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999 Third Avenue Suite 4200

Seattle, Washington 98104

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LOS ANGELES

2321 Rosecrans Avenue Suite 2250

El Segundo, California 90245

310.297.1777 tel 310.297.0878 fax

www.wurts.com

Fresno County Employees’ Retirement AssociationThe Integration of Risk Management and Asset Allocation

October 2011

Max GiolittiDirector of Risk Allocation

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Risk Management Tab One

Risk Allocation Tab Two

Sample Risk Dashboard Tab Three

T A B L E O F C O N T E N T S

I N V E S T M E N T P R I N C I P L E S

Principles

Valuation

Risk

3

Diversification

SecuritySelection

Manager Selection

Active Risk Budgeting

Risk Allocation

Risk Framework

1. Risk is Not VolatilityDrawdown risk and failure to satisfy liabilities

2. Allocate Risk, Not AssetsSeemingly dissimilar assets carry the same risks

3. DiversificationDetermined by risk factors and economic sensitivities

4. Price MattersValuation based asset allocation methodologies

5. Micro-efficiency of Markets Manager alpha is fleeting and hard to find

6. Macro-inefficiency of Markets Opportunistically allocating to risk factors can add value

7. Minimize Fees and CostsTrading costs and fees should be expertly managed

Delegated to Investment Managers

I N V E S T M E N T P H I L O S O P H Y

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Model

Principal

Investment Income

Active Risk

Leverage

Commitment

Concentration

LiquidityVolatility

Real Estate

Interest Rate

Political

Credit

Company

Deflation

Inflation

Spending Rule

Counterparty

Business Partner

Peer

Country

Currency

Turnover

Pricing

Asset Allocation

Refinancing

Headline Risk

Operational

Staff

Fiduciary

Sample List

Margin

Liabilities

T H E W O R L D O F R I S K S

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Culture

Alignment of Risk &

Objectives

Defining Boundaries

Communication Tool

Risk Response

Seizing Opportunities

Deployment of Capital

Not a System!

Risk is NOT just the standard deviation of returns!

Risk is first and foremost the risk of losing principal. At what point is the drawdown too deep?

Risk is failing to meet the demands of the organization.

Risk is an unexpected negative event.

W H A T I S R I S K M A N A G E M E N T ?

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Passive:information reporting on aggregate risk

Defensive:controlling risk through limits

Active: managing risk through capital allocation

A P P L I C A T I O N S F O R R I S K M A N A G E M E N T

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R I S K P L A N

Risk

Pla

nRi

sk P

lan

Establish Risk Limits Establish Risk Limits

Define points of success and failureDefine points of success and failure

Design contingency plans for negative scenariosDesign contingency plans for negative scenarios

Identify critical internal and external dependenciesIdentify critical internal and external dependencies

It’s imperative to monitor risks from several points of view and models, there is no silver bullet!

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R I S K G U I D E L I N E S

Dollar Allocation Limits

•Asset class•Private assets

Specific Risk Limits•Liquidity•Counterparty•Concentration•Leverage•Pricing•Derivatives notional exposure

•Derivatives “delta” equivalent exposure

•Etc.

Absolute Risk LimitsAbsolute

Risk Limits “Normal” Market Risk

•Value-at-Risk

“Tail” Risk•Scenario analysis•Stress testing

“Active” Risk• Ex ante tracking

error

Relative Risk LimitsRelative

Risk Limits

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R I S K A L L O C A T I O N

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Buy and hold

60% Stocks / 40% bonds portfolio Markowitz mean-variance Black-Litterman model

Endowment Model Private equity, hedge funds, commodities, etc.

Risk Parity Equal risk from major risk-factors

Programmatic tail-risk hedging Insurance

Wurts Risk Allocation Strategy (WRAS)

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A S S E T A L L O C A T I O N M E T H O D O L O G I E S

O P T I M A L D O L L A R A L L O C A T I O N ?

