Harnessing the Full Potential of Alternative Strategies Edwin Conway, Managing Director Head of BlackRock U.S. and Canada Institutional Client Business & Global Head of BlackRock Alternatives Specialists
Topics 1. Market Context 2. The Next Frontier of Alternative Investing
Market context
Investors are increasingly challenged to meet their return needs Equity investors are vulnerable to the business cycle Index Max Draw-down Peak Trough Length Equity valuations are above their historical averages 24 Rolling average P/E ratios for public equities S&P 500-53% 20 MSCI World -55% MSCI EM -63% October 2007 February 2009 16 months 16 12 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Rolling Average MSCI MSCI World Mean Rolling Average S&P500 S&P500 Mean Global rates continue to be at historical lows 1 Fixed income supply is dwindling across the globe 2 Percent 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2006 2008 2010 2012 2014 US UK Germany Japan USD billions 4,000 3,000 2,000 1,000 - (1,000) 1980 1985 1990 1995 2000 2005 2010 2015 US Europe UK Japan Total 1. BlackRock Investment Institute, Barclays, Thomson Reuters (as of June 2014). The bars show market capitalization weights of assets with an average annual yield of over 4% in a select universe that represents about 70% of the Barclays Multiverse Bond Index. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future returns 2. Morgan Stanley Research, Dealogic, Haver, OECD, DMO, US Bureau of Public Debt, ECB, Fed, BoE, SIFMA, TREPP, January 2015 4
Diversification implies looking beyond traditional asset classes Over time equities and fixed income exhibit low to moderate correlation but those correlations are not stable and spike during periods of economic stress US Equities US Equities 1.00 Global Equities Global Equities 0.97 1.00 EM Equities EM Equities 0.77 0.86 1.00 Eur. Equities Global Corp Credit Global High Yield T-Bills LIBOR 1 r = 0.5 0.5 r = 0.7 Eur. Equities 0.83 0.86 0.71 1.00 0 Global Corp. Credit 0.22 0.30 0.34 0.17 1.00 Global High Yield 0.67 0.74 0.76 0.59 0.60 1.00 T-Bills -0.13-0.13-0.09-0.08-0.03-0.13 1.00-0.5 r = -0.6 LIBOR -0.16-0.15-0.08-0.09-0.01-0.15 0.95 1.00 High correlation (0.75 < r < 1.00) Moderate correlation (0.50 < r < 0.75) Low correlation (0.00 < r < 0.50) Negatively correlated (-0.25 < r < 0) -1 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Rolling 12-Month Correlation: Global Equities & Global Corporates r = correlation Sources: BlackRock (as of Jan 2015). Notes: Correlation calculated from monthly returns from January 2000 through December 2015. Indices referenced include S&P 500 (US equities), MSCI World Index (Global Equities), MSCI Emerging Markets Index (EM equities), Euro STOXX 50 (European equities), Barclays Global Aggregate Corporate Total Return Index Value Hedged USD (global corporate credit), Barclays Global High Yield Total Return Index Value Hedged USD (global high yield), BofA ML 3 Month Treasury Index (t bills) and US Cash Indices LIBOR Total Return 3 Month (LIBOR). 5
Alternative investments can help achieve various outcomes Desired Outcomes Asset Characteristic Absolute Return / Hedge Funds Private Equity Illiquid & Opportunistic Credit Real Estate (private equity & debt) Infrastructure (private equity & debt) Income Stable cash flows Growth High target returns Inflation Protection Inflation-linked cash flows Diversification Low correlation Reduce vol / tail risk Low volatility Source: BLK SPM, from Towers Watson survey, client interviews, BLK team materials, Deutsche Bank survey, CitiBank, Pyramis Survey. For illustrative purposes only. It serves as a general summary, is not exhaustive and should not be construed as investment advice. 6
Considerations for implementing an Alternative investments portfolio The challenges facing alternative investment managers are real, but the current landscape presents opportunities to deliver alpha to clients Increased demand for institutional quality products Greater regulation / capital requirements Harder to add uncorrelated alpha Higher and rising operating cost Alternatives are being used for portfolio construction and across a broader client base, including pensions and sovereign wealth funds New regulations challenged traditional capital suppliers (banks), stimulating investment from large pools of money (asset managers) Managers need investment knowledge, market insights, and trading relationships to source investments and add alpha Manager / client interests can be at odds as the client seeks to add alpha and the manager seeks asset scale to cover its operating costs Requirements for success given these challenges and opportunities 1 Proven record of performance in various market environments 2 3 Alignment, transparency, and implementation within risk parameters A solutions approach that can deliver the client's desired outcome 7
The next frontier of alternative investing
1. Real Assets
