Strategic factor allocation

Transcription

1 INVESTMENT ACTIONS PORTFOLIO DESIGN RISK MANAGEMENT REGULATORY MARKETS Strategic factor allocation Case studies in applying factors in portfolio design

2 Summary Portfolios that appear diversified from an asset class perspective may be less diversified than investors think, as their risk is often concentrated in one or more factors. Andrew Ang, Ph.D. Head of BlackRock s Factor-Based Strategies Group Bob Bass Head of BlackRock s Factor Allocation Platform Sara Shores, CFA Head of Investment Strategy for BlackRock s Factor-Based Strategies Group We believe that investors can construct better-diversified portfolios that may be more likely to help them meet specific objectives by incorporating factor insights into their asset allocations. To do so, investors must understand which factors they own, which factors they want to own and how to adjust portfolios along factor lines. We help answer these questions through two case studies: one starts with a blank slate and then builds a targeted factor portfolio; the other considers multiple options for shifting factor allocations in an existing portfolio. Contributors Di Sanborn Kristin Fergis, CFA Katelyn Gallagher About factors and asset allocation Investment factors are the broad, persistent drivers of return that underlie all asset classes, and we separate them into two groupings, macro and style factors. Macro factors economic growth, real rates, inflation, credit, emerging markets and commodities explain the majority of returns across asset classes. Style factors value, carry, momentum, and defensive explain the majority of variation within asset classes. While macro factors describe movements of whole markets, style factors explain relative movements of securities within markets. See page 11 for more details on each factor. Risk management attributes are a separate, but also important, category. Whereas macro and style factors are few, broad and persistent, risk management attributes are many, nuanced and specific, and they help explain risk at the individual security level. Thus, macro and style factors are more relevant for top-level strategic portfolio allocation decisions, while risk management attributes must be highly granular to help minimize unintended security-level risks. In order to analyze an asset allocation through a factor lens, we need a way to translate seamlessly between assets and factors. We start by proxying a client s strategic asset allocation with a set of asset class representations. Each asset class consists of hundreds, or even thousands, of underlying securities, and each of these securities can be mapped onto a granular set of risk exposures, like spread, duration, and sector for corporate bonds, and industry, valuation ratios, and other balance sheet and earnings variables for stocks. In total, there are thousands of these risk exposures spanning all asset classes. Once we create a risk exposure representation of a portfolio, we can map those risk exposures onto the much smaller set of macro factors by using a combination of qualitative (e.g., economic intuition) and quantitative (e.g., regression analysis) approaches. Time series of the asset classes and factors are used to quantify the magnitude and direction of those relationships. The result is not just a measure of the total risk of a portfolio but also of how each asset class or factor contributes to that total. Although analyses such as these leverage hundreds of thousands of data points, state of the art tools and models can perform them in a matter of seconds. 2 STRATEGIC FACTOR ALLOCATION

3 Asset allocation is one of the most important decisions institutional investors have to make. One of the primary goals of the asset allocation process is to construct well-diversified portfolios that are designed to meet risk and return targets in a variety of market and macroeconomic environments. Unfortunately, portfolios that appear diversified from an asset class perspective may be less diversified than investors think, as their risk is often concentrated in one or more macro factors. This became painfully apparent during the global financial crisis of , when many allegedly diversifying assets moved in lockstep. We believe that investors can construct better-diversified portfolios that may be more likely to help them meet their specific objectives by incorporating factor insights into their asset allocation. Factor investing first involves an understanding that asset classes are merely combinations of factors. (For an overview of the relationship between factors and assets, see the About factors and asset allocation callout on page 2.) And, importantly, that many asset classes share similar factor exposures. For example, portfolios with large exposure to equity and private equity are in fact doubling-down on economic growth risk rather than diversifying risk away. See the Different assets, common risks chart. The predominance of the economic growth factor across many asset classes has helped that factor to dominate the risk of a variety of institutional investors