Steven Hartt, CAIA

Senior Vice President

Meketa Investment Group

May 21, 2013 NCPERS 2013 Annual Conference

Alternative Investments:

Measuring the Risks

What are Alternative Investments?

Why is it Important for Trustees to Understand Alternatives?

How are Alternatives Similar to Traditional Investments?

Why Invest in Alternatives?

What are the Risks with Alternative Investments?

Summary

Agenda

What are Alternative Investments?

Something other than US stocks, bonds and cash

Anything you don’t understand

Something that sounds risky or makes you

uncomfortable

Something you never heard of before

Anything outside your mainstream thinking

What is an Alternative?

1975: Mortgage backed bonds (e.g., Fannie Mae)

1985: European and Japanese stocks

1990: High yield bonds

1995: Emerging markets (e.g., China)

2000: Treasury Inflation Protected Securities (TIPS)

Today’s Alternatives Can Become

Tomorrow’s Mainstream

Private Equity

Infrastructure

Real Estate

Commodities

Hedge Funds

What is Considered an Alternative in 2013?

Why is it Important for Trustees

to Understand Alternatives?

The return for a “standard” investment portfolio

has declined dramatically over the past decade.

This Used to be Easier

Current = 4.6%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Oct-91 Jan-94 Apr-96 Jul-98 Oct-00 Jan-03 Apr-05 Jul-07 Oct-09

65% Stock / 35% Bond 10-Year Rolling ReturnAverage

20-year average = 10.4%

Sep-11

Stocks remain relatively expensive…

Current Investment Challenges

0

5

10

15

20

25

30

35

40

45

50

1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 2015

Year

No

rmalized

Pri

ce-E

arn

ings

Rati

o

+ 1 Std. Dev.

Average

-1 Std. Dev.

Source: Shiller, Global Financial Data, S&P 500, Meketa Investment Group

Bond yields remain near historic lows…

A traditional portfolio of stocks and bonds will not get your 7.5%!

Current Investment Challenges

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1900 1915 1930 1945 1960 1975 1990 2005

Year

10-Y

ear

Tre

asu

ry Y

ield

How are Alternatives Similar

to Traditional Investments?

Alternatives have many of the Same

Characteristics as Traditional Investments

Alternatives are exposed to many of the same

risks as traditional investments

Characteristics of Traditional and Alternatives

Traditional Alternatives

Stocks Public Equity Private Equity

Bonds Bonds Private Debt

Real Estate REITs Private Real Estate

Infrastructure Utility Stocks Private Infrastructure

Commodities & Natural Resources Natural Resources Stocks Commodities

Why Invest in Alternatives?

Chance to participate in new opportunities

A higher expected return for giving up some liquidity

Greater alpha potential

Ability to moderate risks associated with ordinary

stocks and bonds

Diversification benefits

What Can Alternatives Offer?

Historical Private Equity Returns

What have been the returns?

Source: Thomson Reuters. All Regions all Styles

As of December 31, 2012

1

Year

10

Years

20

Years

Upper Quartile 22.8% 20.3% 33.0%

Median 12.6% 11.3% 11.1%

S&P 500 Index 16.0% 7.1% 8.2%

Over the last twenty years, Median Private Equity has returned

11.1% annually, while Upper Quartile has returned 33.0%

This compares to 8.2% for the S&P 500 Index

What are the Risks with Alternative

Investments?

