Tangent-Added Approaches for Better Risk-Adjusted...

Lex Huberts, CFA President, Investments and Finance

BNY Mellon Global Investment Conference 2013 | OCTOBER 17, 2013

Tangent-Added Approaches for Better Risk-Adjusted Returns

Joe Miletich, CFA Managing Director, Global Investment Strategist

Additional information in Disclosure Statements at the end of this presentation 2

Table of Contents

  The Risk/Return Conflict Gets Worse

  Growth with Downside Protection


The Risk/Return Conflict Gets Worse

In our view,   The costs of structural downside protection have grown

►  High quality fixed income safe havens appear exhausted

  Diversified growth opportunities away from equities are hard to find ►  The era of “not-so-alternative” alternatives

  Private Pension Funds need liability hedging, returns and liquidity

  Public Pension Funds and E&F’s need to minimize today’s material cost for dedicated downside protection

  Private clients seek risk controlled growth strategies


30 years of “Free Insurance”

10 Year Treasury Constant Maturity Rate1

January 1980 – August 2013

Bank of America Merrill Lynch U.S. Corporate AA Effective Yield2

December 1996 – August 2013

0

2

4

6

8

10

12

14

16

18

Yiel

d (%

)

0

1

2

3

4

5

6

7

8

9

Yiel

d (%

)

1.  Data Source: Board of Governors of the Federal Reserve System 2.  Data Source: BofA Merrill Lynch, used with permission. BOA MERRILL LYNCH IS LICENSING THE BOFA MERRILL LYNCH INDICES “AS IS,” MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE

SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE BOFA MERRILL LYNCH INDICES OR ANY DATA INDCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THEIR USE, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND MELLON CAPITAL MANAGEMENT, OR ANY OF ITS PRODUCTS OR SERVICES.


-20%

-15%

-10%

-5%

0%

5%

10%

Dec-87 Dec-92 Dec-97 Dec-02 Dec-07 Dec-12

Exce

ss E

quity

Spr

ead

S&P 500® Earnings Yield less Bond Yields S&P 500 Earnings less Ten Year TreasuriesS&P 500 Earnings less Barclays High Yield Index

25-Yr Avg

25-Yr Avg

5%

6%

-$1,000-$750-$500-$250

$0$250$500$750

$1,000$1,250

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12

Billio

ns

Mutual Fund Flows

Bond FlowsEquity Flows

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

1.  Data Source: ICI (www.ici.org/research/stats); Investment Company Institute 2.  Data Source: Bloomberg, Robert Shiller, Yale University (www.econ.yal.edu/~shiller/data/ie_data.xls), Barclays Benchmark Source: Barclays POINT/Global Family of Indices. ©2013 Barclays Capital Inc. Used with permission.

1

2

As of December 31, 2012.

Market Pessimistic Toward Equity, Euphoric for Credit


40%

50%

60%

70%

0.3

0.5

0.7

0.9

1.1

1.3

1.5

Recovery Period Financial

Crisis Recovery Period Tech Bust

After Two Huge Drawdowns, Institutions Are Reducing Equity

Historical Asset Allocation 1999 to 2013


1.  Data Source: BNY Mellon Asset Servicing based on a universe of its clients

2.  Data Source: MSCI and Bloomberg Time periods shown above are based on the nearest quarter to stock market (MSCI World Equity Index) peaks and troughs.

Cum

ulat

ive

Ret

urn2

(M

SC

I Wor

ld E

quity

Inde

x)

Pla

n A

lloca

tion

to E

quiti

es1

-48% equity decline

Stable equity allocation through the tech bust

-49% equity decline

Equity Market Returns 1999 to 2013


$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

0%

5%

10%

15%

20%

25%

2 Industry Assets Under Management (Right Scale) Rolling 5 Year Total Return (Left Scale)

Total Hedge Fund Industry Assets ($ in Trillions) and Rolling 5-Year Performance

December 1995 to December 2012

Ass

ets

Und

er M

anag

emen

t

HFR

I FW

C In

dex1

Tot

al R

etur

n

1. Fund Weighted Composite. 2. Hedge Fund Industry. Data sources: Mellon Capital, Bloomberg, Mellon Capital, Hedge Fund Research, Inc. ©2013, www.hedgefundresearch.com PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Hedge Fund Assets and Performance Trends


