Foundations of Asset Management: A Practitioner’s PerspectiveOctober 2013

Robert C. Merton, PhDSchool of Management Distinguished Professor of Finance, MIT Sloan School of ManagementResident Scientist, Dimensional Holdings Inc.

Dimensional Fund Advisors Pte. Ltd. holds a capital markets services license for fund management serving accredited and institutional investors under the Singapore Securities and Futures Act. For institutional use and for informational purposes only. Not for use with the public. Robert Merton is an Advisory Board member of Dimensional SmartNest LLC, an affiliate of Dimensional SmartNest (US) LLC, which is an investment advisor registered with the US Securities and Exchange Commission. This document is for distribution in the People's Republic of China (excluding Hong Kong, Macau and Taiwan for the purpose of this document only, the “PRC”) only to the specific investors that are expressly authorized under relevant laws and regulations of the PRC to buy and sell securities and other financial instruments or products in foreign exchange in the following circumstances which do not constitute a public invitation to offer, or a public offer or a public sale of the same or the provision of securities investment consulting or advisor services within the PRC, and should not be deemed public under relevant laws and regulations of the PRC: (i) no public media or other means of public distribution or announcement will be used within the PRC in connection with the delivery or distribution of this document; (ii) each of the above-described PRC domestic investors who receives this document is advised that redistributing or sending this document, in any way, to any third party (other than to its authorized advisers, counsels and/or representatives), or discussing any information contained herein with any third party (other than with its authorized advisers, counsels and/or representatives), by such qualified domestic investors is prohibited; and (iii) this document further does not constitute any securities or investment advice to citizens of the PRC, or nationals with permanent residence in the PRC, or to any corporation, partnership, or other entity incorporated or established in the PRC. Potential investors resident in the PRC are responsible for obtaining all relevant approvals from the government authorities of the PRC, including but not limited to the State Administration of Foreign Exchange.

• Goal-based approach to investment management: setting the correct objective function

• Investment management process

– Only three primary ways to manage risk: diversification, hedging, and insuring

– Market portfolio: foundation of the optimal combination of risky assets (OCRA)

– Failure of the Capital Asset Pricing Model (CAPM) implies alpha exists relative to the passive market portfolio benchmark

• Sources of alpha: seeking to create superior performance over the market portfolio

• Potential sources of superior and sustainable investment performance

– Traditional alpha seeking versus financial services alpha seeking

– Traditional alpha seeking versus dimensional alpha seeking

– Functions served by asset management institutions as part of the financial ecosystem

• Innovation to help pursue comparative advantage in investment management

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Agenda

Goal-Based Approach to Investment ManagementA Solution-Focused Perspective

Determination of the appropriate objective function for the portfolio before optimization

• Example: Liability-driven investing with the goal of repaying targeted liabilities according to a schedule, as in a defined-benefit pension fund.

• Example: A managed DC product where the goal is inflation-protected retirement income for life adequate to sustain the late-in-work-life standard of living.

• Example: Goal is four years of tuition and housing at a university within a selected classification beginning when each child is 18 years old.

• Example: Sovereign wealth fund goal derived from its role in an integrated A/L management perspective on meeting the overall economic goals set for the sovereign.

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Although the management of sovereign wealth funds, currency reserves, and sovereign debt policy can be decentralized, the objective function from which the optimal policies for each are derived should reflect an integrated, comprehensive asset/liability management perspective on overall country risk exposures.

The principal functions of the sovereign wealth fund are to facilitate a) the execution of intergenerational transfers and other intertemporal savings and b) efficient risk diversification and risk modulation for the country.

The sovereign fund should generate the highest expected return for the risk taken. In effect, it should maximize its franchise value, subject to performing its principal functions. This can be done if it has the capability to generate “alpha” through superior investment skills of security selection and market timing. It can be done by performing financial services for which it has a competitive advantage, earning an above-competitive profit margin, based on its comparative advantages in credit-standing, long-horizon, lack of liquidity needs, reputational capital, and sponsorship value.

