The New World Of Asset Allocation

May 19 New York The New World Of Asset Allocation Thomas Schneeweis Founding Editor of The Journal of Alternative Investment Co-Founder of the Chartered Alternative Investment Analyst Association

Topic Slide Number New World of Asset Allocation: Basic Points 3 Alternative Investments What Are They? 4 How Did We Get Here? 5 Where Do We Go From Here? 6 Why Alternatives Now? 10 Alternative Investment 101 - Why Alternatives? 12 Alternative Investments 102 - Understand Basic Drivers 15 Alternatives in DC Space 20 What do We Do When We Get There? 22 What Is A Wizard To Do? 24 How Do Strategies Work? 26 Sometimes There is A Solution 30 Where To In the Future 32 2

New World of Asset Allocation: Basic Points Markowitz based asset allocation(modern Portfolio Theory/MPT) is now over 60 years and simple expected return/risk (e.g. correlation) based models have their shortcomings. MPT is really APT (Ancient Portfolio Theory). It is time for Postmodern Investment. Today s investment climate (risk on and risk off, low rate environment ) requires a wide range of asset classes and risk management approaches including new approaches to measuring market sensitivity and accessing alternative sources of return. Traditional assets will increasingly be traded in for alternative investments. Alternative investments will be incorporated into Defined Contribution plans, less as stand-alone investments than as parts of newly developed multi-asset product designs (e.g., target date funds, smart beta, risk control approaches, multi-strategy funds). 3

Alternative Investments: What Are They? Investment Opportunities Traditional Alternative Modern Alternative Traditional Investments Private Equity Real Estate Commodities Hedge Funds Managed Futures Stocks Bonds Traditional Alternatives (Tradals) Modern Alternatives (Modals) Traditional Investments (Tradins) In its most general sense, alternative investments are investments which offer risk and return opportunities not traditionally found in long bias stock and bond investment. The issue in Postmodern Investment Management is the degree to which one considers the use of Modals and Tradals when one Trades IN one s traditional investments. 4

How Did We Get Here? Modern Portfolio Theory (MPT) Alternative Investment/Risk Managed Products Targeted Investment Programs Currency Hedged Products Hedge Funds Managed Futures Risk Parity Low Volatility Programs Multi-Factor ETFs/ETNs Tracker Funds Return Models (Small/Large Cap Target Date Funds Value vs Growth) Commodity Alternatives Futures Traditional Index Funds Hybrid Mutual Funds Markowitz Options Stock/Bond Dynamic Diversification Portfolio Stuctured Insurance Products CAPM Efficient Market Hypothesis 1950 1960 1970 1980's 1990's 2000 2010 2020 Market and Products Change: Investment management has evolved as investment markets, technology and regulation have forced changes in what is traded, how it is traded, and who packages and sells it. Today, alternative investments exist which increasingly offer unique ways to meet individual client needs. 5

Where Do We Go From Here? Leave the Land of Traditional Investments to the Little Known World of Alternatives Traditional Market Based Investors View of the World of Alternative Investments HC SVNT DRACONES" (i.e. hic sunt dracones, 'here are dragons'); 6

Where Do We Go From Here? Leave The Land of Traditional Assets Traditional Asset Allocation exists primarily in a world of two primary asset classes opportunities (primarily equity and fixed income) in which knowledge of assets historical correlations is the principal means to manage risk (e.g. standard deviation). CML: Known as the Capital Market Line 7

Where Do We Go From Here? Why Are We Leaving The Land Of Traditional Investments? Reduced Correlation Benefits: Increased globalization of the financial markets has reduced the correlation benefits (e.g., diversification properties) within equity and fixed income asset classes. Single Factor Risk Emphasis: Traditional measures of return variability (e.g., standard deviation) as well as risk based performance (e.g., Sharpe Ratios) may not match the risk concerns (maximum drawdown, liquidity, transparency) of certain investors. Static/Long Term Investment: The long term approach to investment management may not meet changing market (risk on and risk of) and investor demographics (aging population) or the changing asset/ liabilities mix (real estate, fixed income holdings). 8

Where Do We Go From Here? Why Are We Leaving Land of Traditional Investments? Traditional core products offer some differences but are impacted by the same factor exposures in extreme return environments such that within equity based asset class the returns are dominated by similar directional return. 9