portfolios. Pension and endowment portfolios may have a disproportionate exposure to the growth factor due to their heavy reliance on equities and other growthsensitive assets. And even insurance company portfolios that are heavily concentrated in fixed income and have relatively small weightings to equities may end up with economic growth as their largest source of macro risk, due to the relative riskiness of equities compared to Different assets, common risks Macro factor decomposition of different asset classes 30% 25 Total risk contribution equity Emerging equity inflationlinked bonds U.S. treasuries credit high yield bonds USD EM bonds Commodities real estate private equity infrastructure Hedge funds - aggressive Economic growth Real rates Inflation Credit EM Commodities Other Source: Aladdin Factor Workbench, June, asset classes are all hedged to USD. Risk contribution is the risk decomposition of the portfolio by factor, taking into account the correlations between the factors and the benefits of diversification, using a lookback period of 15 years. Other includes risk contributions from style factor exposures and idiosyncratic risks. Asset classes are represented by the following indices: equity, MSCI All Country World Index; Emerging equity, MSCI Emerging Marets; inflation-linked bonds, BofA ML Governments Inflation-Linked Index; U.S. Treasuries, Bloomberg Barclays Government Index; credit, Bloomberg Barclays Aggregate Corporate Index; high yield bonds, Bloomberg Barclays High Yield Index; USD EM Bonds, JP Morgan EMBI Diversified Index; Commodities, Bloomberg Commodity Index Total Return; real estate, BlackRock Proxy; private equity, BlackRock Proxy; infrastructure, BlackRock Proxy; Hedge funds aggressive, HFRI Equity Hedge Index. CASE STUDIES IN APPLYING FACTORS IN PORTFOLIO DESIGN 3

4 Growth dominates Macro factor decomposition of institutional portfolios 13% 11 Total risk contribution U.S. endowment U.S. public pension U.S. insurance EMEA pension Economic growth Real rates Inflation Credit EM Commodities FX Other Source: Aladdin, December Risk contribution is the risk decomposition of the portfolio by factor, taking into account the correlations between the factors and benefits of diversification, using a lookback period of 15-years. U.S. Endowment portfolio is based on the Nacubo Survey. U.S. Public Pension portfolio is based on the BlackRock Public Pension Peer Survey. U.S. Insurance portfolio is based on BlackRock FIG Study (SNL Data). EMEA Pension portfolio is based on a representative portfolio. Other includes risk contributions from style factor exposures and idiosyncratic risks. FX is included to show an important source of risk common in institutional portfolios, however we do not consider it a rewarded factor and it is not included in the analysis going forward. See Client Portfolios Asset Allocation on Page 12 for information on the underlying asset allocation. other asset classes. See the Growth dominates chart. Although economic growth may be attractive from a risk/return perspective, lack of diversification across macro factors can offset some or all of that benefit during periods when the growth factor is not being rewarded. By examining their total asset allocation including alternatives and private assets through a factor lens, investors can gain new insights into their risk and diversification, and some may wish to adjust their factor exposures as a result. Different institutions will, of course, have different objectives when thinking about a desired factor allocation. Some, such as wellfunded private endowments or family offices, may have relatively few constraints and can simply seek to maximize long-term returns. Pensions and insurers, on the other hand, will likely need to work with tighter constraints. Pensions have to budget for quarterly benefits payments and may wish to consider liability matching, while insurers need to consider surplus risk and account for uncertain future payouts. Other parameters such as investment horizon (very long for an endowment, shorter for a pension), the willingness to take risk in illiquid assets, and the ability to employ leverage can also play into the allocation decision. While each institution faces a unique set of circumstances, a factor-based approach to strategic asset allocation may provide benefits to all. By deliberately diversifying across macro factors, institutions may unlock potential sources of return that were previously underrepresented, or not represented at all, in their portfolios, such as credit and emerging markets. Adding an allocation to style factors may bring an additional source of return and diversification. Diversifying across macro and style factors may also help improve risk mitigation, as factors have historically displayed low correlations to each other, even during periods of market stress. 1 To illustrate these ideas, we present two case studies. First, we examine a hypothetical institution s investment goals and guidelines and, starting with a blank slate, outline three approaches to adopting factor-based allocations to help meet their objectives. Next, we draw on real-world data from our 2017 U.S. Public Pension Peer Survey to create a representative model portfolio, and then examine how institutions looking to reduce their reliance on economic growth can use factor-based allocations to help improve diversification. Similar analyses can be performed for any type of institutional investor to help meet a particular investment outcome. 1 Rewarding Risk: How the science of rewarded risks is redefining diversification 2015 K. Hogan, P. Hodges, M. Potts, D. Ransenberg. 4 STRATEGIC FACTOR ALLOCATION

