“assessing risk – what has changed?” beta risk management - the new investment paradigm...

“ASSESSING RISK – WHAT HAS CHANGED?”BETA RISK MANAGEMENT - THE NEW INVESTMENT PARADIGM

PRESENTATION TO HAWAII CFA

Richard Sandulli – Global Co-Head - Institutional Investment SolutionsWells Fargo Securities, LLC

July 14, 2009

2 | Wells Fargo Securities, LLC - Institutional Investment Solutions Group

Section I: Risk Awareness

Section II: Value Proposition and Content

Section III: Risk Management SolutionsHow Can They be Delivered?Basic Product Descriptions

Section IV: Portfolio Effect

Table of Contents


RISK AWARENESS


RISK AWARENESS – Negative Correlation? Where?

CDS SPREADS, VIX AND COMMODITIES

050

100150200250300350400450500

Time Line

(nor

mal

ized

).

VIX Index DJUBS Index

IBOXUMAE - (Investment Grade) IBOXHYSE - (Non-Investment Grade)


Volatility as a Diversification / Risk Management Tool

• Negative convexity tied to Equity Markets

• Increased Vega hedging needs

• Supply constraints on Vega

• Low interest rates

• Wide credit spreads

• Lack of capital raise alternatives

• Expensive Reinsurance

Source: Wachovia Capital Markets, LLC.

600

800

1000

1200

1400

1600

May-08 Jun-08 Aug-08 Oct-08 Nov-08 Jan-09 Mar-09 Apr-09

20%

23%

25%

28%

30%

33%

35%

38%

40%

S&P 500 10 yr ATM Vol

1

RISK AWARENESS – Is Volatility as an Asset Class?


Implied Volatility for SPX has changed significantly through the term structure

The implied daily volatility on 1 yr term went from 1.25% to 2.25%

Many Investors consider ‘Tail Risk Hedging’ when its

extremely expensive and abandon the

strategy when it is optimal to implement

it

Source: Wachovia Capital Markets, LLC.

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

1 3 5 10

Term

6/15/2009 3/16/2009 12/15/2008 9/15/2008 6/16/2008

As of 1 3 5 106/15/2009 27.73% 28.34% 29.65% 31.72%3/16/2009 35.33% 33.94% 33.96% 33.94%12/15/2008 43.00% 39.04% 38.24% 37.40%9/15/2008 25.16% 25.05% 26.17% 28.18%6/16/2008 21.81% 23.46% 24.95% 27.56%

Term

RISK AWARENESS – Using Volatility For Risk Hedging

6/08

9/08

12/08

3/09

6/09

Note: Approx. 16% annual vol. implies 1% average daily moves in S&P


RISK AWARENESS – Desperately Seeking Alpha

· “One irrefutable truth about equity investing is that the aggregate efforts of all active managers is the market. Investment management boards, consultants, and managing fiduciaries are forever trying to identify the silver bullet that will enable them to identify tomorrow’s best managers; they have been quite adept at identifying yesterday’s winners. In a zero-sum game, being right only slightly better than half the time seems like an easy proposition, until you try to accomplish that feat. While studies can demonstrate that only one in four active managers exceed the median manager in two consecutive years and one in eight for three such years, within our industry, woefully little is done with this knowledge. (John L Maginn and Donald L. Tuttle, Managing Investment Portfolios: A Dynamic Process, 2nd ed)

· “Anecdotal evidence and data from major investment consultants show that institutional enhanced index products have delivered on their performance promise – consistent outperformance with low levels of additional risk – generating high information ratios.” Callan Associates, “Enhanced Indexing: In Search of a free lunch?” (1999)

· “My comment… was that if there’s $30 billion of market inefficiency (alpha) in a world of $30+ trillion of equities and bonds, then we have about 0.1% inefficiency – less than the typical bid-ask spread!” – David Hseih, Fuqua School of Business at Duke University as quoted in Barron’s, March 2006

· “If he’s right about the $30 billion figure, a lot of well-heeled individuals and institutions could be paying large sums to get the same market (or Beta) risks available at a fraction of the cost…” – Jack Willoughby from same article, Barron’s, March 2006

* Michael Mueller as quoted in “Active Index Investing” by Steven Schoenfeld , © 2004 page 542/543


RISK AWARENESS – Alpha? Where’s the Beef?