Why Alternative Investments Now? New World of Investment Choice: Today investors consider a broader range of traditional alternatives (real estate, private equity, commodities) as well as modern alternatives (equity long short, multifactor funds) which provide both liquidity as well as new approaches to selecting assets with unique risk and return characteristics. New World of Risk Based Investment: Investors consider more advanced risk management techniques including both tactical (dynamic) or insurance based risk management (options programs) as a means to limit downside risk while participating in upside market returns. New World of Investor Targeted Investments: Investment products (Life Cycle funds, Target Date Funds) are being created to meet individual investor needs and to consider the alternative investments in the broader range of clients risk concerns. 10

Alternative Investments in the New World of Asset Allocation The Question Is Not If But How Passive Algorithmic Put/Spread Enhanced Protective Srategies Collar Strategies Put Risk Risk Parity Volatility Futures Management Managed and Risk Overlay Targeted Strategies (often Alternatives Based whch are Designed to Control Portfolios Market Risk and Volatility Exposures Income Based Funds Use of Tax Efficient Active Index Asset Allocation Alternative Investments Investor Targeted Funds Based Investment Programs Help Clients Meet Investment Goals Multi Asset Through Custom Risk Based Asset Add-on Programs Risk Based Management Solutions with Alternativs and Factor Based to Core Asset Allocation Target Date Active Factor (Traditional/Alternative) or Risk Managed Funds Based Portfolios ETF Based Manager Based Tracker Funds Commodity Funds Life Cycle Funds 11

Alternative Investments 101: Why Alternatives? Acceptable Stand-Alone Return to Risk Tradeoff and Expanded Portfolio Return Opportunities 1.02 Information Ratio: Multi-Asset Portfolio (With and Without Hedge Funds) 1994-2014 1 0.98 0.96 0.94 0.92 0.9 0.88 Portfolio A: Equal Weights S&P 500 and BarCap U.S. Aggregate Portfolio B: 90% Portfolio A and 10% Hedge Funds Portfolio C: 75% Portfolio A and 25% CTA/Commodities/Private Equity/Real Estate Portfolio D: 90% Portfolio C and 10% Hedge Funds 12

Alternative Investments 101: Why Alternatives? Correlation Differences 13

Average Monthly Return Alternative Investments 101: Why Alternatives? Greater Diversity at Fund level and within Economic Markets 10.0% 5.0% 0.0% Monthly Returns Ranked by S&P 500 (1994-2014) -5.0% -10.0% Average/Bottom Third Months Average/Middle Third Months Average/Top Third Months S&P 500 BarCap U.S. Aggregate SP GSCI Private Equity CISDM CTA EW BarCap U.S. Government BarCap U.S. Corporate High Yield FTSE NAREIT All CISDM EW Hedge Fund 14

Alternatives 102: Understanding Basic Drivers Understand Source of Investments Beta Hedge Funds (Markets traded, Leverage, Liquidity) CTAs General style (trend-following, countertrend) Private Equity, Real Estate (Liquid comparisons, corresponding multiples, fair value calculations) Commodities (Momentum trading, rebalancing, Contango) Note Changes in trading style through time Understanding Source of Manager Alpha Style classification and style drift are major considerations in manager selection. 15

Beta (T-Stat) Alternatives 102: Understand Basic Drivers Multi-factors are source of Alternative Asset Returns R-Square Single Factor and Multi-Factor Regression (1994-2014) 0.80 0.60 0.40 0.20 0.00 CISDM Equal Weighted Hedge Fund CISDM Equity Market Neutral CISDM Convertible Arbitrage CISDM Event Driven Multi Strategy CISDM Merger Arbitrage CISDM Distressed Securities CISDM Equity Long/Short CISDM Global Macro CISDM CTA EW S&P 500 BarCap High Yield Four Factor(S&P, BarCap Govt, Agg, HY) 15.00 Hedge Fund Beta (T-Stat): Multi-Factor Regression - Traditional Market Factors (1994-2014) 10.00 5.00 0.00-5.00 S&P 500 Russell 2000 BarCap U.S. Government BarCap U.S. Corporate High Yield CISDM Equal Weighted Hedge Fund CISDM Equity Market Neutral CISDM Convertible Arbitrage CISDM Event Driven Multi Strategy CISDM Merger Arbitrage CISDM Distressed Securities CISDM Equity Long/Short CISDM Global Macro 16

Alternatives 102: Understanding Basic Drivers CTAs may provide access to positive returns due to non-traditional market factors 17