5 Case study: The blank slate Building a targeted factor allocation from the ground up To illustrate how a factor-based approach to asset allocation may help meet specific objectives, we will examine a hypothetical asset owner, referred to as ABC Plan. ABC targets a total plan risk of 10%, and does not target an explicit level of return. The investment committee at ABC is particularly sensitive to extended periods of losses, and would like to limit the possibility and magnitude of twoyear drawdowns. Given modest forward-looking asset class returns, ABC is particularly concerned about maximizing potential returns relative to its risk target. ABC has a strong preference for liquid investments to accommodate annual spending needs. With these objectives and constraints in mind, we can start with a blank slate and consider three potential factor-based allocations: an equal-weighted macro factor portfolio, a targeted macro factor portfolio, and a portfolio that combines targeted allocations to macro and style factors. Portfolio 1: Equal-weighted macro factors We start by examining an equal risk-weighted combination of the six macro factors: economic growth, credit, inflation, real rates, emerging markets and commodities. Allocating an equal amount of risk to each factor helps to ensure that the hypothetical portfolio is diversified, with the opportunity to benefit from many independent sources of return. The equal-weighted portfolio has the benefit of being simple and not overly reliant on forward-looking assumptions of risk, return or correlations. This equal risk-weighted portfolio would be mathematically optimal if each factor had an equal Sharpe ratio and the correlations between the factors were equal to zero. But we know that in reality not all factors are created equal. This simple combination does not take into consideration the varying characteristics of each factor, and it doesn t meet all of our investor s specific preferences. The total portfolio targets an expected risk of 10%, but it is not the most efficient from a return perspective because we don t take into account the different expected return potentials or Sharpe ratios of each factor. However, this well-diversified portfolio would have a conservative drawdown profile. Portfolio 2: Targeted macro factors A more nuanced approach would be to build upon the equal-weighted macro portfolio by taking into consideration the characteristics of each factor along with all of our investor s preferences. Here we use a hybrid approach based on both qualitative preferences and quantitative inputs to arrive at a hypothetical targeted combination of factor exposures. We use the diversified equal-risk portfolio as the starting point and then increase the allocation to some factors and decrease it to others, as guided by our client s objectives, while still remaining diversified. To build our hypothetical targeted portfolio, we evaluate the attractiveness of each macro factor in light of three key considerations for ABC: Sharpe ratio, drawdown mitigation and liquidity. First, we consider the potential risk-adjusted return of each factor. BlackRock research, supported by economic intuition and historical data, tells us that the economic growth and credit factors have had the highest riskadjusted returns, and are decidedly pro-cyclical. Assets with high exposures to economic growth and credit have historically been rewarded when investors are risk-seeking and the global economy is strong. The real rates factor has also historically displayed high risk-adjusted returns, with the persistent decline in global interest rates over the last thirty years driving robust returns in bond markets. However, with interest rates now beginning to rise from record lows in much of the world, we expect more modest returns in the years ahead. CASE STUDIES IN APPLYING FACTORS IN PORTFOLIO DESIGN 5

