Can We Lower Portfolio Volatility and Still Meet Equity Return Expectations? Richard Yasenchak, CFA Senior Vice President, Client Portfolio Manager, INTECH FOR INSTITUTIONAL INVESTOR USE/NOT FOR PUBLIC VIEWING OR DISTRIBUTION C-0415-1402 07-30-15
AGENDA I. Market Observations II. III. How to Structure a Managed Volatility Strategy Implementation of a Managed Volatility Strategy
INTECH Overview: Active Equity Manager Across All Markets and Regions As of March 31, 2015 More than 25 Years of Investment Experience Risk-Managed Mathematical Investment Styles Value $278.0M Income $2.0M Staff - 84 Employees Worldwide - 23 Investment Professionals Office Locations - West Palm Beach, FL (Corporate Headquarters) - Princeton, NJ (Research Facility) - London, UK (International Office) Absolute-Risk $4.0B Growth $9.1B Core $12.3B Enhanced $25.6B INTECH manages $51.2 billion in equity portfolios Broad Distribution Across Market Segments Asset Distribution by Client Domicile Mutual Funds 4.2% Non-Profit 3.4% Foundations 0.6% North America $34.2 B Europe $4.6 B Africa $295.7 M Asia (ex Japan) $5.3 B Japan $3.8 B Commingled 5.7% Taft-Hartley 10.7% Public 40.1% Australia $3.0 B Corporate 35.3% 1
Overview Managed Volatility strategies have the potential to reduce overall risk and provide downside protection Managed Volatility provides a dynamic risk reduction approach to equity management in varying volatility regimes Determining how a Managed Volatility strategy fits into a portfolio structure is necessary 2
Implication of a Significant Market Drawdown 1000% 800% Gain Needed to Recoup Loss Potential Loss The Importance of Limiting Losses* 900% 600% 400% 400% 233% 200% 0% 1.01% 5.26% 11% 25% 43% 67% -1% -5% -10% -20% -30% -40% 100% 150% -50% -60% -70% -80% -90% -200% As an investment decreases in value, the gain needed to get back to even increases substantially. *The hypothetical example does not represent the returns of any particular investment. 3
Efficient Frontier: Illustrative Example Reward Relative Risk Managed Volatility Low Volatility Capweighted Index Illustrative example; not to scale. The cap-weighted index is not efficient; absolute risk portfolios can potentially be constructed with lower risk and higher return. Risk 4
Style Index Beta vs. Russell 1000 Index December 31, 2004 December 31, 2014 1.20 Style Index Beta vs. Russell 1000 Index 1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 12/2004 12/2005 12/2006 12/2007 12/2008 12/2009 12/2010 12/2011 12/2012 12/2013 12/2014 Style Index Beta vs. Russell 1000 Index Russell 1000 Growth Index Russell 1000 Value Index Growth and Value styles are not defined by risk, and have no consistency to the risk exposure. Barra U.S. Long-Term Model. Data reflects past performance, which does not guarantee future results. 5
Absolute-Risk Strategy Beta vs. Russell 1000 Index December 31, 2004 December 31, 2014 1.20 Absolute-Risk Strategy Beta vs. Russell 1000 Index 1.10 1.00 0.90 0.80 0.70 0.60 0.50 0.40 12/2004 12/2005 12/2006 12/2007 12/2008 12/2009 12/2010 12/2011 12/2012 12/2013 Absolute-Risk Strategy Beta vs. Russell 1000 Index 12/2014 Simulated INTECH U.S. Low Volatility Simulated INTECH U.S. Managed Volatility Absolute-risk strategies are minimizing risk, and persistently have less risk than the market. See Simulations Disclaimer. 6
Volatility is Volatile Rolling 36-Month Annualized Return and Rolling 36-Month Annualized Standard Deviation January 1, 1987 March 31, 2015 35% 25% MSCI World Index Annualized Return 45% 35% 25% 15% 5% -5% -15% Russell 1000 Index 14.55%, 10.75% Annualized Return 15% 5% -5% -15% 14.97%, 7.87% -25% 5% 10% 15% 20% 25% Annualized Annualized Standard Standard Deviation Deviation -25% 5% 10% 15% 20% 25% Annualized Standard Deviation 60% 50% 40% MSCI Emerging Markets Index Rolling 3-Year Annualized Risk and Return Annualized Risk and Return Over the Entire Period Market volatility varies over time and can deviate substantially from the long term average. Data reflects past performance, which does not guarantee future results. Annualized Return 30% 20% 10% 0% -10% -20% 23.28%, 11.55% -30% 10% 15% 20% 25% 30% 35% Annualized Standard Deviation 7