Common Issues with Alternatives

Issue Consideration

Lower level of liquidity or illiquid Subject to redemption terms (if any at all)

Limited/no market for investor’s interest

Lower level of transparency into

underlying assets

Specific assets often not identified at the time of investment

Limited/no ability to control the assets in the portfolio

Some managers utilize leverage and/or derivatives

Hard to value Many assets are not publicly traded and are subject to

appraisal based valuation techniques

No clear benchmarks

Best managers are critical

to success

Spread between top performing and median managers

is wide

Common Issues with Alternatives

Issue Consideration

Higher fees Managers typically charge both management fees

(1% - 2%) and performance fees (20% +)

Lumpy cash flows Investments may have unpredictable capital call and return

patterns

Self liquidating structures require reinvestment in order to

maintain target allocation

Administrative burden Alternative investments often require monitoring, accounting

and tax specialists

Potential headline risk Limited ability to exit manager in case of investment or

other issue

Summary

Investing in Alternatives

The Eight Golden Rules

Understand it first

Adopt a well-considered long-term strategy

Take your time to get invested

Avoid fads

Plan for the necessary illiquidity

Avoid unnecessary pyramided costs

Use the right professionals

Diversify, diversify, diversify

Summary

BOSTON MIAMI SAN DIEGO

100 Lowder Brook Drive

Suite 1100

Westwood, MA 02090

Telephone Number: (781) 471-3500

Fax Number: (781) 471-3411

1001 Brickell Bay Drive

Suite 2000

Miami, FL 33131

Telephone Number: (305) 341-2900

Fax Number: (305) 341-2142

5796 Armada Drive

Suite 110

Carlsbad, CA 92008

Telephone Number: (760) 795-3450

Fax Number: (760) 795-3445

Contact Information

M E K E T A I N V E S T M E N T G R O U P

www.meketagroup.com

1

Alternative Investments: Measuring the Risks

Matt Appel, CFA – Vice President

State Street Global Exchange – Analytics

May 21, 2013

2

Agenda

• Introduction

• Alternative Investments

– Trends

– Importance

• What are the Risks

– Quantitative

• Hedge Funds

• Private Equity & Real Estate

• Risk Measurement and Solutions

• Assimilating Risks into Total Portfolios

• Trends in Alts

3

State Street Global Exchange

State Street Bank &Trust

State

Street

Global

Markets

State

Street

Global

Services

State

Street

Global

Advisors

State

Street

Global

Exchange

• State Street Global Exchange (SSGX) is a global provider of advisory, analytics, investment, information, and

electronic trading solutions.

• SSGX is committed to providing value to the front office in the same way State Street has and continues to do in the

middle and back office.

• SSGX leverages State Street’s unique data sets and industry-leading technology platforms to provide information

products, software, and services across all asset classes and buy-side industry segments.

4

State Street Global Exchange - Analytics

State Street Global Exchange

Information

Solutions

Research &

Advisory

Analytics • Independent

valuation

• “What-if”

performance

attribution

• Risk/Return

Optimization

• Analytics for

regulatory risk

• Structured

investment

products

Trading &

Clearing

Solutions

Software

Solutions

5

Full Service Risk Solution for Institutional Clients

• We have been in existence since 2001

– for 11+ years

• Extensive history with derivatives

and alternative investments

• Grown from servicing only HFs to

servicing all of the State Streets clients

• More than $1.5 trillion across ALL asset

classes including private markets

History

Staff

• Global Staff consists of 90+ people

dedicated to risk services

– Client Support

– Development

– Risk Advisory

– Financial Engineering

– Research

– Business Development

– Administration

Assets Serviced

17

19

Public

Corporate

Global Pension Fund Clients

• 36 Pension Fund Clients

• Over 125 Clients Globally

6

Public Pension Funds Increase Allocation to Alternative Investments

• State pension systems shifted 10% of their

assets from public equities to alternatives

over the five years ending June 30, 2011

• Alternatives now average 20% of total

state fund assets

• Private equity and real estate allocations

were the primary driver behind the better

performing state funds

• Median allocation to alternatives by

public plans with assets >$1B was 15.07%

as of June 30, 2012, up from 1.81% as of

June 30, 2003

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1-Jan-03 1-Jan-11

Public Pension Plan Portfolio Allocation

2003 v. 2011

Other

Alternatives

Fixed Income

Equities

Sources: Pension & Investment and Cliffwater Inc.

