The Risk in Asset Allocation

The Risk in Asset Allocation

SAMER HABL Managing Director Tactical Allocation Franklin Templeton Multi-Asset Strategies Franklin Advisers, Inc. June 5, 2013

Agenda Asset Allocation Post a 30 Year Bond BulI Market Inflation Protection in a QE World Portable Alpha Strategies for a Low Yield Environment 3

Asset Allocation Post a 30 Year Bond BulI Market Equities Have Underperformed Fixed Income from a Combined Return and Risk Point of View Over the Past 30 Years! Equities Were Significantly Riskier Too Global Fixed Income Has Outperformed Equities On a Risk Adjusted Basis CITI WGBI Index (USD), 40% 60/40 Balanced Portfolio 700 600 500 400 300 200 100 0 1987 1992 1997 2002 2007 2012 MSCI World Index CGBI WGBI Index CITI WGBI Index (USD), 10.7% MSCI World Index (USD), 60% MSCI World Index (USD), 89.3% Equities Contributed the Most to Risk Source: MSCI, Citigroup, Franklin Templeton Tactical Asset Allocation Group proprietary research for the period 12/31/87 through 4/30/13. Past performance does not guarantee future results. 4

Asset Allocation Post a 30 Year Bond BulI Market Changing the Strategic Mix Alone Might Not Be the Answer! Adding a Managed Volatility Approach to Tactical Asset Allocation Simulated MV TAA Portfolios Could Have Generated Higher Annualized Returns with Lower Average Volatility Hypothetical Simulation for the period from January 1990 through November 2012. Risk is the annualized standard deviation of daily portfolio returns. Data shown in this chart represent the mean outcome of the range of possible results from our simulation, and actual results may be higher or lower than the hypothetical results shown. Each data point represents an equity/fixed income asset mix within a portfolio. The data are presented gross of fees and expenses. Fees and expenses will lower a managed portfolio s returns. Please refer to disclosures for important additional information about the simulated results. Past or simulated performance does not guarantee future results. Source: MSCI, Citigroup, Franklin Templeton Tactical Asset Allocation Group proprietary research for the period 1/3/90 to 12/4/12. 5

Inflation Protection Strategies in a QE World The Equity and Interest Rate Risk Imbedded in Traditional Inflation-Hedging Assets Can Be Very Large! 7.00 6.00 5.00 4.00 S&P500 = -50.9% CPI+3% = +5.9% 6.00 5.00 Commodities have Traded with Equity s Volatility USD 3.00 4.00 2.00 1.00 0.00 1991 1992 1994 1996 1998 1999 2001 2003 2005 2006 2008 2010 2012 CPI+3% S&P500 USD 3.00 2.00 1.00 0.00 1991 1992 1994 1996 1998 1999 2001 2003 2005 2006 2008 2010 2012 CPI+3% DJ-UBS Commodity Index Source: DataStream, Bloomberg, Bureau of Labor Statistics for the period 2/28/91 through 3/31/13. Past Performance does not guarantee future results. 6

Inflation Protection Strategies in a QE World The Equity and Interest Rate Risk Imbedded in Traditional Inflation-Hedging Assets Can Be Very Large! 6.00 5.00 USD 4.00 3.00 2.00 1.00 0.00 For Over a Decade Gold Underperformed CPI 1991 1993 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 TIPS Total Return %1 5% 0% -5% -10% -15% -20% TIPS TR= -7.13% TIPS TR= -15.40% Gold CPI+3% -25% 0% 1% 2% 3% Change in Interest Rate Source: DataStream, Bloomberg, Bureau of Labor Statistics for the period 2/28/91 through 3/31/13. Barclays U.S. Treasury TIPS. Past performance does not guarantee future results. 7

Inflation Protection Strategies in a QE World We Believe Inflation is Best Hedged Using a Diversified Set of Real Assets, Tactical Allocations and Tactical Risk Hedging Derivatives seek to reduce downside risk by hedging interest rate and equity risk Cash/ Derivatives Inflation Protected Bonds Direct inflation hedge Inflation Sensitive Equity Commodities Long-term inflation hedge Long-term return potential (Natural Resource and Infrastructure ) Real Estate Short-term inflation hedge Chart is for illustrative and discussion purposes only. Long-term inflation hedge Long-term return potential 8

Portable Alpha Strategies for a Low Yield Environment Yield of Global Safe-Haven Bonds Has Been Low! Equal-weighted Average of Australia, Canada, Germany, Japan, UK, and USA 12% 10% 8% 6% 4% 2% 0% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012-2% 10Y Nominal Yield Exp. 10Y Inflation* 10Y Expected Real Yield Source: DataStream and Bloomberg for the period 1/1/90 through 5/1/13. * Market Implied Inflation since 2004. Past performance does not guarantee future results. 9

Portable Alpha Strategies for a Low Yield Environment An Alternative is to Reduce Duration and Enhance Returns with a Duration-Neutral Portable Alpha Strategy Portable Alpha Example 2.5% 2.0% 10Y Safe-Haven Bonds Expected Yield (%) 1.5% 1.0% 0.5% 0.0% Step 2: Add alpha potential and risk in a durationneutral portfolio Lower Duration Step 1 0 1 2 3 4 5 6 7 8 9 Duration (Years) Source: DataStream and Bloomberg. Chart is for illustrative and discussion purposes only. Chart is hypothetical and does not reflect the characteristics of an actual account. An actual account s characteristics may differ significantly from the illustration. 10

