Funds 0.50 0.50 0.50 1.00
Directional Hedge Funds 0.60 0.60 0.60 0.65 1.00
Venture Capital 0.35 0.30 0.30 0.20 0.50 1.00
Private Equity 0.50 0.45 0.30 0.30 0.50 0.65 1.00
REITs 0.50 0.50 0.50 0.40 0.40 0.00 0.15 1.00
Commodities 0.00 0.00 0.20 0.10 0.10 0.20 0.00 0.10 1.00
TIPS -0.10 -0.15 -0.15 0.15 0.15 -0.15 0.05 0.00 0.30 1.00
Fixed Income -0.20 -0.20 -0.20 0.10 0.10 -0.10 -0.10 -0.10 -0.05 0.70 1.00
Cash 0.00 -0.10 -0.10 0.00 0.00 0.00 0.00 -0.10 0.00 0.25 0.25 1.00
Strongly diversifying asset relationships (with correlations less than or equal to zero) are indicated in red.
2005 Asset Allocation ReviewReturn Correlation Assumptions
5 - 50
UTIMCO: Developing the Downside Risk Threshold
May, 2005 50
Policy Payout Rate 4.75
+ Expense Rate 0.35Only expenses that are not netted from returns are included here
+ Inflation Rate 3.00Have used CPI, but HEPI is more appropriate. HEPI is about 1% higher.
+ Safety Margin 0.00A Safety Margin could be useful in avoiding the Purchasing Power Wall and other calamities
= MAR 8.10 %
Calculating the Minimum Acceptable Return (MAR)
5 - 51
UTIMCO: Some Thoughts About Investment Restrictions
May, 2005 51
Constraints Should be Considered Carefully:
They Might be Useful to Express Uncertainty Rather Than Aversion
Constraints Should Define Unacceptable, Not Just Undesirable, Alternatives
Remember That Every Constraint Has a Real Cost (We will show the estimated costs of all constraints adopted.)
5 - 52
UTIMCO: The Cost of Constraint - 2003 Allocation
March, 2005 39
PMPT Efficient Frontier
7.00
8.00
9.00
10.00
11.00
12.00
13.00
14.00
15.00
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00
Downside Risk
Exp
ecte
d R
etr
urn
(%
)
Constrained Frontier Unconstrained Frontier
The Opportunity Cost of the Constraints is About $900 million Over a 5 Year Period
PMPT Efficient Frontier
7.00
8.00
9.00
10.00
11.00
12.00
13.00
14.00
15.00
2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00
Downside Risk
Exp
ecte
d R
etr
urn
(%
)
Constrained Frontier Unconstrained Frontier
The Opportunity Cost of the Constraints is About $900 million Over a 5 Year Period
5 - 53
UTIMCO: Existing and Recommended Constraints
May, 2005 53
Risk & Return Assumptions Summary: PVA Assumptions: Constraints:
Data ItemConsultant Average
HistoricalUTIMCO
2003UTIMCO
2005
▪ 75th Pct PVA ▪ 25th Pct PVA
V/A Spread
Capture Ratio
▪ Exp PVA ▪ Std Dev
UTIMCO 2003 with
PVA
UTIMCO 2005 with
PVA
2003 Minimum %
2003 Maximum %
2005 Minimum %
2005 Maximum %
US Equity 20% 100% 20% 100% Nominal Returns 8.85% 11.53% 8.50% 8.50% 2.50% 35% 0.88% 9.13% 9.38% Real Returns 6.37% 6.86% 5.50% 5.50% -2.50% 6.13% 6.38% Std Deviation 16.44% 15.82% 17.00% 17.00% 5.00% 3.71% 17.40% 17.40%
Non-US Developed Equity 10% 100% 10% 100% Nominal Returns 8.85% 11.86% 8.50% 8.50% 3.00% 35% 1.05% 9.25% 9.55% Real Returns 6.38% 7.19% 5.50% 5.50% -3.00% 6.25% 6.55% Std Deviation 17.48% 16.77% 19.00% 19.00% 6.00% 4.45% 19.51% 19.51%
