When my children used to ask what I did for a living, I found it difficult to explain how I spent most of my time counseling large financial institutions and institutional investors on financial risk management. So I resorted to the allegory of an alligator's bite to explain how my parabolic curves are used to depict ranges of expected investment performance. These alligators became a popular way for my children to learn about sophisticated risk management techniques. By showing them that the alligator's bite is much more dangerous when their mouth is opened wide, I was able to help them understand the risk of uncertainty of a wide distribution of returns. Moreover, I was able to show them that portfolios with unpredictable ranges of outcome are frightening as well.

There are many theories on the definition of success in the investment management business. Gerald Loeb's theory of "putting all eggs in one basket--and then watch the basket" can work for those who have extraordinary confidence in both the investment quality of the "eggs" and the tolerance for periods of illiquidity likely combined with low valuations.

Institutional Investors have obligations that change their tolerance for risk and their investment objective. The need to meet liabilities, and in many cases accept new contributions to the portfolio, creates a demand for consistency in portfolio performance. And yet, their high tolerance for equity volatility suggests that they are, perhaps unwittingly, "watching the basket" instead of managing their risks. This article will describe the flaws in using traditional benchmarks for institutions and solutions for investors who wish to perform like the best in the business.

Traditional Benchmarks
We will go through this analysis with help from a few alligators who will demonstrate how their bite varies in similar fashion to investment risk. In Chart A, we see how the "bite" would match the market risk of equities and fixed income.

The top and the bottom jaws of the alligator depict the range of investment outcomes projected by the volatility of the markets they define. The dotted line in the center shows the mean return, in this case, since January 1st, 2001. The range of outcomes varies from the statistical top third of expected outcomes to the bottom third of expected outcomes. The slope of the mean reflects the Sharpe Ratio (risk adjusted return) of performance.

Volatility and the Volatility of Volatility (A mouthful-even for an alligator!)
This equity chart reflects the danger of an alligator or portfolio whose range of performance outcomes is naturally wide, making the range of returns variable and difficult to predict (volatility). Remember, that the top and the bottom of the range each represent a third of potential outcomes, which make it highly probable (33%) that over time performance will be at those points. If it's not frightening enough that this gator has a big bite, it's even more alarming to note that his temper changes frequently (volatility of volatility). At times he can appear to be relatively harmless, only to turn around and open his mouth far wider then the mean.

By using this equities rollercoaster as a benchmark to measure success, even by meeting or exceeding the benchmark performance it may still be hard to cover your liabilities. Of course, equities have the advantage of positive beta over the long haul, yet the risk adjusted slope of the mean return in the past six years has been negative and over the long term the Sharpe Ratio of excess return divided by standard deviation has been a meager 0.4x.

Watered Down Risk and Return
Chart B reflects the tameness of the fixed income alligator whose bite is not particularly dangerous, whose return is more consistent, but whose appetite will likely leave him unsatisfied for long periods of time.

Traditional logic in the institutional money management business has been to combine stocks and bonds in a way that results in less volatility and more consistency. But the problem with this approach is that the key driver of performance remains the fickle equity market and bonds only have the effect of watering down both risk and return. Another major issue with bonds is that their volatility and correlation vary as well.

Short memories cannot relate to the 70's and 80's when bonds danced to a beat that reverberated throughout the investment world. How many current practitioners remember the cover of Business Week the first week of 1975 that suggested Wall Street should be renamed Bond Boulevard? I sure do. As in many other times when public pronouncements resulted in doom, the bond market subsequently crashed and I well remember worrying about whether First National City Bank would actually fund our February bonus payments for our terrific performance in 1974 when the bank realized the huge losses we suffered after the cover story.

The other problem with bonds is co-variance with equities, which also varies. It was a big help to 60/40 investors that when the market crashed in 2000. The Fed eased rates to unprecedented levels to provide liquidity in the hostile market environment. Profits from bond portfolios somewhat dampened the equity impact, but most institutional investors lacked sufficient duration exposure to radically modify the downdraft of equities.

These 60/40 portfolios of stocks and bonds don't appear at the top of any of the long term league tables, unless you are willing to accept the junior varsity leagues they belong in. Remember, limiting your investments with stocks and bonds is not only not conservative, it is extremely risky!

Return Comparison	Last 5 Years	Last 10 Years
Public Pensions	8.87	8.77
Corporate Pensions	8.57	8.93
Endowment/Foundation	8.90	9.33
Taft-Hartley Database	7.89	8.37
DUKE	11.4	16.3
YALE	14.5	17.4

So why are we talking about gators? Not just because Florida won the National Championship in Football and Basketball in the same year. The goal is to create a portfolio that is trim and fit, sufficiently productive to cover liabilities and compound, and not dangerous to the health of the sponsor or its trustees. This portfolio will have a relatively small range of outcomes, indicating a reliable return pattern, but will be reaching toward the sky, with a very positive Sharpe Ratio.