Portable Alpha Strategies for a Low Yield Environment A Portable Alpha Seeking Portfolio Could Be a Duration- Neutral Long and Short Using Futures on Interest Rates of the 6 Largest, Most Liquid Bond Markets Portable Alpha Portfolio Example 6% 4% Position as a % of NAV 2% 0% -2% -4% -6% -8% -10% Australia Canada Germany Japan United Kingdom Source: DataStream and Bloomberg. Chart is for illustrative and discussion purposes only. Chart is hypothetical and does not reflect the characteristics of an actual account. An actual account s characteristics may differ significantly from the illustration. USA 11

Important Information All investments involve risks, including possible loss of principal. The information provided during this conference is not a complete analysis of every material fact regarding any market, industry sector, security, or portfolio. Statements of fact cited by the presenters have been obtained from sources considered reliable but no representation is made as to their completeness or accuracy. Because market and economic conditions are subject to rapid change, opinions provided are valid only as of the date of the material and are subject to change without notice. The manager s opinions are intended solely to provide insight into how the manager analyzes securities and are not intended as a recommendation or individual investment advice for any particular security, strategy, or investment product. Indexes are for illustrative purposes only. One cannot invest directly in an index. For more information on Franklin Templeton products or services, please contact your local Franklin Templeton representative at 1.800.362.6243. This presentation is provided by Franklin Templeton Institutional for informational purposes only. This information is considered proprietary and shall be treated as confidential. It shall not be distributed or otherwise communicated to third parties. While every effort has been made to ensure the accuracy of the information contained within these materials, we do not guarantee such accuracy. Additional Information 2013 Morgan Stanley Capital Index (MSCI). All MSCI data is provided as is. The Fund described herein is not sponsored or endorsed by MSCI. In no event shall MSCI, its affiliates or any MSCI data provider have any liability of any kind in connection with the MSCI data or the Fund described herein. Copying or redistributing the MSCI data is strictly prohibited. An index is unmanaged and one cannot invest directly in an index. 2013 Franklin Templeton Investments. All rights reserved. 12

Important Information About Simulated Performance The simulated results are derived from the retroactive application of the model, are hypothetical and are used for illustrative purposes only. They do not represent the performance of any actual investment or portfolio. No representation is being made that the use of the model will result in a profit or that any account will achieve returns similar to those being shown, and actual performance may differ substantially from the performance shown. The model used in these hypothetical examples was created with the full benefit of hindsight and knowledge of factors that could have positively affected the results. Hypothetical results have certain inherent limitations as they do not represent actual trading, cannot account for all financial risk that may affect the performance of an actual portfolio, and may have under or over compensated for the impact, if any, of certain factors, such as lack of liquidity. Economic and market factors may impact the portfolio manager s decision making when using the model to manage actual client accounts. No market risk was taken in the hypothetical portfolios. The returns are not represented to be compliant with GIPS standards. All performance shown is gross of investment management fees and all other fees, transaction costs and expenses. An actively managed portfolio will be subject to investment management fees and other fees, costs and expenses that will reduce performance. The simulation period covers daily observations between January 1990 through November 2012, which is dictated by the availability of historical macro-economic forecasts data. The passive portfolio data assumes daily rebalancing without transaction costs and is represented by taking fixed percentages of both the MSCI World Index returns in USD net of dividend withholding tax and inclusive of reinvested dividends and the Citigroup World Government Bond Index (WGBI) returns in USD. For example, the 20/80 portfolio s daily returns for any given day are calculated by taking 20% of the MSCI World Index (USD) and 80% of the WGBI Bond Index return (USD). Once each of the daily returns of the passive portfolios is calculated, their respective daily returns are annualized along with the standard deviation of all the returns in the sample. The Sharpe Ratios shown in exhibit 4 are calculated by assuming a zero risk free rate and taking the annualized return divided by the annualized risk. 13

Important Information About Simulated Performance For the MV TAA portfolios illustrated, we applied our proprietary process on top of the same passive portfolios based on the same allocations between the stocks / bonds. The proprietary process also assumes daily rebalancing. The process relies on market data inputs that precede the rebalance dates at any point in the period which is intended to eliminate any look forward bias. In other words, on any given rebalance date in the historical simulation, the proprietary process is designed to not be reliant on future market data that it would not otherwise have had access to at that point in history. The instrument used in this paper for the proprietary hedging process is the MSCI USA Index, and returns for that index provided in this paper include dividend reinvestment and dividend withholding tax but not fees or transaction costs. The use of the index as a hedge instrument is purely illustrative. An actual portfolio could utilize any number of derivative instruments with exposure to a broad index of stocks, such as the S&P500 index future. For the purposes of this paper, the strategy is agnostic with respect to specific instruments (e.g., swaps, exchange traded futures, etc.) and thus uses the MSCI US Index as a generic hedging instrument solely for illustration purposes. The risk referred to in the results represents the annualized standard deviation of the daily returns over the full period of the simulation. The simulated performance data are reported gross of fees and transaction costs. Additional fees, such as the investment management fee, would reduce the returns. For example, if an annualized gross return of 7% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 40.3% to 33.8%. An actively managed portfolio will be subject to investment management fees and other fees and expenses that will reduce performance. 14