Alternatives 102: Understanding Basic Drivers CTAs Offer the Potential for Manager Based Excess Return Period: 2001-2013 Performance Correlation Correlation Correlation Correlation Asset Class/ Strategy Annualized Return Stdev MFSB Currency Subindex MFSB Interest Rate Subindex MFSB Physicals Subindex MFSB Currency Subindex -0.18% 5.61% 1.00 0.25 0.44 0.34 MFSB Interest Rate Subindex 1.35% 1.77% 0.25 1.00 0.18 0.26 18 MFSB Stock Subindex MFSB Physicals Subindex 6.68% 12.39% 0.44 0.18 1.00 0.33 MFSB Stock Subindex 0.85% 10.41% 0.34 0.26 0.33 1.00 Barclay CTA Index 3.94% 6.70% 0.53 0.44 0.46 0.27 Barclay Discretionary Index 5.26% 3.90% 0.18 0.17 0.28 0.06 Barclay Systematic Index 3.70% 8.14% 0.53 0.45 0.49 0.30 Barclay Currency Index 2.77% 4.40% 0.58 0.07 0.09 0.07 Barclay Agricultural Index 2.22% 7.36% -0.06 0.02 0.14 0.00 Barclay Fin. & Met. Index 3.81% 5.17% 0.49 0.55 0.27 0.25 Portfolio 8.43% 12.36% 0.52 0.45 0.54 0.33 MFSB: Managed Futures Strategy Benchmarks are based on passive systematic algorithmic trading process based on series of short term, mid-term and longer term momentum indices with a volatility weighting across multiple futures contracts. They have been used in multiple papers on CTA Performance: See Recent Publications (Schneeweis, Spurgin, and Szado, 2013)

1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 129 137 145 153 161 169 177 185 193 201 209 217 225 233 Alternatives 102: Understanding Basic Drivers Note: Similar Return Pattern of Active Manager and Passive Index 0.12 0.1 0.08 Currency CTA Returns: Ranked by Barclay Currency CTA Index 0.06 0.04 0.02 0-0.02-0.04-0.06 Barclay Currency Index 1994-2013 Monthly Data MFSB Currency Subindex ELS passive systematic algorithmic trading process based of series of investible ETFs. The benchmark reflects equal weighted five Mutual Fund ELS managers. MFSB reflects systematic futures based passive trend following model. See recent publications (Schneeweis et al. 2012; Schneeweis et. al, 2013). 19

Alternatives In DC Space We Go To Where Investors and the Markets Demand Investor Demands: Find means to increase access to less liquid and less transparent strategies in effort to increase expected returns to meet investors future anticipated cash flow needs while reducing exposure to sudden changes in value. This often requires moving to alternative investment and alternative risk management space. Market Demands: Alternative investments must be structured to meet needs of changing regulatory and market environment. The alternative space needs to find means to provide institutional quality support, compliance, pricing, transparency, for underlying investor products in space historically known for its lack of liquidity and transparency. 20

Alternatives In DC Space Traditional and Alternatives: Potential Trade Ins Traditional Market Trade Ins FIA (Spread Trades) for FI in world of Rising Rates EMN (low vol EQ) for FI/LV EQ in world of rising rates Merger Arb, ELS etc. (in low growth market) Private Equity (as alternative to levered equity) Traditional Asset Allocation Trade Ins Liquid Alternatives for Illiquid asset Index ETFs for less liquid assets Option Based Risk Vehicles (non path dependent) for dynamic path dependent allocation Replication/Tracker vehicles as cash substitutes to reduce tracking error or increase liquidity of comparable asset. 21

What Do We Do When We Get There? The Enemy is US We Are The World Satellite II Some Liquidity & Alpha Manager Based Products Satellite I Source of Diversification & Liquidity (Index Products, ETFS and Replication/Tracker Products) Trad. Alt. CORE Equity Indexed Products Modern Alt. Fixed Inc. 22

