Diversified Strategy Fund

Asset Allocation and Alternative InvestmentsPaul Moody – Head of Investment Development

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Agenda

The importance of asset allocation

The problems with traditional approaches

Alternative assets

Commodities

Currency and tactical asset allocation overlays

Infrastructure assets

Private Equity

Hedge Funds

Europe 25%

Europe 29%

Europe 22%

Europe 7%

Europe -1%

Europe 21%

Europe 37%

Europe -18%

Europe -32%

Europe 13%

N. America 29%

Asia Pac 84%

Property 11%

UK Credit 7%

Global FI 17%

Em Mkts 56%

Em Mkts 26%

Japan 45%

Em Mkts 33%

Em Mkts 66%

UK Credit 10%

Property 7%

Property 10%

Asia Pac 44%

Property 19%

Em Mkts 35%

Asia Pac 30%

World 25%

Japan 47%

O/S Govt 8%

O/S Govt 5%

UK Credit 9%

World 34%

World 15%

UK Credit 15%

Cash 5%

Cash 4%

O/S Govt 8%

N. America 30%

Asia Pac 27%

World 21%

UK Equity 14%

World 25%

Global FI 3%

Global FI 2%

Cash 3%

Japan 23%

UK Equity 13%

UK Equity 22%

Property 18%

Global FI 14%

UK Equity 24%

Em Mkts -2%

Em Mkts -6%

N. America 11%

Property 19%

UK Equity 17%

Property 12%

N. America 23%

UK Equity -6%

Asia Pac -4%

Asia Pac -14%

UK Equity 21%

Japan 11%

World 10%

N. America 7%

O/S Govt 9%

Property 14%

N. America -12%

N. America -12%

Japan -19%

Global FI 13%

Global FI 9%

UK Credit 9%

Japan 7.35%

Cash 6%

Cash 4%

World -13%

UK Equity -13%

World -20%

Property 11%

Asia Pac 7%

N. America -7%

Global FI 7%

Japan -9%

UK Credit 0.1%

Japan -20%

World -17%

N. America -22%

UK Credit 0.8%

UK Credit 7%

Cash 4%

Cash 4%

Asia Pac -9%

O/S Govt -1%

Em Mkts -31%

UK Equity -23%

Cash 3%

O/S Govt 5%

O/S Govt 4%

UK Credit 0.8%

Em Mkts -25%

Global FI -5%

Asia Pac -36%

Japan -19%

O/S Govt 2%

Cash 4%

Global FI -4%

O/S Govt 0.7%

Em Mkts 40%

Asia Pac 37%

World 10%

Global FI 9%

N. America 8%

UK Equity 5%

Cash 5%

O/S Govt 4%

UK Credit 0.4%

Property -5%

Japan -10%

N. America 29%

Asia Pac 84%

Property 11%

UK Credit 7%

Global FI 17%

Em Mkts 56%

Em Mkts 26%

Japan 45%

Em Mkts 33%

Europe 25%

Em Mkts 66%

UK Credit 10%

Property 7%

Property 10%

Asia Pac 44%

Property 19%

Em Mkts 35%

Asia Pac 30%

World 25%

Japan 47%

O/S Govt 8%

O/S Govt 5%

UK Credit 9%

World 34%

World 15%

Europe 29%

Europe 22%

UK Credit 15%

Europe 37%

Cash 5%

Cash 4%

O/S Govt 8%

N. America 30%

Europe 13%

Asia Pac 27%

World 21%

UK Equity 14%

World 25%

Global FI 3%

Global FI 2%

Cash 3%

Japan 23%

UK Equity 13%

UK Equity 22%

Property 18%

Global FI 14%

UK Equity 24%

Europe -1%

Em Mkts -2%

Em Mkts -6%

Europe 21%

N. America 11%

Property 19%

UK Equity 17%

Property 12%

N. America 23%

UK Equity -6%

Asia Pac -4%

Asia Pac -14%

UK Equity 21%

Japan 11%

World 10%

N. America 7%

O/S Govt 9%

Property 14%

N. America -12%

N. America -12%

Japan -19%

Global FI 13%

Global FI 9%

UK Credit 9%

Japan 7.35%

Cash 6%

Cash 4%

World -13%

UK Equity -13%

World -20%

Property 11%

Asia Pac 7%

N. America -7%

Global FI 7%

Japan -9%

UK Credit 0.1%

Japan -20%

World -17%

N. America -22%

UK Credit 0.8%

UK Credit 7%

Cash 4%

Cash 4%

Asia Pac -9%

O/S Govt -1%

Em Mkts -31%

Europe -18%

UK Equity -23%

Cash 3%

O/S Govt 5%

O/S Govt 4%

UK Credit 0.8%

Em Mkts -25%

Global FI -5%

Asia Pac -36%

Japan -19%

Europe -32%

O/S Govt 2%

Cash 4%

Global FI -4%

O/S Govt 0.7%

Em Mkts 40%

Asia Pac 37%

World 10%

Global FI 9%

N. America 8%

Europe 7%

UK Equity 5%

Cash 5%

O/S Govt 4%

UK Credit 0.4%

Property -5%

Japan -10%

50% Difference in 2007

Europe 29%

Europe 22%

Europe 7%

Europe -1%

Europe 21%

Europe 37%

Europe 25%

Europe -18%

Europe -32%

Europe 13%

Em Mkts 40%

Japan -10%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Asset Allocation: Harder than it looks!

Improve overall risk budget by combining less correlated assets

Our process considers the asset class returns, correlation and consequently the optimal mix