Investors are reportedly increasing allocations to real assets % of total survey respondents invested in real assets by sector 1 Planning to increase allocations in all sectors 2 Real Estate 96% Infrastructure 66% Commodities 29% Organizational structure changes to incorporate real assets into portfolios 3 Increase the number of employees dedicated to real assets 25% 34% 34% EMEA Americas Decrease the number of employees dedicated to real assets 6% 1% 7% APAC No Change 48% 51% 71% 1 Please indicate the approximate proportion of your company s total portfolio that is allocated to each of the following real asset types : Real Estate Debt; Private Real Estate Equity; Public Real Estate Securities; Infrastructure Debt; Infrastructure Equity; Commodities (energy/oil, metals, agricultural); Timber; Farmland. (Enter percentage allocation. Totals should not add up to 100%). Information derived from participant s self-reported investment characteristics (including current organization s investment and portfolio description) and responses to survey questions. 2 Q5a, Q12a, Q18a:How has your company s allocation to real asset investments changed (relative to its current allocation) over the past three years, and do you expect it to change over the next 18 months? Participants indicated their re-allocation plans by selecting: Substantial decrease (10%+) Moderate decrease, No significant change, Moderate increase, Substantial increase (10%+) 3 Q3b Which of the following best describes the most likely changes in your company s organizational structure for investing in real assets over the next 18 months? ( Participants answered by indicating Increase, decrease, no change, will have no employeesdedicated to real assets) 10
Key drivers for investing in real assets Key drivers for investing in real assets relate to current market conditions Macro environment considerations 55% 52% 63% Increase return 49% 63% 70% Replace or enhance current income 38% 37% 43% Address long-duration liabilities 24% 31% Diversify overall portfolio 24% 22% 22% Portfolio rebalancing 11% 23% 23% Inflation protection 17% 19% 29% Cyclical adjustment 22% Real Estate Infrastructure Commodities Q6/Q13/Q19: You indicated that your company expects to increase its [real estate / infrastructure / commodities] investment allocation. Please indicate the most important factors motivating this change (Participants answered by selecting up to three of the options listed above). Cyclical adjustment was only asked for Q19. 11
The benefits of investing in infrastructure Infrastructure can provide solutions that investors seek in their portfolios Structure of asset class creates consistent returns and enables long-term investors to tailor allocations to achieve desired outcomes Emerging opportunity for investors to get access to a less traditional asset class Uncorrelated risk/return targets optimize a client s portfolio What can infrastructure provide? Lower defaults and higher recovery rates 1,2,3,4 Income Stable income aligned with clients focus on long-term liabilities Growth Increased opportunities for institutional capital deployment as traditional lenders are constrained by the new regulatory environment Diversification Low correlation with traditional asset classes improving risk/return profile Default rate 4.8% 4.6% 4.4% 4.2% 4.0% 3.8% 3.6% 3.4% Broad Infrastructure (OECD) Baa Corporate Bonds Broad Infrastructure (OECD) Senior Secured Bonds 100% 80% 60% 40% 20% 0% Recovery rate 1. Private Infra Debt is private infrastructure debt transactions rated BBB or BBB- (Private Infra Debt spread data obtained via Bloomberg, Dealogic, InfraNews, and Market Participants); Public Corp Index is Barclays 1% Cap Corporate index customized for BBB/BBB- rating and average life of private infrastructure debt transactions; Public Corp (Infra) Index is Barclays 1% Cap Corporate index that includes corporate issuers in Utilities, Transportation and Energy sectors having maturities between 9 and 20 years and includes only BBB/BBB- issues. Data as of December 2014 2. Moody s Default and Recovery Rates for Project Finance Bank Loans 1983-2011 Addendum 3. Moody s Annual Default Study: Corporate Default and Recovery Rates, 1920-2011 ; Corporate default rates based on 1983 2011 and recovery rates based on 1987-2011 4. Based on Moody s definition of Broad Infrastructure, including social and transport assets as well as transmission and distribution financings. Data shown is not an indication of future projections. Past performance is not indicative of future returns. 12
Global real estate universe is large and growing $12.9 trillion invested in global real estate market 1 Equity Debt Real estate returns have historically been attractive 1 Global REITs Private $4.6 tn $5.8 tn US Core RE US RE Debt Direct private real estate investments (equity) Whole loan mortgages and high-yield/ mezz debt US CMBS* Global Equities Public $1.0 tn REITs and other publicly traded vehicles Americas EMEA APAC $1.5 tn Commercial mortgage backed securities and other similar vehicles Global Bonds 5-Yr Treasuries 10-Yr Inflation 20-Yr 0% 5% 10% 15% Total Return At $12.9 trillion, global real estate represents ~8% of global investment universe 1. DTZ Research; four quadrants represent capitalization of underlying invested real estate market; as of June 2014. "Invested" = investment-grade commercial real estate held by different investor groups; defined as total value of CRE debt outstanding plus total value of equity in CRE holdings. 