Different Volatility Market Regimes Index Annualized Standard Deviation (12/1987 to 3/2015) Interquartile Range of the 3-Year Rolling Standard Deviation (50% of observations are outside of the range) Russell 1000 Index 14.55% 10.2% - 17.2% MSCI World Index 14.97% 10.7% -17.3% 35.0% MSCI Emerging Markets Index 23.28% 18.7% - 27.1% Rolling 36-Month Standard Deviation vs. Long-Term Standard Deviation From 12/31/1987 to 3/31/2015 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1/1988 1/1989 1/1990 1/1991 1/1992 1/1993 1/1994 1/1995 1/1996 1/1997 1/1998 1/1999 1/2000 1/2001 1/2002 1/2003 Annualized Standard Deviation 1/2004 1/2005 1/2006 1/2007 1/2008 1/2009 1/2010 1/2011 1/2012 1/2013 1/2014 1/2015 Russell 1000 Index - Rolling 3-Year Standard Deviation MSCI World Index - Rolling 3-Year Standard Deviation MSCI Emerging Markets Index - Rolling 3-Year Standard Deviation Data reflects past performance, which does not guarantee future results. Russell 1000 Index - LT Standard Deviation MSCI World Index - LT Standard Deviation MSCI Emerging Markets Index - LT Standard Deviation 8
Managed Volatility Investing There are many different types of absolute-risk equity strategies but many share a common theme: Reduce absolute volatility "as much as possible." By how much should we reduce volatility? During a market crisis, ideally as much as possible. During a sustained bull run in equity markets, too much volatility reduction: - is likely to sacrifice returns; and - may not be needed. Dynamic volatility management can be achieved through portfolio construction. 9
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Implementation Options Defined Benefit Plans: Reducing risk by lowering the volatility of return-generating assets Meeting funding status and short-term funding requirements Defined Contribution Plans: Reducing risk in target-date retirement fund Meeting the time horizon of plan participants Allocation Weight 100% 80% 60% 40% 20% 0% Reduce Risk Equity Managed Volatility Equity Bonds/Other Cash Managed Volatility Hypothetical illustration. 11
Potential Benefits of Using a Managed Volatility Strategy in a Multi-Manager Portfolio Replacing the 1/4 of Russell 1000 allocation with simulated INTECH U.S. Managed Volatility reduced standard deviation from 13.77% to 12.95%. Returns improved from 10.12% to 10.97%. Sharpe Ratio also increased from 0.63 to 0.74. Standard Deviation (2003-2014) Sharpe Ratios (2003-2014) 14.0% 13.62% 13.77% 0.80 0.74 13.0% 12.95% 0.70 0.64 0.63 0.60 12.0% 1/3 Blend U.S. Large Cap Core 25th, Median, 75th Mgrs 1/4 Blend U.S. Large Cap Core 25th, Median, 75th and Russell 1000 Index 1/4 Blend U.S. Large Cap Core 25th, Median, 75th and INTECH USMV 0.50 1/3 Blend U.S. Large 1/4 Blend U.S. Large 1/4 Blend U.S. Large Cap Core 25th, Median, Cap Core 25th, Median, Cap Core 25th, Median, 75th Mgrs 75th and Russell 1000 75th and INTECH USMV Index Source: evestment. These portfolios are hypothetical and used for illustration purposes only. They do not represent the performance of any particular investment. Information presented gross of fees. Data presented reflects past performance, which is no guarantee of future results. See Simulations Disclaimer and Hypothetical Performance Disclosure at the end of this presentation for additional information. 12
Why Managed Volatility? Expected Risk Profile Going Forward 2013 10-Year Expected 10-Year Expected 10-Year Historical Change Asset Class Return Return Std. Dev. Std. Dev. in Volatility US Equity - Large Cap 7.4 7.0 17.5 15.0 2.5 US Equity - Small/Mid Cap 7.8 7.4 21.1 19.8 1.4 Non-US Equity - Dev. 7.7 7.4 19.8 18.2 1.6 Non-US Equity - EM 9.0 8.7 26.4 23.7 2.6 US Fixed Investment Grade 2.9 3.5 5.4 3.2 2.1 US Fixed High Yield 5.6 5.5 11.5 10.5 1.0 Non-US Fixed Income - Dev. 2.6 2.9 7.6 5.7 1.9 Non-US Fixed Income - EM 5.2 5.6 10.9 8.1 2.8 Treasuries 1.9 2.2 2.3 1.4 0.9 TIPS 2.5 3.2 6.3 6.3 0.0 Hedge Funds 6.0 5.8 9.0 5.1 3.9 Commodities 4.8 4.5 18.0 18.2-0.1 Real Estate* 6.6 6.4 Infrastructure* 6.8 7.7 Private Equity* 9.9 