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Functions of Sovereign Wealth Funds

Integrated A/L Mgt: Government Risk Balance SheetDetermining the Objective Function for a Sovereign Wealth Fund

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Assets$ Bn

Present Value of Incomes from:### TAXES 1130.7### Income 573.65% Assets 83.70% Customs 1.1

### Excise & GST 220.44% Motor Vehicles 80.99% Others-Tax 171.0

### FEES 84.80% Sales of Goods 4.91% Rental 26.43% All other Fees 53.5

7% SEIGNORAGE TBD

0% Balances of:INVESTMENTS 688.0

Pension Fund 160.0### Wealth Fund 528.0

TBD CASH 112.3

6% INFRASTRUCTURE TBD

TBD Government-owned Enterprises TBD

TBD CURRENCY RESERVES 204.0

REAL ESTATE TBD

OTHER ASSETS 6.0

### TOTAL 2225.7TRUE

Liabilities$ Bn

Present Value of Non Discretionary Expenses on:SOCIAL DEVELOPMENT 653.0

SECURITY & EXTERNAL RELATIONS 600.6

ECONOMIC DEVELOPMENT 193.4

GOVERNMENT ADMINISTRATION 70.7

Balances of:MONETARY BASE TBD

GOVERNMENT DEBT OUTSTANDING TBD Foreign Currency Local Currency

PENSION LIABILITIES TBD

Contingent Claims (Implicit Guarantees)GUARANTEES TO BANKS AND NON-BANKS TBDGUARANTEES ON RETIREMENT INCOME TBDGUARANTEES ON SOCIAL WELFARE TBD

General Balance(Economic Assets in excess of Economic Liabil 708.1

TOTAL 2225.7

Note: Economic Balance Sheet integrates central bank.

For illustrative purposes only.

Integrated Risk Balance Sheet Approach to Asset AllocationDetermining the Objective Function for a University Endowment

Assets

• Tuition: Undergraduate

• Tuition: Executive Education

• Endowment

• Alumni Gifts

• Grants

• Sponsored Research

• Publishing

• Real Estate: Commercial

• Real Estate: Residential

• Patents

Liabilities

• Salaries: Tenure Faculty

• Financial Aid

• Energy

• Forward Tuition Contracts

• Other Liabilities

Net Worth

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Domain of Investment Management Stages of Production Process for a Given Investment Goal

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• Components of Max-Sharpe-Ratio Risky Assets-Only Portfolio

• Diversification Risk Modulation

PassiveBenchmark

Market Portfolio

Efficient Diversification

Superior PerformingMicro Aggregate

Excess-ReturnPortfolio

“Alpha Engines”

Active Asset-Class Allocation

Macro SectorMarket Timing

Non-CAPM Equilibrium

Super EfficientMax Sharpe Ratio

Portfolio of Risky Assets

RisklessAsset

Portfolio

OptimalMean-Variance

Portfolio

Alter Shape of Returns onUnderlying

Optimal Portfolio

StructuredEfficient Form of Returns to

Client

(Optimal Combination of Risky Assets)

(Derivative Securities Non-Linear Payoffs)

• Risk Modulation through Hedging or Leveraging Risky Portfolio

• Constrained Asset Holdings

• OCRA Market Timing Active Management

• Tailor payoffs to specific goal

• Risk Modulation with Insurance or non-linear leverage

• Pre-programmed dynamic trading

• “Building Block” State-Contingent Securities to create specialized payout patterns

• Expropriation efficient

• Regulatory efficient

• Liquidity tradeoff• Transaction cost

efficient

Combine with State-Variable

HedgingPortfolios

Transform Shape of Payoffs from Investing in the Optimal Portfolio: Derivatives

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Traditional Active Management Designed to Enhance Portfolio Performance

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Optimal Weighting

Super-PerformingMicro Aggregate

Excess-ReturnPortfolio

• Security Analysis• Technical Analysis• Proprietary derivative-Security Pricing Models

Asset-Class Allocation: Macro-Sector Market Timing “Long-Short” combinations to change fractional allocations from Benchmark Weights

ASSET CLASS BENCHMARK WEIGHT LONG (SHORT) INCREMENTAL REVISED WEIGHT

Small-Cap Equity 5% +5% 10%

Mid-Cap Equity 10% 0% 10%

Large-Cap Equity 30% (10%) 20%

Emerging Market Equity 15% (5%) 10%

Domestic Fixed-Income 30% 5% 35%

Real Estate 10% 5% 15%

100% 0% 100%

Micro ”Excess Return” Portfolio: Security Selection: “Alpha Engines”Engine #1U.S. RiskArbitrage

Hedge Fund

Engine #2Technical

Analysis ofEquities Fund

Engine #3FundamentalAnalysis of

Equities Fund

Engine #4Foreign Currency

Forecast Fund

Engine #5Private Equity

Fund

Engine #NMortgage-back

Security Relative Value Fund

Passive Market PortfolioFoundation for the Optimal Combination of Risky Assets

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S = Sharpe Ratio

Total Portfolio Risk-Return Portfolio Component Risk-Return

Failure of CAPM Implies Alpha Exists for Market Portfolio BenchmarkSources of Alpha: Traditional Alpha, Financial Services Alpha, Dimensional Alpha Possible Reasons for CAPM Failure