1.81% 15.07%

7

What are the Risks?

1. Lose Money

2. Liquidity – can’t get your money out when you need it

3. Over invested in certain exposures

4. Don’t make expected return

8

How do I get the Information to Model?

1. Transparency Services

2. Proxy

3. Open Protocol

4. Regulation & Industry Standard Reporting

9

Transparency

• Execution of non-disclosure agreements to protect confidential information

• Monthly aggregation of hedge fund positions from:

– Fund administrators

– Fund prime brokers

– Fund custodians

– Funds themselves

• Position verification, cleanse, and augmentation with market data each reporting period

• Independently calculated position pricing

• Exposure reporting, including standardized and client-driven tags attributed to each

position, enabling high flexibility

• Full range of position-based analytics including stress testing, VaR analysis, risk

decomposition, sensitivities and what-if analysis

Today, more than ever, hedge fund investors are seeking ways to better measure and

understand the dynamics and risks in their alternative investments.

10

Proxy – What Information Do you Need

1. Exposures

2. Return Streams

3. Indices

4. Blended Proxies

11

Open Protocol

Regulatory Reform and Strong Investor Pressure has Necessitated Standard Risk Reporting

Procedures for Alternative Investments

Source: www.theopenprotocol.org

1

THE WORKING GROUP – responsible for developing the first draft of Open Protocol reports for

consultation by a wider audience as well as ongoing maintenance and development of the protocols

Alongside Albourne Partners, State Street was a champion in the working group and continues to be

actively involved in the Open Protocol initiative.

Reasons for Open Protocol Reporting

2 The UK Financial Authority

recognized reporting

inconsistencies as it discussed

assembling its first template to

capture capital market risk in 2008.

Where investors were able to see

transparency into their hedge fund

investments, it was complicated to

view and monitor risk due to:

• Multiple sources of data

• Inconsistent calculation

methods

• Different reporting formats

Post US financial crisis, there was a

growing demand from institutional

investors for standardized risk

reporting to ensure consistency of

data to better aggregate risk

information.

3

12

What is Open Protocol?

• Open Protocol brings together

three types of information

– State Street uniquely provides

counterparty and investor information

• Predefined levels of granularity

allow managers to provide consistent

information without compromising

the trade in the market

Completed in August 2011, the Open Protocol Template Provides Your Investors With a

Consistent Level(s) of Hedge Fund Transparency

Granularity Mandatory Example

(Sector Exposure)

Grade

I Low

Yes, for all

metrics

• Materials

• Industry

Grade

II* Medium

Manager /

Client Discretion

• Materials

– Chemicals

Grade

III* High

Manager /

Client Discretion

• Materials

– Chemicals

• Diversified

• Chemicals

2. Investor

Information (10%)

3. Risk

Information (80%)

1. Counterparty

Information (10%)

* In development

13

Who Does OP Benefit? Open Protocol Benefits Hedge Fund Managers, Institutional Investors and Regulators

• Transparency of asset classes traded (not trading strategy) makes hedge funds more attractive

investments for institutional investors (no more “black box” investing)

• The standard reporting template is flexible, easy to implement and comprehensive

• Aggregate reports will minimize managers’ and investors’ investment in additional technology

and resources

Benefits

Beneficiaries

Hedge Fund

Managers

Institutional

Investors Regulators

1. Fund Transparency X X X

2. Standardized Reporting Procedure X X X

3. Decreased Reporting Costs X X

14

3. Regulatory and Industry Standard Risk Reporting

Regulatory Reporting Industry Standard

Reporting

SEC

Form PF

CFTC

Form CPO-PQR UCITS IV AIFMD Solvency II Open Protocol

A rule that

requires private

fund advisors to

report regulatory

assets under

management to

the FSOC.

These

requirements are

intended to

provide risk

exposure

statistics

regarding the

type and size of

assets held by

private firms.