Correlation is the degree to which two assets have a tendency to move together ranging from (1) perfect correlation to (-1) perfect inverse correlation

Diversification benefits

+

Risk

Return

=

Risk

Return Return

Risk

Asset Class A Asset Class B Combined returns of asset class A + B

Ontario teachers pension scheme

Source:Ontario teachers website

The problems with traditional asset allocation approaches

Peer group benchmarks results in:

herd-like mentality with

constrained asset allocation

In practice this has resulted in over reliance on equities which:

creates problems because of volatility

Are rarely diversified across markets

inconsistent with regulatory valuation requirements

Strategic Asset allocation has a major influence on investment performance

Asset allocation

Long-term return

forecasts

Risk-return target

Historic volatilities

Correlation of asset classes

Primary asset allocation inputs:

* Brinson et al., (1986 & 1991) referenced in J Annaert et al Journal of Banking and finance (2005) 661-680 and Blake et al., (1999) referenced in J Annaert et al Journal of Banking and finance (2005) 661-680

Evidence shows asset allocation contributes up to 95% of return variance*

Creating optimal portfolios

Absolute Risk

Absolute Return

Bootstrap Frontier

Efficient Frontier

Emerging Markets

Cash

Emerging Markets

Cash

Other Assets

So what are the main alternatives?

Commodities

Currency and tactical asset allocation overlays


Private Equity

Hedge Funds

Commodities

A consumption asset, not a financial asset

Access via commodity (index) futures/Exchange Traded Funds

Choice of index crucial

Gorton and Rouwenhorst (2006): commodities have historically provided:

equity returns at lower level of risk and with positive skew

diversification from equity returns

inflation hedge

Sources of return

spot prices driven by nominal GDP and demand/supply balance

backwardation and downward sloping futures curve: positive “roll”

Presenter�

Presentation Notes�

Earlier this year BT put 3% of its assets into commodities (via the Hermes Commodity Index Fund) Commodities are not financial assets that generate a stream of income but a consumption asset. Nor are they “rarities” Commodities are typically accessed via product specific futures or commodity index futures (and now ETFs based on the latter). The choice of index is crucial as the weightings of the two most widely followed indices – the Goldman Sachs Commodities Index and Dow Jones-AIG Commodities Index - to energy products, for instance, vary enormously as do the bases by which they weight constituents US Profs Gorton (Pennsylvannia) and Rouwenhorst (Yale) found that whilst between 1959 and 2004 equities and commodities returned 11.5% pa, the standard deviation of commodities at 12.1% pa was lower than for commodities at 14.8% pa Most importantly equities and commodity returns were found to be negatively correlated, whilst commodity returns were found to be positively correlated with inflation and changes in both expected and unexpected inflation. Commodities were also found to have less downside risk than equities (as commodities unlike equities have a positively skewed distribution and smaller fat tails) As commodities are typically accessed via futures, returns are determined by the movement in spot commodity prices, interest earned on the collateral not committed to the market and the futures price in relation to the spot price. Whilst the latter have historically traded at a discount to the spot price so providing an additional source of return, the sheer weight of money piling into commodity futures and concerns over the supply of particular commodities has seen futures prices trading above spot prices, ie in contango The implication of this is that spot prices will need to rise by 10%, possibly 15%, before the futures route provides a positive return, at a time when commodity prices are moving south So whilst commodities are a good diversifier of returns, in the short run, at least, their return attractions have been severely dented �

Most popular commodity indices: composition variations

Source: Thompson Financial constituents snap shot as at end-2007

69.4

10.8

2.4

12.8

4.7

33.0

18.5

9.1

30.2

9.2

0.0

20.0

40.0

60.0

80.0

Energy Industrial metals Precious metals Agriculture Livestock

% o

f ind

ex

S&P Goldman Sachs Commodity IndexDow Jones - AIG Commodity index

Currency and tactical asset allocation overlay strategies

Currency management

TAA overlay

generate returns from long/short positions across global equity, bond and currency markets

exploits inefficiencies in asset prices resulting from:

investor sentiment such as excessive optimism or pessimism

structural anomalies such as legislation, tax or market habit

non profit-maximising market participants

Presenter�


The well publicised move to manager and asset specialisation has been at the expense of TAA and currency management, which has been shown to be a consistent source of alpha, ie risk-adjusted outperformance Whilst currency doesn’t have any definable risk premium, contemporary research by Watson Wyatt and Frank Russell suggests that active currency overlay managers generate excess returns at low levels of risk as a result of exploiting the actions of central banks and those hedging currency risk who participate in the market for reasons other than profit maximisation TAA, which captures active currency management, generates returns from engineering long and short positions via derivatives across asset markets and exploiting anomalies resulting from phenomena such as investor biases etc The growing recognition that overlay strategies are a valuable source of alpha has generated considerable interest in these products�


Long term capital intensive projects that fulfil major social and/or economic needs

Increasingly PFI financed given public sector spending constraints

Economic infrastructure, eg utilities, toll roads

Social infrastructure, eg hospitals, prisons

As regulated natural monopolies/oligopolies offer bond-plus characteristics:

Relatively high and stable longer term inflation linked cash flows

High duration

Infrastructure assets are ideal for matching long dated liabilities

Presenter�


Infrastructure assets are capital intensive, long term projects that fulfil major economic and social needs. They typically operate as monopolies/oligopolies in markets where there are few, if any, substitute products and whilst subject to regulatory intervention, generate relatively stable long term (inflation linked) income streams. They can be categorised as: Economic infrastructure: projects providing services for which end-consumers are typically prepared to pay Social infrastructure: assets providing services that contribute to the overall well-being of society for which end-consumers do not expect to pay Both categories have historically been owned, funded and built by the public sector but constraints on public finances have increased private sector participation through Private Finance Initiatives (PFI) Infrastructure can be accessed through: Unlisted equity: taking ownership stakes in projects either directly or via a fund Listed equity: investing in listed companies that own, operate or provide services to an infrastructure asset Debt instruments: investing in the long dated inflation linked debt that finances the infrastructure project Value investors have been snapping up cash generating assets such as airports and ports Infrastructure assets provide a higher inflation linked income (whether coupons or dividends) than generated by “conventional” inflation linked bonds With their inflation linked cash flows and long duration, infrastructure assets are ideal for matching long dated pension scheme liabilities�

Private Equity

What is it?