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I. Empirical Deviations from CAPM Black, Jensen and Scholes (1972); Fama and MacBeth (1973); Fama/French (1992)

II. Market Information Inefficiency: Traditional Alpha

III. Market Frictions: Affected by Technology, Institutions, and Regulation

• Institutional rigidities from regulation or charter/prospectus restrictions/requirements

• Taxes and accounting rules

• Leverage inefficiency; borrowing constraints

• Short-sale restrictions and cost

• Stock loan limitation and tracking requirements

IV. Other Dimensions of Risk besides Market Beta

• Hedging roles for securities in addition to diversification

• Uncertainty about the future investment opportunity set; i.e., changing interest rates, volatility and Sharpe ratio risks

• Uncertainty about human capital labor income

• Uncertainty about inflation and the menu of possible consumption goods in the future

• Uncertainty about relative prices of consumption goods;

• Uncertainty about liquidity

• Uncertainty about mortality and longevity

V. More-Complete Equilibrium Asset Pricing Models: Multiple Betas and Risk Dimensions with Risk Premiums

• Where is the (theoretical) multiple-regression coefficient from regressing the return on security j on the returns on the “m” dimension portfolios, “E1,...,Em”

• Intertemporal Capital Asset Pricing Model (Merton 1973,1975)

• Arbitrage-Pricing Theory Asset Pricing Model (Ross 1976)

• Consumption-based Capital Asset Pricing Model (Breeden 1979)

• Fama/French 3- or 4-Factor Model (reduced-form model)

Traditional Alpha Seeking

• Depends on being faster, smarter, better models or better information inputs

• Is it sustainable? Is it scalable?

• Kenneth French, “The Cost of Active Investing,” Journal of Finance (August 2008)Compares the fees, expenses, and trading costs society pays to invest in the US stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980 to 2006, finds that investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society's capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980 to 2006 period if he switched to a passive market portfolio.

• Non-economic costs and benefits

Financial Services Alpha: Financial Intermediation of Institutional Rigidities & Market Frictions

• Depends critically on being lightly regulated, with highly skilled professionals who can identify which rigidities are binding; diagnose which security prices are impacted by the rigidities; devise an efficient trading strategy to provide “the other side” of the trade to alleviate the impact of the rigidity on affected institutions; and earn an intermediation fee in the form of theexcess return on the strategy. Other helpful but not essential advantages: strong credit-standing, long-horizon, flexible liquidity needs, large pool of assets, reputational capital, and sponsorship value.

• Is it sustainable? Is it scalable?

• Hedge funds have a comparative advantage vs. traditional intermediaries that define their functional purpose in the financial“ecosystem.”

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Traditional Alpha vs. Financial Services Alpha

Strategic Analysis of Financial Services Functions Served by InstitutionsAssessing and Pursuing Comparative Advantage of the Institution

• What are the functions served by the institution within the financial ecosystem?

• What are the comparative advantages of the institution?

• Have technological, regulatory, or market conditions changes created new opportunities for the institution’s comparative advantages?

• Have technological, regulatory, or market conditions changes caused the institution to have a comparative disadvantage in performing any of its current financial functions in the future?

• How best can the institution implement its comparative advantages and exit from its comparative disadvantages to improve its performance?

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• In the CAPM equilibrium, the market portfolio is the OCRA for mean-variance investors, and those investors hold the same risky portfolio of assets. However, in more complete equilibrium models, investors use securities to hedge other dimensions of risk in addition to the overall market risk. So in general, investors will not hold the same proportions of risky assets, and thus the market portfolio will not be mean-variance efficient [aka OCRA], and the CAPM will fail.

• The existence of alphas relative to the passive market benchmark is entirely consistent with perfect-market and efficient-market conditions, and these alphas are long-run sustainable because these are risks that, on balance, investors are willing to pay a risk premium to avoid.

• While theoretical structural models suggest the potential identity of these other dimensions of risk, the search for these dimensions with alphas has been largely empirical, resulting in reduced-form models with surrogate dimensions and factors, rather than the actual structural ones. Well-known examples of factors that appear to have significant alphas over long time periods and across geopolitical borders are size of company [small – large], ratio of book-to-market value [high – low], ratio of profits-to-market value, and possibly liquidity [low – high].

• Alphas from identified dimensions of risk with risk premiums are called “dimensional alphas.”