2. DTZ Research, forecast by BlackRock. Forecast based on BCG s Global Wealth Survey 2014 (5.5% CAGR of global wealth) and real estate allocations going from 8.2% to 10%. Global wealth includes cash and deposits, money market funds, and listed securities held either directly or indirectly through managed investments or life and pension assets, and other onshore and offshore assets. It excludes investors own businesses, any real estate, and luxury goods. Global wealth reflects total financial assets across all households. Unless stated otherwise, wealth figures and percentage changes are based on local totals that were converted to U.S. dollars using year-end 2013 exchange rates for all years in order to exclude the effect of fluctuating exchange rates. 13
Global real estate portfolios benefit from powerful diversification effect Favorable risk-adjusted returns for global portfolio Stable income returns 7.0% +7.5% Global Ex US RE 25% 20% 6.9% +7.5% US RE 15% 10% Total return 6.8% 6.7% Traditional 60% EQ / 40% FI Total Return 5% 0% -5% Hypothetical Portfolio Equity 6.6% Fixed Income US Private EQ RE Global Private EQ RE Ex US 6.5% 8.5% 9.5% 10.5% 11.5% 12.5% 13.5% 14.5% 15.5% 16.5% 17.5% -10% -15% -20% -25% 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 Standard deviation Income return Appreciation Return Source: BlackRock, NCREIF, IPD, Barclays, MSCI, Standard & Poor s; based on historical total returns in US$, 1993-2013; IPD Global Ex US is capital value-weighted average of IPD country returns; as of December 31, 2013 Past performance is not indicative of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index 14
2. Systematic Investing
Factor-based investment strategies Factor-based strategies target broad, persistent drivers of return, taking advantage of economic insights, diversification, and efficient execution opportunities that may lead to improved investor outcomes Looks beyond traditional asset class labels to directly target true economic drivers of returns Common framework provides more accurate and intuitive risk management Greater diversification and a higher probability of achieving investment goals Factor-based investing is more than investing in factors: at its best, it is a powerful and empowering management philosophy Simple: Translates the complex to the intuitive Unifying: Provides a common language and culture, enabling consistent management of assets, liabilities and the enterprise Flexible: Allows for more flexibility in asset allocation and manager selection decisions There has been a radical increase in the amount of information available for investment decision making in recent decades. We believe active managers need to evolve investment processes to capture alpha in today s market Must advance infrastructure, people and technology 16
Factor investing looks through asset class labels Asset based views of portfolios obscure underlying drivers of risk In the sample portfolio below, the portfolio appears well diversified across many asset classes, with only 32% invested in global equities Examining risk along factor dimensions reveals that economic risk dominates, contributing 70% of portfolio risk Capital Allocation by Asset Class Factor Allocation 100% 15% 90% 80% Cash 22% 12% FX Credit 70% 60% 50% Long Treasuries EM Bonds 24% 11% 9% 6% Rates Total Risk: 7.7% 40% 30% 20% 10% High Yield EM Equity Intl Equity US Equity 11% 5% 10% 17% Equity: 32% 3% 0% -3% Diversification Economic Growth: ~70% 0% -6% For illustrative purposes only. Calculations performed using the BlackRock Solutions risk model and exposures as of April 30, 2015; Monthly Constant Weighted (MTC model) with 102 monthly observations; Macro Factor scheme. 17
Finding alpha is increasingly challenging in today s market environment 90% of the data in the world today has been created in the last 2 years IBM 2015 Image by The Centre for Learning and Teaching, Vocational Training Council (Hong Kong) 18
New ways to answer old questions: Management Quality Employee sentiment can be measured from anonymous social media postings Employee s view on culture, management, opportunities Positive employee sentiment leads to higher productivity Happy employees are more productive employees! The Virtuous Cycle of Positive Sentiment Business Customers Employees Source: BlackRock and Glassdoor.com, illustrative purposes only 19
3. Custom / Opportunistic Solutions
