CALLAN Why Diversify? INSTITUTE · Markets Research . 2017 Regional Workshops . June 27 –...

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?


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


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)


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?


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


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


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


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


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


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.









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



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











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










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


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











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


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


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


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


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


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”


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?


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


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


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%


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%


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%


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


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


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


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


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


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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CALLAN Why Diversify? INSTITUTE · Markets Research . 2017 Regional Workshops . June 27 –...

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