6 Consider the factors Ranking of each macro factor when considering ABC Plan s criteria Consideration Economic growth Real rates Inflation Credit Emerging markets Commodities Drawdown Mitigation + + Return/Risk Ratio + + Liquidity in Market Downturns + + Real rates and inflation can provide a natural hedge during downturns Economic and credit factors have had higher expected return/risk ratios Certain asset class representation of the factors have provided more liquidity in times of stress Conclusion: Overweight/Neutral/ Underweight? (Relative to Equal Risk Weighting) Source: BlackRock, September For illustrative purposes only. This information is not indicative of future results and is not a recommendation of an investment strategy or allocation. ABC is also highly sensitive to the potential for drawdowns. The real rates and inflation factors are defensive in nature, and our research indicates that they have historically performed well when investors seek perceived safe-haven securities like nominal and inflation-adjusted bonds. In contrast, the economic growth, credit and emerging markets factors have displayed deeper drawdowns in times of market crisis or a slowing global business cycle, our work suggests. While the demand for commodities can be correlated to the global growth cycle, these real assets also have historically exhibited diversification and inflation-protection attributes that may provide a ballast in times of market stress. Finally, ABC s preference for liquidity suggests allocating to factors that can be accessed via assets that have generally displayed relatively high liquidity, even during periods of market stress. The Consider the factors table ranks each factor according to ABC s criteria and leads us to overweight real rates; to underweight credit, emerging markets and commodities; and to keep neutral weights for economic growth and inflation. Taking all of the above into consideration, we arrive at the hypothetical targeted portfolio shown in the On target chart, which is designed to meet ABC s unique goals and preferences. The aggregate portfolio incorporates the desires for liquidity and to limit potential drawdowns, and explicitly considers the expected risk-adjusted returns across factors. These qualitative tilts, founded in economic intuition and historical data, are incorporated into an optimization, which can be customized depending on client preferences and considers the volatilities and correlations between the factors, to arrive at the final portfolio weights. On target Targeted macro factor exposures of ABC s hypothetical portfolio EM Credit Commodities 10 % 15 % Economic growth 13 % 16 % 16 % Inflation 30 % Real rates Portfolio and analysis provided for illustrative purposes only to demonstrate BlackRock s approach to factors. It is not representative of any actual client s portfolio. 6 STRATEGIC FACTOR ALLOCATION

7 Portfolio 3: Targeted macro plus style factors Our hypothetical targeted macro portfolio is welldiversified across the fundamental drivers of asset class returns, and it allocates to systematic risk premiums in a way that incorporates ABC s goals. ABC might consider trying to boost returns and enhance diversification by incorporating new sources of return: style factors, which can be implemented via a long/short, multi-asset strategy. Style factors may provide additional sources of return that are uncorrelated with macro factors potentially increasing expected returns while still preserving the balance of macro risks and adhering to ABC s goals. To illustrate, we add a 20% allocation to a hypothetical long/short style factor strategy to our hypothetical targeted macro portfolio, and we make corresponding pro-rata decreases to each of our macro factors. The addition of style factors is diversifying, as the average pairwise correlation between style and macro factors is approximately zero. See the right side of the Diversifying factors chart. While any individual style factor may be highly cyclical and experience periods of strong and weak performance, style factors have exhibited low correlations with each other, as seen in the left side of the chart. These low correlations make intuitive sense, as each style factor targets very different sources of return. Value strategies, for example, favor those securities that have low prices relative to fundamentals and that have recently been out of favor. In contrast, momentum strategies are trend-following, favoring those securities that have had strong recent performance. Blending value and momentum strategies together leads to a more diversified portfolio. Investing in style factors across asset classes may provide another layer of diversification. For example, while equity value strategies have struggled in 2017, value has been one of the better-performing factors in fixed income and commodities over the same period, based on BlackRock data. Diversifying factors Five-year correlations of macro factors and long/short style factors Carry Momentum Value Quality Min Vol Economic growth Real rates Inflation Credit Emerging markets Commodities Carry Momentum Value Quality Min Vol Source: BlackRock, June Correlations are calculated over five years of monthly data. Macro factor returns are adjusted to ex-ante annualized risk level of 10%. Style factor returns are adjusted to ex-ante annualized risk level of 5%. Factor returns are based on underlying exposures to the particular factor premium, based on BlackRock s models. Exposures include broad index exposures across markets. This analysis is limited to the index universe available to BlackRock in Aladdin. Factor returns are gross of all fees and transaction costs. CASE STUDIES IN APPLYING FACTORS IN PORTFOLIO DESIGN 7