Total Hedge Fund Industry Assets ($ in Trillions) and Rolling 5-Year Correlation vs. S&P 500®

December 1995 to December 2012

Cor

rela

tion

(H

FRI F

WC

Inde

x1 v

s. S

&P

500®

Inde

x)

Ass

ets

Und

er M

anag

emen

t

1. Fund Weighted Composite. 2. Hedge Fund Industry. Data sources: Mellon Capital, Bloomberg, Mellon Capital, Hedge Fund Research, Inc. ©2013, www.hedgefundresearch.com PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

2 Industry Assets Under Management (Right Scale) Rolling 5 Year Total Return (Left Scale)

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

0.50

0.60

0.70

0.80

0.90

1.00

Hedge Fund Assets and Correlation Trends


Observations

In our view,   Expected returns from safe haven asset classes appear limited

►  Government and investment grade bonds

  Based on flows, public market equities are the out-of-favor asset class ►  Investors have been reducing equity allocations

  Enormous interest in alternative investments ►  Can they absorb the cash in-flow and still deliver historical results?

  Has the risk/return trade-off become mutually exclusive?


Necessity as the Mother of Invention

In our view,   Positive trends in the investment industry

►  Investors are much more open minded and oriented toward specific outcomes ►  Deeper understanding of risk factors and diversification ►  The application of Capital Market Theory (1958)

  Potential risks and limitations in asset allocation ►  Are we yet again moving towards expensive and away from cheap? ►  Style box mentality still dominates in public equity allocations

•  Inconsistent with alternative investments that have wide latitude


More Aware of Both Capital and Risk Allocations

  How do you define balanced?

  Using the capital allocation, an investor may define 60/40 as balanced

  An alternative classification may be suggested by looking at the risk allocation

60% Equity

40% Fixed

Income

Capital Allocation

90% Equity

10% Fixed

Income

Contribution to Expected Risk


Long-Term Market Equilibrium

The above graph is for illustrative purposes only and does not reflect actual returns.


The Efficient Frontier

Efficient Frontier The above graph is for illustrative purposes only and does not reflect actual returns.


The Most Efficient Portfolio on the Frontier

A represents a portfolio of 100% bonds. B represents a portfolio of 75% bonds and 25% stocks. C represents a portfolio of 50% bonds and 50% stocks (The Most Efficient Portfolio). A’ represents a portfolio of 50% cash and 50% bonds. The above graph is for illustrative purposes only and does not reflect actual returns.


A More Efficient Portfolio: Tangent Theory



Asset Class Specific


Total Return (Policy Basis)

Example #1: US large cap equity strategy

Example #2: Dynamic total return strategy

15% 12%

Two Ways to Deploy Capital Market Theory


0%

2%

4%

6%

8%

10%

12%

14%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Ann

ualiz

ed G

ross

Ret

urn

(%)

Risk (Standard Deviation)

What’s the Potential?


Performance Since Inception

Risk/Return Characteristics3

September 1989 to June 2013

Tangent-Added Composite

S&P 500® Index Barclays U.S. Long Treasury Index

Citigroup 30-Day CD Index

0%

2%

4%

6%

8%

10%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

Ann

ualiz

ed G

ross

Ret

urn

(%)

Risk (Standard Deviation %)

Risk/Return Characteristics3

December 1997 to June 2013

Global Tangent-Added Composite

WGBI 1+ Half-Hedged

MSCI World Index Half-Hedged

Citigroup 90 Day Treasury Bill

1. Performance shown for “Tangent-Added Approach” is Mellon Capital’s Tangent-Added® Composite. 2. Performance shown for “Global Tangent-Added Approach” is Mellon Capital’s Global Tangent-Added® Composite. 3. The indexes are shown to illustrate various market sectors and individually are not necessarily appropriate benchmarks for the Composite. Data sources: Mellon Capital, Barclays POINT/Global Family of Indices. ©2013 Barclays Capital Inc. Used with permission.

