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					   Argyle Conversations
          by Argyle executive Forumsm

                             featuring

                        Seth Finkelstein
                 Senior Vice President
Head of Client Portfolio Management
    Multi-Asset Strategies & Solutions
      ING Investment Management

                                      &

                       Jason Redlus
                Managing Member
             Argyle Executive Forum
                                           On November 24, 2010, Seth
                                           Finkelstein, senior vice president and
                                           head of client portfolio management
                                           for ING Investment Management, and
                                           Jason Redlus, managing member of
                                           Argyle Executive Forum, spoke about tail
                                           risk, portable alpha, and diversification.
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November 24, 2010


  Seth Finkelstein                         Seth Finkelstein is responsible for a variety of multi-asset
                                           strategies including traditional asset allocation products,
      portable alpha strategies, and customized asset/liability solutions that address clients’ plan lev-
      el investment objectives. He co-founded the multi-asset strategies and solutions (MASS) group
      in late 2006 with Paul Zemsky. Seth has direct portfolio management responsibility for portable
      alpha strategies and other custom multi-asset solutions.

      In addition to his responsibilities within MASS, Seth oversees the broader team of client portfo-
      lio managers and portfolio specialists across asset classes, and is involved extensively in new
      product development in the institutional and retail product arenas. Seth joined ING Investment
      Management in 2005 as senior portfolio specialist, responsible for a variety of fundamental
      equity strategies, including 130/30, research analyst portfolio, and sector-specific portfolios.
      Seth has 16 years investment experience spanning a variety of traditional and alternative asset
      classes, and has worked with a broad spectrum of retail and institutional client segments.

      Prior to joining ING, Seth was with Seneca Capital Management where he served as a portfolio
      advisor on the firm’s growth equity and domestic fixed income strategies. Earlier in his career,
      he was a lead product manager for JPMorgan Investment Management’s retirement business.
      Seth graduated summa cum laude with a BBA in finance and holds the Chartered Financial
      Analyst designation.




   Jason Redlus Jason Redlus isExecutiveExecutive Forum’s managing member that
                founder. Argyle
                                Argyle
                                         Forum is a professional services firm
                                                                               and

      convenes and connects business leaders from highly targeted business-to-business communi-
      ties for strategic collaboration and business development.

      Over 25,000 executives participate in one or several of Argyle Executive Forum’s communities with
      over 200 new members joining every month.

      Prior to forming Argyle Executive Forum, Jason launched the private-equity business effort for Cap-
      ital IQ. Capital IQ was acquired by Standard & Poor’s in 2004. Prior to Capital IQ, Jason was an in-
      vestment banker, focused on middle-market M&A and LBO transactions. He holds a BS from Cornell
      and an MBA from Harvard Business School.




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  JASON REDLUS: When you go to work everyday, what topic is most top-of-mind?

  SETH FINKELSTEIN: The investment team I am part of manages asset allocation and other multi-
  asset portfolios for institutional and retail investors. Asset allocation funds, target date products, LDI
  and portable alpha are some of the categories we cover. As such, our job is to allocate our client’s
  capital prudently across a number of asset classes and risk exposures in a way that maximizes the
  chances of them achieving their investment objectives. So, unlike a single asset class manager, who
  might be concerned about security selection and beating a common market benchmark, we are ob-
  sessive about asset allocation, risk allocation, correlations among and within markets, and the pos-
  sibility of severe losses and latent risks that hide beneath the surface of our portfolios. The questions
  we ask ourselves everyday are many: Are our clients’ portfolios best positioned to thrive, or survive,
  under a variety of different economic and market scenarios? Are we positioned in such a way that
  gives us undue or unintended exposure to certain types of events? Are we making full and efficient
  use of the body of investment ideas we generate that can add value? We try to be well positioned from
  the standpoint of taking risk where we see interesting opportunities, diversifying that risk, and paying
  very close attention to the probability of large negative outcomes that can arise from our positioning.

