The Best Offense Is Often a Good Defense: The Case for Targeted Volatility Investing. Investment Focus

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1 Investment Focus The Best Offense Is Often a Good Defense: The Case for Targeted Volatility Investing A critical objective for investors is to generate returns consistent with their tolerance of risk. This can be challenging in today s environment, where headlines regularly trigger market turmoil and painfully remind investors of their vulnerability to volatility and drawdowns. Worse, this uncertainty can cause them to make emotional decisions that undermine longterm investment plans. To avoid these pitfalls and benefit from the evolving market environment, we believe investors should consider a multi-asset, dynamic investment approach that seeks returns at targeted levels of volatility.

2 2 Introduction: Approaching an Inflection Point? For the past several years, markets have been dominated by the actions of central banks. By lowering interest rates and employing unconventional policies, such us quantitative easing and negative interest rates, central bankers have sought to restore confidence and help their economies and markets heal from the global financial crisis. These policies have supported broad gains in asset prices. However, we believe the next several years are likely to be very different. Interest rates started to rise in late 216, and while this might reverse, we doubt they will go much lower than previous levels. The changing environment has the potential to increase uncertainty and result in higher volatility, which can drive investors to make quick, ill-considered investment decisions. At the same time, in our view, capital returns are likely to be lower on average than in the decades before the global financial crisis. This, in turn, may create opportunities and reward active managers who invest in securities of companies that are most effective at deploying capital and growing their businesses. Given this outlook, we believe investors should consider investment strategies that offer excess returns at targeted levels of volatility. In the Lazard Global Dynamic Multi-Asset strategy, the team historically has aimed to reach these goals through: dynamic allocation across a range of asset classes; a disciplined, volatility-sensitive approach; the ability to leverage Lazard s expertise and resources; and multiple sources of alpha. Investors and Uncertainty: A Volatile Mix In our view, long-term investors are best served by smoothing their pattern of performance to maximize annualized returns over a market cycle. These investors do not necessarily need to fully participate in market peaks but, more importantly, they do need to avoid or minimize the impact of market downturns. Doing this successfully allows them to better fulfill their long-term investment plans, especially by preventing the short-term mistakes many investors make when responding to market swings, such as selling out in down markets or buying at elevated levels. For example, investors selling at the lows of the 28 9 market correction locked in losses and failed to participate in the subsequent rally. While these actions may have been forced or driven by a need for liquidity, another motive appears to have been panic generated by portfolio drawdowns. This is not a new pattern. Investors, according to empirical evidence, are often their own worst enemies when it comes to allocating assets for the long term. Equity mutual fund flows over the past 15 years show that investors have routinely inverted the classic investment guidance of buy low/sell high. Instead, flows have increased when assets reached their highest prices and turned negative when prices fell. While higher volatility is not a threat to an investment plan in and of itself, an investor s reaction to it can be. As a result, in our view, managing volatility is of utmost importance, in order to discipline investment responses and to preserve capital. Investors with lower exposure to market downturns don t need to take the outsized risks necessary to rebuild wealth after significant losses. After all, a 5% decline in a portfolio cannot be recovered through a 5% gain. Rather, the value of the remaining investment will have to double or rise by 1% to make the portfolio whole again (Exhibit 1). Of course, taking on the risk to achieve this return will likely subject the portfolio to even higher volatility and the possibility of further downside. Exhibit 1 Losses Require Far Greater Gains to Recover Capital Gains/Losses (%) 11% 25% 43% 67% 1% 15% 233% 4% 9% -1% -2% -3% -4% -5% -6% -7% -8% -9% Investment loss Subsquent gain neccesary for breakeven Memorable Decline S&P 5 (2 22) -49% S&P 5 (27 29) -59% NASDAQ (2 22) -78% DJIA ( ) -89% These figures are hypothetical and do not take into account taxes or fees. Recovery of losses means coming back to a performance of zero. Source: Crestmont Research, Lazard

