Post on 10-Jul-2020
CALLAN INSTITUTE Why Diversify?
Mark Andersen Trust Advisory Group
Brian Smith, CFA Fund Sponsor Consulting
Jay Kloepfer Capital Markets Research
2017 Regional Workshops June 27 – Atlanta, GA June 29 – San Francisco, CA
1 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Why Diversify?
●Did investors err in adopting diversified portfolios over the past 30 years?
●How long does your time horizon need to be to reap the benefits?
●What exactly should we be diversifying? Has the theory of diversification changed?
● View from the field: which is the “most diversified” portfolio?
●What should investors do going forward? Do we still believe in diversification?
2 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Average Annual Returns for periods ended 12.31.2016
2012 2013 2014 2015 2016 5 Years 10 Years 15 Years 20 Years Broad U.S. Stock Market Russell 3000 16.42 33.55 12.56 0.48 12.74 14.67 7.07 7.11 7.86 Large Cap U.S. Stocks S&P 500 16.00 32.39 13.69 1.38 11.96 14.66 6.95 6.69 7.68 Small Cap U.S. Stocks Russell 2000 16.35 38.82 4.89 -4.41 21.31 14.46 7.07 8.49 8.25 Non-U.S. Stock Markets MSCI EAFE US$ 17.32 22.78 -4.90 -0.81 1.00 6.53 0.75 5.28 4.17 MSCI Emerging Markets 18.63 -2.27 -1.82 -14.60 11.60 1.64 2.17 9.85 5.73 Fixed Income Bloomberg Barclays Aggregate 4.21 -2.02 5.97 0.55 2.65 2.23 4.34 4.58 5.29 Bloomberg Barclays Glbl Agg ex USD 4.09 -3.08 -3.09 -6.02 1.49 -1.39 2.44 4.96 3.48 Bloomberg Barclays Long Gov/Credit 8.78 -8.83 19.31 -3.30 6.67 4.07 6.85 7.03 7.28 Real Estate NCREIF 10.54 10.98 11.82 13.33 8.01 10.92 6.94 9.01 9.79 Hedge Funds CS Hedge Fund Index 7.67 9.73 4.13 -0.71 1.25 4.34 3.75 5.74 7.06 Private Equity Cambridge Private Equity 13.54 21.09 11.84 8.68 9.20 12.78 9.40 11.62 13.91 Commodities Bloomberg Commodity -1.14 -9.58 -17.04 -24.70 11.40 -9.06 -6.23 -0.11 -1.65 Cash Market 90-Day T-Bill 0.11 0.07 0.03 0.05 0.33 0.12 0.80 1.34 2.29 Inflation CPI-U 1.74 1.50 0.76 0.73 2.07 1.36 1.81 2.10 2.12
Why Are We Even Talking About This?
●U.S. equity dominated the last five years
●Most diversification hurt
●Non-U.S. equity was the costliest diversifier
●Hedge funds disappointed
●Best diversifiers had the least attractive returns
Historical Capital Market Performance Ended December 31, 2016
3 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Why Aren’t Smart Investors Keeping Up with the S&P 500?
● Simple portfolios – 60% U.S. Equity/40% U.S. Fixed – 70% U.S. Equity/30% U.S. Fixed – 70% Global Equity/30% U.S. Fixed
●Broadly diversified mix – 27% Broad U.S. Equity – 21% Broad Non-U.S. Equity – 20% Broad U.S. Fixed Income – 5% High Yield – 9% Real Estate – 8% Hedge Funds – 7% Private Equity – 3% Commodities
Endowments/Foundations Accused of Seriously Lagging “Simple” Portfolios
Quarter 1 Year 2 Years 3 Years 5 Years-5.0
0.0
5.0
10.0
15.0
Group: Callan Endowment / Foundation DatabaseReturns for Periods ended December 31, 2016
Median 0.72 7.00 2.71 3.48 7.74
60% U.S. Equity/40% U.S. Fixed A 1.10 8.31 4.74 6.66 9.6970% U.S. Equity/30% U.S. Fixed B 1.78 9.23 5.21 7.23 10.93
70% Global Equity/30% U.S. Fixed C 0.15 6.96 2.67 3.35 7.65Broadly Diversified D 0.79 7.50 3.74 4.40 7.94
B (14)
B (8)
B (3)B (2)
B (2)
A (32)
A (19)
A (7)A (3)
A (8)
C (73)
C (51)
C (51) C (51)
C (53)
D (47)
D (37)
D (22) D (25)
D (44)
4 June 2017 Regional Workshop C ALLAN IN ST ITUTE
High Cost to Diversification for U.S. Investors
●Many institutional investors diversified away from the liquid, public equity markets, and particularly U.S. equity – The endowment model – The new public funds model—looks a lot like endowments – The new corporate funds model—focus on risk mitigation
●U.S. stocks averaged 14.7% return annually over the last five years – Diversifying assets failed to keep pace – Diversified portfolios lagged U.S. stock-centric peers – The diversifiers are in the hot seat
●When does short-term performance matter? When the performance is extreme
●Boardroom risk emerges: the premise of diversification brought into question
●Challenge to all investors: how to survive the short term to reap the benefits of a long-term strategy?