  You were quoted in The Wall Street Journal not too long ago saying that you are looking for
  the next frontier of diversification. How do you define diversification?

  We think about diversification in a multi-dimensional framework. Many investors have a tendency
  to diversify their portfolios across two parameters—asset
  classes and underlying managers. This is not bad, per se. “The traditional approach
  But it is incomplete and often leads to the types of concen- to diversification has led
  trated, correlated portfolio exposures that harm investors to portfolios that are over-
  profoundly in times of market stress. We have been advis-
  ing clients to move beyond the notion of splitting up the
                                                                  exposed to systematic
  world along asset class lines. The paradigm of allocating risk and correlated risks of
  assets among tons of managers, each defined by the small various forms”
  segment of the market they cover, should eventually yield
  to a more elegant and dare I say accurate way of divvying up the world and building and managing
  a complex portfolio. To say it more plainly, the traditional approach to diversification has led to port-
  folios that are over-exposed to systematic risk and correlated risks of various forms. There are so
  many vectors of diversification investors can access—diversification of alpha sources, geographies,
  risk premiums, time horizons and structures, just to name a few. We definitely think diversification
  will work better for investors if they focus more on diversifying sources of risk and risk premiums they
  invest in, including active management risk, rather than just diversifying among asset classes or even
  more generically between “traditional” and “alternative” investments.

  When I refer to risk premiums, I am referring to those systematic risk exposures that reward investors
  over time but add a certain amount of volatility to the portfolio along the way. Examples include the eq-
  uity risk premium, the credit risk premium, the commodity risk premium, the term structure premium,
  the volatility risk premium, the illiquidity risk premium, and many others. These risk premiums do not


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    exactly line up neatly with the traditional breakdown of asset classes. We urge investors to evaluate
    any investment strategy and also look at the entire portfolio along the lines of these systematic risk
    factors, as well as any risks and returns that come from active management. When you approach the
    asset allocation and risk management exercise from the standpoint of risk premiums, and allocate a
    risk budget along these lines, you get much closer to building a portfolio that truly has uncorrelated
    sources of return and a more manageable risk profile. And, as we know, allocating a risk budget is
    very different than simply allocating assets due to the disproportionate risk that some investments
    carry relative to the size of their allocation in a portfolio.

    Can you tell us more about this idea of alpha diversification or diversifying active risk?

                                                                The notion of dividing a portfolio’s risk and
     “A non-technical definition of tail risk is the            return into the portion driven by systematic
     probability of extreme outcomes in the                     risk and the portion driven by active manage-
     performance of assets or investment                        ment is not new. Kurt Winkelmann, formerly
     strategies that have uncertainty associated                of Goldman Sachs, did a lot of work in the
                                                                arena of allocating a total risk budget across
     with their return patterns“                                a variety of market risks and active manage-
                                                                ment risks. Diversifying active risk by em-
    ploying a variety of active managers who genuinely pursue different types of investment strategies at
    different points in time and in different parts of the capital markets can actually provide a diversifica-
    tion benefit, even in stress periods when the correlations among market sectors go to 1. When you
    couple alpha diversification with an asset allocation approach that is built around capturing system-
    atic risk premiums tactically or strategically, then you’ve got yourself a viable and effective approach
    to diversification. Having said all this, risk management should not begin and end with diversification.
    There’s more to it.

    Let’s keep drilling into the concept of risk and risk management. How do you define tail risk?
    And how do you protect against it?

    A non-technical definition of tail risk is the probability of extreme outcomes in the performance of
    assets or investment strategies that have uncertainty associated with their return patterns. Most
    people focus on left tail risk and what they’re really talking about is this persistent financial markets
    phenomenon whereby large losses in financial assets occur far more frequently and are of far greater
    magnitude than investors expect based on the asset’s return and standard deviation profile.

