Northern Trust PODCAST PRESENTATION STRATEGIC ASSET ALLOCATION BILL WHITT: Thank you for joining us. I am Bill Whitt, Director of Research at Northern Trust. I will be your host for the podcast, Strategic Asset Allocation, presented by John Skjervem, Chief Investment Officer for Personal Financial Services at Northern Trust. Prior to his current role, John served as a Portfolio Manager in our Santa Barbara, California office. He earned his MBA from the University of Chicago and also holds a CFA designation with membership in both the Chicago and Los Angeles CFA societies. This podcast will be an informative discussion that will interest anyone who would like to learn more about the rapid growth in global financial markets and investment opportunities emerging from that growth; specifically, strategic asset allocation. John brings a unique perspective to the topic as he is responsible for investment policy development, with a particular focus on portfolio construction and implementation. Please understand that the strategies discussed during this podcast are not intended to be legal or investment advice. As always, you should contact your attorney and other financial advisors to review the strategies in light of your specific situation. Thank you for joining us, John. There have been a lot of changes in the way people invest over the last 10 years, what do you see as the most important change? JOHN SKJERVEM: Without a doubt, Bill, the most important change over the past decade has been the dramatic expansion of the global investment opportunity set. We enjoy increases in international trade and global economic integration. We have ongoing improvements in accounting and regulatory transparency. And we also benefit from constant financial market innovation. All of these developments combine to provide investors with access to new markets, new asset classes and new investment vehicles. 1
How has this affected Northern Trust s approach to investment management? These trends have certainly encouraged and even accelerated our efforts to build a broad array of investment management capabilities. They ve also helped reinforce our commitment to be a truly global financial services provider. Today, we offer personal and institutional clients both proprietary and externally managed investment capabilities across active, passive and quantitative investment disciplines. Just as important, these capabilities are delivered with personal and often highly customized client service through our offices in the United States and more than a dozen international locations. John, how has Northern Trust s approach to asset allocation changed? Asset allocation has, and will continue to represent, in our opinion, the foundation of prudent and effective risk management, but the financial market innovation I mentioned previously has made several asset classes accessible to investors that heretofore had been either illiquid or prohibitively expensive or often both. Examples include private equity, emerging market equity and even global real estate. At Northern Trust, we ve expanded our approach to incorporate these additional asset classes into our clients investment portfolios, but we ve also empowered our portfolio managers with new desktop tools to enable them to model for clients the effects and trade-offs inherent in various asset allocation strategies. What is the difference between strategic and tactical asset allocation? The primary difference is simply the time horizon that an investor is using. In our vernacular, a tactical asset allocation strategy is one predicated upon a 6-18 month time horizon. In other words, it is a relatively short-term approach; whereas, strategic asset allocation is predicated, in our framework, on a 3-5 year time horizon. So, simply put, tactical is a short-term outlook, strategic is a longer-term outlook. John, tell our listeners what diversification means and why it is important. Well, qualitatively, diversification is the simple notion that it is indeed wise to hold your investment eggs in more than one basket. Quantitatively, diversification is built on the premise that for any given level or any given level of desired return, an investment portfolio will exhibit lower volatility or have lower risk if it is comprised of multiple assets that are less than perfectly correlated with one another. The idea here is, for any given level of return, that trajectory, the appreciation profile over time will be positive, but in any one period a quarter, a month, even a year certain components of the portfolio will be up while others will be down. So the notion is, you put together this collection of investment assets in a way that over longer periods of time you enjoy capital appreciation, but in quarter-to-quarter, year-to-year time periods, the zigs in one asset class are partially offset by the zags in another asset class, and so you moderate the volatility or the risk for any long-term return trajectory. 2
How does Northern Trust manage risks? The short answer is that we manage risks very rigorously. The longer answer is that we insist on effective and robust diversification at each level of a client s investment solution. At the asset allocation level stocks, bonds, cash, hedge funds, private equity we make sure that we have broad representation across all of those asset classes. Within any one asset class let s say stocks we insist that we have multiple mandates; so we ll have some growth stocks, we ll have some value stocks, we ll have some large cap stocks and some small cap stocks. And then within any one mandate let s say small cap stocks we ll insist that there are multiple securities; so within a small cap equity mandate, we would prefer to have greater than 50 individual stocks, and then down at the mandate level, we would insist on having, not only multiple managers and let s use large cap stocks as an example so we would want to have multiple managers within the large cap equity mandate, but then within those portfolios themselves we would want to have at least 50 individual securities. Again, the notion here is to emphasize diversification at each level of the client s investment solution. Alternative investments have gotten a lot of press lately. John, what are the