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Traditional Alpha vs. Dimensional Alpha

References: Chacko, G., S. Das, and R. Fang (2012): "An Index-Based Measure of Liquidity," Working Paper, Santa Clara University.Chacko, G., C.L. Evans (2012): "Liquidity Risk in Corporate Bond Markets," Working Paper, Santa Clara University.Past performance is no guarantee of future results.

Relation Between Illiquidity Risk Factor and Hedge Fund Returns, 1994–2010A Case Study Exploring a Potential New Dimension of Risk Performance Attribution between Traditional Alpha and Dimensional Alpha

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STRATEGY ALPHA W/O LIQ. T-STAT ALPHA ALPHA WITH LIQ. T-STAT ALPHA

Convertible Arbitrage 7.23% 2.82 3.07% 1.58

Dedicated Short -1.27% 0.84 -1.48% 0.98

Emerging Markets 12.48% 4.25 5.23% 2.21

Equity Market Neutral 6.07% 4.11 1.65% 1.44

Event Driven 8.65% 2.74 6.38% 1.61

Fixed Income Arbitrage 9.47% 3.27 4.33% 2.07

Global Macro 10.98% 3.63 3.29% 1.08

Long/Short Equity 10.07% 3.06 4.53% 0.78

Managed Futures 4.10% 1.54 3.82% 1.82

Multi-Strategy 7.39% 2.28 3.09% 1.53

References: Chacko, G., S. Das, and R. Fang (2012): "An Index-Based Measure of Liquidity," Working Paper, Santa Clara University.Chacko, G., C.L. Evans (2012): "Liquidity Risk in Corporate Bond Markets," Working Paper, Santa Clara University.Past performance is no guarantee of future results.

Cumulative Returns Liquidity-Event Risk Portfolio1994-2010

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Liq

uid

ity P

rem

ium

Fun

d N

et A

sset

Val

ue

Time

Innovation and Investment ManagementEfficient Implementation of Comparative Advantage

Financial contracting technology permits the separation of risk-exposure selection and management from physical investment choices, capital expenditure plans, ownership, and governance of assets. Risk exposures can be radically changed without capital flows or investment. Investment management solutions should take full advantage of this technology in pursuing the client’s objectives.

Innovations in asset management and financial technology offer the prospect for achieving more efficient risk-return frontier risk allocations while addressing other goals.

Innovation in using an integrated risk balance sheet approach to tailor asset allocation designed to provide a superior client performance.

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Separating Risk Exposures from Cash Investments, Governance, and Liquidity Pursuing Both Comparative Advantage and Efficient Diversification

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Private EquityPortfolio

Cash Holding

Swap Contract

Illiquid Cash Fund

Portfolio Return = Public Equity Index + α + E

Public Equity Index

LIBORFund Return = LIBOR + a + e

Fixed Income Portfolio

Cash Holding

Portfolio Return = Public Bond Index

Local XYZPortfolio

Cash Holding

Portfolio Return = World XYZ

Swap Contract

DiversifiedFund

Bond Index

World Market

Fund Return = World Market + a + e

Counter-parties

Counter-parties

Swap Contract

Diversified Fund

Counter-parties

Fund Return = World Market

World XYZ

World Market

Black, F., M. Jensen, and M. Scholes (1972), ”The Capital Asset Pricing Model: Some Empirical Tests,” in M. Jensen, ed. Studiesin the Theory of Capital Markets,” Praeger.

Breeden, D.T. ( 1979), “An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities,” Journal of Financial Economics, September.

Chacko, G., S. Das, and R. Fang (2012), “An Index-Based Measure of Liquidity,” Working Paper, Santa Clara University.

Chacko, G., and C.L. Evans (2012), “Liquidity Risk in Corporate Bond Markets,” Working Paper, Santa Clara University.

Fama, E.F. and K. French (1992), “The Cross-section of Expected Stock Returns,” Journal of Finance, June.

Fama, E F. and J. MacBeth (1973), “Risk, Return, and Equilibrium: Empirical Tests,” The Journal of Political Economy, May-June.

Lo, A. (2001), “Risk Management for Hedge Funds,” Financial Analysts Journal, Nov-Dec.

Merton, R.C. (1973), “Intertemporal Capital Asset Pricing Model,” Econometrica, September [Ch. 15 in CTF].

Merton, R.C. (1975), “The Theory of Finance from the Perspective of Continuous Time,” Journal of Financial & Quantitative Analysis, November.

Merton, R.C. (1992), Continuous-Time Finance, [CTF], Blackwell, Revised edition.

Ross, S.A, (1976), The Arbitrage Theory of Capital Asset Pricing,” Journal of Economic Theory.

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References

Important Disclosure

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