    Investors traditionally approach the asset allocation process by conducting a Markowitz-type mean-
    variance optimization analysis to arrive at a set of portfolios that maximize return for a given level of
    risk. For years people have been familiar with the main assumptions or shortcomings that underlie
    this process, the most impactful of which are that the returns of financial assets are normally distrib-
    uted and stationary, meaning that the distribution of returns itself is fixed and does not change with
    the passage of time. After optimizing, some investors then try to get a better handle on the inherent
    uncertainty of the allocation and understand the potential worst case outcomes by using simulation


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    tools that project random paths of returns. They will also test new asset allocations and active port-
    folio strategies using these stochastic simulators. Unfortunately, most simulation tools commercially
    available are not capable of simulating non-normal return patterns. And so the worst case outcomes
    in a 10,000 scenario simulation will be understated, and sometimes dramatically so. Not factoring in
    the non-normality of returns and the time-varying nature of asset class correlations and return dis-
    tributions in the optimization process itself is a key reason why many investors end up with portfolio
    allocations that drastically understate the true risks.

    There are many theories as to why fat tails exist and more broadly what causes financial assets to be
    so much more volatile than their underlying fundamentals. We think that one of the best of these is
    Mordecai Kurz’s Theory of Rational Beliefs or the concept of Endogenous Uncertainty and Correlated
    Errors. I strongly recommend that readers review these papers, as they are fascinating, intuitive,
    empirically proven and airtight. But you didn’t ask me what causes tail risk—you asked me what we
    can do about it.

    It’s hard to answer this one succinctly but I will try. If investors want to earn returns above cash and
    have a remote chance of meeting their objectives, they have to take on risk. And risk itself is not a
    stable measure—it changes over time, and the complex-
    ion of risk of a given asset, and how that asset correlates “At the end of the day, good
    with others, changes over time. This adds another layer risk            management requires
    of complexity to the fact that individual asset prices and
    returns have fat tails. As I said before, most investors
                                                                    vigilence, determination, and a
    begin and end the risk management process at the stage willingness to explore avenues
    of diversification. But we learned in past crises, not just and instruments that many
    in 2008, that traditional asset class diversification can fail folks have avoided in the past”
    when we need it most. So let me highlight some ideas,
    tools and techniques that we use and advise clients to use. The mantra we go by is “measure it, moni-
    tor it, manage it.” At the end of the day, good risk management requires vigilance, determination and
    a willingness to explore avenues and instruments that many folks have avoided in the past. Having
    said this, we are quite humble in the face of risk and are sure that even with the most advanced risk
    tools, there are risks we cannot see and cannot predict at the moment because they lie outside the
    scope of our ability to conceive of them.

    Can you be more specific?

    To measure and monitor risk in a way that adequately captures the true behavior of assets over time,
    investors can look at several metrics. First, we like looking at a measure called Modified Value-at-
    Risk, or Cornish Fisher VaR, for an asset or a portfolio. Unlike conventional VaR, which is calculated
    from using the mean and standard deviation parameters of a normal return distribution, Modified VaR
    explicitly includes skewness and kurtosis in the calculation. So in one risk number you can get a fla-
    vor for what your maximum loss will be at a given probability, taking into account the non-normality
    of the asset’s probability distribution. This is really neat because you can then use Modified VaR in
    your optimization process instead of standard deviation or regular VaR. You can also look at differ-


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    ent managers’ marginal contributions to the Modified VaR of a total portfolio. In fact, you might limit
    a strategy’s marginal contribution to Modified VaR in your allocation process. Another helpful tool is
    looking at Conditional VaR. Conditional VaR is the average of the worst 5% or 1% of historical return
    observations or return paths from a stochastic simulation. This metric tells you something about the
    size of the loss in tail events. It’s tangible and quantifiable. Third, we strongly advocate looking at the
    maximum drawdown of an asset or a strategy. If an asset has enough history, why not look at the
    worst peak-to-trough performance over its life? That number will be a lot worse than VaR, Modified
    VaR or even Conditional VaR. An investor would also want to look at the maximum historical draw-
    down of their entire portfolio based on their current or potential asset allocation. This will help them
    understand whether they can endure such a drawdown without becoming insolvent or getting fired.
    Lastly, we are big believers in using multi-factor risk analysis and style analysis to understand which
    hidden risk exposures may exist in portfolios, markets and actively managed products. It helps you
    get a firmer grasp on the true sources of a manager’s returns and whether or not they have delivered
    pure alpha. When you apply this factor analysis to hedge fund indices, you can explain over 90% of
    the returns of hedge funds with just a few risk factors.

