Letter from David Remstein

Second Quarter 2012 Edition

Welcome to the latest issue of J.P. Morgans Investment Analytics & Consulting newsletter, which aims to provide informative and thought-provoking articles on topics relating to portfolio optimization. In this issue we provide an in-depth analysis of Stress Testing and discuss its implementation as an effective risk management tool within an investment management organization. Security Level Contribution to Return Analysis is covered in our Product Highlight. We welcome your thoughts and suggestions, and hope that this issue provides you with useful information. David Remstein Managing Director and Global Executive, Investment Analytics & Consulting J.P. Morgan Worldwide Securities Services david.m.remstein@jpmorgan.com About J.P. Morgans Investment Analytics & Consulting Group
J.P. Morgans suite of Investment Analytics and Consulting services provides clients with the information they need to make more informed investment decisions through innovative and forward-looking solutions. J.P. Morgan provides Investment Analytics & Consulting services to over 300 clients globally with over 9,000 institutional portfolios, representing approximately $2 trillion in assets. Our diverse client list includes corporate and public DB/DC pensions, investment managers, endowments and foundations, corporate treasuries, insurance companies, central banks and hedge funds. Having the broadest and deepest Investment Analytics and Consulting product offering in the market, J.P. Morgan offers security-level, multi-currency performance measurement (monthly and daily) using J.P. Morgan or third party accounting; characteristics and attribution at the asset class, sector, country, and individual security level; ex-ante risk measurement (including Risk Budgeting and security-level VaR); investment manager analysis, universe comparison, and peer grouping; global consolidated reporting for multi-national plans; and consultative services in the areas of liability and plan allocation strategy. For further information, please visit www.iac-opal.com or www.jpmorgan.com/visit/iac, or contact:
Americas & Asia: Mark Huamani Managing Director mark.huamani@jpmorgan.com Europe, Middle East, Africa: Alex Stimpson Executive Director alex.stimpson@jpmorgan.com
Any opinions, estimates and forecasts offered in this newsletter constitute the authors judgment as of the date of the materials and are subject to change without notice, as are statements of nancial market trends, which are based on current market conditions. We believe the information contained in this newsletter to be reliable but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any nancial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only and it is not intended to provide and should not be relied on for investment, accounting, legal or tax advice. Any opinions, estimates and forecasts are solely those of the authors and not of J.P. Morgan. This document contains information that is the property of JPMorgan Chase & Co. It may not be copied, published, or used in whole or in part for any purposes other than expressly authorized by JPMorgan Chase & Co. Copyright 2012 JPMorgan Chase & Co. All rights reserved

Table of Contents
Stress Tests: Aspects and Considerations Product Update: Security Level Contribution to Return Analysis

Global Markets

Australia: Stuart Hoy Vice President stuart.d.hoy@jpmorgan.com

Hypothetical Stress Testing

Stress Tests: Aspects and Considerations
By Andrew Robertson, andrew.d.robertson@jpmorgan.com
Stress testing has become an integral part of portfolio risk management to help eliminate potentially large losses from extreme events. This article explores the aspects and considerations needed to implement hypothetical stress testing as an effective risk management tool within an investment management organization. risk drivers, a data generating process to map the exogenous factors to a set of exposure specic risk factors, an exposure, and nally, a risk measure. These building blocks are illustrated below.
Exhibit 2: Stress test building blocks.
Data Generating Process of Systematic Risk Factors (Regression Model)

Hypothetical Scenario (Euro breakup)

Exposure (Portfolio)

Risk Measure (P&L)

Portfolio Risk Management

Perhaps the most important element of any risk management framework is buy-in from the top. Senior management within an organization needs to promote a risk culture where the identication and measurement of risk becomes a central business driver. For senior management the risks need to be identied, measured and managed. Statistical models, such as Value at Risk, have long been used for risk management purposes. In general, VaR models assume normal market conditions. Under extreme market conditions, the underlying assumptions of these models break down. In these situations, stress testing has been used as a complementary technique to identify potential loss.
Exhibit 1: VaR capturing risk as a plane, stress testing capturing risk as a point.