What Do We Do When We Get There? Asset Allocation Non-Investible Asset Allocation Program Benchmark Index Products and ETFs Manager/Fund Based Multiple Asset Classes and Factor Exp Equity Large Cap Russell 1000 Large Cap Mutual Fund Small Cap Russell 2000 Small Cap Mutual Fund Non-U.S. Developed MSCI EAFE Internaltional Mutual Fund Fixed Income Government/Credit Barclay Gov.Credit FI Government Mutual Fund Aggregagte Barclay U.S. Aggregate FI Broad Mkt. Mutual Fund High Yield Barclay U.S. Corp. High Yield FI High Yield Mutual Fund Alternatives Private Equity S&P PE Micro Cap MF/BDCs Real Estate NAREIT Real Estate Mutual Fund Commodities SP GSCI Commodity Mutual Fund Hedge Funds Hedge Fund Hybrid Mutual Funds Managed Futures Managed Futures Global Macro/CTA Mtual Fund Note: Investible Products Must Reflect Return and Risk Expecations of Benchmarks for Benchmark Based Asset Allocation Processes to Be Meaningful ETFs/Securities Multiple Investment Risk Vehicles Investment Risk Characteristics Manager/Fund Higher Transparency, Investor Liquidity (ability to redeem) Lower Higher Consistency, Scalability, Liquidity (ability to trade) Lower Lower Fees, Relative Returns, Operational Risks Higher Goal: Move from core to satellite portfolios to increase expected alpha without fundamentally changing market and volatility exposures. 23

What is A Wizard To Do? The Advisor s Value As A Real Option In PMI World Without Change They Could Hire a Monkey and Feed It Bananas TRS Those Who Only Remember the Past Are Plagued to Repeat it Inverse Paraphrase of George Santayana Oh, no, my dear; I'm really a very good man, but I'm a very bad Wizard Wizard of Oz 24

What Is A Wizard To Do? Identify the areas of liquid alternative investments (multialternative, equity long/short, market neutral, managed futures, commodities, real estate, private equity) that are suitable for Defined Contribution investment space. Identify the unique characteristics of each alternative investment strategy approach and the degree to which each alternative differs from comparison illiquid asset or liquid alternative. Identify which manager/programs fit investor needs and detail its expected return and risk characteristics in various market as well as factors used in estimating liquid alternative investment. Hope you get lucky We don t sell our best ideas, we sell the best ideas we can sell. 25

How Do Strategies Work? It is All in the Design: Option Based Collar Strategies Program which provides greatest downside protection in periods of extreme S&P 500 negative returns and generally provide least upside participation in positive S&P 500 markets 26

How Do Strategies Work? It is All in the Design: Equity Long/Short Mutual Funds While most ELS mutual funds are long bias, there seems to be a wide variation in fund/strategy performance in both up and down markets but in truth ELS which provide best protection in down markets provide least participation in up markets. 27

5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 5/3/2012 5/10/2012 5/17/2012 5/24/2012 5/31/2012 6/7/2012 6/14/2012 6/21/2012 6/28/2012 7/5/2012 7/12/2012 7/19/2012 7/26/2012 8/2/2012 8/9/2012 8/16/2012 8/23/2012 8/30/2012 9/6/2012 9/13/2012 9/20/2012 9/27/2012 How Do Strategies Work? It is All in the Design: Why Not Manage Risk at Asset Class Level 110 105 100 95 90 85 80 Growth of $100: S&P 500 Collar and S&P 500 ETF 110 105 100 95 90 85 80 Growth of $100: Russell 2000 Collar and Russell 2000 ETF 110 105 100 95 90 85 80 Growth of $100: EAFE Collar and MSCI EAFE ETF S&P 500 Collar S&P 500 Russell 2000 Collar Russell 2000 EAFE Collar MSCI EAFE 105 100 95 90 85 80 Growth of $100: EEM Collar and EEM ETF 110 105 100 95 90 85 80 Growth of $100: Real Estate Collar and Real Estate ETF (IYR) 110 105 100 95 90 85 80 Growth of $100: Commodity Collar and GSCI Commodity EEM Collar MSCI EEM IYR Collar IYR Commodity Collar GSCI

How Do Strategies Work? It is All in the Design: Why Not Use ETF/Securities Tracking Strategies? ETF Tracker of Multi-Asset Alternative Mutual Fund (Benchmark) Performance summary (5/2/2014 to 4/30/2015) Portfolio Avg Annual Return (%) Standard Deviation(%) Information Ratio Correlation Benchmark 0.20 4.44 0.04 1.00 Replication 4.81 3.53 1.36 0.90 ISHARES BARCLAYS AGGREGATE BOND FUND-AGG ISHARES S&P GSCI COMMODITY INDEXED TRUST-GSG ISHARES IBOXX $ HIGH YIELD CORPORATE BOND FUND- HYG ISHARES S&P MIDCAP 400 INDEX FUND-IJH ISHARES RUSSELL 1000 INDEX FUND- IWB 5/4/2015 0 1.65 0 0 30.13 5/1/2015 0 1.62 0 0 29.54 4/30/2015 0 1.46 5.94 0 27.32 4/29/2015 0 1.53 4.7 4.96 22.83 4/28/2015 0 1.52 5.92 5.32 22.2 4/27/2015 0 1.57 5.33 5.74 22.14 4/24/2015 0 1.58 6 6.21 21.56 4/23/2015 0 1.61 6.06 6.66 21.29 4/22/2015 0 1.62 5.23 5.65 22.75 4/21/2015 0 1.54 3.95 4.63 23.48 Weight of cash is not shown. It can be calculated by subtracting sum of factor weights from 1. 29