9.4 2014 Expected risk is higher than the historical average and equity returns are expected to be lower. *Historical standard deviations for illiquid asset classes are not shown. Source: Horizon Actuarial Services 2014 and 2013 Survey of Capital Markets Assumptions. For historical std. deviation, benchmarks used, in order: Russell 1000 Index, Russell 2000 Index, MSCI World ex U.S. Index, MSCI Emerging Markets Index, Barclays U.S. Aggregate, Barclays U.S. Corporate High Yield, Barclays Global Aggregate Unhedged, JPM EMI Global Diversified, Barclays U.S. 1-3 Year U.S. Treasuries, Barclays U.S. TIPS, HFN Global Index, Bloomberg Commodity. 13
APPENDIX 14
Volatility is Volatile Rolling 60-Month Annualized Return and Rolling 60-Month Annualized Standard Deviation January 1, 1987 March 31, 2015 35% 30% MSCI World Index Annualized Return 35% 30% 25% 20% 15% 10% 5% 0% -5% Russell 1000 Index 14.55%, 10.75% Annualized Return 25% 20% 15% 10% 5% 0% -5% 14.97%, 7.87% -10% 5.0% 10.0% 15.0% 20.0% 25.0% Annualized Annualized Standard Standard Deviation Deviation -10% 0% 5% 10% 15% 20% 25% Annualized Standard Deviation 50% 40% MSCI Emerging Markets Index Rolling 5-Year Annualized Risk and Return Annualized Risk and Return Over the Entire Period Market volatility varies over time and can deviate substantially from the long term average. Data reflects past performance, which does not guarantee future results. Annualized Return 30% 20% 10% 0% -10% 23.28%, 11.55% -20% 0% 5% 10% 15% 20% 25% 30% 35% Annualized Standard Deviation 15
Different Volatility Market Regimes Index Annualized Standard Deviation (12/1987 to 3/2015) Interquartile Range of the 5-Year Rolling Standard Deviation (50% of observations are outside of the range) Russell 1000 Index 14.55% 12.4% - 17.5% MSCI World Index 14.97% 12.7% -16.8% MSCI Emerging Markets Index 23.28% 19.9% - 27.5% 35.0% Rolling 60-Month Standard Deviation vs. Long-Term Standard Deviation From 12/31/1987 to 3/31/2015 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1/1988 1/1989 1/1990 1/1991 1/1992 1/1993 1/1994 1/1995 1/1996 1/1997 1/1998 1/1999 1/2000 1/2001 1/2002 1/2003 Annualized Standard Deviation 1/2004 1/2005 1/2006 1/2007 1/2008 1/2009 1/2010 1/2011 1/2012 1/2013 1/2014 1/2015 Russell 1000 Index - Rolling 5-Year Standard Deviation MSCI World Index - Rolling 5-Year Standard Deviation MSCI Emerging Markets Index - Rolling 5-Year Standard Deviation Data reflects past performance, which does not guarantee future results. Russell 1000 Index - LT Standard Deviation MSCI World Index - LT Standard Deviation MSCI Emerging Markets Index - LT Standard Deviation 16
Managed Volatility Applied to the U.S. Equity Market Simulated U.S. Managed Volatility vs. Russell 1000 Index January 1, 1979 December 31, 2014 35% 30% Outperformance Annualized Rolling Three-Year Performance 25% Simulated U.S. Managed Volatility (Absolute Performance, Gross of Fees) 20% 15% 10% 5% 0% -5% -10% -15% Underperformance -20% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% Russell 1000 Index (Absolute Performance) Simulated U.S. Managed Volatility outperformed 302 of 397 periods, or 76% of the time (gross of fees). Rolling periods calculated monthly. Performance for rolling periods other than three years are different and are available upon request. Outperformance is not indicative of positive absolute performance. See Simulations Disclaimer at the end of this presentation for additional information. 17
Reduced Volatility Increases Consistency Simulated U.S. Managed Volatility Russell 1000 Index January 1, 1979 December 31, 2014 100% Absolute Performance vs. Time Horizon 100% Best/Worst Absolute Performance 90% 80% % of Rolling Periods 80% 70% 60% 50% 40% 30% 20% Higher Probability of Positive Performance Lower Probability of Negative Performance Absolute Return 60% 40% 20% 0% -20% Similar Magnitude of Positive Returns Less Severe Negative Returns 10% -40% 0% 1 Mo 3 Mos 1 Yr 5 Yrs 10 Yrs 15 Yrs 20 Yrs 25 Yrs 30 Yrs -60% 1 Yr 5 Yrs 10 Yrs 15 Yrs 20 Yrs 25 Yrs 30 Yrs Simulated U.S. Managed Volatility Russell 1000 Index Lower volatility can result in a shorter expected time to achieve return objective. Rolling periods are calculated monthly. Results are annualized. See Simulations Disclaimer at the end of this presentation for additional information. 18