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GOLDMAN SACHS Average Public Fund PIMCO

BRIDGEWATER AQRGMO

R I S K B A S E D A L L O C A T I O N

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Average Public FundGOLDMAN SACHS PIMCO

BRIDGEWATER AQRGMO

Economic factor analysis

Risk factor analysis Equity, rates, credit, currency, commodities, etc.

Scenario analysis

Stress testing

Relative risk (VaR & active risk)

Return composition (ex ante) Income versus capital appreciation Return by risk factor

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W U R T S R I S K A L L O C A T I O N S T R A T E G Y ( W R A S )

CommoditiesInfrastructureReal Estate

EquitiesCorporate bonds

Emerging market debt

Inflation linked bondsCommoditiesInfrastructure

Real Estate

EquitiesCorporate Bonds

Emerging market debtInfrastructure

MortgagesGovernment Bonds

Real EstateCommodities

Government BondsCorporate bonds

Emerging market debtInflation linked bonds

GROWTHRising Falling

INFLATION

Rising

Falling

E C O N O M I C R I S K M A P

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R I S K A L L O C A T I O N B U I L D I N G B L O C K S

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‘Liquid’Beta & Alpha

Illiquid Beta & Alpha

Liquid Beta & Alpha

High Fees

Moderate Fees

Hedge Funds and Real Return Managers

Real EstateInfrastructur

eTimber

AgricultureEnergy

Private Equity

Distressed Debt

Bank Loans

Mezzanine Debt

Rates Credit EquityReal

Assets Currency

Rates

Domestic

International

Emerging Markets

Curve

Duration

Liquidity

Country

Credit

Investment Grade

High Yield

Emerging Markets

Private

Curve

Duration

Liquidity

Country

Sector

Equity

Domestic

International

Emerging Markets

Private

Country

Value

Momentum

Sector

Size

Inflation

TIPS

Commodities

Private

Country

Curve

Duration

Liquidity

Currency

Developed

Emerging Market

Country

Carry

Primary Risk Factors

Secondary Risk Factors

TertiaryRisk Factors

R I S K F A C T O R B U I L D I N G B L O C K S

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A C T I V E R I S K B U D G E T I N G

Size Fear of regret vs. fear of losing money Peer risk Reputational risk/career risk

Methodology to measure Relative VaR Ex ante Tracking Error Modeling illiquid/private assets requires

both art and science

Who has the proven skill? Board Staff External Managers

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Fat Left Tail DistributionNormal Distribution

Markets exhibit larger drawdowns with greater frequency than normal distribution would suggest.

Compound Return 10 Years at 10% return produces an annualized return of 10%

W H Y I S T A I L - R I S K I M P O R T A N T ?

What would be the annualized return be if on the 10th year we have a -30% return?

The Importance of Limiting Drawdowns 9 years at 10% return plus a one year return of -30% produces an annualized return of 5.14%

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T A I L R I S K M A N A G E M E N T

Superior Portfolio Construction

“True” Diversification Risk factors Geography Manager Economic sensitivity Return contribution

Active Risk Budgeting

Managers with sound risk management philosophy

Diversification of alpha risk factors

Tail Risk Hedging

Opportunistically purchase relative inexpensive insurance

Actively harvest gains

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S A M P L E R I S K D A S H B O A R D

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1- = Policy allocation benchmark per Investment Policy

D O L L A R A L L O C A T I O N L I M I T S

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1- = Policy allocation benchmark per Investment Policy 10-05

D O L L A R A L L O C A T I O N L I M I T S B Y A S S E T C L A S S

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1- Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS

H I S T O R I C A L M O N T H L Y R E L A T I V E V A RP O R T F O L I O V S P O L I C Y R I S K B E N C H M A R K

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Portfolio

Real Assets

Currencies Special Opportunities

EquitiesInterest Rates

Credit

Company Exposure

R E L A T I V E C O M P O N E N T R I S K - V A R

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Portfolio

Interest Rates

Company Exposure

TIPS Credit

Investment Grade

Equities

Currency

Tracking Error: A measure of how closely a portfolio follows the index to which it is benchmarked. Usually the standard deviation of the difference between the portfolio and benchmark returns. Tracking Error is annualized.