    What are some of the most effective ways in which you’re guiding clients away from these
    potential bad outcomes and helping them manage these tail risks?

    We see three things an investor can do with the help of their investment consultants, asset managers
    or in-house staff. Note that these are all things one can do in addition to diversifying risk exposures
    as discussed earlier. These are direct and explicit approaches to tail risk hedging, and given that they
    are forms of risk reduction, they will involve some sacrifice of the best return outcomes so as to avoid
    the worst ones.

                                                                       The first and most simple thing an in-
     “When bad things start to happen, we want to                      vestor can do is just avoid or dramati-
     be able to react to them quickly and take risk                    cally underweight asset classes and
     off the table as briskly as possible so that bad                  investment strategies that are prone
     outcomes don’t turn into horrible outcomes”                       to big drawdowns and tail risk scenar-
                                                                       ios. If you don’t get on roller coasters,
    there’s no way you can get nauseous from riding them. We advocate that investors do this if their
    return objectives or liability obligations are such that they do not need much return in excess of cash.
    The second approach is to employ one or several dynamic asset allocation strategies. The third
    approach involves taking tactical or strategic positions in securities or derivatives that thrive when
    markets turn to mush.

    With dynamic asset allocation strategies, you’re making asset allocation moves either through de-
    rivatives or the underlying securities with a reasonable degree of frequency based on the riskiness
    observed or predicted in the market. To be clear, we’re not talking about tactical asset allocation or
    market timing to add returns. Incremental returns are the by-product and not the purpose of a risk-fo-
    cused dynamic strategy. When bad things start to happen, we want to be able to react to them quickly
    and take risk off the table as briskly as possible so that bad outcomes don’t turn into horrible out-


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    comes. When you lose less money in downturns, the portfolio volatility decreases, and the return
    you need to recover from drawdowns is less herculean. You experience a smoother ride from point
    a to point b. There are a variety of different dynamic asset allocation strategies that can be based
    off of the realized volatility in the market. When realized volatility spikes, assets tend to perform
    badly, but with a dynamic strategy, you’d be systematically de-risking in times of elevated volatility.
    And since volatility tends to cluster or have momentum, you can get out of the way of some fairly
    steep drawdowns. You can also have dynamic strategies that target a maximum drawdown, such
    that if the portfolio loses a certain amount of money, you completely defease into a risk-free asset.
    Here, you’d want to use rules that allow you to reset the threshold if the portfolio increases in value
    and/or reset the strategy on a given date so as not to permanently go to cash and miss the vigorous
    rebounds that tend to happen after multi-period declines.

    The third approach is one that involves holding securi-
    ties or taking on certain counter-cyclical positions rather
                                                                 “Say what you will about runaway
    than dynamically allocating portfolio assets. Today, the deficits and debt, enormous
    vast majority of investors own assets that decline in uni- unfunded liabilities, and loose
    son in a true market crisis, especially when that crisis is
    accompanied by a wholesale shift in investors’ risk ap-
                                                                 monetary             policy,       but       the
    petites. Despite the regular occurrence of market crises, dollar and Treasuries are still
    most investors don’t seem to hold much of anything that the assets that rally most when
    rallies in such a scenario. Again, they own too much cor-
    related risk exposure. One answer to this is to be long
                                                                 investors seek safety”
    Treasury bills or bonds throughout the cycle. Say what
    you will about runaway deficits and debt, enormous unfunded liabilities, and loose monetary policy,
    the dollar and Treasuries are still the assets that rally most when investors seek safety. We don’t see
    that changing. The two Eurozone debt crises over the last several months proved this, as did the mag-
    nificent rally in Treasuries through the financial crisis. How to go long Treasuries is up to you. Static
    Treasury holdings, purchasing deep out of the money calls on Treasury futures, being long Treasury
    futures, are all ways to do this. Other than Treasury positions, you can hold securities that effectively al-
    low you to take a long position in volatility. When markets decline, volatility itself spikes, so if we’re able
    to engineer some long exposure to volatility in our portfolio, then at least we can have one investment
    strategy that will rally when the market declines. There are several ways to go long volatility, and inves-
    tors should search for the cheapest and/or the most sensitive to vol spikes. Exchanged traded funds
    that track the VIX index and VIX futures are now available and trade well in the market. There are also
    variance swaps, which are a form of over-the-counter derivative where an investor can earn or pay an
    amount directly connected to the change in volatility in the market over some period of time. Lastly, an
    investor can always go out there and buy protection in the options market.