Emerging Markets Equity 0% 10% 0% 15% Nominal Returns 10.34% 15.04% 11.00% 10.50% 10.00% 25% 2.50% 12.50% 13.00% Real Returns 7.86% 10.36% 8.00% 7.00% -10.00% 9.50% 10.00% Std Deviation 24.80% 23.25% 26.00% 26.00% 20.00% 14.83% 29.93% 29.93%
Absolute Return Hedge Funds 0% 20% 0% 25% Nominal Returns 6.91% 10.79% 7.00% 7.00% 4.00% 25% 1.00% 8.00% 8.00% Real Returns 4.42% 6.12% 4.00% 4.00% -4.00% 5.00% 5.00% Std Deviation 6.49% 6.15% 7.50% 7.50% 8.00% 5.93% 9.56% 9.56%
Equity Hedge Funds 0% 20% 0% 20% Nominal Returns 8.46% 10.48% 8.00% 8.00% 5.00% 25% 1.25% 9.25% 9.25% Real Returns 5.97% 5.81% 5.00% 5.00% -5.00% 6.25% 6.25% Std Deviation 8.37% 8.16% 11.00% 10.00% 10.00% 7.41% 13.26% 12.45%
Venture Capital 0% 10% 0% 10% Nominal Returns 14.24% 15.16% 14.00% 14.00% 15.00% 15% 2.25% 16.25% 16.25% Real Returns 11.57% 10.49% 11.00% 11.00% -15.00% 13.25% 13.25% Std Deviation 31.63% 18.78% 30.00% 30.00% 30.00% 22.24% 37.34% 37.34%
5 - 54
UTIMCO: Existing and Recommended Constraints (cont.)
May, 2005 54
Risk & Return Assumptions Summary: PVA Assumptions: Constraints:
Data ItemConsultant Average
HistoricalUTIMCO
2003UTIMCO
2005
▪ 75th Pct PVA ▪ 25th Pct PVA
V/A Spread
Capture Ratio
▪ Exp PVA ▪ Std Dev
UTIMCO 2003 with
PVA
UTIMCO 2005 with
PVA
2003 Minimum %
2003 Maximum %
2005 Minimum %
2005 Maximum %
Private Equity 0% 10% 0% 15% Nominal Returns 11.85% 11.32% 11.50% 11.50% 10.00% 20% 2.00% 13.50% 13.50% Real Returns 9.38% 6.65% 8.50% 8.50% -10.00% 10.50% 10.50% Std Deviation 28.25% 9.04% 20.00% 24.00% 20.00% 14.83% 24.90% 28.21%
REITS 0% 10% 0% 10% Nominal Returns 7.89% 14.54% 7.50% 7.50% 3.00% 25% 0.75% 8.25% 8.25% Real Returns 5.41% 9.87% 4.50% 4.50% -3.00% 5.25% 5.25% Std Deviation 13.64% 14.74% 15.00% 15.00% 6.00% 4.45% 15.65% 15.65%
Commodities (Financial) 0% 10% 0% 10% Nominal Returns 6.40% 13.37% 5.00% 6.00% 3.00% 25% 0.75% 5.00% 6.75% Real Returns 3.70% 8.70% 2.00% 3.00% -3.00% 2.00% 3.75% Std Deviation 18.47% 18.43% 18.00% 18.00% 6.00% 4.45% 18.00% 18.54%
TIPS 0% 10% 0% 15% Nominal Returns 4.94% 9.07% 5.50% 5.50% 1.00% 25% 0.25% 5.50% 5.75% Real Returns 2.40% 4.39% 2.50% 2.50% -1.00% 2.50% 2.75% Std Deviation 6.00% 3.69% 6.00% 6.00% 0.00% 1.48% 6.00% 6.18%
US Fixed Income 10% 100% 10% 100% Nominal Returns 5.18% 8.80% 5.00% 5.75% 1.00% 25% 0.25% 5.25% 6.00% Real Returns 2.70% 4.13% 2.00% 2.75% -1.00% 2.25% 3.00% Std Deviation 5.34% 6.02% 6.00% 7.00% 2.00% 1.48% 6.18% 7.16%
Cash 0% 0% -10% 0% Nominal Returns 3.33% 6.43% 4.00% 4.00% 0.00% 0% 0.00% 4.00% 4.00% Real Returns 0.86% 1.75% 1.00% 1.00% 0.00% 1.00% 1.00% Std Deviation 0.88% 0.91% 1.00% 1.00% 0.00% 0.00% 1.00% 1.00%
Inflation Returns 2.48% 4.67% 3.00% 3.00% 3.00% 3.00% Std Deviation 1.25% 1.17% 2.00% 1.50%
5 - 55
UTIMCO: Mean-Downside Risk Optimization Candidate Policy Portfolios Derived From 2005 Capital Market Assumptions
May, 2005 55
2005 EFFICIENT FRONTIERConstrained vs Unconstrained Frontiers
7.75%
7.95%
8.15%
8.55%
8.75%
8.95%9.05%
9.65%
9.05%8.95%
8.75%
8.55%
8.35%
8.15%
7.95%
7.75%
8.35%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0%1 Yr Downside Risk