How can you reposition your portfolio to emulate the best performers? First you need to look at your current portfolio. Then you decide what you need to do to whip it into shape, most likely by following a Risk Diet. The diet will require that you take volatile risk off the table and replace with investment strategies capable of generating positive returns when stocks are down, making profits when stocks are up and demonstrating reliable volatility patterns regardless of the market. By diversifying effectively, you will train your alligator to hold his small bite high with confidence that he will be satisfied.

How does risk allocation differ from asset allocation?
Portfolio construction based on risk allocation rests on a foundation of ranges of return, correlations between investment buckets and risk adjusted returns. Let's start with the ideal investment portfolio in terms of expected range of performance and then work backwards to the investment strategies that would get us there? We would want the portfolio to have a very narrow range of returns with a lifted Sharpe elevation, optimizing risk adjusted return. Then we will need to continue to monitor and manage the correlations that make diversification work.

What do we actually do?
We start with risk and back into asset allocation to determine the dollar amounts we invest. Expected risk and return is only part of the equation. Risk managers expect volatility and correlation to change over time, only because both always do. Forecasting the expected volatility of volatility and volatility of correlation is crucial in constructing a solid portfolio. Then managing the inevitable trading risk through risk management is essential.

What would this portfolio include?

• Equities for the long haul beta
• Commodities for the long haul inflation protection
• Real estate a variety of income producing with long revenue growth
• A small dose of fixed income
• A large allocation to Absolute Return Strategies

Absolute Return
Absolute Return Strategies with generous excess return potential and can be effectively managed to a target level of risk. A relatively small allocation of risk to a well managed fund of hedge funds will result in a large allocation of assets, due to low correlations to equities. The result is a stable portfolio with more reliable returns. The combination of reliable returns and controlled risk results in Sharpe Ratios significantly above other investment alternatives - requiring a large allocation of risk and assets.

Benchmarks
No American endeavor keeps score better than baseball and the investment business. All participants line up based on batting averages and returns measured against historical ranges, competitors and pre-season projections. Also we all have the same markets and investment opportunities as Yale and Duke (who, unlike Harvard, use outside managers) One of the best investors in the business, Yale University, has been using Absolute Return Strategies since 1991 and today they allocate 28 percent of the total $18 billion portfolio to ARS. That's almost twice the 15 percent allocation to U.S. public equities.

What happens when we measure our performance against the best in the business rather than the erratic equity market? They have the same markets, the same investment opportunities and the same demands on their liabilities, so what is different about them and how did they trim their risk and gain absolute return muscle? The big difference is the trustees' decision to reduce risk and improve return through risk diversification. The results have been stunning. Over the past six years, when the S&P 500 produced an annual return lower than 90 day treasuries and a total return of 7.4 percent, the Yale portfolio performed at 13.6 percent per annum with a total return of 114 percent. Every pension and endowment should evaluate their risk allocation process at the strategic level and manage the tactical implementation to ensure that the portfolio performs at the expected level of risk. It works. And the rewards put them in a different ocean than their 60/40 counterparts.

Another successful endowment, Duke University, has a website that sums it up beautifully, "More important than the risk itself is the level of return generated for risk taken. The Sharpe Ratio measures this, calculating incremental return per unit of risk... Duke's return has not only been higher, but was generated with significantly less risk. The resulting higher Sharpe Ratio affirms our strategy of using diversification to increase return while moderating risk."

Final Thought - The Healthy Risk Diet
In closing, let me leave you with action steps that will make the Risk Diet work for your portfolio.

1. Define your investment objectives in terms of risk.
2. Seek the advice of consultants and advisors who have risk allocation capability and experience to help you construct a portfolio appropriate for your specific needs.
3. Hire Absolute Return Managers who understand the trading business and have the tools and experience to manage and control trading risk and access the best hedge fund managers.
4. Always compare your investment performance first to what you need to cover your liabilities and stay abreast of inflation, then to the best institutional investors like Duke and Yale. Always compare absolute returns and relative risk profiles.
5. Continue to seek ways to lower the range of expected and real performance outcomes while lifting the risk adjusted return (Sharpe Ratio) of your total investment portfolio. A risk diagnostic of your current portfolio will help you determine how much risk weight you need to lose.

At the end of the day, your portfolio should perform at a higher rate than your actuarial assumptions. The excess return will be helpful in staying ahead of inflation and creating real portfolio value.

Ferrell Capital Management, founded in 1988 as a financial market risk management consulting firm, has advised many of the largest banks, pensions, endowments and hedge funds on risk allocation. The firm currently manages Ferrell Concert Ltd., an offshore fund of 70 hedge funds in nine strategy buckets. More information is available at www.ferrellcapital.com.