Source: Drehmann 2008

Stress tests perform two main tasks: act as an instrument of measurement for limit setting and capital allocation or to act as a tool for communication, allowing the discussion of risk within an organization to take place. If the purpose of the exercise is for communication, the priorities for the stress test model design are transparency and story telling suitability.1 The model design should be simplistic, with few systematic risk factors and simple relationships between variables. If a stress test is to be used as a measurement instrument, the priority is model accuracy and forecast performance.1 In this case, a complex model should be created, containing many intricate parts and risk factors. Mechanisms such as feedback loops should be incorporated, liabilities considered and sophisticated quantitative models for co-movement employed. The type of portfolio also plays a fundamental role in the design of the stress test model. This requires an understanding of the way the fund manager makes money and to what risk types they are exposed. For example, the model design for a credit risk incorporating probabilities of default will be fundamentally different from a market risk stress test model.

Scenario Development
The purpose of a stress test is to explore the behavior of a portfolio under extreme conditions and make decisions based on their results. Developing a hypothetical stress scenario is a complex process because it requires not only envisioning an event that hasnt happened before, but it also needs to be able to persuade others the event is plausible. If a scenario is too extreme, it may be hard to justify to decision makers and could be dismissed as too unlikely to occur. If a scenario isnt extreme enough, it will provide limited information and may be disregarded as too insignicant to act on. Therefore it is important to nd the right balance between severity and plausibility when developing a scenario. This is best achieved through the collaboration of different experts within an organization, such as risk managers, economists and fund managers. Using their expertise and experience, a state of the world can be formulated based
Exhibit 3: Iterative cycle of hypothetical scenario generation
Senior Management Risk Manager

Source: Yuko Kawai, Bank of Japan, 2006

Stress tests fall into three main categories: scenario analysis, historical stress testing and hypothetical stress testing. Scenario analysis identies a portfolios sensitivity to an individual risk factor, for example, a 100 basis point shock to interest rates. Historical stress testing recreates a past extreme event, such as the September 11 attacks. Hypothetical stress testing uses potential future extreme events to stress a portfolio. Examples include the break up of the Eurozone or a severe downturn in China. The obvious difference between hypothetical stress tests and the two other forms is the requirement to create a complex severe event not yet encountered. This presents unique challenges and can take considerable resources to produce. However, hypothetical stress tests may allow an organization to prepare for events in advance and lower the chances of a shock and awe response if the event were to occur.

Hypothetical Model Building Blocks

Hypothetical stress test models are comprised of four key building blocks1 - an extreme hypothetical scenario to dene a set of exogenous
Source: J.P. Morgan
Fund Manager Economist

Second Quarter 2012 Edition

Hypothetical Stress Testing

on possible future events and then cross checked by senior management. Using this approach a scenario may not only be more realistic, but will also incorporate the culture and risk appetite of the organization. Stress testing is most effective when a number of hypothetical stresses are applied to give an overall risk prole of a portfolio. The ultimate goal is to create a library of scenarios covering many possible future events, so scenario generation should be iterative and ongoing. To keep scenarios relevant, they should be periodically screened, challenged and cross checked in light of changing economic events and the risk prole of the portfolio. The process should be dynamic and engage people from across the organization. The most obvious starting point to develop a stress scenario is envisioning a future extreme world event. As well as having a degree of imagination, this calls on using economic fundamentals to create a forecast model. The extreme event is played through the model, with considerations made for arbitrage relationships between asset types and relationships between currencies. The laws of supply and demand are explored and challenged to produce a set of stress systematic risk factors such as global indices and major currency pairs. Another popular approach to building an extreme event is to consider the interrelationship of nancial markets and the effect a liquidity shock may have on it. The technique starts with a thought experiment on liquidity key drivers. Features to be considered are the interconnection of the nancial system through advances in information technology and how this can amplify events through feedback in the nancial system. The effects of market participants all managing risk in the same manner is another element that may need to be explored. An example of this technique might be an event causing a sharp increase in market risk and dealers exiting positions to avoid breaching trading limits. This contributes to further volatility and triggers action to be taken by other market participants resulting in herd behavior and further feedback in the system. The behavior spreads to other markets through the deterioration in liquidity and the inability to implement hedging strategies, thus causing further increases in volatility. As a result, a major market event unfolds. A third technique is to identify a maximum portfolio loss using mathematical optimization to create a hypothetical event scenario. The worst case scenario can be created by modifying the systematic risk factors within a stress test model under plausibility constraints, while ensuring the events are sensible due to the mathematical nature of the technique.
Exhibit 4: Probability impact chart

Source: J.P. Morgan, www.mindtools.com

scenarios to a portfolio and use judgment to rank each on a probability of occurrence vs. impact of risk chart. The result is both intuitive and informative, giving a quick, clear view of which scenarios warrant most attention, as well as an overall risk prole of the entity being stressed. Further insight can be gained by building up a history of probability/impact charts over time, thus allowing the ability to perform trend analysis on changes to business and the economic environment. The process of interpreting the results of stress tests also aid psychological preparation to events. Bringing different members of an organization together to discuss the topic of risk helps raise decision and thought awareness within an organization. In turn, this helps formulate contingency plans and impact mitigation, lowering the chances of a shock and awe response to market events.