OVERALL AVERAGE RESULTS FOR EQUITY MUTUAL FUNDS RELATIVE TO VANGUARD 500 INDEX Return Differentials (1978 - 1998)* -

Needed: A change in mind-set.

20 years 15 years 10 years

With Survivor Bias

No Survivor Bias

With Survivor Bias

No Survivor Bias

With Survivor Bias

No Survivor Bias

Relative Pre-Tax Returns -1.75% -2.12% -3.50% -4.17% -3.06% -3.51%

Relative After Cap. Gain & Div. Tax -2.58% -2.82% -4.55% -5.06% -4.17% -4.49%

Relative After All Taxes -2.00% -3.73% -3.18%

* Including deferred taxes, at current capital gains rate, at the end of the period

*SOURCE: How Well Have Taxable Investors Been Served in the 1980s and 1990s, Arnott, Berkin & Ye, Journal of Portfolio Management 2000 Vol. 26, No. 4

Note: Vanguard index includes fees and expenses for the Vanguard 500 Index, a proxy for the S&P 500 Index

9

Risk Hedging Considerations

The implied daily volatility on 1 yr term went from

1.25% to 2.25%

Many Investors consider ‘Tail Risk Hedging’

when its extremely

expensive an strategy when it is optimal to implement it

RISK AWARENESS – Use of Volatility For Risk Hedging

• Strategic Necessity

• Market-Implied Risks vs. Capital Market Assumptions

• Targeted Cost (real or opportunity) vs. Targeted Risk

• Understanding and hedging the right factors (equity, rates, FX, etc.)

• Robust Scenario Analysis

• Timing of expected returns vs. scheduled or anticipated liabilities

| Wells Fargo Securities, LLC - Institutional Investment Solutions Group


RISK AWARENESS – “A better way to achieve index exposure”


VALUE PROPOSITION AND CONTENT



Work directly with institutional investors with to create innovative, strategic and tactical solutions they require to balance return expectations with risk tolerance.

Help our institutional clients use superior risk management support to achieve long term investment goals by generating “alpha” through better management of “beta”.

Provide transparency, liquidity, credit diversification and innovation.

Deliver solutions in a variety of way (structured notes, SPVs, Separate Accounts)

Do this for substantially lower average cost than traditional “alpha” seeking models.


Applying Risk Management involves re-configuring components of risk and return in order to:

(i) control and manage risks;

(ii) leverage investors’ return expectations;

(iii) balance investors’ return requirements with their risk tolerance.

(iv) better “beta” management can lead to superior investment results vs. “alpha” seeking

Beta management strategies are simply ways to manage market risks to generate superior

LOWER COST RISK-ADJUSTED RETURNS

The Key - to implementing a successful risk management portfolio practice is to exchange things the investor does not place a high value on for things the investor does place a high value on… in other words, give up what the investor doesn’t need for something they want. Market and Educate along these lines!

It’s important to understand most investors (esp. pensions and individuals) have an asymmetric risk/return profile… in other words, they feel more pain from a 50% loss then they do pleasure from a 50% gain.


It is now how much return you make that determines how good an investor you are, but rather how much return you make PER UNIT OF RISK . In the long

term, the market rewards those investors who seek out the best return per unit of risk absorbed. The best investors can synthesize risk that is best priced in

any market and transport the associated return into any asset class.


RISK MANAGEMENT SOLUTIONS


RISK MANAGEMENT SOLUTIONS - How can they be delivered?

