OPTICS integrated risk management & portfolio construction

1. OPTICS – Advanced Portfolio Construction System*
* Adopted by CalPERS to assist with managing risk
across its hedge fund and equity programs.
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of leverage which may increase the risk of investment loss. As a result, performance may be volatile and an investor may lose some or all of his or her investment. Furthermore, the ability to withdraw investments or redeem shares or to transfer
such shares or interests will be limited. It is anticipated that there will not be a secondary market for interests or shares in Ermitage’s products nor is any expected to develop. Fees and expenses may offset trading profits. Please refer to the
Confidential Private Offering Memorandum for all risks associated with investments within Nexar Group’s products.

2. Introduction
Liability funding has generally been based on the view that while market behaviour is largely unpredictable, OPTICS - key points:
there is a reliably positive relationship between expected return and risk. As a result, many funding
programmes have adopted a policy of retaining a more or less static allocation across a range of asset • Creates customised portfolios to meet specified
classes, beginning with traditional assets and extending the programme to bring in additional sources of objectives across a range of market environments
uncorrelated return. Hedge fund ‘alpha’ has been seen as one such source, and as a result hedge funds • Handles conventional assets and alternatives
have become an established part of many institutional portfolios.
• Integrates specialised (qualitative) hedge fund knowledge
The events of 2008 have led many investors to question the world-view that underpins this approach to
• Focuses on forward-looking estimates, not past returns
funding. When equities crashed, hitherto uncorrelated hedge funds also failed, precisely when they were
needed most. For correlation, just as for performance, the past turned out to be an inadequate guide to • Fully transparent construction process
the future. And that has profound implications for risk management. • Allows active client participation at every stage
Once we accept that correlations can change, the question of how best to manage risk shifts from
being a matter of finding uncorrelated assets – to understanding the specific circumstances in which an
investment programme might fail. We might express it as shifting the focus towards understanding the
dynamics of correlation, but it is more accurate to say that correlation, other than in the broad sense of “OPTICS features a powerful
return similarity, is not the critical determinant of diversification. It is easy to find examples of assets with
no statistical correlation that fail to diversify each other. range of analytics that can
We believe that an effective investment programme must deal with market conditions as they really evaluate an investor’s entire
are, and not follow the prescriptions of idealised and simplistic theoretical models that entirely fail to portfolio in relation to its
capture the periodic upheavals and occasional violence of real market moves. A pragmatic approach to
objectives. We can assess the
risk management must start from a real-world understanding of the behaviour of the assets that make
up the programme, across the range of conditions the portfolio might encounter. Hedge funds, as a likelihood that a portfolio will
case in point, are not a new asset class; they are adaptive strategies, that in some circumstances may perform in both positive and
be profoundly affected by market events. Their value derives mainly from their ability to adapt to new
conditions, so if they are to be included in an investment programme, we must understand the nature and
difficult environments, and
scope of their response to change. then work with you to design an effective portfolio
This is why we created OPTICS – an advanced risk management and portfolio construction system that can integrate hedge funds alongside your current
that gives professional investors the ability to build a totally customised portfolio to meet their specific investments in a way that best meets your needs.”
requirements in terms of risk, return and other investment preferences, taking account of the range of
market conditions the portfolio may encounter. Nick Macleod Investment Solutions

3. Building portfolios for the Real World
Many funding schemes operated by insurance companies and pension funds rely on the assumption Dynamic Markets: Environmental Shift
that investments will achieve known ‘long run average rates of return’ over the life of the investment
Cumulative Return
programme. In effect, they employ time as the primary means of risk management.
We believe this view seriously underestimates the dynamic nature of financial markets.
Changes in market conditions are not mere fluctuations in a stable long-run return distribution; they are
genuine shifts in the environment whose persistence can disrupt convergence towards long-term average
returns and lead to serious funding issues.
In our view, relying on the long run (and thereby failing to acknowledge the reality of shifts in the
economic and financial environment) is not an effective way of managing the risk associated with a
liability funding programme. To succeed, you need to manage risk in the near-term, and think about
return in the long-term - not the other way around.
We think the way forward for many investment programmes lies in ‘risk-managed’ assets. When we say Dynamic markets:
Source: Bloomberg, Ermitage
‘risk-managed’ assets, we mean investments (such as certain hedge funds) that can adapt to changes in Environmental shift
market environment. 3
Environment A
2.5
While it is extremely difficult to predict a change in the market environment, it is certainly possible to 2
Environment B
Long-run average
build hedge fund portfolios that can adapt to the range of market conditions they may encounter over an 1.5
extended funding period. And since changes in the environment tend to be persistent, it is possible to 1
detect changes and react to them in time to control losses. 0.5
“The cosy theoretical 0
The OPTICS system recognises this and takes a pragmatic “real world” approach to portfolio and risk -0.95 -0.65 -0.35 -0.05 0.25 0.55 0.85
management, reflecting the way that experience tells us markets do behave, rather than merely how they world in which average
should behave. It provides a framework within which investment professionals can deploy their expertise returns converge convincingly on their long-term
without invoking theories of investor behaviour, without requiring specialist mathematical knowledge,
values over a 10 to 30 year funding period is an
and without relying on statistical measures drawn from the past.
illusion. Instead, the real world is much more dynamic
Guiding principles:
where the long term is composed of a sequence of
• Failure to take account of market dynamics leads to systematic and serious underestimation of risk
distinct and persistent short-term environments.”
• Low correlation between investments does not guarantee effective diversification
• Reliance on long run averages can lead to failure in the near term Nick Macleod Investment Solutions