Hypothetical Performance Disclosures The slide on page 12 13 is being provided for illustrative purposes only. The results are hypothetical, not real, and have many inherent limitations. They do not reflect the results or risks associated with actual trading or the actual performance of any portfolio, and have been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. The hypothetical results are based on random manager selection as discussed on the slide. The managers and INTECH have not traded contemporaneously to formulate the results. In no circumstances should the hypothetical results be regarded as a representation, warranty, or prediction that investors will achieve or are likely to achieve the results displayed or that investors will be able to avoid losses. The hypothetical results reflect the reinvestment of dividends and other earnings, include trading fees, but do not reflect the deduction of advisory fees and other expenses, which will materially lower results over time. Performance of INTECH simulated data combined with the past live performance of managers in the evestment universes shown is no guarantee of future results. As with all investments, there are inherent risks. There are no warranties, expressed or implied, as to the accuracy or completeness of the information obtained from evestment or other third parties used to create the hypothetical results. Please also see Simulations Disclaimer at the end of this presentation for additional information on the inherent limitations of INTECH s simulated performance used herein. 19
Simulations Disclaimer All simulated performance results have been compiled solely by INTECH and have not been independently verified. Simulations potentially allow investors to understand and evaluate INTECH s investment process by seeing how a strategy/product would have performed hypothetically during certain time periods. This material is provided for illustrative purposes only and should not be construed as an offer to sell, or the solicitation of offers to buy, or a recommendation for any security. It has been prepared for, and authorized for internal use by, designated institutional and professional investors and their consultants or for such other use as may be authorized by INTECH or its affiliates. This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of INTECH. Although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness cannot be guaranteed. Simulated results are hypothetical, not real. They do not reflect the results or risks associated with actual trading or the actual performance of any account. Simulated performance results are prepared with the benefit of hindsight. As a result, the simulations may be theoretically changed from time to time to obtain results that are more favorable. Simulation results do not reflect material, economic, and market factors that may have impacted INTECH s trading or decision-making in the actual management of a client s account. Simulated returns should not be considered indicative of INTECH s mathematical process, as INTECH may not have managed money during some of the periods shown or may not have managed money for the particular strategy/product shown. INTECH s mathematical optimization process was applied to historical data to produce the simulations. Unlike traditional simulations that do involve fundamental estimates, INTECH s do not. In addition, the proprietary mathematical investment process used by INTECH may not achieve the desired results. INTECH s simulated performance results have inherent limitations, including, among other things: 1) simulated performance results are prepared with the benefit of hindsight; 2) no price-based or volume-based deleted list; 3) no posted list; 4) index constituent changes done as a group at the beginning of the month (typically done once or twice a year based on the index changes); 5) simulated