A rule designed

to provide

information

about

operations and

strategies of

commodity

pools in order

to establish a

baseline picture

of potential

systemic risk in

the industry

The Committee of

European Securities

Regulators (CESR)

requires

Undertakings for

Collective

Investments in

Transferable

Securities (UCITS)

funds to employ a

risk management

framework that

monitors and

measures the risk of

their holdings and

contribution to

overall portfolio risk

at any time.

A regulatory directive

whose primary

objective is to provide

common rules for the

authorization and

supervision of

alternative

investment fund

managers (AIFM).

All managers of AIFs

operating in the EU,

providing investment

management

services to non-

UCITS, irrespective

of legal form or

domicile, are subject

to transparency

requirements.

An EU directive that

codifies and

harmonizes the EU

insurance

regulation regarding

the amount of

capital that EU

insurance

companies must

hold to reduce the

risk of insolvency

An 11-tab

spreadsheet

report that

standardizes

reporting

procedures for

the collection,

collation and

conveyance of

hedge fund risk

information.

US-domiciled EU-domiciled Both

15

Losing Money

• Value at Risk (VaR)

• Drop Down Risk

• Sensitivities

• Stress Scenarios

16

Liquidity

• Legal Terms

• Gates

• Lock-ups

• Fees

17

Exposures

• Currencies

• Countries

• Sector

• Counterparties

• Issuers

18

Stress Scenarios

• Custom

• Historic

• Economic

(2.97%)(2.80%)

(7.20%)

3.64%

0.36%

4.10%

1.18%

(6.55%)

(3.53%)

(4.32%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

9/11 Attack - 5

Day

Asian Crisis

97-98 - 5 day

Bond Crash:

Feb 94 - May94

Emerging

Markets Rally:Jan 99 - May

99

Fed

Tightening:April - June 99

IR

Steepening:Sept 98 - Nov

98

Nadaq Rally:

Nov 99 - Jan00

Nasdaq

Correction:July 98 - Aug

98

Russian Crisis

- 5 Day

Government

Intervention

Fixed Income Domestic Equity Alternative Investments International Equity Total

19

Investment Vehicles to Mitigate Hedge Fund Risk

• Hedge Fund of Funds

• Commingled Funds

• Separate Accounts

• Funds of One

• 1940 Act Funds (Registered Products)

20

Liquid Alternative Strategies

1. Fidelity/Arden

2. Blackstone

3. KKR

4. Goldman

5. ARIA

1. Franklin Templeton / K2

2. NYLIM / Private

Advisors

3. Legg Mason / Permal

Liquid Products

Traditional and Hedge FOF

21

ARIA – Alternative Road Investment Advisors

• Registered 1940 Act Mutual Fund

• Access to Veteran Hedge Fund Managers

• Single 1.97% Fee

• (No performance fees or multiple layers of fees)

• Daily Liquidity

• Real-Time Transparency

• Multiple Hedge Fund Subadvisers & Strategies

• Endowment Asset Allocation Model

• Uncorrelated Return Stream Versus Broad Market Indices

• Downside Risk Protection

• Absolute Return Stream

• Long Term Capital Appreciation

22

Private Equity & Real Estate Investments

1. Liquidity

2. Exposure

3. Volatility

4. Opportunity Costs

23 23

PE Market parameter and assumption:

Parameter Description Possibility Lower End Upper End

1 Robust 13.4% 1sd 1.96sd

2 Sound 15.0% 0.5sd 1sd

3 Neutral 38.2% -0.5sd 0.5sd

4 Slow 15.0% -1sd -0.5sd

5 Weak 13.4% -1.96sd -1sd

Total: 95.0%

PE Market Parameter is served

as a Probability Density

Function, which generates a

random process from its

observed behavior during a

finite period of time, within

user defined range.

For example, based on SSPEI

database observations, first year

Buyout Fund on average drawdown

16% of commitment in year 1 with 6%

Standard Deviation.