FORM OF DELIVERY

OTC Contracts Sr Unsecured Notes Separate Account

- ISDA - Counterparty concentration - fiduciary v non-fiduciary roles?- Collateral / counterparty - accounting / tax implications

DERIVATIVE TOOLS European / American / AsianBarriersRatiosSpreadsCancellableStrike ResetsLookbackAccreting StikeExchangeables

STRATEGIES

Buy Puts

Host Beta

Alternative Beta Creation

Sell Puts Sell Calls

Buy Calls

Tail Risk Management

Capital Efficiency

Income Enhancement

Return Enhancement

Algorithmic Strategies


Principal Protected Products

RISK MANAGEMENT SOLUTIONS - Basic Product Descriptions

· Principal protected structured products are structured to return the investor’s principal at maturity plus a “supplemental payment” that is based on the performance of an underlying asset.

· For example, in addition to receiving 100 percent of their principal at maturity, investors could be entitled to receive a percentage of the appreciation of an underlying asset such as an equity security, equity index, currency and commodity. The most “common” of these principal protected notes is convertible bond (correlated equity / credit risk).

· In return for receiving principal protection, investors may receive below-market interest (or no interest). Additionally, it is important to note that the protection is only as strong as the credit quality of the issuer of the structured product.

· There are numerous ways that performance maybe calculated in determining the supplemental payment, such as an average of the performance of an underlying asset on specified dates, a percentage of point-to-point performance, or a periodic return subject to a cap.

· In the fixed income arena, some products also seek to protect the market value of investor’s securities (e.g. floating rate notes) and / or the purchasing power of investors’ assets (e.g. inflation linked notes) in addition to protection of principal at maturity.


RISKRETURN

S&P 500 Principal Protected Note

Basic Financial Insurance – Example S&P 500

S&P 500 Index


Target Market: A Wide Range of Investors

Ideally for: a) Less tax-sensitive accounts

b) Baby-boomers, Pensions, Insurance

Make sure you ask about: a) Possible Path-Dependency of payout

b) Tax implications

- 100% Downside

- 100% Upside

- Dividends

RISKRETURN

- 100% Downside

- 100% Upside

- Dividends

Sometimes:

- Averaging- Caps/Call Rights- Exchange

Features- Currency

Protection

Sometimes:

- <100% Protected



$6.00

$7.00

$8.00

$9.00

$10.00

$11.00

$12.00

$13.00

$14.00

-40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%

S&P 500 Final Index Return at Maturity

S&P 500 Principal Protected Notes S&P 500 Index

Not

e Pay

out at

Mat

urity


Hypothetical Pricing for illustration purposes only

Past performance cannot predict future results



Fundamental Concept

A variation on the traditional covered call strategy

• Traditional Covered Call (income enhancement)

investor agrees to a cap on upside performance of underlying equity and, in exchange, receives payment of option premium

• Enhanced Growth Strategy (growth enhancement)

investor agrees to same cap on upside performance of underlying equity but, in exchange, receives enhanced participation in the underlying equity up to the cap

investor is functionally re-investing the option premium from the sale of the cap on the underlying equity in additional call spreads (and potentially put spreads to reduce downside risk) on the underlying equity

Enhanced Growth



· Enhanced Growth structured product allows for potential enhanced participation in the movement of an underlying asset within a certain range

· For example – while a direct investment in the underlying asset provides for 100 percent participation in the price appreciation and depreciation of the asset, an investment in an enhanced growth structured product might provide for 200 percent participation in the price appreciation of the underlying asset, subject to a maximum return or cap.

· In return for a specified multiple of the price appreciation, investors forego potential upside potential if the return of the underlying asset exceeds the maximum return or cap.

· Enhanced growth securities can be structured on equity securities, equity indices, currencies or commodities.