Venture capital funds: provide start up and development equity capital

Buyout funds:

buy into companies cheaply, restructure/change their business model, or

buy stake in quoted companies, act as friendly activist…

…and sell stake to the market or trade buyer at a sizeable profit

What is the objective?

generate a return in excess of that from quoted equity

Presenter�


The wide and diverse universe of venture capital and buyout funds creates a paradox of choice for the investor J curve effect: initial years’ returns negative Uncertain performance data: IRRs are merely an estimate until a sale has been achieved Many of these disadvantages can be overcome by adopting a fund of funds approach�

Private Equity has divergent performance

Performance derives from combination of asset class and skill set:

Buyout funds outperform venture capital funds*

Returns heavily skewed towards top performing funds*:

22.9% top quartile IRR

10.6% mean IRR

0.5% median IRR

Evidence of performance persistency*

Apparent diversification results from Private Equity values being booked at cost

Manager and strategy selection is crucial – increasingly accessed via fund-of-funds

* Net Pooled Returns for 279 Private Equity Funds formed 1980 - 2005. Source: Thomson Financial, European Private Equity and Venture Capital Association. 27 July 2006.

Presenter�


With Private Equity, perhaps more so than any other asset class, success is wholly attributable to selecting and staying with a top performing fund as the variation in performance is enormous, it’s skewed towards top performing funds and performance persistency is in evidence Long run mean returns are in line with quoted equity Although seemingly counterintuitive, the large buyout funds have outperformed the less liquid venture capital funds over the past 25 years �

Hedge Funds

What is a Hedge Fund?

Private limited partnership/unregulated pooled investment fund administered by professional investment managers

What do Hedge Funds seek to do?

Generate absolute returns, ie positive returns independent of market conditions

How?

By employing wide range of investment strategies, techniques andinstruments

Hedge Funds

Are all hedge funds the same?

No agreed definition of what constitutes a hedge fund: very heterogeneous universe

Not an asset class: more of a skill set as low correlation between and within strategies

Most combine specific strategy with leverage to magnify returns - few are truly hedging market risk as name implies

Around 8,000 known hedge funds managing total assets c.$1.5tn –many others escape scrutiny

Originally for HNWIs: now institutional investors driving growth

Presenter�


The term “hedge fund” captures a multitude of different strategies, which are constantly evolving. These can be categorised as either directional or non-directional or as arbitrage/relative value, event driven and opportunistic Not an asset class/more of a skill set/a very heterogeneous universe: whilst there is a low correlation between the various hedge fund strategies there is also a low correlation within strategies, owing to the unique individualistic approach taken by hedge fund managers �

Optimised portfolio including fund manager skill

EM Equities

UK Property

Commodities

UK Equities

UK Gilts

UK CashReturn

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

2%

Risk

7% 12% 17% 22% 27% 32%

CAPS balanced managed

Optimised portfolio including fund manager skill

Alternative assets and

manager skill

Risk and return

Resulting in a highly diversified portfolio targeting equity-like returns for bond-like risk

Presenter�


To explain portable alpha and how this can add value, it is worth summarising the high level investment process: We forecast the future long-term returns of each asset class, consider the historic volatilities and correlations between asset classes, and understand our risk budget and return requirements. This data all feeds into the optimisation process. Then we add value through: Dynamic, quarterly asset allocation Porting of alpha in order to harness known fund manager skills �

Lessons learned

Asset allocation is the main driver of investment returns

Unconstrained asset allocation makes sense

The are an ever increasing number of exotic and alternative asset classes

It makes sense to consider the widest array of asset classes

Important notes

Except where stated as otherwise, the source of all information is Morley as at 31 May 2008.

Any future returns and opinions expressed are based on our internal forecasts and should not be relied upon as indicating any guarantee of return from an investment with Morley. No part of this document is intended to constitute advice of any nature nor should any part be construed as a recommendation to purchase or sell stocks.

Where past performance has been illustrated it is not intended to be a guide to the future.

When investing with Morley investors should be aware that the value of an investment and any income from it may go down as well as up. Investors may not get back the original amount invested.

Morley is a business name of Morley Fund Management Limited, registered in England No. 1151805. Registered Office: No. 1 Poultry, London EC2R 8EJ. Authorised and regulated in the UK by the Financial Services Authority and a member of the Investment Management Association.

Morley is also a business name of Morley Fund Services Limited and Morley Pooled Pensions Limited. All are Aviva companies.

Contact us at Morley Fund Management Limited, No. 1 Poultry, London EC2R 8EJ. MFM/MFM/08/xxx

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