8 Like macro factors, style factors are embedded within the strategies already present in investors portfolios. We see evidence of significant style exposures in both fundamental and quantitative active strategies. For example, many commodity trading advisory strategies are trendfollowing and are inherently exposed to the momentum factor. Relative value strategies, whether fundamental or quantitative, are, not surprisingly, inherently exposed to the value factor. Carry is commonly found embedded in both fixed income and commodities strategies. As with macro factors, our research suggests that a deliberate and diversified set of exposures to style factors may be preferable to the incidental exposures that come from allocations to multiple managers. A large and growing industry of managers that directly targets style factors has emerged to provide investors with diversified style strategies. Our hypothetical example includes a 20% allocation to style factors to illustrate their efficacy in helping improve risk-adjusted returns. The preferences of different investors will guide the appropriate sizing of style factor allocations. If we now examine the expected risk and return of each of our three hypothetical factor-based portfolios (equal weighted, targeted macro, and targeted macro plus style), we can see the results of incorporating a broader and more targeted approach to factor investing. While each of the portfolios is diversified across the most important drivers of return, and each fulfills our hypothetical client s desire for a 10% risk target, moving from the equalweighted portfolio to the targeted one would modestly improve expected returns, and adding style factors could help improve returns further while reducing risk. See the Targeted outcomes chart. Targeted outcomes Risk and return profiles of hypothetical equal-weighted, targeted macro, and targeted macro plus style portfolios Portfolio 3: Targeted macro + style Expected return Portfolio 2: Targeted macro Portfolio 1: Equal-weighted macro 0% 10% Expected risk Source: BlackRock. For illustrative purposes only. The Targeted Macro & Equal-Weighted portfolios are constructed to target 10% risk. 8 STRATEGIC FACTOR ALLOCATION

9 Case study: The real-world framework Implementing factor shifts in existing portfolios Investors usually aren t working from a blank slate. They have well-ingrained asset allocation frameworks and existing portfolios, and it may be unrealistic to make drastic changes to these. Instead, investors may want to make strategic and tactical shifts away from their existing portfolios. One change that may be worth considering is a targeted reduction in exposure to the economic growth factor. As we highlighted in the Growth dominates chart on page 4, many institutional investors portfolios are highly dependent on this factor, making their results quite reliant on the strength of the global economy. This may have been a boon over the last several years, but it leaves portfolios susceptible to a softening in the economy or a spike in geopolitical tensions that leads to adverse market movements. There are many incremental steps investors can take to help diversify portfolios along factor dimensions. For our example, we use the asset allocation and macro exposures of the average U.S. pension, as determined by BlackRock s 2017 U.S. Public Pension Peer Survey, as the starting portfolio. See the Starting point chart. Our objective is to reduce the relative risk exposure to economic growth by 20% and to reallocate that risk among other rewarded factors. We consider three different approaches, each of which reduces exposure to developed equities and spreads it across different strategies. Option 1: TIPS plus smart beta Shifting a portion of the portfolio from developed equities to inflation-linked debt results in a direct reduction in exposure to the economic growth factor and an increase in exposure to the real rates factor. However, given the significantly lower levels of expected risk and return of TIPS relative to equities, this shift would reduce the total risk and return of the plan. Leverage would be required to maintain the same level of return as the starting portfolio, and leverage is hard to find (and costly) in inflationlinked bond markets, where synthetic exposures are not readily available. To offset the reduction in risk and to seek enhanced returns, our approach instead shifts a portion of the plan s cap-weighted equity exposure into a multi-factor smart beta strategy that offers exposure to rewarded style factors. Starting point U.S. pension plan representative portfolio asset allocation and factor exposure Idiosyncratic Alternatives 27 % 17 % Emerging sovereign debt Credit Inflation-linked debt 1 % 7 % 1 % Developed sovereign debt 15% 3 % 46 % Emerging equity FX Developed equity Commodities EM 8 % 3 % 10 % 3 % Credit Inflation 6 % 6 % Real rates 47 % Economic growth Source: BlackRock Public Pension Peer Survey, August See Client Portfolios Asset Allocation on Page 12 for information on the underlying asset allocation. CASE STUDIES IN APPLYING FACTORS IN PORTFOLIO DESIGN 9