3 3 Innovations in Diversification To protect their assets, investors have long been told to diversify. Traditionally, diversification meant static vehicles (e.g., 6% stocks/4% bonds) that were rebalanced on a schedule (following changes in market prices) or when asset weight imbalances reached a specific level. This approach, while it can offer a buffer against drawdowns, is relatively simplistic, and the portfolio still has significant exposure to equity volatility (Exhibit 2). Exhibit 2 A Balanced Portfolio of Stocks and Bonds May Offer Little Protection against Volatility Spikes Annualized Volatility (%) Vol Contribution from Stocks Vol Contribution from Bonds Diversification Benefit a Vol of a 5/5 mix As of 31 March 216 a Diversification benefit measures the difference between the volatility contribution from stocks and the volatility of a 5%/5% equity/bond portfolio. Source: Barclays, Lazard, MSCI Recently, some investors have been turning to volatility targeting. In this approach, they seek to take advantage of two important statistical facts. The first is that volatility and return are generally negatively correlated. By selling equities while their risk-adjusted expected return is falling (i.e., when volatility is rising) and buying equities when their risk-adjusted expected return is rising (i.e., while equity volatility is falling), investors may increase riskadjusted returns and dampen the portfolio s overall volatility. The second fact is that volatility trends over the past three decades have been persistent. In other words, periods of high volatility and low volatility have alternated over long periods of time. This can allow managers to adjust allocations and target volatility more effectively through the investment cycle. Another important consideration in targeted volatility investing is the potential use of low-volatility equities (also called low-beta stocks) in allocations. These stocks are often companies with historically more defensive characteristics e.g., less debt, less volatile earnings, and higher dividend payout ratios. Over the long term, low volatility equities have offered lower risk exposure to the markets, giving managers a further allocation lever and potentially improving diversification benefits. Also, effective investing tools necessary for volatility targeting are now more broadly available than before. Access to markets and asset classes around the world is far broader. Technological innovations have also lowered transaction charges and improved risk management. In this environment, portfolio managers can monitor strategies and the volatility of underlying securities on a daily basis to determine risk levels and optimize portfolio volatility. In addition, given these improvements in market access and risk management technology, investors can access volatility managed portfolios through both separate account and pooled vehicle structures. In our view, a targeted volatility, diversified multi-asset approach is more likely to buffer against volatility and drawdowns, while also delivering strong returns than a static diversified portfolio. For example, a multi-asset portfolio targeting 1% volatility has historically been more likely to generate 5% average annual returns than a static diversified portfolio made up of stocks and bonds. The probability of success changes over time. Over one year, the divergence in probability between a targeted volatility multi-asset portfolio and a globally diversified portfolio is marginal (Exhibit 3). Over four years, however, the odds for the success of the multiasset portfolio begin to rise. Over seven years, the difference is significant. Based upon our strategy performance records, as well as research and testing, we believe that a targeted volatility vehicle with the proper defensive characteristics can protect capital and outperform through a full market cycle. The Importance of Correlation Investors have questioned the value of diversification over the past ten years, mostly because portfolios that appeared to be diversified often showed unexpected weakness when volatility rose. In times of market stress, different asset classes sold down together, rather than performing differently and thus more defensively in aggregate. This resulted in unforeseen downside in some portfolios. To avoid this, we believe it is critical to understand that true diversification is achieved when correlations are minimized a characteristic that is best revealed by stress testing a strategy through market scenario analysis. In times of extreme volatility, however, the diversification benefit effect may not be sufficient to maintain a target level of volatility in the strategy. In these scenarios, portfolio managers also have additional tools to help reduce downside, such as a linear hedging instrument (e.g., a total return swap against a global equity index). This is designed to mitigate or remove the equity beta from the portfolio, further reducing cross-correlations, improving diversification, and protecting against downturns.

4 4 Exhibit 3 Multi-Asset Approaches Are More Likely to Achieve Targeted Returns over Time than a Static Diversified Portfolio Probability of Achieving 5% Average Annual Returns over Various Time Periods (%) M Multi-Asset 1% Volatility Target 3M 6M 1Y Static Diversified Portfolio a 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 1Y As of 3 June 216 a The diversified portfolio is 68% equities/32% bonds, which is the average weight of the Multi-Asset 1% Volatility Target Portfolio over each respective time period. Results are averages of the portfolios invested each Wednesday since 31 December 1993 for every time horizon. Multi-Asset = MSCI World Index and Barclays Global Aggregate Bond Index managed to a 1% volatility target Static Equity/Debt Portfolio = MSCI World Index/Barclays Global Aggregate Bond Index Target volatility does not represent a promise or guarantee of future results. Source: Lazard Risk Management Effective risk management is very important to the success of a targeted volatility strategy. We believe that multiple levels of risk control are necessary for portfolio managers to fulfill their investment objectives. For example, the liquidity of each security, and the portfolio as a whole, should be monitored methodically. In order to raise, or lower, volatility via exposure to the markets, country, sector, and market capitalization weights all need to be actively monitored. Another level of risk management is factor analysis. Factors are specific characteristics that can help explain the risk-return pattern of a given asset, such as price to earnings (P/E) levels, dividend yield, market exposure (beta), and volatility. Factor impact is measured by constructing factor portfolios, which are typically built by sorting an investment universe on a specific characteristic, and then calculating the return difference between the highestranked securities and the lowest-ranked securities based on those characteristics. Given the importance of downside protection and targeted volatility, in our view, managers should incorporate factor analysis into their process. A Dynamic Solution We believe the Lazard Global Dynamic Multi-Asset strategy can help investors fulfill their long-term investment objectives as it seeks to generate attractive returns while managing volatility to a target band of 8% 12% over a full market cycle. Managers of the Lazard Global Dynamic Multi-Asset strategy can allocate the portfolio among more than 1 Lazard strategies, which include exposure to equity, fixed income, commodities, currencies, and other diversifying asset classes. Through the use of Lazard strategies, we have transparency into holdings, daily liquidity, and management style, but we avoid multiple layers of expenses for clients. The team bases allocation decisions on its forward-looking market forecast. The forecast is determined by assessing risks and opportunities around four broad, equally important areas: Economy, Valuation, Liquidity, and Sentiment (Exhibit 4). To analyze these four macro areas, the team considers both qualitative and quantitative inputs. Quantitative inputs include macroeconomic indicators (e.g., manufacturing, housing, consumption, employment, PMI surveys, etc.) and market data. Qualitative inputs include on-the-ground observations and research (on-site discussions with local economists, policymakers, industry specialists, company meetings, etc.) and Dragonfly (an internal, proprietary investment social media network), which provides a range of internal opinions about these topics. Using these inputs, the team makes a qualitative decision about the probability of each macro outcome, ranging from extremely bearish to overly bullish. By examining the possible future states of capital markets, the team seeks to determine the probability of each possible state. Through this process, we believe a more accurate forecast can emerge over time. The team uses its forecast and other research to dynamically allocate among various asset classes within the portfolio, with the goal of managing volatility to the target. We believe this is a significant differentiator to Lazard s approach to multi-asset investing.