5 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Cracks in the Periodic Table Is the Periodic Table Losing Its Power?
Large Cap
33.36%
Large Cap
28.58%
Large Cap
21.04%
Large Cap
-9.11%
Large Cap
-11.89%
Large Cap
-22.10%
Large Cap
28.68%
Large Cap
10.88%
Large Cap
4.91%
Large Cap
15.79%
Large Cap
5.49%
Large Cap
-37.00%Large Cap
26.47%
Large Cap
15.06%
Large Cap
2.11%
Large Cap
16.00%
Large Cap
32.39%
Large Cap
13.69%
Large Cap
1.38%
Large Cap
11.96%
GrowthLarge Cap
36.52%Growth
Large Cap
42.16%
GrowthLarge Cap
28.24%
GrowthLarge Cap
-22.08%
GrowthLarge Cap
-12.73%Growth
Large Cap
-23.59%Growth
Large Cap
25.66%Growth
Large Cap
6.13%
GrowthLarge Cap
4.00%
GrowthLarge Cap
11.01%
GrowthLarge Cap
9.13%
GrowthLarge Cap
-34.92%Growth
Large Cap
31.57%
GrowthLarge Cap
15.05%
GrowthLarge Cap
4.65%
GrowthLarge Cap
14.61%
GrowthLarge Cap
32.75%
GrowthLarge Cap
14.89%Growth
Large Cap
5.52%
GrowthLarge Cap
6.89%
ValueLarge Cap
29.98%Value
Large Cap
14.69%
ValueLarge Cap
12.73%
ValueLarge Cap
6.08%
ValueLarge Cap
-11.71%Value
Large Cap
-20.85%
ValueLarge Cap
31.79%
ValueLarge Cap
15.71%
ValueLarge Cap
5.82%
ValueLarge Cap
20.81%
ValueLarge Cap
1.99%
ValueLarge Cap
-39.22%Value
Large Cap
21.17%
ValueLarge Cap
15.10%
ValueLarge Cap
-0.48%
ValueLarge Cap
17.68%
ValueLarge Cap
31.99%
ValueLarge Cap
12.36%
ValueLarge Cap
-3.13%
ValueLarge Cap
17.40%
Small Cap
22.36%
Small Cap
-2.55%
Small Cap
21.26%
Small Cap
-3.02%
Small Cap
2.49%
Small Cap
-20.48%
Small Cap
47.25%Small Cap
18.33%
Small Cap
4.55%
Small Cap
18.37%
Small Cap
-1.57%
Small Cap
-33.79%
Small Cap
27.17%
Small Cap
26.85%
Small Cap
-4.18%
Small Cap
16.35%
Small Cap
38.82%
Small Cap
4.89%Small Cap
-4.41%
Small Cap
21.31%
GrowthSmall Cap
12.95%
GrowthSmall Cap
1.23%
GrowthSmall Cap
43.09%
GrowthSmall Cap
-22.43%
GrowthSmall Cap
-9.23%
GrowthSmall Cap
-30.26%
GrowthSmall Cap
48.54%
GrowthSmall Cap
14.31%
GrowthSmall Cap
4.15%Growth
Small Cap
13.35%
GrowthSmall Cap
7.05%
GrowthSmall Cap
-38.54%
GrowthSmall Cap
34.47%
GrowthSmall Cap
29.09%
GrowthSmall Cap
-2.91%
GrowthSmall Cap
14.59%
GrowthSmall Cap
43.30%
GrowthSmall Cap
5.60%Growth
Small Cap
-1.38%
GrowthSmall Cap
11.32%
ValueSmall Cap
31.78%
ValueSmall Cap
-6.45%
ValueSmall Cap
-1.49%
ValueSmall Cap
22.83%Value
Small Cap
14.02%
ValueSmall Cap
-11.43%Value
Small Cap
46.03%
ValueSmall Cap
22.25%
ValueSmall Cap
4.71%
ValueSmall Cap
23.48%
ValueSmall Cap
-9.78%
ValueSmall Cap
-28.92%
ValueSmall Cap
20.58%
ValueSmall Cap
24.50%
ValueSmall Cap
-5.50%
ValueSmall Cap
18.05%
ValueSmall Cap
34.52%
ValueSmall Cap