T R A C K I N G E R R O R R I S K

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1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS2-Real estate and infrastructure are modeled as real estate investment trusts

‐40% ‐35% ‐30% ‐25% ‐20% ‐15% ‐10% ‐5% 0% 5% 10% 15%

1972 - 1974 Oil Crisis (Dec. to Sep.)

1987 Market Crash (Oct. 14 to Oct. 19)

1989 1990 Nikkei Crash

1992-1993 EMS Turbulence

1994 Rate Hike

1997 - 1998 Asian Financial Crisis

1998 Russian Financial Crisis

2001 Dot-com Slowdown

2007 - 2009 Subprime Mortgage Meltdown (Oct. to…

Portfolio Benchmark

T A I L R I S K – S C E N A R I O A N A L Y S I S

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1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS2-Real estate and infrastructure are modeled as real estate investment trusts

-14% -12% -10% -8% -6% -4% -2% 0%

EM Eq -30%

EM FX -20%

Global Eq -20%

Global Rates 200bps

US Eq -20%

US Rates 200bps

US Spread Corp 100bps

US Tre Shift Long End

USD FX 20%

Portfolio Benchmark

T A I L R I S K – S T R E S S T E S T I N G

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-40% -35% -30% -25% -20% -15% -10% -5% 0%

Equities

Avg. Endowment

Avg. Pension

Benchmark

APFC

60/40

Bonds

Cash

97.5 %, 1 year VaR or 1 event every 40 years under normal market conditions.

Bonds: Global Treasury Index, Hedged

Equities: MSCI All Country World Investable Market Index (ACWI IMI)

1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS

SWF

R E L A T I V E R I S K - V A R

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-40% -35% -30% -25% -20% -15% -10% -5% 0%

EquitiesCompany exposureAPFCReal AssetsAbsolute ReturnSpecial OpportunitiesFixed IncomeInterest RatesCurrency

97.5 %, 1 year VaR or 1 event every 40 years under normal market conditions

Contribution to Total Risk from Equities 79%Components together do not equal 100% due to Diversification

1-Real estate and infrastructure are modeled as leverage adjusted real estate investment trusts

PLAN

R E L A T I V E C O M P O N E N T R I S K

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Emerging Market Currency Risk

Top Five Exposure $Brazil $ 366 Korean Won $ 358 New Taiwan Dollar $ 277 Indian Rupee $ 215Mexican Peso $ 153 Total $ 1,369

Developed Market Currency Risk

Top Five Exposure $US Dollar $ 29,029Euro $ 2,560

British Pound $ 2,009 Japanese Yen $ 1,536 Canadian Dollar $ 794Total $ 35,927

1-Non-Dollar (*) includes emerging markets2-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS

0% 20% 40% 60% 80%

Non-Dollar*

Dollar71%

67%

29%

33%

0% 10% 20% 30% 40%

EM

Non-Dollar*29%

33%

5%6%

C U R R E N C Y R I S K

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0%

10%

20%

30%

40%

50%

60%

70%

NorthAmerica

Europe Pacific EM Asia Other LatinAmerica

EMEurope &MiddleEast

DevelopingCountry

Exposure $

China $ 491Korea $ 355 Taiwan $ 263 Brazil $ 248India $ 211 South Africa $ 133 Mexico $ 120Israel $ 110Indonesia $ 105Turkey $ 103 Total $ 2,140

1-Risk Benchmark: 2% T-Bills, 6% Barclays Global Treasury Hedged, 14.8% Barclays Global Corporate Hedged, 59.2% MSCI ACWI, 13.5% NCREIF, 4.5% Barclays US TIPS