Expe
cted
Ret
urns
Unconstrained (no short sales)
GEF w Constraints
2003 Asset Allocation Policy
5 - 56
UTIMCO: 2005 Candidate Policy Portfolios – No Constraints
May, 2005 56
Portfolio 1 3 5 7 9 11 13 142003
PolicyGEF Unconstrained (no short sales)US Equities 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 20.0%Global ex US Equities 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 10.0%Emerging Markets Equities 0.0% 0.0% 0.4% 1.0% 1.4% 2.1% 2.5% 2.6% 7.0%Absolute Return Hedge Funds 34.2% 34.1% 34.7% 33.4% 33.6% 34.0% 34.3% 33.8% 15.0%Directional Hedge Funds 0.0% 0.0% 0.0% 0.0% 0.2% 0.5% 1.2% 2.0% 10.0%Venture Capital 14.6% 16.0% 17.4% 18.6% 20.1% 21.4% 22.7% 23.4% 6.0%Private Equity 3.9% 4.8% 5.5% 6.4% 7.0% 7.7% 8.6% 8.8% 9.0%REITS 13.1% 14.5% 15.0% 16.6% 17.0% 16.8% 17.1% 17.4% 5.0%Commodities 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 3.0%Oil & Gas 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%TIPS 12.7% 7.2% 6.2% 0.0% 0.0% 0.0% 0.0% 0.0% 5.0%Fixed Income 21.5% 23.3% 20.8% 23.9% 20.7% 17.4% 13.7% 12.0% 10.0%Cash 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Expected Return 7.75% 7.95% 8.15% 8.35% 8.55% 8.75% 8.95% 9.05% 8.39%1 yr DR 5.2% 5.4% 5.7% 5.9% 6.2% 6.5% 6.8% 7.0% 7.6%3 yr DR 3.1% 3.2% 3.3% 3.4% 3.5% 3.6% 3.7% 3.8% 4.3%Vol 7.0% 7.5% 8.0% 8.6% 9.2% 9.7% 10.3% 10.6% 10.8%95% 1 yr VAR -7.7% -8.5% -9.4% -10.1% -11.0% -11.8% -12.6% -13.1% -13.6%PVA (1 Yr $ mil) $43.4 $45.8 $48.4 $50.8 $53.4 $56.2 $58.9 $60.1 $53.2Average Future Distribution ($ mil) $253.4 $256.1 $259.1 $262.3 $265.8 $269.4 $273.3 $275.4 $265.2Illiquidity 40.1% 42.4% 44.8% 46.3% 48.5% 50.9% 53.3% 54.4% 32.4%
5 - 57
UTIMCO: 2005 Candidate Policy Portfolios – 30% Hedge Fund Constraint
May, 2005 57
Portfolio 1 3 5 7 9 11 13 142003
Policy
GEF with 30% Hedge Fund Constraint GEF Beg Value ($ mil): $4,660US Equities 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 30.0% 45.0% 20.0%Global ex US Equities 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%Emerging Markets Equities 0.0% 0.0% 0.2% 4.3% 8.3% 13.9% 15.0% 15.0% 7.0%Absolute Return Hedge Funds 15.0% 15.0% 15.0% 15.0% 15.0% 13.1% 0.0% 0.0% 15.0%Directional Hedge Funds 8.3% 10.4% 15.0% 15.0% 15.0% 15.0% 15.0% 5.0% 10.0%Venture Capital 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 6.0%Private Equity 7.4% 9.7% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 9.0%REITS 1.4% 2.2% 5.0% 5.0% 5.0% 3.0% 5.0% 0.0% 5.0%Commodities 3.9% 3.2% 3.3% 2.4% 1.7% 0.0% 0.0% 0.0% 3.0%Oil & Gas 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%TIPS 4.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 5.0%Fixed Income 25.0% 24.5% 16.5% 13.3% 10.0% 10.0% 10.0% 10.0% 10.0%Cash 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Expected Return 7.75% 7.95% 8.15% 8.35% 8.55% 8.75% 8.95% 9.05% 8.39%1 yr DR 6.5% 6.7% 7.0% 7.4% 7.9% 8.5% 9.4% 10.3% 7.6%3 yr DR 3.8% 3.9% 4.0% 4.2% 4.5% 4.8% 5.2% 5.7% 4.3%Vol 8.7% 9.2% 9.8% 10.6% 11.4% 12.3% 13.7% 15.0% 10.8%95% 1 yr VAR -10.6% -11.4% -11.8% -12.9% -14.4% -16.3% -18.1% -21.1% -13.6%PVA (1 Yr $ mil) $42.3 $45.1 $48.4 $52.4 $56.5 $60.8 $60.8 $59.4 $53.2Average Future Distribution ($ mil) $254.9 $257.8 $260.8 $264.3 $268.1 $272.2 $277.0 $280.0 $265.2Illiquidity 29.1% 32.6% 35.3% 35.4% 35.4% 34.6% 27.3% 22.0% 32.4%