4. OPTICS portfolio inputs
In contrast with many commercial systems (and in house tools) which place great emphasis on historical statistics,
OPTICS is driven by a rational forward-looking return forecast structure.
The process begins by agreeing each portfolio’s objectives, in terms of:
• Risk-return profile
• Geographic specialisation
• Concentration on / or avoidance of certain strategies
• Other constraints and preferences (e.g. manager liquidity etc)
OPTICS accesses our complete knowledge base:
• Our proprietary database (‘LEWIS’) covers over 5400 hedge funds, includes meeting notes on 2500
funds, and comprehensive reports on over 80 approved funds.
• Analysts’ direct and detailed knowledge of managers and strategies, obtained through face-to-face
meetings, regular telephone conversations etc.
• Macro-economic outlook across a range of environments, driven by bottom-up manager / analyst
insights, coupled with a broader top-down perspective.
• Overall Hedge Fund strategy forecasts (reflecting macro-economic outlook).
• Individual Hedge Fund forecasts
OPTICS incorporates proprietary statistical software specifically designed to accommodate the
special features of hedge funds and to distinguish between significant and non-significant features of
past performance.
Advanced proprietary algorithms within OPTICS use the forecasts to identify portfolios with a high
probability of meeting the client’s stated return objectives across a range of plausible market environments.
Forecast driven approach for each fund and market factor
across multiple scenarios.

5. Initial Portfolio to Final Portfolio
1 2 3 4
Once we have confirmed the portfolio objectives with the client, we begin by specifying a range of plausible
economic environments that we expect the portfolio to be able to cope with. The main stages in this process are:
• Assessing the range of market conditions the portfolio may encounter.
• Boiling them down to a small number of model scenarios.
• Expressing the scenarios in terms of return to various market factors.
• Modelling the behaviour of the candidate funds in each environment, thereby creating a forecast for each
fund in each scenario.
• Translating the individual fund forecasts into portfolios that have a high probability of achieving their objectives
in each of the scenarios, without taking on undue risk, taking proper account of limitations on liquidity, etc.
Our model scenarios currently range from double dip, through low growth to full-blown recovery. The scenarios
are expressed in terms of returns to influential market and strategy factors. A difficult environment for equities,
for example, might be expressed as an expected annualised return for MSCI World of -20%, accompanied by
25% annualised volatility.
The next step is to create forecasts for individual funds in each of the scenarios. The forecasts reflect each
fund’s degree of dependence on whatever factors influence their returns in each environment coupled with an
assessment of their ability to add an idiosyncratic return.
Once we have forecasts for each fund in each scenario, we translate them into portfolios that have a high
probability of meeting specified objectives across the whole range of model environments. The first step uses
proprietary algorithms to create a suitable portfolio structure; that portfolio, referred to as the Initial Portfolio,
is then modified to take account of practical considerations and other factors that lie outside the model inputs.
These can include simplification of portfolio structure, stress-testing in alternative scenarios, recognition of
particular circumstances at individual funds, and so on. Each step in the transition from the Initial Portfolio to
the Final Portfolio is fully documented.
Once we have agreed the Final Portfolio, the forecasts for each constituent fund serve as real-world Each stage of the process is entirely transparent and reviewed each
benchmarks for performance. In other words, we know exactly what each fund’s role in the portfolio is, month to ensure that the underlying funds are performing according
and as a result we are quick to spot when a fund is not performing to expectations, even when the overall to expectations, that position sizes remain within set limits, and that
portfolio is. This greatly simplifies and clarifies portfolio monitoring and risk management. portfolio structure is consistent with objectives.