Parameter Lower

bound

Upper

bound

1 4% 10%

2 10% 13%

3 13% 19%

4 19% 22%

5 22% 28%

24 24

PESM provides a range of possible outcomes

Simulation: Percentile Distribution

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

0% 10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Simulation: Histogram

0

10

20

30

40

50

60

70

-0.7

%0.3

%1.3

%2.3

%3.3

%4.3

%5.3

%6.3

%7.3

%8.3

%9.3

%

25

Sample of Simulation Result: Year 2013 to 2021

PE Market Barometer (CF Projection Parameters): 3, Neutral

T0 T1 T2 T3 T4 T5 T6 T7 T8 T9

Contribution (253.3) (316.1) (361.0) (414.9) (428.2) (446.1) (459.9) (485.6) (504.4) (419.7)

Buyout (147.2) (203.1) (252.8) (284.6) (294.9) (309.5) (322.7) (343.9) (365.0) (311.9)

Venture Capital (16.1) (21.7) (27.0) (29.6) (37.5) (36.9) (37.2) (42.0) (39.5) (34.5)

Debt Related (90.0) (91.3) (81.1) (100.7) (95.9) (99.7) (100.0) (99.6) (99.9) (73.2)

Distribution 254.6 247.0 251.2 255.5 295.5 356.4 426.9 462.8 493.1 511.3

Buyout 160.6 156.3 131.5 133.0 170.5 235.4 306.5 355.0 380.9 394.9

Venture Capital 7.2 2.2 4.0 6.8 9.9 14.5 16.3 17.8 20.2 25.9

Debt Related 86.9 88.4 115.6 115.6 115.2 106.4 104.2 90.1 92.0 90.5

Net Cash Flow 1.3 (69.2) (109.8) (159.4) (132.7) (89.8) (33.0) (22.8) (11.2) 91.6

Buyout 13.4 (46.8) (121.3) (151.5) (124.4) (74.1) (16.2) 11.0 15.9 83.0

Venture Capital (8.9) (19.5) (23.0) (22.8) (27.6) (22.4) (20.9) (24.2) (19.3) (8.6)

Debt Related (3.2) (2.9) 34.5 14.9 19.3 6.7 4.1 (9.6) (7.9) 17.2

Fair Marktet Value 1,130.4 1,278.2 1,423.9 1,606.3 1,773.0 1,908.9 2,055.9 2,196.5 2,338.4 2,324.4

Buyout 649.7 748.8 892.2 1,060.9 1,219.9 1,347.8 1,476.6 1,599.0 1,712.9 1,715.1

Venture Capital 41.2 52.3 70.8 91.0 113.0 136.8 162.9 187.8 208.9 216.4

Debt Related 439.5 477.1 460.8 454.5 440.2 424.2 416.4 409.7 416.6 392.9

T0 T1 T2 T3 T4 T5 T6 T7 T8 T9

Ending AUM Value 18,503 21,278 24,470 28,141 30,955 34,050 37,455 41,201 45,321 49,853

Ending PE Allocation % 6.11% 6.01% 5.82% 5.71% 5.73% 5.61% 5.49% 5.33% 5.16% 4.66%

26

Private Equity & Real Estate Exposures

1. Country

2. Currency

3. Sector

4. Industry

5. Leverage

6. Vintage

27

Volatility & Opportunity

1. Proxy

2. Funds

3. Portfolio Companies

4. Leverage

5. PME

28

Stress Scenarios Transparency

Oversight, Analysis and Actionable Information

Exposures Tracking Error

(2.97%)(2.80%)

(7.20%)

3.64%

0.36%

4.10%

1.18%

(6.55%)

(3.53%)

(4.32%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

9/11 Attack - 5

Day

Asian Crisis

97-98 - 5 day

Bond Crash:

Feb 94 - May94

Emerging

Markets Rally:Jan 99 - May

99

Fed

Tightening:April - June 99

IR

Steepening:Sept 98 - Nov

98

Nadaq Rally:

Nov 99 - Jan00

Nasdaq

Correction:July 98 - Aug

98

Russian Crisis

- 5 Day

Government

Intervention

International Equity Alternative Investments Domestic Equity Fixed Income Total

Industry R ankings

R elat ive W eight A bso lut e W eight R isk T racking

Pharmaceut icals B io t echno logy & Lif e Sciences 2.3% Sof t ware & Services 11.5% Energy -1.1% Pharmaceut icals B io t echno logy & 0.4%

Sof t ware & Services 1.9% Pharmaceut icals B io t echno logy & Lif e 10.1% D iversif ied F inancials -0.8% Sof t ware & Services 0.3%

M edia 1.4% Energy 9.1% Sof t ware & Services -0.7% Techno logy Hardware & 0.3%

C onsumer Services 1.1% Techno logy Hardware & Equipment 7.6% C ap it al Goods -0.7% Semiconduct ors & Semiconduct or 0.3%

R et ail ing 0.8% C ap it al Goods 7.2% Pharmaceut icals B io t echno logy & Lif e -0.5% C onsumer Services 0.2%

C ap it al Goods -0.9% U t il it ies 1.6%

Energy -1.1% Househo ld & Personal Product s 1.2%

Telecommunicat ion Services -1.2% R eal Est at e 1.2%

U t il it ies -2.0% A ut omob iles & C omponent s 0.8%

R eal Est at e -2.4% C ommercial Services & Supp lies 0.4%

Issuer R ankings

R elat ive W eight A bso lut e W eight

M IC R OSOFT C OR P 0.9% A PPLE IN C 3.2%

T IM E W A R N ER IN C 0.8% M IC R OSOFT C OR P 2.3%

N A TION A L OILW ELL V A R C O IN C 0.7% GOOGLE IN C 1.6%

C OM C A ST C OR P 0.7% EX X ON M OB IL C OR P 1.3%

FED EX C OR P 0.6% PF IZER IN C 1.3%

A PPLE IN C -0.8%

V ER IZON C OM M U N IC A T ION S IN C -0.8%

IN TER N A TION A L B U SIN ESS M A C HIN ES C OR P -0.9%

A T&T IN C -1.0%

EX X ON M OB IL C OR P -1.4%

• Mid cap

overweights vs.

Large Cap

•  Energy,  Financial,

and Software &

Services are largest

contributors to risk

•  4 out of top 5

relative under

weighted securities

stay constant from

prior qtr with

rankings changed; 3

out of top 5 relative

over weighted

securities remain

constant  from

prior qtr with

rankings changed

0%5%

10%15%20%25%

Allocation By Risk

Allocation

Risk

45%

18%

14%

11%

12%

Risk Contribution by Market Cap

Large

Med/Lrg

Med/Small

Medium

Smal l

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

Allocation by Market Cap

Actual BM

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Allocation by Sector

Actual

BM

COMPLETE TRANSPARENCY INTO ALL ASSET CLASSES

Hedge Funds – position level information assimilated with rest of

your assets

Private Equity – portfolio company proxy capturing exposures

and volatility

Real Estate - portfolio company proxy capturing exposures and

volatility

Co-mingled – integration of all positions with rest of portfolio

-10.9%-10.3% -10.5% -10.4% -10.4% -10.6%

-10.1% -10.0% -10.1%-9.4% -9.4% -9.7%

-10.4%-9.7% -9.9% -9.6% -9.6%

-10.2% -9.9% -9.8% -9.8%-9.4% -9.4% -9.5%

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

10/11 11/11 12/11 01/12 02/12 03/12 04/12 05/12 06/12 07/12 08/12 09/12

Monthly Risk 95% VaR

TOTAL ASRS FUND POLICY BENCHMARK