2005 EFFICIENT FRONTIERPUF with West Texas Lands as Cash Flow
9.05%
8.95%
8.75%
8.55%
8.35%
8.15%
7.95%
7.75%
7.5%
7.7%
7.9%
8.1%
8.3%
8.5%
8.7%
8.9%
9.1%
9.3%
5.5% 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5%
1 Yr Downside Risk
Expe
cted
Ret
urns
GEF
PUF (WTL as Risky CF)
PUF (WTL as Asset Value)
2003 Asset Allocation Policy
5 - 58
UTIMCO: Selecting a Strategic Asset Allocation
The portfolio optimization process—regardless how the investment problem is framed—results in an optimal set of asset allocations that are efficient in the sense each optimal allocation minimizes risk for a given return goal
Once the efficient frontier is established, investors must next answer the following question: Which single allocation (or range of allocations) from the efficient frontier is appropriate for them?
Decisions Factors represent one approach to this problem. A decision factor is a measure or characteristic which may be used to relate specific goals to a particular decision.
5 - 59
UTIMCO: How Decision Factors Work
Evaluating Candidate Asset Mix Policies with Decision Factors
0
1
2
3
4
5
6
7
8
9
10
0 1 2 3 4 5 6 7
Candidate Asset Mix Policy
Dec
isio
n F
acto
r S
core
Decision Factor A Decision Factor B
May, 2005 59
Comparing Effects of Different Decision Factor Weights
3
4
5
6
7
8
0 1 2 3 4 5 6 7
Candidate Asset Mix Policy
Dec
isio
n F
acto
r S
core
75% A and 25% B 50% A and 50% B 25% A and 75% B
Idea: A portfolio optimization simulation can be designed to determine which potential asset allocation would be optimal for each decision factor (or combination of factors).
5 - 60
UTIMCO: Specific Decision Factors & Voting Process
May, 2005 60
Relative Importance
Score
G1Minimize the possibility that distributions made under the current distribution policy will be "frozen" at the upper bound payout rate of 5.5% in any year within the next 15 years.
G2Maximize the possibility of rolling 10 year compound annual GEF real returns exceeding 5.1%.
G3Minimize the possibility that the real value of the GEF, after distributions, will decline over future 10 year periods.
G4Maximize the possibility that future actual annual GEF returns will exceed the GEF Policy Portfolio return.
G5aMaximize the possibility that the GEF will have returns in the top quartile of the UTIMCO performance compensation peer universe over future 3 year periods.
G6a
Maximize the possibility that future real returns over rolling 10 year time periods will exceed the 5.1% MAR by 1%, the margin necessary to maintain HEPI purchasing power by historical standards.
G7Minimize the possibility that the GEF will have a return of minus 20% or less over any future 3 year time period.
