Purpose Driven Investing Stephanie A. Chedid, AIF LeadingAge New York, September 11, 2013 Business Assets An often overlooked aspect that can lead to issues of over allocation, reduced diversification and limited capital planning analysis LeadingAge New York Financial Manager s Annual Conference September 11, 2013 Stephanie Chedid, AIF President Cleary Gull Advisors Inc. (414) 270-2276 schedid@clearygull.com 1
Agenda Holistic Approach to Balance Sheet Management Industry Perspective on Future Returns Portfolio Construction Tools Measuring Balance Sheet Risk Alternative Investments Considering Direct Investments In Portfolio Construction Building Complements Around Direct Investments 3 Average Asset Allocation Alternatives Asset Class includes: Hedge Funds, Hedge Fund of Funds, Real Estate, Private Equity, Commodities and Hard Assets. Data from Cleary Gull 2013 Senior Living Study What do organizations include in their asset allocation? How do you define an Alternative investment 4 2
Institutional Investor Outlook Use of alternative investments has trended upwards 2010 46% of participants 2011 50% of participants 2012 67% of participants 2013 54% of participants Most popular types of alternatives being used as reported in 2013 Hedge Fund of Funds 44% Commodities 44% REITs 60% Private Equity & Real Estate 28% Source: Cleary Gull Advisors Senior Living Asset Allocation Study, 2010, 2011, 2012, 2013 A Holistic Approach to Balance Sheet Management 6 3
Objectives of the Balance Sheet Approach Allocate risk based on your operating environment, capital structure, strategic plans and required rate of return Method of creating a risk budget that includes potential risks relating to assets and capital structure Provide an integrated approach to capital and asset management for use in strategic planning 7 Integrated Asset Allocation Assets and liabilities of your balance sheet, along with your operations and strategic plans, are considered in developing an integrated asset allocation strategy and risk profile for your investments. Operations and Strategic Plans: Understand where NOI comes from Does free cash flow meet your needs What is interest expense as % of revenue Liabilities and Debt Structure: Operations/ Strategic Plan Investment Assets: Debt service coverage ratio Avg. Life of debt Allocation of fixed vs variable Liabilities Debt Structure Investment Assets Time weighted rate of return Volatility Value at risk 8 4
Asset Allocation and Risk Management Risk = volatility of returns and changing correlation between asset classes Use diversification and liquidity to manage risk Quantify portfolio risk using metrics such as Value at Risk (VaR) Mean Variance Optimization (MVO) efficient frontier theory Conduct scenario analysis on both assets and liabilities Stress test assumptions under various economic and market conditions 9 Policy Framework Investment Policy Return expectations Asset classes available Range of risk Maximum drawdown Legal issues Liquidity Time horizon Spending policy Distribution requirements Contribution to NOI Identify covenant restrictions 10 5
Returns were Returning 25 20 15 10 5 0-5 Investment Returns (net of fees) 18.8% 10.9% 12.5% 11.6% -1.9% FY 2008 FY 2009 FY 2010 FY 2011-10 -15-20 -21.2% -25 Sources: 2009, 2010, 2011, 2012 Commonfund Benchmarks Study Healthcare Organizations Report Returns shown were obtained from sources we believe to be reliable, but we cannot guarantee their accuracy. Past performance does not guarantee future results. You cannot invest directly in an index. 11 Returns are Returning 12 Average Annual Trailing Returns 10 11.1% 8 9.6% 2011 3-year period includes the strong 09 and 10 returns 9.0% 6 3-Year 5-Year 2011 5-year period reflects the -21.2% return reported in 2008 when financial crisis was most severe 4 2 0 2011 1.8% 0.4% 4.1% 2010 2007 Source: 2008, 2011, 2012 Commonfund Benchmarks Study Healthcare Organizations Report Returns shown were obtained from sources we believe to be reliable, but we cannot guarantee their accuracy. Past performance does not guarantee future results. You cannot invest directly in an index. 12 6
Asset Allocation Over a 200% increase in Alternatives Asset Allocation for Healthcare organizations 2002-2011 Asset Class 2002 2005 2008 2011 U.S. Equities 37% 30% 24% 20% International Equities 10% 12% 12% 15% Fixed Income 43% 34% 39% 36% Alternatives 9% 15% 18% 21% Short-term securities/cash/other 1% 9% 7% 8% 2003, 2006, 2009, 2012 Commonfund Benchmarks Study Healthcare Organizations Report 13 Institutional Investor Outlook Expectations remain positive for equities 2013 S&P returns 7.9% average vs. 8.3% in 2012 Dispersion is wide 20% expecting 5% or less 33% expecting at least 10% 3-year returns 7.1% average vs. 6.8% in 2012 78% (vs. 75% in 2012) expect emerging markets to outperform the S&P on a three-year basis 55% of respondents indicated they would increase allocations over the next 12-18 months Low expectations for fixed income 67% (vs. 37%) expect high-yield fixed income to underperform the S&P 91% (vs. 84% in 2012) expect the Barclay s Agg to underperform the S&P over the next three years The average expected yield on the 10-year Treasury was 2.1% by YE 2013 52% indicated decreasing allocations to Treasury 43% indicated decreasing allocation to core fixed income Source: Commonfund Forum Investor Outlook Survey March 2013 7