Enhanced Growth



ILLUSTRATION OF PAYOUT AT MATURITY BASED ON FINAL SPX VALUE (Final Term = 2.0yrs)

80

85

90

95

100

105

110

115

120

125

130

135

140

75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150

Final Index Level (v Initial Index Level 100)

Fina

l N

ote

Val

ue (v

Ini

tial

Not

e V

alue

of

100)

S&P 500 Price SPX Enhanced Growth (1.5x) SPX Enhanced Growth (2.0x) SPX Enhanced Growth (3.0x)

capped up 34%

capped up 29%

capped up 26.5%

1.11x outperformance

10% Downside Proteced

Enhanced Growth (with 10% “Buffer”)



EXTREMELYBULLISH

MODERATE BULLISH

MODERATE BEARISH BEARISH

100% SPX (Price

Return)

50% SPX Price Return

50% SPX 2x EGS

(10% Buffer)

33% Fixed Income*

67% SPX 1.5x EGS

(10% Buffer)

50% Fixed Income*

50% SPX 3x EGS

(10% Buffer)

-25.0% -20.8% -8.7% -4.6%

-20.0% -15.6% -5.0% -1.8%

-15.0% -10.3% -1.2% 1.0%

-10.0% -5.0% 2.5% 3.8%

-5.0% -2.5% 2.5% 3.8%

0.0% 0.0% 2.5% 3.8%

+5.0% 7.5% 7.5% 11.3%

+10.0% 15.0% 12.5% 17.0%

+15.0% 22.0% 17.6% 17.0%

+20.0% 24.5% 22.6% 17.0%

+25.0% 27.0% 25.3% 17.0%

+30.0% 29.5% 25.3% 17.0%

+35.0% 32.0% 25.3% 17.0%

+40.0% 34.5% 25.3% 17.0%

Hypothetical Price Return Illustration for Selected “Equity” Allocation Alternatives – 2yr Holding Period

* Fi

xed Inco

me a

lloca

tion a

ssu

mes

3.7

% p

.a.

retu

rn o

ver

hold

ing

peri

od b

ase

d.

Enhanced Growth (with 10% Buffer)



Maturity Payoff Profile for Selected Equity Allocation Alternatives (2yr Term)

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

-25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

Total SPX Price Return over Period (2yrs)

Tot

al P

ortf

olio

Ret

urn

over

Per

iod

(2yr

s)

Bul l ish (100% SPX) Moderate Bul l ish (50% SPX & 50% 2x EGS) Moderate Bearish (33% FI & 67% 1.5x EGS) Bearish (50% FI & 50% 3.0x EGS)

Enhanced Growth (with 10% Buffer)



· Enhanced yield structured product encompasses a number of income-oriented structures which provide higher current yields than could be achieved by investing directly in an equity security or in traditional debt instruments of similar credit quality and maturity. In many of these structures, investors give up some potential price appreciation.

· For example, a simple enhanced yield structured product linked to an underlying asset such as common stock or a commodity may incorporate a capped return or a call feature; this enhanced yield structured product would pay a coupon that is higher than the current yield on the underlying asset, such as the dividend on an underlying stock.

· Enhanced yield structured product allow for enhanced yield in return for the “reallocation” of the return profile of a low (or zero) yielding underlying asset.

· Enhanced yield securities may provide an investment opportunity for investors who have moderate growth expectations for the underlying investments, and are willing to forego price appreciation above a specified level in return for a higher current yield than the existing yield of the underlying.

Enhanced Yield



RISKRETURN

XYZ Enhanced Yield w Contingent Protection

Income Generating Opportunities

XYZ Common Stock

Enhanced Yield

Target Market: Suitable High-Yield Investors

Ideally for: High-Yield Bond Alternative, buy a portfolio!

Make sure you ask about: a) the Trigger Level and how it works

b) Tax Treatment

- 100% Downside

- 100% Upside- Dividends

RISKRETURN

- 100% Downside

- Contingent Trigger (-25%)

- 100% Upside- Dividends- Yield

Enhancement (+600-1200 bps)

Sometimes:

- 100% Downside exposure

Sometimes:

- Upside participation, subject to cap or call



A. Type:

i. Reverse Converts

Enhanced Yield

$600.00

$700.00

$800.00

$900.00

$1,000.00

$1,100.00

$1,200.00

$1,300.00

$1,400.00

-40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%

Stock Return at Maturity

Enhanced Yield Securities - Knock-In Event has Occurred

Enhanced Yield Securities - Knock-In Event has not Occurred$1,000 Invested

Secu

rity

Pay

out at

Mat

urity





· Access Securities provide direct exposure to global markets, industry sectors, investment strategies and/or asset classes that may not be available to investors or that may not be available in a cost-efficient manner.