10 Option 2: Leveraged nominal bonds plus smart beta Another option is to shift from developed equities to nominal developed market bonds. An allocation to nominal bonds would result in an increase in exposure to real rates and inflation, both of which are highly diversifying to economic growth. As with option one, such a shift would also reduce the expected risk and return of the portfolio. With nominal bonds, however, leverage is readily available via exchange-traded futures, which are highly liquid and relatively inexpensive to trade. In order to diversify risks further and to limit the amount of leverage, our approach here also shifts a portion of the plan s cap-weighted equity exposure into a multi-factor smart beta strategy. Option 3: Holistic macro and factor strategies A more holistic approach to factor diversification can be found in strategies that explicitly target balanced exposure to macro or style factors, or both. These strategies employ modest amounts of leverage to target a similar level of expected return as equities, while retaining broad diversification across return drivers. The task of managing factor exposures and leverage can be outsourced to the manager. While holistic macro factor strategies will generally include a healthy allocation to economic growth to seek robust long-run returns, the strategies can still be highly diversifying to investors portfolios. The portfolio changes detailed in each of these examples are displayed in the Weighing the options chart. Each approach may be appropriate for institutions with varying investment parameters. Options one and two offer the most direct diversification benefit by explicitly reducing exposure to economic growth in favor of real rates, and, in the case of option two, inflation. However, these options require leverage to maintain returns in-line with equities, which may be costly in the case of option one, or prohibited altogether at the plan level. Option three mitigates this leverage concern without sacrificing returns. Investors choosing any of these options may additionally attempt to boost returns further by tactically rotating between single-factor smart beta strategies, to take advantage of the inherent cyclicality in style factor returns. A future with factors As we ve now seen, macro factors can provide an intuitive way to build an institutional portfolio from the ground up and to reallocate the risks within an existing portfolio. In either case, the addition of a targeted exposure to style factors can introduce a diversifying source of returns. The examples we ve laid out are just some of the many ways that investors can use factors to incorporate their unique market views, preferences and constraints into the portfolio construction process. As investors become more well-versed with the language of factors and their fundamental role in driving both risk and return, we expect their usage to grow in the years ahead. Weighing the options Three options to help reduce exposure to the economic growth factor TIPS plus multi-factor smart beta Leveraged nominal bonds plus multi-factor smart beta Holistic macro and style factor strategies diversified multifactor Physical inflationlinked bonds US small cap ex-us large cap US large cap diversified multifactor Government bond futures US small cap ex-us large cap US large cap Style factors Macro factors US small cap ex-us large cap US large cap -20% -10% 0% 10% 20% -20% -10% 0% 10% 20% -20% -10% 0% 10% 20% Source: Aladdin Factor Workbench, BlackRock Investment Institute, September See factor strategies modeling assumptions on Page 12 for more information. 10 STRATEGIC FACTOR ALLOCATION

11 BlackRock introduces Aladdin Factor Workbench (AFW) Created in 2017, AFW is an analytical framework and technology that reframes asset allocation, portfolio analysis and manager selection along factor dimensions. If you are interested in obtaining a custom factor analysis of your investment plan, contact your relationship manager for further details. Macro Factors Explain returns across asset classes Primary drivers of returns that have historically rewarded investors for taking on non-diversifiable risks: Style Factors Explain returns within asset classes Historically rewarded characteristics that capture a risk premium, behavioral anomaly or structural impediment: Economic growth Bearing exposure to the business cycle Value Buying cheap Real Rates Bearing risk of rising rates Carry Harvesting income Inflation Bearing risk of changes in prices Momentum Taking on trends Credit Bearing risk of company default Defensive Flight to safety Emerging markets Exposure to political and sovereign risks Commodities Exposure to commodity prices This material is provided for educational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2017 and are subject to change. References to specific securities, asset classes and financial markets are for illustrative purposes only and are no intended to be and should not be interpreted as recommendations. Indices do not include fees or operating expenses and you are not able to invest directly in an index. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. This material may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, any historical performance information of other investment vehicles or composite accounts managed by BlackRock, Inc. and/or its subsidiaries (together, BlackRock ) included in this material is presented by way of example only. No representation is made that any performance presented will be achieved by any BlackRock Funds, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example. In Canada, this material is intended only for institutional investors that qualify as both an accredited investor and a permitted client as defined by Canadian securities laws. In Latin America and Iberia, for institutional investors and financial intermediaries only (not for public distribution). This material is for educational purposes only and does not constitute investment advice or an offer or solicitation to sell or a solicitation of an offer to buy any shares of any fund or security and it is your responsibility to inform yourself of, and to observe, all applicable laws and regulations of your relevant jurisdiction. If any funds are mentioned or inferred in this material, such funds have not been registered with the securities regulators of Brazil, Chile, Colombia, Mexico, Panama, Peru, Portugal, Spain Uruguay or any other securities regulator in any Latin American or Iberian country and thus, may not be publicly offered in any such countries. The securities regulators of any country within Latin America or Iberia have not confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America or Iberia. The contents of this material are strictly confidential and must not be passed to any third party. In Hong Kong, this material is issued by BlackRock Asset Management North Asia Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong. This material is for distribution to Professional Investors (as defined in the Securities and Futures Ordinance (Cap.571 of the laws of Hong Kong) and any rules made under that ordinance) and should not be relied upon by any other persons or redistributed to retail clients in Hong Kong. In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no N) for use only with institutional investors as defined in Section 4A of the Securities and Futures Act, Chapter 289 of Singapore. In Korea, this material is for Qualified Professional Investors. In Japan, this is issued by BlackRock Japan. Co., Ltd. (Financial Instruments Business Operator: The Kanto Regional Financial Bureau. License No375, Association Memberships: Japan Investment Advisers Association, The Investment Trusts Association, Japan, Japan Securities Dealers Association, Type II Financial Instruments Firms Association.) for Professional Investors only (Professional Investor is defined in Financial Instruments and Exchange Act) and for information or educational purposes only, and does not constitute investment advice or an offer or solicitation to purchase or sells in any securities or any investment strategies. In Taiwan, independently operated by BlackRock Investment Management (Taiwan) Limited. Address: 28/F, No. 95, Tun Hwa South Road, Section 2, Taipei 106, Taiwan. Tel: (02) CASE STUDIES IN APPLYING FACTORS IN PORTFOLIO DESIGN 11

12 Issued in Australia and New Zealand by BlackRock Investment Management (Australia) Limited ABN AFSL (BIMAL) for the exclusive use of the recipient who warrants by receipt of this material that they are a wholesale client and not a retail client as those terms are defined under the Australian Corporations Act 2001 (Cth) and the New Zealand Financial Advisers Act 2008 respectively. This material contains general information only and does not constitute financial product advice. This material has been prepared without taking into account any person s objectives, financial situation or needs. Before making any investment decision based on this material, a person should assess whether the information is appropriate having regard to the person s objectives, financial situation and needs and consult their financial, tax, legal, accounting or other professional advisor about the information contained in this material. This material is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. BIMAL is the issuer of financial products and acts as an investment manager in Australia. BIMAL does not offer financial products to persons in New Zealand who are retail investors (as that term is defined in the Financial Markets Conduct Act 2013 (FMCA)). This material does not constitute or relate to such an offer. To the extent that this material does constitute or relate to such an offer of financial products, the offer is only made to, and capable of acceptance by, persons in New Zealand who are wholesale investors (as that term is defined in the FMCA). BIMAL is a part of the global BlackRock Group which comprises of financial product issuers and investment managers around the world. This material has not been prepared specifically for Australian or New Zealand investors. It may contain references to dollar amounts which