Conclusion
The business of risk management is a balancing act of risk against return. It sometimes feels like the playing eld is not even, as small frequent opportunities to make prot are offset by large infrequent losses. The aim of hypothetical stress testing is to explore weaknesses in a portfolio under extreme circumstances to help mitigate these losses. But it is clear that there is no one-size-ts-all formula for stress testing in an organization. This is determined by the culture, the objective at hand and the overall risk appetite. A hypothetical stress testing program needs to have buy-in from all aspects of the organization. In some sense, stress testing is born of a state of mind, where ideas can be explored and where people and methodologies are open to be challenged. It is most important that senior management is involved in the design process, as ultimately they will be the ones making decisions on the back of any stress scenario. As with any practice, experience gains understanding and grows condence in a method.

Interpretation of results
Hypothetical stress testing does not act as a crystal ball for future events. Stress testing is a risk management tool that requires both a quantitative and qualitative approach to establish the risk prole of a portfolio. The qualitative element of stress testing has led to skepticism in the past and the rationale results are of little use without associating a probability to an event. Yet, this is the nature and challenge inherent in risk management. Trying to assign a probability to a hypothetical stress test in isolation seems to be a dangerous exercise, which could lead to a false sense of security in numbers. One answer is not to look at single stress tests, but to apply a number of
References: BIS 2009, Principles for sound stress testing practices and supervision PRM Handbook Volume III, pages 173 184 Kawai 2006, Stress Testing at Major Financial Institutions: Survey Results and Practice
1

Drehmann 2008, Stress Tests: Objectives, Challenges and Modelling Choices Riksbank Economic Review.

Second Quarter 2012 Edition

Product Update
Security Level Contribution to Return Analysis
By James Eaton, james.eaton@jpmorgan.com
While traditional attribution analysis models allow clients to understand how and why their investment manager achieved any over or under performance, it relies on a suitable benchmark being in place that can be deconstructed to the level required for the analysis (e.g., economic sectors, countries, securities, etc.). While in many cases a suitable benchmark does exist and attribution can be provided, there are increasingly many types of alternative investment strategies for which a suitable attribution benchmark is not available (or required). In these cases a more appropriate and relevant tool for the client is to understand the drivers of the absolute return of a portfolio through the use of contribution to return reporting. J.P. Morgans Investment Analytics and Consulting group (IAC) has developed a range of contribution to return reports which enable clients to understand the drivers of return, whether it be decomposing a Total Pension Scheme return into underlying asset class/investment manager contributions, or as we shall cover in this article, a security level contribution to return analysis. Available via the J.P. Morgan ACCESS, Views Portfolio Reporting tool, IAC can provide clients access to daily or monthly security level contribution to return reporting which allows clients to decompose their Portfolio or Composite returns into the underlying security level contributors. The reporting is available for any type of portfolio, covering any asset class and security, whether long or short. It is therefore a particularly valuable tool when looking to explain the impact of derivatives, exchange traded or OTCs, hedging or short positions within a portfolio. Alternatively, IAC clients can use this reporting function to compare portfolios with the same mandates in order to understand how one investment managers selection decisions compare to anothers.

Methodology
Contribution to return methodology has traditionally used a weight (%) multiplied by return approach to generate the contribution to return. While this methodology will produce an accurate representation of an assets contribution, it does rely on accurate returns being generated across ALL security positions to ensure contributions are accurate and roll up exactly to the portfolio return. For certain situations that can prove to be more difcult, such as where OTCs are held, market values moving from positive to negative or if there is heavy restructuring activity within a portfolio. To get around this while still calculating an accurate contribution, IAC uses a monetary gain/loss approach to calculate the security contribution to return. Monetary gain/loss is dened as: Ending market value - Beginning market value - Net cash ow*