Sometimes There Is A Solution A Tin Man s Heart 30

Sometimes There Is A Solution Do Not Look for the Simple Answers but Search out the Important Simple Questions Why Not a New Definitions of Asset Class?: What Makes An Asset Class? Expected Return is based not on asset class but one sensitivity to alternative risk factors. Without a fundamental shift in accepted process of investment, few investors can risk investing in stand-alone alternatives. Why Not Liquid Alternatives?: Liquid alternatives offer access to principal return characteristics of less liquid traditional alternatives. This is not to say that the less liquid investments do not offer additional return and risk characteristics only that one must carefully consider the additional market and manager risk characteristics. Why Not New Forms of Alternative Risk Management?: Indirect (Dynamic) and Direct (Options) to offer additional means to manage investor risk exposure. These non-traditional/alternative managed approaches to control risk must be viewed as acceptable alternatives to traditional correlation based diversification. 31

Where To In The Future Make it Simple But Make it Right: We are torn between the simple, easy-to-act-on yet incorrect answer, and the less simple, yet often misunderstood, but correct one. The issue remains how to ease investor s transition from the simple to the more complex. (hint: alternatives are really not that complex. How complex is going long some stocks and short others? We must stop apologizing for using equal signs in explaining strategies). Who Changes For Who? Newly designed investment products are required to meet changes in regulation, technology and market structure. But even then they do not provide a free lunch. The fact is that sometimes they will lose money. One must prepare investors for this eventuality. However, how do Defined Contribution Plans manage new products within this world of change (hint: they don t use the product) and how are they brought to the new world (hint: the products may need to exist as part of a larger product in order to gain acceptability). Education but Whose Education? Advisors need to understand the pros and cons of various investment platforms and investment opportunities. That responsibility is not costless and it takes constant re-education. Advisors are generally not incentivized to take on that education or the risk of using that knowledge. (hint: Develop source of quality education see CAIA). 32

Final Comments: What Ever Your Decision Remember Truth Dies a Quick Death, but a Lie Well Told Lasts Forever Paraphrase of Mark Twain Quote It Ain t Lying if They Never Expected The Truth in the First Place Paraphrase of The Oft Described Washington Lie 33

Recent Publications Thomas Schneeweis. Where Academics and Practitioners Get It Wrong, Alternative Investment Analyst Review, Vol. 1, Issue 3 (Q3, 2012). Thomas Schneeweis. (Co-Authors: Garry B. Crowder, Hossein Kazemi). Asset Class and Strategy Investment Tracking Based Approaches, The Journal of Alternative Investments, Winter 2011. Thomas Schneeweis. (Co-authors: Garry Crowder and H. Kazemi). The New Science of Asset Allocation: Risk Management in a Multi-Asset World (John Wiley, 2010). Thomas Schneeweis (Co-Authors: Gary Crowder,, and H. Kazemi). Postmodern Investment: Facts and Fallacies in Growing Wealth in a Multi-Asset World (John Wiley, 2012). Thomas Schneeweis (Co-Author: Ed Szado). Risk Management in a Multi-Asset World: Collaring Multi-Asset ETF Positions (OIC, 2012). Thomas Schneeweis Growing Wealth in a Complex World Alternative Investment Analyst Review, Vol. 3, Issue 1 (Q2, 2014). Thomas Schneeweis. Hedge Funds: Where Investors Get It Wrong (and Right) Journal of Alternative Investments. (Winter 2015, Vol. 17, No. 3), pp. 115-122. Thomas Schneeweis, Richard Spurgin, and Edward Szado. Managed Futures Research: A Composite CTA Performance Review (Winter 2013), Vol. 15, No. 3, pp. 32-61. See www.trs-assoc.com for a complete listing of articles, commentary and short position papers. 34

Thomas Schneeweis 145 University Drive, Suite 2807 Amherst, MA 01004 Tel: 413.549.3351/3352 tschneeweis@isenberg.umass.edu 35