trades take place at the closing price (+80 bps for countries in the MSCI Emerging Markets Index and +40 bps for developed countries), while INTECH actually trades intra-day (historically, INTECH's domestic trading costs have been below the 40 bps used in the simulations); and 6) six trading tranches are simulated with the average of the six tranches being reported as the result for the period. Past performance of simulated data is no guarantee of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to either the simulated performance results shown or any corresponding historical index. In particular, simulations do not reflect actual trading in an account, so there is no guarantee that an actual account would have achieved the results shown. In fact, there may be differences between simulated performance results and the actual results subsequently achieved. In no circumstances should simulated returns be regarded as a representation, warranty, or prediction that investors will achieve or are likely to achieve the performance results displayed, or that investors will be able to avoid losses. Investing involves risk, including fluctuation in value, the possible loss of principal and total loss of investment. There are numerous other factors related to the markets in general or to the implementation of any specific trading strategy, which cannot be fully accounted for in the preparation of simulated performance results, all of which can adversely affect actual trading results. Any clients invested in the strategy/product may have experienced investment results during any relevant periods that were materially different from those portrayed in the simulations. The simulated results include the reinvestment of all dividends, interest, and capital gains, but do not reflect deduction of investment advisory fees. Thus, simulated returns will be reduced by advisory fees and any other expenses that may be incurred in the management of an account, which will materially lower returns over time. Simulated benchmark returns are computed using daily stock returns and a constituent list that is updated monthly (quarterly, in the case of Russell indices for dates prior to 1987). This construction methodology implies the following potential differences between the simulated and actual indexes during the period between two consecutive sampling points: (1) the simulated index may include a security that has been dropped from the actual index sometime after the latest sampling point; (2) the simulated index may not include a security added to the actual index until the following sampling point; and (3) the market weights of the simulated index for a stock belonging to both the simulated and the actual index may differ slightly due to floating capitalization adjustments, or treatment of returns (due to different sources of returns, dividends, mergers, spinoffs, and other corporate actions). Actual benchmark returns may be higher or lower than simulated returns and are available upon request. An index is unmanaged, is not available for direct investment, and does not reflect the deduction of management fees or other expenses. 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Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in INTECH s presentation thereof. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein, if shown. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report has not been approved, reviewed, or produced by MSCI. Non-U.S. investments are subject to certain risks of overseas investing, including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets. Data Source: The Center for Research in Security Prices ("CRSP") Deciles are market value weighted benchmarks of common stock performance provided by the CRSP at the University of Chicago Booth School of Business. The CRSP universe includes common stocks listed on the NYSE, AMEX, and the NASDAQ National Market excluding the following: preferred stocks, unit investment trusts, closed-end funds, real estate investment trusts, Americus Trusts, foreign stocks and American Depositary Receipts. 20