key alternative asset classes, and what role can they play in an investment portfolio? Well, Bill, we apply a fairly broad definition of alternative asset classes. So within our approach, alternative asset classes include: hedge funds, private equity commodities and real estate, and in terms of their primary role, the primary role again is diversification. Each of these asset classes each of these alternative asset classes have unique risk-return attributes so that when they are included in a client s investment portfolio, they provide long-term return opportunities, but just as importantly, provide quarter-to-quarter, year-to-year diversification benefits. Another popular investment strategy is the use of a number of investment managers within one portfolio, often referred to as open architecture. When should an investor consider this strategy? Well, I think the answer to that is whenever possible. Open architecture is yet another avenue of diversification, and it is particularly important in an environment where the opportunity set continues to broaden. And in that broadening opportunity set, it s really not realistic for any one manager to hold him or herself out as an expert across that entire array, so that increasingly, investment managers need to specialize in the one or two asset classes where they have demonstrable expertise and skill. The remaining asset classes and parts of this solution should be delegated to other experts. So open architecture is really a terrific opportunity to not only get access to multiple asset classes, but also focus in on managers within each of those asset classes who have a specialty. Does Northern Trust use external managers, and if so, what role do they play? We do, in fact, we use external managers fairly extensively. Although, the role depends very much on each client s unique set of circumstances so for one client, we may employ an external manager for just one slice of the investment pie, whereas for other clients we may use external managers for multiple parts of the investment solution. The point is to align the client needs, with respect to asset allocation or maybe even specific investment mandates with the relative levels of expertise, both internally provided by Northern Trust or in some areas the expertise provided by an external asset manager. 3
Are there other strategies and asset classes investors should consider? Sure, there are lots of potential asset classes that we could incorporate into an investment portfolio. We could, on any given day, look at baseball cards, for instance, or art and antiques these and others are viable in that they have a unique set of risk-return attributes that would enhance at least the theoretical diversification profile of a client s investment portfolio, but they may also come with explicit costs that would make them punitive in a real-time, real-world implementation. So back to the example of art, antiques or baseball cards, these asset classes aren t particularly fungible; they certainly would require special custody and have additional costs like insurance. So it is not enough just to identify an asset class as viable from a pure risk-return perspective. You also need to consider the attendant costs that would be incurred for it to be incorporated into a client s investment program. John, how often should investors review their asset allocation and investment goals? I would say no less than annually, but no more frequent than quarterly. And this is a good question because often investors, particularly those that spend a lot of time in front of their computers, want to monitor the results of their portfolios on a much more frequent basis monthly, weekly, sometimes even daily. The reality though is a lot of that volatility, especially that which manifests monthly, daily, weekly is really just white noise, and so we would suggest that no more frequently than quarterly can you start to identify trends in both performance or risk management. And yet, at the same time, you don t want to examine your portfolio s results any less frequently than annually. In other words, we think it s a good idea to at least have an annual check-up and reconfirm a portfolio s asset allocation profile with the investor s investment objectives and financial aspirations. John, do you have any final thoughts? Well, I think my best advice for both investors and their advisors is to remain vigilant in maintaining a broad diversification profile and prudent in their asset allocation strategies. You know, today s constant and instantaneous dissemination of information, when combined with this expanding global opportunity set, makes us all vulnerable to the seduction of the hot stock or the hot manager or the hot asset class du jour. And yet financial market history is littered with speculative bubbles that end badly, and other than the gift of clairvoyance, disciplined diversification and prudent asset allocation remain the most important elements of a successful, long-term investment program. Thank you, John. I think you ve helped our listeners better understand the changing investment options and their importance in strategic asset allocation. If you would like more information, we invite you to contact a Northern Trust Relationship Manager or visit northerntrust.com. For professional advisors, we have additional information available on our dedicated advisors website, northerntrust.com/wealthadvisor. 4
INVESTMENT NOTICE: Past performance is not necessarily a guide to the future. There are risks involved with investing, including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and asset allocation models do not promise any level of performance or guarantee against loss of principal. This material is directed to market counterparties and intermediate investors only. It should not be relied upon by private investors. This information is provided for informational purposes only and does not constitute investment advice or a recommendation for investment strategy or any product described herein. Opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable but its accuracy and interpretation are not guaranteed. northerntrust.com northern trust corporation northern trust banks are members fdic equal housing lenders Q17836 (03/07)