    Make no mistake: Each of these tail risk management strategies will cause a drag on total returns
    in normal market environments. Historically, in the wake of a financial market crisis, investors get
    very, very serious about risk management. But when they actually examine what the ongoing costs
    are for that risk management, they default to their original position: “I’m a very long-term investor. I
    can endure this market volatility. I don’t want to sacrifice any upside.” After this recent crisis though,


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    I get the sense folks are actually going to follow through, which will represent a huge leap forward
    in the sophistication and stability of institutional portfolios.

    Two buzzwords that keep rolling around are “risk parity” and “portable alpha.” Can you share
    some perspective on these topics?

    Risk parity is an approach that seeks to earn better risk-adjusted returns over time in a multi-asset
    portfolio by allocating equal amounts of portfolio risk, rather than dollars, to different asset classes
    through the use of leverage. We don’t have a categorical view on these products, but we do believe
    in the robustness of the idea as a strategy for improving risk-adjusted returns and reducing volatility.
    Investors, however, will want to tackle their misperceptions about the riskiness of leverage and also
    figure out where a risk parity strategy fits into their overall portfolio, especially if they’re using the old
    fashioned approach to asset allocation and manager selection. If they use the risk budgeting method
    I touched on earlier, it would be much easier to find risk parity strategies a natural home.

                                           Portable alpha is one of the most misunderstood investment strat-
     “Portable alpha is one of             egies in the industry because, similar to risk parity, it is viewed by
     the most misunderstood                investors as a product, rather than what it truly is which is a port-
     investment strategies in              folio construction technique. Its reputation has suffered and its
                                           usage has ground to a halt because investors have confused im-
     the industry”                         plementation mistakes made by certain portable alpha adopters
                                           with the validity of the approach itself. Portable alpha addresses
    a hugely inefficient portfolio constraint that’s been around for years—the notion that wherever my as-
    set allocation dictates I invest, so goes my selection of managers to earn incremental excess returns.
    Portable alpha detaches the asset allocation decision from the alpha decision and can lead to a more
    efficient portfolio from the standpoint of risk-adjusted returns, just like risk parity. The truth is that
    alpha opportunities are not equal across markets, but with the help of very plain vanilla derivatives,
    you can earn excess returns where they’re plentiful and port them to the benchmark dictated by your
    investment policy. That’s an intelligent investment strategy in my book. Saying portable alpha is bad is
    the same as saying hedge funds are bad or emerging markets are bad simply because they suffered
    steep declines in the crisis. What’s interesting is that investors have quickly forgiven the hedge fund
    industry for its disappointments and are now lining up to increase their hedge fund allocations. They
    didn’t throw the baby out with the bath water, as many did with portable alpha.