Even in this challenging situation, every security position fed from the accounting system during the holding period, whether they are OTC derivatives, cash receivables/payables or expense accruals, will have at least one of these three data points available in order for the monetary gain/loss to be calculated. Considering the value of a portfolio is always the sum of the underlying security values, it is therefore consistent that the sum of the security level monetary gain/loss will always roll up to the total portfolio level monetary gain/loss. Conceptually, it is this relationship that ensures that when we come to calculate the security level contributions they will always sum up to the total portfolio level return. So how do we move from a monetary gain loss value to a contribution to return? We do this by rstly working out the weight that each securitys monetary gain/ loss forms of the total monetary gain/loss. We then multiply this weight by the total return of the portfolio, whether Net or Gross of fees, to produce the securitys contribution to return. Security contribution to return = Security monetary gain/loss Portfolio monetary gain/loss x Total portfolio return

This formula not only provides an accurate calculation of contribution, which takes into account any cash ow timing method set up on the portfolio, but also ensures contributions roll up to the total portfolio even where individual security returns may be missing or difcult to produce.

Multi-period contribution methodology

The methodology outlined above is only accurate for any given single period (one day or one month if reporting frequency is monthly). For longer periods, to ensure the most accurate calculation of the contribution is reported, the security contributions for all single periods within the total period are calculated and then aggregated using an appropriate smoothing algorithm. For example, a three month contribution to return report for a daily service client would calculate daily contributions for each day within the three month period and then aggregate. This extensive but automated calculation ensures highly accurate results over longer periods.

Outputs
As the calculation is always at a security level, the contribution being additive allows us to roll up the contributions to any level within a portfolios asset class hierarchy. To utilize this, IAC contribution reporting allows clients to group securities by a number of different aggregation options depending on the classication scheme required. The following graphics show examples of available grouping options. Alternatively, clients may just wish to see a full security list sorted by best to worst contributors or a Top 10/Bottom 10 output.

*Net value of all transactions; purchase, sales, dividends, interest etc

Second Quarter 2012 Edition

Product Update
Security contribution to return by Economic sectors/industries

Security contribution to return Top X Bottom X*

*Client can input X (e.g., 10)

Second Quarter 2012 Edition

Product Update
Composite level outputs
In addition to a portfolio view of the security contributors, the contribution to return reporting can also be performed at a composite level. When run at a composite level, an additional option is available which allows securities to be reported on an aggregated or un-aggregated basis. When run using the aggregated option, security positions are aggregated across all underlying portfolios. Only one position per security is reported at the composite level and no reference to the underlying manager holding that position is made. This option provides the same view of a composite as you see for an individual portfolio. When the un-aggregated option is selected, the contribution report reects each individual position per underlying portfolio; therefore you may see the same security several times if held by more than one underlying portfolio. Details of which portfolio is holding each position is shown on the report in this case. This option allows clients to see how each portfolios security position contributed to the overall composite return. The following graphics are examples of un-aggregated output.
Security contribution to return Composite Level Un-aggregated view

Should you be interested in receiving contribution reporting as part of your performance measurement service from J.P. Morgans Investment Analytics and Consulting group, please contact your IAC representative.

This article is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any nancial instrument or as an ofcial conrmation of any transaction. All market prices, data and investment holdings within are solely for illustrative purposes. This document contains information that is the property of J.P. Morgan. It may not be copied, published, or used in whole or in part for any purposes other than expressly authorized by J.P. Morgan.

Second Quarter 2012 Edition

Global Markets
Multiple Asset Class Comparison as of March, 2012
By Karl C. Mergenthaler, CFA, William Pometto and Jessica Lin karl.c.mergenthaler@jpmorgan.com, william.x.pometto@jpmorgan.com and jessica.c.lin@jpmorgan.com
Index Russell 3000 (Gross) MSCI EAFE (Net) MSCI Emerging Markets (Net) Barclays U.S. Aggregate Bond Index Merrill High Yield Index JPMorgan GBI Emerging Markets Bond Index NAREIT Index Goldman Sachs Commodity Index (Gross)
(%) 25 20 15 10 5 0 -5 -10 -15 Monthly Return Trailing 3 months Year To Date
Russell 3000 (Gross) Merrill High Yield Index MSCI EAFE (Net) JPMorgan GBI Emerging Markets Bond Index

Monthly Return Trailing 3 months 3.08 (0.46) (3.33) (0.10) (0.10) (1.24) 4.84 (2.35) 12.87 10.86 14.08 0.30 5.05 10.42 10.49 5.88

Year To Date 12.87 10.86 14.08 0.30 5.05 10.42 10.49 5.88

1 year 7.18 (5.77) (8.80) 7.71 5.71 1.08 11.29 (6.21)