4.22%
ValueSmall Cap
-7.47%
ValueSmall Cap
31.74%
EquityNon-U.S
1.78%
EquityNon-U.S
20.00%
EquityNon-U.S
26.96%
EquityNon-U.S
-14.17%
EquityNon-U.S
-21.44%
EquityNon-U.S
-15.94%Equity
Non-U.S
38.59%
EquityNon-U.S
20.25%
EquityNon-U.S
13.54%Equity
Non-U.S
26.34%Equity
Non-U.S
11.17%
EquityNon-U.S
-43.38%
EquityNon-U.S
31.78%
EquityNon-U.S
7.75%Equity
Non-U.S
-12.14%
EquityNon-U.S
17.32%
EquityNon-U.S
22.78%
EquityNon-U.S
-4.90%
EquityNon-U.S
-0.81%
EquityNon-U.S
1.00%
IncomeU.S. Fixed
9.64%
IncomeU.S. Fixed
8.70%
IncomeU.S. Fixed
-0.82%
IncomeU.S. Fixed
11.63%Income
U.S. Fixed
8.43%
IncomeU.S. Fixed
10.26%
IncomeU.S. Fixed
4.10%Income
U.S. Fixed
4.34%Income
U.S. Fixed
2.43%Income
U.S. Fixed
4.33%
IncomeU.S. Fixed
6.97%
IncomeU.S. Fixed
5.24%
IncomeU.S. Fixed
5.93%Income
U.S. Fixed
6.54%
IncomeU.S. Fixed
7.84%
IncomeU.S. Fixed
4.21%
IncomeU.S. Fixed
-2.02%
IncomeU.S. Fixed
5.97%
IncomeU.S. Fixed
0.55%
IncomeU.S. Fixed
2.65%
MarketsEmerging
-11.59%Markets
Emerging
-25.34%
MarketsEmerging
66.42%
MarketsEmerging
-30.61%
MarketsEmerging
-2.37%
MarketsEmerging
-6.00%
MarketsEmerging
56.28%Markets
Emerging
25.95%Markets
Emerging
34.54%Markets
Emerging
32.59%Markets
Emerging
39.78%
MarketsEmerging
-53.18%
MarketsEmerging
79.02%
MarketsEmerging
19.20%
MarketsEmerging
-18.17%
MarketsEmerging
18.63%
MarketsEmerging
-2.27%
MarketsEmerging
-1.82%
MarketsEmerging
-14.60%
MarketsEmerging
11.60%High Yield
12.76%
High Yield
1.87%
High Yield
2.39%
High Yield
-5.86%
High Yield
5.28%
High Yield
-1.41%
High Yield
28.97%
High Yield
11.13%
High Yield
2.74%
High Yield
11.85%
High Yield
1.87%
High Yield
-26.16%
High Yield
58.21%
High Yield
15.12%
High Yield
4.98%
High Yield
15.81%High Yield
7.44%
High Yield
2.45%
High Yield
-4.47%
High Yield
17.13%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Indices: ●Bloomberg Barclays Aggregate ●Bloomberg Barclays High Yield ●MSCI EAFE ●MSCI Emerging Markets ●S&P 500 ●S&P 500 Growth ●S&P 500 Value ●Russell 2000 ●Russell 2000 Growth ●Russell 2000 Value
6 June 2017 Regional Workshop C ALLAN IN ST ITUTE
How Durable Is Diversification? Correlation Is Not Necessarily Consistent
7576 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 1617-1.00
-0.75
-0.50
-0.25
0.00
0.25
0.50
0.75
1.00
Rolling 12 Quarter Correlation relative to S&P 500 for 42 Years ended March 31, 2017
Cor
rela
tion
-0.10 - Bloomberg Barclays Aggregate
0.71 - MSCI EAFE
0.07 - Bloomberg Barclays Aggregate Average
0.68 - MSCI EAFE Average
7 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Does Diversification Work?