Case Study: Canadian Pension Plan Client Profile Large Canadian pension plan Alternatives strategy: Goal to capture returns through various liquid and illiquid investment strategies Key strengths: Talented investment professionals, deep relationships with market participants and robust understanding of capital markets and investment fundamentals Client Need Source and capitalize on direct opportunistic investments that can t be sourced independently Seek partner with point of access to many market participants Find diversifier to existing, primarily liquid strategies: investments that are complementary to existing mandates Direct Opportunistic Portfolio Pursuing a range of opportunistic strategies Sizable allocation committed over 36 month drawdown period Range of alternative investments targeting IRRs from 8% to 18% Broad and flexible scope of mandate Seeking a concentrated portfolio with position sizes in the 5% 10% range 2 to 5 year weighted average life No asset class or strategy exclusions aside from two specific exceptions Solution Knowledge Sharing Highly collaborative, interactive partnership BlackRock provides extensive information on existing and potential investment opportunities throughout life of fund Investment ideas supported by robust portfolio risk analytics Transparency Comprehensive reporting and portfolio analysis Robust new investment reports paired with client veto right to ensure alignment of interests For illustrative purposes only. There is no guarantee that every solution managed will achieve the same level of diversification as shown above. Each solution s allocation strategies and targets depend on a variety of factors, including prevailing market conditions and investment availability. There is no guarantee that they will be achieved and any particular investment may not meet the target criteria. 21
4. Hedge Fund Solutions
Hedge funds provide diversification benefits to traditional portfolios Hedge funds can exhibit strong risk-adjusted returns, with low beta to traditional asset classes Return Standard Deviation Sharpe Ratio Portfolio Improving risk-adjusted returns, Aug 1995 Jun 2015 100% Hedge Funds 8.33% 4.80% 1.18 100% 16.00% Traditional + HF: 20% Hedge Funds 45% Equity 35% Fixed Income Traditional: 60% Equity 40% Fixed Income 7.59% 7.88% 0.63 7.48% 9.68% 0.50 20% 35% 40% 45% 60% Annualized return (%) 14.00% 12.00% 10.00% 8.00% 6.00% 100% Equity 8.77% 15.20% 0.40 100% 4.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% Standard deviation (%) Hedge funds Fixed Income Equity Source: evestment: Equity: S&P 500 Index; Fixed Income: Barclays Global Aggregate; Hedge Funds: Q-BLK Appreciation Composite ( QAC (net) ). Data is for time period: Aug 1995 Jun 2015. Indices have no fees, are unmanaged, and are used for illustrative purposes only. Indices are not intended to be indicative of any fund s performance. It is not possible to invest directly in an index. Past performance is not an indication of future results. The definitions and disclosures appearing at the end of this document are an integral part of this presentation and should be read in their entirety for a complete understanding of the information contained herein. 23
Hedge funds are complementary to traditional portfolios Optimal hedge fund portfolios seek to emphasize idiosyncratic (e.g., security-specific) sources of return while minimizing broad market risks Sources of return Approach Beta Alpha Idiosyncratic (e.g. deal-specific) Approval of M&A deal, plan of reorganization, model risks Sector/style Equity volatility, liquidity, corporate basis, sovereign risks, industries, market capitalization Market Equity market movement, interest rates, foreign currency, commodity prices Traditional Portfolios Hedge Fund Portfolios Emphasize idiosyncratic returns Affects specific positions, can have significant impact on a portfolio Diversify sector/style risks Affects specific strategies in various magnitudes Mitigate market risks Broad overarching market risks, which a hedge fund seeks to mitigate 24
Case study: custom emerging manager fund Investor Background: Observations & Analysis: Custom Solution: A large Canadian public pension fund Existing hedge fund investments were all direct investments BlackRock was engaged to discuss its experience investing in early stage hedge funds Prospect was interviewing hedge fund manager seeding platforms to supplement their growing direct platform Sought a partner with expertise investing in emerging hedge fund managers and strategies Preferred a highly interactive partnership that included information exchange, education and active dialogue BlackRock sought to design a solution tailored to the client s specific investment goals while leveraging its long emerging manager investment experience The custom fund invests in less than 10 Emerging Managers (i.e., funds with less than six months of performance history or less than $1 billion in capital) A drawdown structure to opportunistically add managers over a set period BlackRock offered a comprehensive reporting package aggregating risks at the underlying manager level and fund of hedge funds level Ongoing education and information sharing is a significant aspect of the relationship This example is shown for illustrative purposes only and there is no guarantee that every solution managed by BlackRock will achieve the same level of diversification as shown above. Each solution s allocation strategies and targets depend upon a variety of factors, including prevailing market conditions and investment availability. There is no guarantee that they will be achieved and any particular investment may not meet the target criteria. 25
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