Institutional Investor Outlook Overall expectations for annual performance is little changed from 2012 1 year 7.6% (7.0% median) 3 year 7.3% (7.0% median) 5 year 7.4% (7.0% median) When asked about tail risk or significant unexpected risks 38% said tail risk is increasing over the next three years vs. 46% in 2012 13% think tail risk is decreasing vs. 9% in 2012 Participants report the following risks relative to portfolio performance, vs. 2012 Washington gridlock over U.S. debt 38% up from 23% Mideast crisis/ Oil price jump 12% vs.16% European Union crisis 11% declining considerably from 32% U.S. recession 5% vs. 4% China economic slowdown 2% Source: Commonfund Forum Investor Outlook Survey March 2013 Institutional Investor Outlook Areas of greatest concern relative to management of assets Market (investment) volatility 59% vs. 69% in 2012 Shortfalls in meeting return objectives 48% vs. 63% Overall concerns about downside risk were reduced Factors of least concern Deflation 77% down from 64% Portfolio liquidity 62% up from 50% Source: Commonfund Forum Investor Outlook Survey March 2012 8
Portfolio Construction Tools 17 Was Markowitz Right? Modern Portfolio Theory (MPT) maximize a portfolio s expected return given a set of asset classes, their expected return, volatility and correlations the efficient frontier Post 2008, manage and measure tail risk Identifying the black swan (Nassim Taleb The Black Swan Identifying the Highly Improbable) Combination of old and newer methods makes the most sense Return distributions are not normal modeling describes where we are (simulate the simulations i.e. fat tails ) versus history and our capital market assumptions 18 9
Let History be Your Guide Avg. P/E 16.2x 19 20 10
Why Diversify? Traditional stock and bond portfolio allocated 60/40% 21 Value at Risk (VaR) Volatility is the typical method for determining risk. However, the direction (positive or negative) is not indicated VaR calculates the maximum loss in dollars that is expected over a specific period of time given a specific degree of confidence Risk is linked with the idea of losing money Drawbacks VaR doesn t include tail risk Benefits Useful when evaluating potential loss versus bond covenants or spending needs 22 11
Conditional Value at Risk (CVaR) Include alternatives or other diversifying asset classes to the long-only portfolio in order to minimize CVaR (i.e., reduce fat left tail) The size of the allocation to diversifying assets will depend on the desired tracking error (TE) or beta between the overall and long-only portfolios. The higher the TE or beta reduction that is acceptable, the large the allocation to alternatives. 23 Portfolio Modeling Techniques Capital asset pricing model (CAPM) suggests some combination of investments will offer better risk/return outcomes than a single investment Modern Portfolio Theory (MPT) constructs an efficient frontier of optimal portfolios offering the highest possible return for a given level of risk High risk / High return Low risk / Low return Medium risk / Medium return Drawbacks Cannot simulate 100% of the possibilities Subjectivity of input values Benefits Useful in considering various scenarios Provides a framework for decisionmaking 24 12
Forward Looking Capital Market Assumptions* Projected Return/Risk Projected Correlations *JP Morgan, January 2013 25 Efficient Frontier 10.0 Emerging Markets 8.0 Mid Cap Small Cap Large Growth Large Cap International Equity Large Value Return (%) 6.0 4.0 Traditional 40/60 International Fixed US Inv. Grade Corp U.S. TIPS 2.0 Cash Short Gov/Credit US Inmdt. Treasuries Equity Fixed Income 0.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 Risk/Annualized Volatility (Standard Deviation) 13
Creating a Risk Budget *In millions 27 Modeling Liabilities 28 14
Where is the Economy and Market Cycle? The Economic Cycle Inflationary 1. Real Assets 2. Corporate Debt 3. Equity 4. Fixed Income Growth Falls The Market Cycle Stagflationary 1. Real Assets 2. Corporate Debt 3. Fixed Income 4. Equity Inflation Rises Inflation Falls Reflationary 1. Equity 2. Corporate Debt 3. Real Assets 4. Fixed Income Growth Rises Deflationary 1. Equity 2. Fixed Income 3. Real Assets Identify and Measure Risk 30 15
Where Does Risk Come From? Not achieving the desired outcome Volatility of performance Liquidity The lesson learned in 2007 and 2008 was that liquidity is key it matters most when it is least available Converging asset class correlations non-traditional risk factors like central bank policy and political risk Non-beta exposures, i.e. how different is my investment from the market I am trying to expose my portfolio to A Market inflection point 31 Where Does Risk Come From? A Market inflection point 32 16