● Fundamental tenet of Capital Market Theory: diversification is the essence of risk control
●Define diversification – Within broad asset classes – Between asset classes – Which is more potent?
●Define how we measure diversification = correlation
●Are asset classes the appropriate focus? – Correlation between asset classes or
correlation to factors?
● Is correlation alone sufficient to articulate diversification?
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0
Pro
ject
ed R
etur
n
Projected Standard Dev iation
Efficient Frontier
Benefit of Diversification
8 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Does Diversification Work?
●Goal: smooth ride, especially over the shorter term—NOT to outperform stocks
●Over last 10, 15, 20, and 25 years, a broadly diversified asset mix has largely delivered returns per unit of risk superior to that of the stock market, and the “simple” portfolio
●Recent 5-year period not unprecedented, but not the norm
Successful Across Broad Asset Classes
5 Years 10 Years 15 Years 20 Years 25 Years0.0
0.5
1.0
1.5
2.0
Sharpe Ratio for Various Periods ended December 31, 2016
Sha
rpe
Rat
io
S&P 500 60% U.S. Equity/ 40% U.S. Fixed
70% U.S. Equity/30% U.S. Fixed 70% Global Equity/30% U.S. Fixed
Broadly Diversified
9 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Future of Diversification
New lens applied to definition of investor portfolios:
●Broader asset classes – Growth – Risk mitigating – Real assets – Opportunistic/diversifiers
●Greater diversification within each broad category – Include liquid and illiquid, public and private – Variety of securities, hybrid “asset classes” – Drives a focus on factors
●Current focus on diversifying growth – Historically large allocations to risky strategies – Seek to control risk without actually taking down the allocation to return-seeking strategies – Equity factors in non-equity securities
Greater Diversification Within Broader Asset Class Definitions
10 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Median Plan Median Plan
Median Plan
Median Plan
Median Plan
Median Plan
Median Plan Median Plan Median Plan
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
12/31/92Ending3 Yrs.
12/31/95Ending3 Yrs.
12/31/98Ending3 Yrs.
12/31/01Ending3 Yrs.
12/31/04Ending3 Yrs.
12/31/07Ending3 Yrs.
12/31/10Ending3 Yrs.
12/31/13Ending3 Yrs.
12/31/16Ending3 Yrs.
The Path Matters
●Without knowing which asset classes will perform best, diversification keeps plan sponsors out of the cellar
●Over the last 27 years, global diversification has swept in and out of favor
● The “aughts” were a pretty good time to think globally, while the ‘90s and the ‘teens have been challenging
●But what was best?
●And worst? Non-U.S. Eq Commodity EM Equity Non-U.S. Eq U.S. Lg Cap High Yield Commodity Gold Commodity
EM Equity Non-U.S. Eq U.S. Lg Cap Commodity REITs EM Equity Gold U.S. Lg Cap REITs
11 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Median Plan Median Plan
Median Plan
Median Plan
Median Plan
Median Plan
Median Plan Median Plan Median Plan
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
12/31/92Ending3 Yrs.
12/31/95Ending3 Yrs.
12/31/98Ending3 Yrs.
12/31/01Ending3 Yrs.
12/31/04Ending3 Yrs.
12/31/07Ending3 Yrs.
12/31/10Ending3 Yrs.
12/31/13Ending3 Yrs.
12/31/16Ending3 Yrs.
Median Plan Median Plan
Median Plan
Median Plan
Median Plan
Median Plan
Median Plan Median Plan Median Plan
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
25th Plan 25th Plan
25th Plan
25th Plan
25th Plan
25th Plan
25th Plan 25th Plan
25th Plan
12/31/92Ending3 Yrs.
12/31/95Ending3 Yrs.
12/31/98Ending3 Yrs.
12/31/01Ending3 Yrs.
12/31/04Ending3 Yrs.
12/31/07Ending3 Yrs.
12/31/10Ending3 Yrs.
12/31/13Ending3 Yrs.
12/31/16Ending3 Yrs.
What if I Am Really Successful?