G8Minimize the exposure of GEF assets to "illiquid" investment options as defined in the GEF Liquidity Policy Statement.
Decision Factor
General Endowment Fund2005 Decision Factors
Relative Importance
Score
P1a
Minimize the possibility that distributions made at the current policy rate of 4.75% of average assets would match or exceed the prior year's inflation adjusted distribution in any future 1 year period.
P2Maximize the possibility that future rolling 10 year compound annual real returns in the PUF will exceed 5.1%
P3Minimize the possibility that the real value of the PUF, after distributions at the current 4.75% distribution policy rate, will decline over future 10 year periods.
P4Maximize the possibility that actual PUF returns will exceed the PUF Policy Portfolio returns in future one year periods.
P5aMaximize the possibility that the PUF will have returns in the top quartile of the UTIMCO performance compensation peer universe over future 3 year periods.
P6a
Maximize the possibility that future real returns over rolling 10 year time periods will exceed the 5.1% MAR by 1%, the margin necessary to maintain HEPI purchasing power by historical standards.
P7Minimize the possibility that the PUF will have a return of minus 20% or less over any future 3 year time period.
P8Minimize the exposure of PUF assets to "illiquid" investment options as defined in the PUF Liquidity Policy Statement.
Decision Factor
Permanent University Fund2005 Decision Factors
24.4%
2.4%
6.1%
18.3%
6.1%
18.3%
12.2%
12.2%
5 - 61
UTIMCO: Decision Factor Scores for Candidate Policy Portfolios
May, 2005 61
Normalized Decision Factors Scores for Candidate Policy Portfolios
-250%
-200%
-150%
-100%
-50%
0%
50%
100%
150%
200%
250%
1 3 5 7 9 11 13 14
Candidate Policy Portfolio Numbers
G1
G2
G3
G4
G5a
G6a
G7
G8
Utility
5 - 62
UTIMCO: 2005 Policy Asset Allocation Comparison
2003 Asset Allocation Policy
Asset CategoryPolicy
TargetsPolicy
Ranges
US Equities 25.0 15 to 45 Traditional US Equities 20.0 15 to 45 REITS 5.0 0 to 10Global ex US Equities Non-US Developed Equity 10.0 5 to 15 Emerging Markets Equity 7.0 0 to 10 Total Equity 42.0 20 to 60Equity Hedge Funds 10.0 5 to 15Absolute Return Hedge Funds 15.0 10 to 20 Total Hedge Funds 25.0 15 to 25Venture Capital 6.0 0 to 10Private Equity 9.0 5 to 15 Total Private Capital 15.0 5 to 15Commodities 3.0 0 to 5Fixed Income 15.0 10 to 30 Traditional Fixed Income 10.0 10 to 30 TIPS 5.0 0 to 10Cash 0.0 0 to 5
Percent of Portfolio (%)
May, 2005 62
2005 Asset Allocation Policy
Asset CategoryPolicy
TargetsPolicy
RangesBenchmark
US Equities 25.0 15 to 45 Wilshire 3000 IndexGlobal ex US Equities Non-US Developed Equity 10.0 5 to 15 MSCI EAFE Index with net divends Emerging Markets Equity 7.0 0 to 10 MSCI Emerging Markets Index with net dividendsHedge Funds 25.0 15 to 25
Directional Hedge Funds 10.0 5 to 15Combination index: 66.7% S&P Event-Driven Hedge Fund Index plus 33.3% S&P Arbitrage Hedge Fund Index
Absolute Return Hedge Funds 15.0 10 to 20Combination index: 50% S&P Event-Driven Hedge Fund Index plus 50% S&P Directional/Tactical Hedge Fund Index
Private Capital 15.0 5 to 15 Venture Economics' Periodic IRR Index Venture Capital 6.0 0 to 10 Private Equity 9.0 5 to 15Inflation Linked REITS 5.0 0 to 10 Wilshire Associates Real Estate Securities Index Commodities 3.0 0 to 5 GSCI Index minus 1% TIPS 5.0 0 to 10 Lehman Brothers US TIPS IndexFixed Income 10.0 10 to 30 Lehman Brothers Aggregate IndexCash 0.0 0 to 5 91 Day T-Bills
Percent of Portfolio (%)