Are Constraints Eating Your Alpha?

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“Topical Issues in Asset Management”

The Goldman Sachs Asset Management Autumn Seminar

Robert LittermanManaging Director

September 14, 2005

1

Best investment practices are improving

• Investing globally

• Managing assets relative to liabilities or cash flow needs

• Measuring risk ex-ante and ex-post

• Attributing performance

• Using derivatives to improve risk management

• Sourcing alpha separately from beta

• Diversifying widely both beta and alpha

• Unfortunately, manager constraints are often out of date

2

Constraints: Key ideas

• Constraints are imposed by the markets and by fiduciaries.

• Constraints are important and serve a purpose, But they can be harmful too.

• Fiduciary-imposed constraints are beneficial when they Define the risk targets, Protect against a failure of the manager’s risk controls, Do not impact the portfolio construction process.

• Constraints eat alpha when they Prevent the manager from reaching the risk target, Force the manager to take risk in the wrong areas, Impair active risk diversification.

• One-size-fits-all solutions may not be optimal.

3

Why focus on constraints now?

“Constraint Reform” can significantly boost performance:

Potentially higher manager returns, Better risk diversification without changing total portfolio risk.

• Constraint Reform means Align constraints to risk targets, Align constraints to manager skills.

• Constraints should be reassessed When market liquidity, transparency or structure changes, When managers or their skills change.

4

Constraints and active management

Graham and Dodd Award of Excellence in 2002

• “Portfolio Constraints and the Fundamental Law of Active Management,”Roger Clarke, et al., Financial Analysts Journal, Sept/Oct 2002.

ForecastedResidualReturns

ActiveWeights

RealizedResidualReturns

The Correlation Triangle

Forecasting Skill

Information Coefficient

Portf

olio

Con

stru

ctio

n Sk

ill

Tran

sfer

Coe

ffici

ent

Manager Value Added

5

The impact of constraints

From Clarke, et al., …

• The transfer coefficient measures the impact of constraints on portfolio construction.

Portfolio Constraint

Unconstrained

Long only

Long only andMarket-cap neutral

TransferCoefficient

0.98

0.58

0.47

InformationRatio

1.47

.87

.70

ExpectedActive Return

7.3%

4.3%

3.5%

Table 1. Summary of Results for Case Studies

Source: “Portfolio Constraints and the Fundamental Law of Active Management,” Roger Clarke, Harindra de Silva, and Steven Thorley, Financial Analysts Journal (September/October 2002):48-66.All portfolios were engineered to a 5% active risk target.The information ratios and expected active returns were calculated on the basis of the generalized fundamental law, ( ).This example is for illustrative purposes only and does not purport to show actual results.

TCIR ≈ NIC

6

Constraints and risk management

• “Determinants of Portfolio Performance,” Gary Brinson, et al., Financial Analysts Journal, 1986 94% of risk comes from asset allocation! (beta)

• Constraints address only the other 6%

• The issue in alpha generation IS NOT to limit active risk

• The issue IS finding and sustaining skilled active management

• Skilled managers, when found, should be encouraged to TAKE active risk

7

How to begin setting constraints

Start every set of investment guidelines with the risk target and the benchmark,

“The portfolio’s primary objective is to outperform the investment benchmark by a target of 1.25% per year, gross of fees, with a targeted tracking error of 3% per year.”

• A necessary constraint

• Sets the risk budget and objectives

• Assigns responsibility

The next step is creating a safety net that protects you against a failure of the manager’s risk management process

8

What to avoid: Ineffective constraints distort the active risk efficient frontier

Lost Alpha

Act

ive

Exce

ss R

etur

n

Active Risk Tracking Error

Risk Target

UnconstrainedEfficient Frontier

of Active Risk

With Ineffective Constraints

This example is for illustrative purposes only.

9

Effective constraints act like a motorway guard rail

This example is for illustrative purposes only.