● Even outperforming 75% of other institutional plans does not propel results to the top of the periodic table
●While underperforming 75% of peers does not drive results to the bottom
Median Plan Median Plan
Median Plan
Median Plan
Median Plan
Median Plan
Median Plan Median Plan Median Plan
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
US 60/40
25th Plan 25th Plan
25th Plan
25th Plan
25th Plan
25th Plan
25th Plan 25th Plan
25th Plan
75th Plan
75th Plan
75th Plan
75th Plan
75th Plan
75th Plan
75th Plan 75th Plan
75th Plan
12/31/92Ending3 Yrs.
12/31/95Ending3 Yrs.
12/31/98Ending3 Yrs.
12/31/01Ending3 Yrs.
12/31/04Ending3 Yrs.
12/31/07Ending3 Yrs.
12/31/10Ending3 Yrs.
12/31/13Ending3 Yrs.
12/31/16Ending3 Yrs.
12 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Contribution to Portfolio Risk
●Concentration in equity risk is obvious, but the benefits of fixed income (duration factor) are obscured
● Equity risk dominates with fixed income contributing very little to overall portfolio risk
Global 60/40 – Contribution to Risk
Large Cap
Small Cap
Non-U.S. Equity
Emerging Market Equity
U.S. Fixed
High Yield
Non-U.S. Fixed
Emerging Market Debt
13 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Contribution to Portfolio Risk (continued)
●How should we think about “allocating” the diversification benefit?
● Low correlated / high volatility assets have the biggest impact
● In this case, U.S. fixed drives most of the benefit, but it simply is not volatile enough to generate much contribution to risk
5.05%
3.55%
1.65%
1.58%
1.05% 0.62% 0.37% 0.19% -2.33%
11.72%
0%
17%
LargeCap
(29%)
Non-U.S.Equity(18%)
Em MktEquity(6%)
SmidCap(7%)
U.S.Fixed(28%)
HighYield(6%)
Non-U.S.Fixed(4%)
Em MktDebt(2%)
Diversi-fication
NetVolatility
Asset Class Contribution to Risk Diversified 60/40
14 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Contribution to Portfolio Risk (continued)
●Now add 15% to commodities; low correlation with high volatility
●Diversification benefits expand significantly
● Standalone risk goes up by 1.5% yet net volatility drops
● Problem is, commodities have a terrible Sharpe ratio
4.18%
3.75%
2.96%
1.37%
1.36% 0.92%
0.54% 0.32% 0.17% -4.45%
11.11%
0%
17%
LargeCap
(24%)
Commodities(15%)
Non-U.S.Equity(15%)
Em MktEquity(5%)
SmidCap(6%)
U.S.Fixed(25%)
HighYield(5%)
Non-U.S.Fixed(4%)
Em MktDebt(2%)
Diversi-fication
NetVolatility
Asset Class Contribution to Risk Traditional + Commodities
15 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Diversification Within a Factor?
●Here we narrow the lens to just the equity book
●While owning various types of equity generates some diversification, it is all equity and that primary factor dominates
●Don’t forget: the above numbers are based on expectations
●Reality can differ from models and diverge meaningfully from expectations
● Post-GFC is not even the biggest divergence of U.S. LC from other equity. See 1995–1999!
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16-60%
-40%
-20%
0%
20%
40%
60%
80%
for 29 Years ended December 31, 2016Annual Excess Return relative to S&P 500
Exc
ess
Ret
urn
Size Non-U.S. EM
18.73%
8.35%
5.91% 2.75%
2.71% -0.99%
0%
5%
10%
15%
20%
Large Cap(48%)
Non-U.S.(30%)
Em Mkts(10%)
Smid Cap(12%)
Diversification NetVolatility
Asset Class Contribution to Risk Global Equity
16 June 2017 Regional Workshop C ALLAN IN ST ITUTE
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 1617-0.5
0.0
0.5
1.0
Equity Classes Rolling 5 Year Correlation vs. S&P 500
Non-U.S. (avg: 0.7) Em Mkts (avg: 0.7) Size (avg: 0.9) Style (avg: 0.9)
Equity Asset Class Correlations Are High
● The diversification benefits of various types of equity exposure have been questioned
●Historical correlations have been very high versus U.S. large caps
● In the past two decades, those benefits have waned somewhat
17 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Equity Factor Lens
●We know that types of long-only equities are highly correlated
●What about market-neutral equity “factors”?