    I believe everything in investing comes down to how you go about applying an investment technique
    or concept. The choices we make and the assumptions surrounding these choices determine both
    the ultimate success or failure of a strategy as well as our reactions to its success or failure. To those
    who condemn portable alpha, I ask that they examine closely the high profile failures and the choices
    investors made around the following issues. First, where did the investors try to get their alpha and
    how pure was that alpha? Alpha’s got to be alpha; if it’s beta in disguise, then it will be correlated
    with market movements. That’s a big problem. Second, what beta or index exposure was the inves-
    tor trying to port alpha on top of? Equities, fixed income, commodities or cash—the beta component
    of the total portfolio exerts a huge impact on the ultimate volatility and tail risk. If you went long the


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    S&P 500 through swaps, then you lost 22% in fourth quarter 2008, before even considering what the
    alpha overlay did. But if your portable alpha strategy had you go long BarCap Aggregate swaps, then
    you gained 4.5%. A portable alpha strategy structured in such a way as to take hedge-fund strategies
    with hidden beta risks and lots of leverage and combine them with a synthetic S&P position is going
    to suffer dramatically in a crisis. Third, how much leverage is being employed, through the combina-
                                                             tion of unfunded synthetic market exposure and
     “My general recommendation to the underlying strategies s/he invests in to earn
                                                                               leverage,
     clients is beware of false prophets and alpha? The more of capital the higher the things
                                                             ity and intensity           losses when
                                                                                                       veloc-

     panaceas that come in the form of go wrong. Fourth, how did the investor go about
     must-have-assets-at-any-price”                          collateral management? If you’re going long the
                                                             equity market through derivatives, you’d be well-
    advised to have cash available or easily accessible to make margin calls. Collateral positions should
    be proportional to the volatility of the overall strategy. Many who got burned had to liquidate holdings
    outside of portable alpha at steep losses to meet margin calls because they didn’t have sufficient
    cash collateral on hand and were unable to liquidate hedge fund holdings to meet the calls.

    A lot of influential people say that gold is the place to invest. What are your thoughts on gold?

    I’m not going to make a call on gold, but I will say that investors should be very clear about the port-
    folio implications of investing in gold and the role they want it to play in their asset mix. Is it for infla-
    tion protection? Is it for higher returns? Is it to hedge against dollar declines caused by flat monetary
    policy? Gold, like any other asset, is neither good nor bad. It just depends on what you’re looking to
    get out of it and what you’re willing to endure to get the benefit. I will say though that the buzz around
    gold sounds an awful lot like the buzz around tech stocks, REITs, MLPs, and many other stand-alone,
    non-diversified investments that investors barreled into in the past. There’s a real difference if you’re
    thinking of gold tactically or as a strategic allocation. My general recommendation to clients is beware
    of false prophets and panaceas that come in the form of must-have-assets-at-any-price. We want to
    always identify a functional purpose for investing in an asset outside of the fact that it’s gone up in
    price and well-respected investors are standing behind it.

    A less jaded response to the question is that I would not put all my eggs in the gold basket if what I
    am looking for is a strategic position in an investment that will do well in a declining dollar scenario.
    Broader exposure to commodities, emerging markets, and non-dollar bonds will all help protect a
    portfolio against a declining dollar.

    Do you have any recommendations for investors as they look toward 2011?

    We recommend that investors not be afraid to truly explore and test-drive the full breadth of invest-
    ment tools, techniques and strategies. I only touched on a few of them in this conversation. There
    have been advances in asset allocation and risk management and measurement that are simply
    under-utilized by the broader investment community. Positioning our portfolios for multiple market
    scenarios and tail risk events must go beyond simply reducing equities and adding alternatives, which


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    many are doing. Good asset allocation and risk management involves spending more time on big pic-
    ture stuff that really moves the needle, as opposed to hunting for the best manager in a particular asset
    class and making sure they don’t exceed their tracking error bands. Collectively, we’ve been doing that
    for 20 years and not once has it protected our portfolios in a serious market downturn.

    Let’s move beyond our fear of derivatives, and beyond the penny wise and pound foolish reluctance to
    sacrifice two basis points of upside in order to get some downside protection. Insurance costs money,
    but it helps us sleep at night. And, if you think about, as individuals we pay a lot of money to insure our-
    selves against events that genuinely have a low probability of occurrence, whereas as investors we re-
    fuse to pay for insurance against financial market tail events that happen once every five years or so.




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