Act

ive

Exce

ss R

etur

n

Active Risk Tracking Error

Risk Target

WithEffectiveConstraints Effective

ConstraintsBlock OnlyThat Part

of the FrontierAbove the

Risk Target

UnconstrainedEfficient Frontier

of Active Risk

10

Constraints should fit the manager

• Some constraints are appropriate for all managers: Regulatory constraints, A risk target and a benchmark

• And for some managers certain constraints are not binding: Long-only constraints are not binding on “stock pickers”, Sector constraints are not binding on managers who do not take

sector views

• But, in many cases, unnecessary constraints will impact portfolio construction inappropriately and may significantly reduce alpha generation

11

Most common, and potentially harmful, constraints

Fixed Income

• Placing notional limits on maturity, credit quality or security type that are inconsistent with the risk target

Currency

• Limiting the amount of under/overweight of a particular currency based on index weights unrelated to expected return or risk

Equities

• Requiring long-only positions

12

Fixed Income: Typical short-maturity guidelines force managers to take too much duration risk

Examples of Recommended Guidelines

Typical Guidelines

YesYesYes- Mortgage-Backed

YesYesNoInterest Rate Derivatives

No LimitNo Limit ≤ 5 yrsLegal Final Maturity

5% Limit3% LimitNo- Currency Deviation from BenchmarkYesYesNo- Active FX-Hedged Country Exposures

Yes5% Limit

NoNo- Sub-Inv.-Grade Corporate

BBB or better10% BBB Limit30% Other Limit

A or better30% Limit

A or better10% Limit- Investment-Grade Corporate

Sectors

1 year½ year1 yearDuration Deviation

100 bps50 bps50 bpsActive Risk Tracking Error

These guidelines are provided as an example of the typical guidelines used vs investment guidelines GSAM would likely use to decrease duration risk for a 1-5 Year Global Government benchmark (USD, currency hedged). They do not refer to any actual investments and should not be construed as a general recommendation of how investment guidelines should be structured in all such cases. Source: GSAM.

13

Currency: Removing constraints means broadening the opportunity set

Maximizing opportunities leads to successful currency strategies: A large universe is better than a narrow one, Negative views can be as profitable as positive, Small country currencies can be as profitable as large

USD JPY

EUR

USD JPY

EUR

HUF

CZK

PLN IDR

INR

THB

ZAR

ILS

USD JPY

EURAUD

NZD

GBP

DKK

NOK

SEK

CHF

CAD

AUD

NZD

GBP

MYR

DKK

NOK

SEK

ISK

CHF

BRL

MXN

ARS

HRK

CLP

PHP

RUB

HKD

CNY

SGD

CAD

SAR

KRW

COPTWD

SKK

TRL

Major, Minor and Emerging Market

Currencies

Constrained Strategy

Major Currencies Only

14

Equity: Information ratios improve dramatically when the no-short constraint is relaxed

The performance results stated above are backtested based on a methodology that is derived from an analysis of past market data with the benefit of hindsight and as such have inherent limitations. These results do not reflect actual trading and are being shown for informational purposes only. Backtest active returns and backtest information ratios may frequently overstate the active returns and information ratios likely to be achieved in any future implementation of a strategy. Our backtest results cover the period from 30 Jan 1987 to 31 Aug 2004.

Investable Universe: S&P 500 Benchmark: S&P 500 Index

3.011.13.7Unlimited Short3.011.63.850% Short, 150% Long2.710.74.025% Short, 125% Long2.38.83.910% Short, 110% Long1.34.63.5Long-Only (100% Long)

Investable Universe: Russell 3000 Benchmark: S&P 500 Index1.97.13.7Unlimited Short1.97.13.750% Short, 150% Long1.86.73.825% Short, 125% Long1.55.93.910% Short, 110% Long1.34.43.3Long-Only (100% Long)

Information Ratio(IR)

BacktestAlpha

(% per year)

BacktestTracking

Error(TE) (%)Backtest Strategy

15

When the long-only constraint is relaxed, even small short positions can have a big benefit

The performance results stated above are backtested based on a methodology that is derived from an analysis of past market data with the benefit of hindsight and as such have inherent limitations. These results do not reflect actual trading and are being shown for informational purposes only. Backtest active returns and backtest information ratios may frequently overstate the active returns and information ratios likely to be achieved in any future implementation of a strategy. Our backtest results cover the period from 30 Jan 1987 to 31 Aug 2004.