● Looking at these market-neutral equity return drivers reveals that correlations are fairly low, and quite variable over time
● This reinforces the value of equity diversification, particularly in periods of U.S. large cap dominance (like 1995–99 and 2010–16)
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 1617-1.0
-0.5
0.0
0.5
1.0
Equity Factors Rolling 5 Year Correlation vs. S&P 500
Non-U.S. (avg: -0.1) Em Mkts (avg: 0.2) Size (avg: 0.3)
Style (avg: -0.3)
Emerging
Style
Non-U.S.
Size
“Equity”
18 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Traditional β
Exotic β
Smart β
Alt β α
Sources of Investment Return
Equity Duration Credit Inflation
Emerging Reinsurance Convexity Illiquidity
Value Size Low Vol Quality
Risk Arbitrage Momentum Carry Volatility
Elusive, expensive, ephemeral?
19 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Value Momentum Volatility Carry Curve Quality Liquidity
Equities Fixed Income Commodities Currencies
Expanding the Opportunity Set
●Academic and behavioral risk premia – Observable – Persistent – Investable – Transparent
●Accessed via – Cash securities (long & short) – Futures, forwards, options – Total return swaps
● Factor construction – Generally market neutral
● Portfolio construction – Significant leverage employed
20 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Add Some Magic Beans…
●Modest assumptions for multi-asset – Equity-like risk, low correlations
to traditional assets
●As with commodities earlier, the inclusion of a new diversifier, one with high volatility, greatly expands the “diversification benefit” across our asset allocation
● 15% alternative beta portfolio – 12% Volatility*** – 0.2 Correlations***
***magic beans
4.18%
2.96%
1.80%
1.37%
1.36% 0.92%
0.54% 0.32% 0.17% -3.23%
10.38%
0%
17%
LargeCap
(24%)
Non-U.S.Equity(15%)
AlternativeBeta
(15%)
Em MktEquity(5%)
SmidCap(6%)
U.S.Fixed(25%)
HighYield(5%)
Non-U.S.Fixed(4%)
Em MktDebt(2%)
Diversi-fication
NetVolatility
Asset Class Contribution to Risk Traditional + Alternative Beta
21 June 2017 Regional Workshop C ALLAN IN ST ITUTE
View from the Field Client Case Studies
U.S. Equity 42%
Non-U.S. Equity 18%
U.S. Fixed Income 30%
Real Estate 5%
Private Equity 5%
Case Study #1 Traditional Stock and Bond Portfolio
Case Study #2 Broad Range of Asset Classes
U.S. Equity 29%
Non-U.S. Equity 24% U.S.
Fixed Income 20%
Real Estate 10%
Private Equity 7%
Absolute Return 10%
22 June 2017 Regional Workshop C ALLAN IN ST ITUTE
A Performance Pattern that Reflects Higher Quality Assets
Returns Volatility
9.8%
8.7%
11.3%
8.8%
Return and Risk Since Inception
03 88 15 94 12 16 01 02 08 09
Fiscal Year Return Rankings vs. Callan Public Funds (>$1bn)
Ten Best Average Percentile Ranking
61% 19%
Ten Best Ten Worst
Ten Worst Average Percentile Ranking
85 86 11 14 97 98 07 95 87 96-25%-20%-15%-10%-5%0%5%
10%15%20%25%30%35%
Percentile Ranking
37% 94%
23 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Combining Asset Classes with Low Correlations
●Client invested in Treasuries so that short-term volatility would not cause the Board to alter its long-term strategy
● The Treasury portfolio’s low correlation to stocks mattered more than its return potential
●Client utilizes liquid government securities as a low-cost means to rebalance
Fifteen Worst Quarters for the S&P 500 (1986 – 2016)
4Q87 4Q08 3Q02 3Q01 3Q11 3Q90 2Q02 1Q01 2Q10 1Q09 3Q98 1Q08 3Q08 4Q00 3Q86-25%-20%-15%-10%-5%0%5%
10%
Three-Year Rolling Correlations to the S&P 500 S&P 500 Treasury
U.S. Stock Portfolio U.S. Bond Portfolio
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17-1.0%
-0.5%
0.0%
0.5%
1.0%
24 June 2017 Regional Workshop C ALLAN IN ST ITUTE
A Compelling Risk-Return Profile with Stocks and Bonds
● $37 billion state-sponsored pension fund
● 8% actuarial investment objective (CPI + 4.5%)
● Simple strategy with few asset classes
● Low-cost structure that relies on asset allocation and disciplined rebalancing