C O U N T R Y R I S K

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21%

0% 10% 20% 30% 40% 50%

Private Investment Limits

1-Public: 144A, securities registered and/or traded on an exchange.2-Private: securities that are not registered and do not trade on an exchange. The price is set through negotiation between the buyer and the seller/issuer (Private Equity, Real Estate, Infrastructure, Hedge Funds, Mezzanine Debt, Distressed Debt).3-Allocation Benchmark: 2% Cash, 6% Interest Rates, 53% Company Exposure, 18% Real Assets, 21% Special Opportunities

0% 10% 20% 30% 40% 50% 60% 70% 80%

Private

Public

29%

71%

21%

79%

P R I V A T E V S . P U B L I C

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8%

0% 10% 20% 30%

F U T U R E C O M M I T M E N T R I S K

Investment Total Undrawn Forecast 1 Year

Private Equity $1,579 $427

Infrastructure $603 $269

Distressed Debt $396 $264

Mezzanine Debt $440 $100

Total $3,018 $1,060

Future Commitments Limits

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Firm Name SWF Assets (mm)

% of Manager Business

% of SWF Portfolio

% of Top 3 Clients ex SWF

Crestline $1,109 19% 3% 15%

L&B $596 15% 1% 58%

Mariner $1,157 11% 3% 20%

McKinley $712 6% 2% 24%

Global Infrastructure $315 6% 1% 17%

Pathway $1,218 5% 3% 37%

AQR $1,601 5% 4% 17%

Cap Guardian $2,172 4% 5% 14%

Citi Infrastructure $382 3% 1% 11%

B U S I N E S S C O U N T E R P A R T Y R I S K

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Firm Name Fixed Income(mm)

Equity (mm)

Alternative(mm) Total % of

SWF

Mellon $6,050 $6,050 15%

Cap Guardian $203 $1349 $621 $2173 5%

GMO $1206 $711 $1917 5%

DFA $1760 $1760 4%

Lazard $1290 $365 $1655 4%

AQR $647 $628 $1275 3%

RCM $1530 $1530 4%

GE $1419 $1419 4%

Pathway $1218 $1218 3%

Mariner II $1157 $1157 3%

B U S I N E S S C O U N T E R P A R T Y R I S K

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Risk

5%

14%

47%

6%

28%

Active Risk 9%

91%

A C T I V E R I S K C O N T R I B U T I O N

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L I Q U I D I T Y R I S K

Liquidity Risk- Limited ability to liquidate an asset or asset classes

Illiquid: Private Equity, Private Real Estate, Infrastructure, Absolute Return, Distressed Debt, Mezzanine Debt, Real Return

Cash: Portfolio Cash, External Managers Cash

Liquid: US Rates, Global Rates, Domestic Large Cap Equity, International Large Cap Equity, REITs, TIPS, Real Return

Quasi-liquid: CDs, MBS/ABS, Investment Grade Debt, High Yield, CMBS, Domestic Small Cap Equity, Emerging Markets Equity, Emerging Market Debt, Real Return

1-Assets are subject to reclassification

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Cash

Liquid

Quasi-liquid

Illiquid

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1-Listed: Cash, Domestic Equities, International Equities, Small Cap Equity, Emerging Market Equity, Real Return2-Readily: Alaska CD Program, MBS, ABS, Investment Grade Debt, US Rates, Global Rates, Real Return3-Less Readily: High Yield Debt, Hedge Funds, Distressed Debt, CMBS, Mezzanine Debt, Emerging Market Debt4-Non Readily: Private Equity, Private Real Estate, Infrastructure5-Allocation Benchmark: 2% Cash, 6% Interest Rates, 53% Company Exposure, 18% Real Assets, 21% Special Opportunities

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

Non-readily

Less Readily

Readily

Listed

21%

21%

16%

42%

13%

12%

18%

55%

P R I C I N G R I S K

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