· For example, an investor can participate in the price movement of normally inaccessible investments such as oil, currencies, gold, commodities, investment strategies etc. through access securities.

· Access securities can also fall under principal protected or enhanced growth strategy

Access



Investment ProcessRather than invest directly in physical commodities, the Fund employs an "enhanced-index" strategy. Specifically, the Fund gains exposure to the commodity markets through investments in commodity-index-linked derivative instruments and through investments in the PIMCO Cayman Commodity Fund I Ltd., a wholly-owned subsidiary of the Fund organized under the laws of the Cayman Islands (the “Subsidiary”). The derivative instruments in which the Fund and the Subsidiary primarily intend to invest are instruments linked to certain commodity indices, specifically the Dow Jones [UBS] Commodity Total Return Index. Additionally, the Fund or the Subsidiary may invest in derivative instruments linked to the value of a particular commodity or commodity futures contract, or a subset of commodities or commodity futures contracts. The Fund collateralizes the commodity-index-linked derivative instruments by investing its assets in an actively managed portfolio of inflation-indexed bonds and other fixed-income securities.

About Commodity-Index-Linked InstrumentsCommodities are assets that have tangible properties, such as oil, metals and agricultural products. Rather than invest directly in these physical commodities, the Fund may use a range of index-linked instruments to gain exposure to the commodities market. As with any commodity-index-linked instruments, the value of these instruments may be affected by overall market movements and other factors that affect the value of a particular industry or commodity, such as weather, disease, embargoes, or political and regulatory developments. The market for these instruments has evolved and become more sophisticated, offering risk management solutions and often acting as a substitute for direct securities ownership.(1) Source Alliance /Pimco Website

PIMCO Commodity Real Return Strategy Fund A (PCRAX) (1)

Access



Hypothetical Payouts on the 100% Principal Protected Note

$8.0

$9.0

$10.0

$11.0

$12.0

$13.0

$14.0

$15.0

$16.0

-20% -10% 0% 10% 20% 30% 40% 50% 60%

% Change in WTI Crude Oil

Tota

l Pay

men

t at

Mat

uri

ty ($)

100% Principal Protected Securities % Change in WTI Crude Oil

Maximum Payment at Maturity - $13.00

Principal Protected at Maturity - $10.00

Access





PORTFOLIO IMPACT


PORTFOLIO IMPACT

Efficient Frontier• Structured Products can help build more efficient portfolios, thereby maximizing the

return per unit of risk


0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

Risk

Ret

urn

Efficient Frontier

Large CapPrincipal Protected Large Cap

2x Enhanced Growth Large Cap

Risk-free rate



PORTFOLIO IMPACT

Large Cap Equities vs. Principal Protected Large Cap

Large Cap Equities vs. Enhanced Growth Large Cap


0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

-17.0%-12.5% -8.1% -3.6% 0.8% 5.2% 9.7% 14.1% 18.6%Average Monthly Returns

Fre

quen

cy

Large Cap Principal Protected Large Cap

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

-17.0%-12.5% -8.1% -3.6% 0.8% 5.2% 9.7% 14.1% 18.6%

Average Monthly Returns

Fre

quen

cy

Large Cap Enhanced Growth Large Cap


PORTFOLIO IMPACT – Example BXM vs. S&P 500 Index

CBOE/S&P500 BUY-WRITE MONTHLY INDEX (“BXM”) – SOURCE: Ibbotson & Associates


“assessing risk – what has changed?” beta risk management - the new investment paradigm...

Documents

investment portfolios

risk awarenesssection

investment management

beta risk management

risk management solutionshow

major investment consultants

tail risk hedging

low levels of additional