2 year 12.18 2.00 3.94 6.41 9.84 5.77 17.96 7.29

3 year 24.26 17.13 25.07 6.83 23.59 13.88 42.21 13.15

5 year 2.18 (3.51) 4.67 6.25 7.74 3.83 (0.12) (2.86)

10 year 4.67 5.70 14.13 5.80 8.83 8.97 10.43 4.74

1 year

2 year

3 year

5 year

10 year

MSCI Emerging Markets (Net) NAREIT Index

Barclays U.S. Aggregate Bond Index Goldman Sachs Commodity Index (Gross)

U.S. Equity
U.S. equities began the year with a solid performance. The Russell 3000 index generated a 12.87% return in the rst quarter. The Russell 3000 was up 7.18% for the past year, and 4.67% over the most recent 10 year period.

Fixed Income
The Barclays U.S. Aggregate index produced an overall return of 7.71% for the past year. The Merrill High Yield index generated a return of 5.05% year to date. The J.P. Morgan GBI Emerging Market Bond Index posted a 1.08% return for 1 year while 3, 5, and 10 year returns remain positive.

International Equity
The MSCI EAFE Index experienced a 5.77% decline since the rst quarter of 2011 attributable to the ongoing stress posed by the European sovereign debt crisis, but posted a 10.86% return in the rst quarter. The MSCI Emerging Market Index experienced a decline of 8.80% for the past year, while continuing to produce impressive 3, 5, and 10 year returns through March 2012.

Real Estate and Other

The NAREIT index over 12 months returned 11.29%, outperforming the broader U.S. equity market and overcoming the macroeconomic turmoil. The Goldman Sachs Commodities Index was up 5.88% for the rst quarter but was still down 6.21% for the past year.

Second Quarter 2012 Edition

Global Markets
Global Equities (ex-North America) as of March, 2012
By Andrew Farmer and Simon Senior andrew.e.farmer@jpmorgan.com and simon.senior@jpmorgan.com
European Indices (all quotes in )
U.K., France, Germany, Switzerland
12,000 10,000 140 8,000 6,000 80 4,000 2,000 20 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 0 60 40 120 100 180 160

FTSE 100

CAC 40

DAX 30

SMI 20

MSCI Europe (right axis)

Commentary:
European markets continue to be dominated by concerns on the continuing Sovereign Debt Crisis. The EMU has been the worst performing global region on a year-to-date basis. Spain came under signicant stress again with the IBEX down 14% in EUR terms for the rst quarter of 2012. It was the worst performing market in Europe and the gap with core European Markets (the Dax in particular) has widened further.
Asian Indices (all quotes in )
5,000

Commentary:
The ASX200 index had a strong start to 2012 at AUD +6.9% (EUR +5.12%), its best rst quarter since 2006 and strongest quarter since the third quarter of 2009; but even the currency gain in AUD to USD at +1.3% did not keep it up with the strong performing world equity markets. The ASX was driven by the strong underlying Industrial and IT sectors. Chinese markets experienced high volatility during the rst quarter of 2012. While the government has been acting to promote growth (monetary policy shifting from containing ination to promoting economic growth), the markets have reacted negatively in March to renewed fears of an economic hard landing. Overall, the market rose +7.15% in euro currency terms. The Hong Kong Chief Executive election held late March along with weak tourism inows and resultant low retail sales in the rst quarter of 2012 halted the rise of the Hang Seng in March (HK$ -5.2%) which had followed two strong months of growth in the year of the dragon. After two strong months driven by underlying property performance, the FTSE Straits Times index began to stabilize late in the rst quarter with a move from Financials and Industrials to Consumer Discretionary as the sector leaders. Japan was a stand-out of the bourse indices with Nikkei 225 gaining +19.3% in local currency terms. The weaker yen boosted corporate earning prospects. The Kospi rose around 12% during the rst quarter, buoyed by heavy net purchases by foreign investors. Cyclical sectors such as shipbuilders, energy & chemicals and steels led the market growth. Expectations of improvements in the European debt situation added to the positive growth.

Australia, Hong Kong, Singapore

4,000

3,000

2,000

1,000

0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 ASX 200 Hang Seng Index Straits Times Index

140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 2002 2003 2004 2005 2006

Japan

2007 Nikkei 225

2008

2009

2010

2011

2012

2.0

South Korea
1.5

1.0

0.5

0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Kospi Index

Source: J.P. Morgans Investment Analytics & Consulting group, J.P. Morgan Equity Research, Morgan Markets, Bloomberg and Rimes

Second Quarter 2012 Edition