Trailing 5-Year Sharpe Ratio Rankings vs. Callan Public Funds (>$1bn)
45% 42%
10% 18%
25% 30% 5%
5% 2% 5%
3% 10% REITs
Private Equity
Real Estate
Non-U.S. Fixed
U.S. Fixed
Non-U.S. Equity
U.S. Equity
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17100908070605040302010
0
Per
cent
ile R
anki
ng Average Rank: 28th
2007 2017
25 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Case Study #2
● $350 million government operated health care system
● 7.5% actuarial investment objective
●Broadly diversified among, and within, asset classes
● Sizable alternatives investment program
Trailing 5-Year Sharpe Ratio Rankings vs. Callan Public Funds ($100mm – $1bn)
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17100908070605040302010
0
Per
cent
ile R
anki
ng
Median
Average Rank: 85th
60%
29%
15%
24%
25%
20%
10% 7%
10% Absolute Return
Private Equity
Real Estate
U.S. Fixed
Non-U.S. Equity
U.S. Equity
2007 2017
26 June 2017 Regional Workshop C ALLAN IN ST ITUTE
Heightened Volatility from Return-Seeking Assets
Returns Volatility
8.7%
6.1%
10.2%
8.7%
9/30/907/1/90 to
6/30/941/1/94 to
9/30/987/1/98 to
9/30/014/1/00 to
3/31/034/1/02 to
3/31/0910/1/07 to
6/30/104/1/10 to
9/30/117/1/11 to
-30%
-25%
-20%
-15%
-10%
-5%
0%
A (75)
A (68)
A (97)A (80)
A (100)
A (81)
A (95)
A (92)
Declining Equity Period Return Rankings vs. Callan Public Funds ($100mm – $1bn)
88% 2%
Percentile Ranking
Return and Risk Since Inception
86%
Average Percentile Ranking
27 June 2017 Regional Workshop C ALLAN IN ST ITUTE
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 1617-30%
-25%
-20%
-15%
-10%
-5%
0%
A Well-Diversified Portfolio Less Susceptible to Drawdown
●Historically, high equity exposure resulted in significant drawdown risk
●Board pursued further portfolio diversification within stocks (market cap, style, and geography) and bonds (credit quality)
●Client improved drawdown protection with the addition of hedge funds, private equity, and real estate
Maximum Annual Drawdown – Historical vs. Current Target
Total Fund
Current Target
Callan Public Fund ($100mm – $1bn)
Returns 7.13 8.24 8.44 Standard Deviation 11.51 10.34 9.78 Maximum Drawdown -34.45 -32.86 -29.54 Sharpe Ratio 0.35 0.50 0.54
28 June 2017 Regional Workshop C ALLAN IN ST ITUTE
07 08 09 10 11 12 13 14 15 16 17-20%
-15%
-10%
-5%
0%
The Pursuit of Further Portfolio Diversification
●Board’s experience with hedge fund implementation was unsatisfactory
●Board considered multi-asset class and private credit strategies as replacements
12-Month Rolling Returns – Hedge Funds vs. Stocks
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 1617-60%
-30%
0%
30%
60%
HRFI Fund Weighted Composite MSCI World
Maximum Annual Drawdown – Multi-Asset Class vs. Hedge Funds HFRI Fund Weighted Composite Callan MAC Absolute Return Style Callan MAC Risk Premia Style
29 June 2017 Regional Workshop C ALLAN IN ST ITUTE
We Believe in Diversification, and You Should, Too
●Because you don’t know what the future will hold; If you knew, you’d hold only the best performer
●Diversification is the cornerstone of risk management – Hedge bets and seek diversifying return streams in the face of market uncertainty
● Investors with a truly long-term time horizon, the wherewithal to endure the financial impact of market volatility, and the durability to outlast short-term questioning are few and far between – Cashflows matter – Size of the dollar loss matters – Boardroom, career, abandonment risks can derail long-term plans – Many investors operate in a political environment, with critical outside observers
●Diversification is personal—it means different things to different investors, depending on their beliefs about the capital markets, starting position, financial status, potential future
●Diversification is evolving—across asset classes, within asset classes, advance of factors
Why Diversify?
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