November 30, 1997 to June 30, 2013

Annualized

Global Tangent-Added

Approach2MSCI World Half-Hedged

Excess Return

Gross Return 8.4% 4.6% 3.8%Standard Deviation 15.7% 15.7%Sharpe Ratio 0.4 0.2

August 31, 1989 to June 30, 2013

AnnualizedTangent-Added

Approach1 S&P 500®Excess Return

Gross Return 12.2% 8.9% 3.3%Standard Deviation 15.2% 14.8%Sharpe Ratio 0.6 0.4


-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

Downside Performance

Tang

ent-A

dded

App

roac

h

S&P 500

Underperformed S&P 500

Outperformed S&P 500

R2 = 0.86

Calendar Year Returns – Gross of Fees Tangent-Added Approach1 vs. S&P 500® Index2

1990 – 2012

1.  Performance shown for “Tangent-Added Approach” is Mellon Capital’s Tangent-Added® Composite.. 2.  Diagonal line represents the periods when the Strategy's annual return equals that of the S&P 500. Performance shown is not in chronological order Data sources: Mellon Capital, S&P 500, Barclays POINT/Global Family of Indices. ©2013 Barclays Capital Inc. Used with permission. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.


Can a Tangent Portfolio be Defined as an Equity Strategy?

Over the last ten years, the Tangent Added Approach has averaged 112% equity and 22% bonds

60% Equity

40% Fixed

Income90%

Equity

10% Fixed

Income

Capital Allocation

Contribution to Expected Risk

Illustration - Traditional 60/40 Portfolio1

1. These graphs are for illustrative purposes only and do not reflect actual results.

Tangent-Added Approach

98% Equity

2% Fixed

Income

112% Equity

22% Fixed

Income

Average Capital

Allocation

Historical 10-Year Contribution

to Risk

As of June 30, 2013


Static Allocations Ignore Valuation

Rolling 5 Year Sharpe Ratios for Asset Classes December 31, 1996 – March 31, 2013

Bonds=Citigroup WGBI; Stocks=MSCI World Total Return Index; Commodities=Dow Jones-UBS Commodity Index Total ReturnSM

Data sources: Bloomberg, Mellon Capital. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

-0.8-0.40.00.40.81.21.62.0

Rol

ling

5 Ye

ar S

harp

e R

atio

s

Stocks Bonds Commodities


44%38%

Capital Allocations

130%

33%

33%

33%

Risk Allocations

Fixed Income CommoditiesEquity

Risk Parity – Looking Ahead the Next Few Years

Static Equal-Risk Allocations on June 30, 2013 Potential Results Under Different Rate Normalization Scenarios1

1.  Equity refers to global equities. Fixed Income expected return assumes the buy and hold of a 10Y Treasury bond, taking into account the roll down effect and possible yield changes. Rate increase scenarios assume a parallel shift in the yield curve. Cash=U.S. Treasury Bills; Commodities=Dow Jones-UBS Commodity Index Total ReturnSM.

Assumptions1 – No Rate Change

Exposure 3Y Expected Returns

Assumptions

Equity 40% 7.9%

Fixed Income 130% 3.0%

Commodities 35% 2.4%

Cash -105% 1.0%

Hypothetical Example – Comparing Potential Results in Three Years

Static Equal-Risk and Traditional 60/40 will likely fall short of the 7-8% target.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN.

3.5%

1.5%

-0.4%

8.0%

4.1%

0.4%

6.2%5.3%

4.6%

-2%

0%

2%

4%

6%

8%

10%

No Rate Change 100 bps Increase 200 bps Increase

Exp

ecte

d G

ross

Ret

urn

Expected Returns in 3 Years

Fixed Income Static Equal-Risk Traditional 60/40


Potential Policy Benefits of Deploying Tangent Concepts

Some examples are:   Private pension funds: Return and liability hedging

►  Equity index fund with a duration component

  Public pension funds and E&F’s ►  Decrease policy level allocation to fixed income ►  Growth strategies own the insurance assets without sacrificing upside

  Private Clients ►  Access to low cost risk controlled growth strategies


Solving the Risk/Return Conundrum

In our view,   Dedicated policy level downside protection is very expensive

►  Comes at a real cost and can be operationally difficult

  Growth strategies must do their own internal hedging ►  Public market equities remain a key driver of long term returns

  Capital market tangent principles may be ideal for this environment

  There is no static allocation that is permanently optimal ►  Valuations and initial conditions matter ►  Dynamic allocation processes


Q & A


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