5 5 Exhibit 4 Lazard's Market Forecast Is Based on Four Categories Categories Economy Valuation Liquidity Sentiment What stage of the business cycle are we likely to be in over the next 6 12 months relative to trend? How attractively valued will risk assets be over the next 6 12 months? How are credit markets likely to be characterized over the next 6 12 months? How supportive will politics and/or public opinion be for returns over the next 6 12 months? Scenarios Depression/Recession Broadly undervalued Very weak Not at all Source: Lazard Below trend Mostly attractively valued Weak Somewhat Stable Growth Fewer attractively valued Normal Very Overheating Broadly overvalued Very strong Too much Exhibit 5 GDMA Volatility Was Lower than Comparable Benchmarks during the Euro Crisis (%) Lazard GDMA Blended Benchmark a MSCI World Index May 212 Jun 212 Jul 212 Aug 212 Sep 212 As of 3 September 212 a 5% MSCI World Index/5% Barclays Global Aggregate Bond Index Performance is preliminary and presented gross of fees. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Source: Lazard This top-down approach is combined with the bottom-up investing processes conducted by the Lazard teams responsible for the underlying investment strategies. A collaborative culture enables the Multi-Asset team to draw upon a range of insights and expertise. We believe different investment approaches today are apt to yield different results in different financial environments; the portfolio construction processes employed by our specialist managers are not in fact equal at all points in time. Our goal is to identify and exploit the differences and allocate the portfolio accordingly. Risk control is an important element for the strategy s success. The team constantly reviews the portfolio to ensure the asset exposures are appropriate and aims to avoid unintended exposures that can impact performance. In order to deliver robust risk-adjusted returns over the long term, the team seeks to limit the portfolio s exposure to drawdowns. In 212, global equities fell in response to the credit crisis in Europe, but the strategy was able to deliver significantly lower volatility and protect capital during this challenging period (Exhibit 5). Factor risk is also managed by the portfolio s allocation to the quantitative equity manager, who is aware of factor exposures in the remainder of the equity portfolio. Conclusion: Staying on Target We believe that the market environment of the past several years which was dominated by government intervention and central bank policy is evolving to one marked by higher uncertainty and volatility. To exploit this, we believe investors should consider solutions run by multi-asset teams that are able to deliver returns at a targeted level of volatility. This will keep investors exposed to a blend of asset classes while reducing the potential for higher volatility and drawdowns. The Lazard Multi-Asset team through its Global Dynamic Multi-Asset strategy has historically been effective at generating consistent returns within specific bands of volatility. With the Lazard Global Dynamic Multi-Asset strategy, we believe investors may be able to improve their risk-adjusted returns and increase the likelihood of achieving their long-term investment objectives and financial goals.

6 6 About the Team The Lazard Global Dynamic Multi-Asset team seeks to generate attractive returns at targeted levels of volatility by implementing a multi-asset, diversified, and dynamic investment approach. The team can allocate across equities, fixed income, commodities, currencies, and other diversifying asset classes, basing decisions on its forward-looking market forecast over the next 6 12 months. This is a differentiating characteristic, as portfolio construction is driven by both top-down asset allocation and bottom-up security selection. The strategy is led by Jai Jacob and is managed on a team basis, which draws upon the firm s extensive network of investment professionals. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Important Information Published on 1 February 217. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. The performance quoted represents past performance. Diversification does not guarantee profit or protect against loss in declining markets. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. 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