6. OPTICS summary
For investors who allocate over $50m to hedge funds, our advanced OPTICS system provides the Examples of requested objectives
opportunity to:
European Multi Strategy portfolio
a) Evaluate an existing portfolio in terms of its ability to meet objectives Designed for Pension Fund
b) Create a customised portfolio of hedge funds to meet your specific requirements with respect to risk, • Beta: 25% to MSCI Europe
return and other specified constraints and preferences. • Volatility target: 50% MSCI AC Europe Index
c) Ensure an effective fit with your pre-existing range of investments and overall portfolio objectives. • Return target: Merrill Lynch 1 Year Treasury Note +5%
CTA Portfolio
OPTICS designed bespoke portfolios offer many potential benefits:
Designed for Family Office
• Risk-managed performance across a range of market conditions – We build portfolios across • Return target: 15 – 20%
multiple market scenarios, allowing for the fact that markets may change course, sometimes dramatically
• Strategy: Commodity Trading Advisors
and often unexpectedly.
• Constraints: High concentration ( 7 managers)
• Control – Clients dictate the investment mandate in terms of included or excluded strategies, liquidity,
risk/return targets, etc. This is particularly helpful if the portfolio is used as an ‘adaptive’ mandate to Global Market Neutral Portfolio
help achieve long term objectives, without having to accommodate other shareholders (as required Designed for Pension Fund
with co-mingled funds). • Return target: Eurobor +3% to 5%
• Transparency – Our ‘glass box’ approach means that clients have access to our comprehensive • Volatility target: 4% to 6%
qualitative and operational due diligence research which provides greater peace of mind in terms of • Constraints: c25 managers, 5 year min. track record
risk management.
• Custody – Solutions can be delivered through a wide range of legal vehicles such as LLP’s, managed Global Long Volatility Portfolio
accounts and offshore funds. Clients specify the structure, with no other external shareholders. Designed for Pension Fund
• Return target: +12% to 15% in volatile period
• Customised reporting – OPTICS provides a clear, repeatable, disciplined and transparent portfolio
(cash otherwise)
decision making framework based on consistency between beliefs, objectives and actions. It establishes
a basis for proper accountability to Boards of Trustees and similar bodies. • Strategy: Managers that perform when volatility spikes
• Constraints: No meaningful correlation with MSCI World
• Partnership culture – Direct access to our investment seniors.

7. Contact us
Lindsay Bateman | lbateman@ermitagegroup.com Ermitage Asset Management Jersey Limited (“EAMJL”; “Ermitage”) is registered
Executive Director – Business Development | +44 (0)1534 615 544 with the Jersey Financial Services Commission for the conduct of investment
business and fund services business and with the U.S. Securities and Exchange
Commission as an investment adviser. Ermitage UK Limited is authorised by the
Antoine Prudent | antoine.prudent@nexarcap.com
Financial Services Authority. Ermitage is a wholly owned subsidiary of Nexar
Global Head of Product Business Development | +33 (0) 1 75 77 80 90
Capital Group SCA (“Nexar Capital Group”). Other subsidiaries in the Nexar Capital
Group include: (i) Nexar Capital S.A.S., approved by the Autorité des Marchés
Financiers (AMF) for managing single strategy funds; (ii) Nexar Capital LLC,
registered with the Securities and Exchange Commission (SEC) as an Investment
Advisor; (iii) Nexar Trading LLC, registered with the Commodity Futures Trading
Ermitage Asset Management Jersey Limited Commission (CFTC) as a Commodity Trading Advisor; (iv) AAAm S.A., authorized
47 The Esplanade, St Helier, Jersey, Channel Islands JE1 9LB | +44 (0) 1534 615500 by the AMF for managing funds of funds; and (v) Nexar Fund Management
(Ireland) Limited, authorized as a Non-UCITS management company by the
Nexar Capital Group Central Bank of Ireland. Ermitage has issued this publication which is for private
127 Avenue des Champs Elysées, 75008 Paris, France | +33 (0) 1 75 77 18 30 circulation only, is published solely for information purposes and does not
constitute an offer to sell or an invitation to buy any of the securities or funds
mentioned herein. This document is only intended for distribution to persons
permitted to receive it by s.238 of the Financial Services and Markets Act 2000
(the “Act”) or by applicable legislation in other relevant jurisdictions. None of the
funds described herein are regulated under the Act, and for such funds protections
provided by the UK regulatory system do not apply, nor are the benefits available
under the Financial Services Compensation Scheme. Ermitage has relied on
external information providers and/or included estimates in the report and accepts
no responsibility for its accuracy, nor the reasonableness of the conclusions based
upon such information. The contents of this document are subject to change
without prior notification. Past performance is not a guarantee of future
performance. The price of units or shares can go down as well as up and may be
affected by changes in rates of exchange. An investor may not receive back the
info@ermitagegroup.com | NexarEUInvestorServices@nexarcap.com | www.ermitagegroup.com amount invested.