are not Australian or New Zealand dollars and may contain financial information which is not prepared in accordance with Australian or New Zealand law or practices. BIMAL, its officers, employees and agents believe that the information in this material and the sources on which the information is based (which may be sourced from third parties) are correct as at the date specified in this material. While every care has been taken in the preparation of this material, no warranty of accuracy or reliability is given and no responsibility for this information is accepted by BIMAL, its officers, employees or agents. Except where contrary to law, BIMAL excludes all liability for this information. Past performance is not a reliable indicator of future performance. Investing involves risk including loss of principal. No guarantee as to the capital value of investments nor future returns is made by BIMAL or any company in the BlackRock Group. In Brunei, BlackRock does not hold a Capital Markets Services License and is therefore not licensed for conducting business in any regulated activity under the Securities Market Order, This document has been issued by BlackRock and is intended for the exclusive use of the recipient. The distribution of the information contained herein may be restricted by law and persons who access it are required to comply with any such restrictions. The information provided herein information is directed solely at persons who would be regarded as Accredited Investors, Expert Investors or Institutional Investors in accordance with the Securities Market Order For use in Thailand, this material is this material is provided to you who warrants by receipt of this material that they are Institutional Investors (as such term is defined by Securities and Exchange Commission). For use in Malaysia: BlackRock does not hold any license or registration under the Capital Market and Services Act 2007 of Malaysia ( CMSA ) or other Malaysian legislation to carry on, nor does BlackRock purport to carry on, any regulated activity in Malaysia. Nothing in this document, directly or indirectly represents to you that BlackRock will provide, or is providing BlackRock products or services to you in Malaysia. This material is intended solely for Sophisticated Investors as defined under Part I of Scheme 6 & 7 of CMSA. FOR INSTITUTIONAL/PROFESSIONAL/PERMITTED CLIENTS ONLY. THIS MATERIAL IS NOT TO BE REPRODUCED OR DISTRIBUTED TO PERSONS OTHER THAN THE RECIPIENT BlackRock, Inc., All Rights Reserved. Client portfolios asset allocation US public pension asset allocation US endowment asset allocation US insurance factor exposures EMEA pension asset allocation US large cap 25.2% US cash 6.0% Macro - USD 2.1% EUR large cap 13.0% ex-us large cap 18.0% US high yield 1.3% Macro - GLB Commodity 2.0% large cap ex-eur 21.0% US small cap 2.3% US aggregate bond index 10.1% Macro - GLB Credit 18.2% EUR government 47.0% EM equity 3.3% ex-us treasuries 1.0% Macro - GLB EM 0.6% aggregate bonds 5.0% US government 1.1% USD EM debt 0.5% Macro - GLB Economic Growth 18.2% Commodities 2.0% US government (10+ years) 0.2% US large cap 22.5% Macro - GLB Inflation 30.6% private equity 3.0% US inflation-linked government 1.2% ex-us large cap 14.4% Macro - GLB Real Rates 28.2% real estate 3.0% US credit (all maturities) 4.4% US small cap 3.5% Hedge funds - aggressive 4.0% US credit (long bonds) 0.7% EM equity 5.6% EUR cash 2.0% US high yield 1.4% US core real estate 3.2% US aggregate bond index 11.7% private equity 9.5% ex-us treasuries 1.2% infrastructure equity 0.0% USD EM debt 1.0% Hedge funds (global) 18.9% Local-currency EM debt (unhedged) 0.3% Commodities 1.8% US bank loans 1.1% infrastructure debt 1.8% US cash 1.5% US core real estate 7.8% private equity 8.2% infrastructure equally 0.8% Hedge funds (global) 5.2% Commodities 1.2% infrastructure debt 0.1% Risk parity 0.4% Real assets 1.6% Factor strategies modeling assumptions Macro Factors: 100% allocation to a hypothetical long-only Macro Factor Portfolio 13.5% to Economic Growth; 35.9% to Real Rates; 16.7% to Inflation; 15.5% to Credit; 11.0% to Emerging Markets; and 4.0% to Commodities. Factors represent the following contributions to risk in the balanced macro factor portfolio: 3.59% from Economic Growth; 2.28% from Real Rates; -0.77% from Inflation; 1.42% from Credit; 1.98% from Emerging Markets; and 1.05% from Commodities. The balance of exposure and risk contribution are from FX and Other. This is modeled with a hypothetical Sharpe Ratio of 0.5. Style Factors: 100% allocation to a hypothetical long/short Style Factor Portfolio 0.5% to Economic Growth; 0.1% to Real Rates; 0.0% to Inflation; 0.1% to Credit; -0.4% to Emerging Markets; and 0.0% to Commodities. Factors represent the following contributions to risk in the style factor portfolio: 1.33% from Economic Growth; -0.02% from Real Rates; 0.00% from Inflation; 0.09% from Credit; -0.04% from Emerging Markets; and -0.03% from Commodities. The balance of exposure and risk contribution are from FX and Other. This is modeled with a hypothetical Sharpe Ratio of T-1017