0%

25%

50%

75%

100%

125%

150%

1987 1989 1991 1993 1995 1997 1999 2001 2003

Cum

ulat

ive

Exce

ss R

etur

n ov

er B

ench

mar

k

Long-Only Strategy (100% Long), S&P 500 Universe10% Short, 110% Long, S&P 500 Universe25% Short, 125% Long, S&P 500 UniverseLong-Only Strategy (100% Long), Russell 3000 Universe10% Short, 110% Long, Russell 3000 Universe25% Short, 125% Long, Russell 3000 Universe

16

Relaxing the no short constraint improves both return and risk diversification

The performance results stated above are backtested based on a methodology that is derived from an analysis of past market data with the benefit of hindsight and as such have inherent limitations. These results do not reflect actual trading and are being shown for informational purposes only. Backtest active returns and backtest information ratios may frequently overstate the active returns and information ratios likely to be achieved in any future implementation of a strategy. Our backtest results cover the period from 30 Jan 1987 to 31 Aug 2004.

Average Number of StocksBacktest Alpha from Stocks

Investable Universe: S&P 500 Benchmark: S&P 500 Index

Investable Universe: Russell 3000 Benchmark: S&P 500 Index

6.26.77.06.44.2

4.64.74.74.74.0

Overweightvs. Benchmark

004.9Unlimited Short024.850% Short, 150% Long153.725% Short, 125% Long3102.510% Short, 110% Long5130.3Long-Only (100% Long)

022.6Unlimited Short052.550% Short, 150% Long292.025% Short, 125% Long3121.210% Short, 110% Long5140.4Long-Only (100% Long)

Contributing 5% or more of TE

Contributing 2.5% or more of TE

Underweightvs. Benchmark

Backtest Strategy

17

Who should be responsible?

• You are: Constraints are part of the investment process and should be

managed within the investment function. Constraints that are managed within the legal, compliance, or risk

functions can lead to inefficiencies.

• It is vital to know when constraints are binding.

• When they are: What is their cost? Do they make sense?

18

Questions you should you be asking your manager

Security Weights

• Do the security weights in my portfolio fully reflect the investment manager’s views on those securities?

Active Views

• Are all of my investment manager’s views reflected in my portfolio?

Effect of Constraints

• What is the impact of constraints on my portfolio’s risk and return?

Risk Limits vs. Position Limits

• Would expressing some constraints as risk limits lead to a better portfolio?

19

Top 10 signals to watch for

• All your managers have the same constraints

• Same constraints for assets of very different durations

• Same constraints for assets of very different credit risks

• Prohibit investments in derivatives

• Limit derivative positions based on notional size, not risk

• Prohibit investments in certain issuers for non-economic reasons

• Set turnover limits

• Set a maximum number of issuer names

• Specify minimum cash levels

• Set position limits based on index weights, not risk exposure

20

Q & A

“Topical Issues in Asset Management”

The Goldman Sachs Asset Management Autumn Seminar

21

General Disclosures

This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell, or the solicitation of offers to buy, any security. Opinions expressed herein are current as of the date appearing in this material.

If any of the assumptions used in the examples in this presentation do not prove to be true, results may vary substantially from the examples shown. These examples are for illustrative purposes only and do not purport to show actual results.

The portfolio risk management process includes an effort to monitor and manage risk, but should not be confused with and does not imply low risk.

Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without Goldman Sachs Asset Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient.

Derivatives often involve a high degree of financial risk because a relatively small movement in the price of the underlying security or benchmark may result in a disproportionately large movement, unfavorable or favorable, in the price of the derivative instrument.

Copyright © 2005, Goldman, Sachs & Co. All rights reserved.