What Are Alternative Investments? 33 Alternative Investments (CG - Complements) Definition (Ibbotson) Asset classes and/or investment strategies that are outside of the traditional stock, bond, and cash categories and that generally display different performance characteristics than these traditional investment categories. The returns of alternative investments have low correlations with the returns of the traditional investment categories, making them a potentially beneficial addition to a traditional portfolio. Size of the market Of the $8.6 trillion in mutual funds, 1.6% is invested in alternative strategies, which is approximately $140 billion Of the $1 trillion in ETFs, 14% is invested in alternative strategies, which is approximately $140 billion There is approximately $1.5 trillion invested in hedge funds 34 17
Expanding the Efficient Frontier 35 REIT s: -60 to +113% Commodities: -50 to +42% Hedge Funds: -22 to 32% 36 18
Correlations 37 REITs Definition REITs A Real Estate Investment Trust is a company that owns and usually operates, income-producing real estate. Some provide mortgage financing and/or purchase mortgage-backed securities. REITs must distribute at least 90% of taxable income to shareholders annually in the form of dividends. Equity REITs own and operate income-producing real estate. Mortgage REITs lend money directly to real estate owners and their operators, or indirectly through acquisition of loans or mortgage-backed securities. REITs are further classified by the properties that are underlying their investments. Seven common categories of REITs are: Office Apartments Lodging Diversified Retail Industrial Residential 38 19
REITs Returns and Risk Data 39 Efficient Frontier Adding Alternatives to your Portfolio 10.0 Emerging Markets Return (%) 8.0 6.0 4.0 Multi-Strategy 30% Liquid International Alternatives Fixed Traditional 40/60 US Inv. Grade Corp U.S. TIPS Mid Cap Small Cap Large Growth Large Cap Global REITs International Equity Large Value US REITS Commodities 2.0 Cash Short Gov/Credit US Inmdt. Treasuries Equity Fixed Income Liquid Alternatives 0.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 Risk/Annualized Volatility (Standard Deviation) 20
Private Equity Definition Private equity Equity capital not quoted on a public exchange, usually LP structure Benefits from market inefficiencies, negotiated transactions and alignment of interests LP makes direct investments into companies Avg. 5 to 7 year holding periods with little or no low liquidity Can be associated with a turnaround of a distressed company LBOs LP investors almost always have majority control Some mutual funds available with greater liquidity, mostly very large funds 41 Private Equity Definition RCP Advisors Fund and index data include various forms of private equity Risk, liquidity and return characteristics differ between stages Identifying stage of investment assists with forecasting returns 42 21
Private Equity Definition RCP Advisors The average VC return from 1980 2009 = 14.8% The average PE return is 11% higher than the DJIA and 11.6% higher than small cap stocks Middle market PE provides the best returns over the time horizon measured 43 Efficient Frontier Adding Alternatives to your Portfolio 10.0 Venture Capital Emerging Markets Return (%) 8.0 6.0 4.0 US Real Estate Mid Cap Private Equity Small Cap Large Growth Large Cap Global REITs International Equity Large Value Multi-Strategy US REITS 20% Private Alternatives International Fixed Commodities Traditional 40/60 US Inv. Grade Corp U.S. TIPS US Inmdt. Treasuries Cash 2.0 Equity Short Gov/Credit Fixed Income Liquid Alternatives Private Alternatives 0.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 Risk/Annualized Volatility (Standard Deviation) 22
Considering Direct Investments in Portfolio Construction 45 Classify My Business Ventures? Real Estate Private Equity Venture Capital Property Home health partnership Independent home healthcare business Adjacent land for Physical therapy business Pharmaceutical venture development New community development Pharmacy Co-op Rental 46 23
Including Direct Investments in Your Portfolio Identify the asset class Estimate the return, volatility and correlation to other assets Include in portfolio construction modeling Identify a like benchmark for reporting Note at least annually, performance vs that benchmark Update modeling assumptions annually 47 Building Complements Around Direct Investments 48 24
Efficient Frontier Adding Alternatives to your Portfolio 6.50 6.25 Return (%) 6.00 5.75 5.50 Private and Liquid Alternatives 20% Private Alternatives 30% Liquid Alternatives 5.25 Traditional 40/60 Allocation 5.00 7.0 8.0 9.0 10.0 11.0 12.0 Risk/Annualized Volatility (Standard Deviation) Cleary Gull Advisors www.clearygull.com/blog Stephanie A. Chedid, AIF President Direct 414-270-2276 Email schedid@clearygull.com Talk to us about what really matters to you your purpose and we will create a solution designed around your intentions. Brian K. Andrew, CFA Chief Investment Officer Direct 414-291-4504 Email bandrew@clearygull.com Cleary Gull Advisors Inc. 100 East Wisconsin Avenue Suite 2400 Milwaukee, WI 53202 (414) 291-4500 Toll Free (888) 349-1600 clearygull.com Copyright 2013 50 25