Diversified growth strategies and their role in Australian Superannuation Funds

Transcription

1 For institutional investors and consultants only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations. Diversified growth strategies and their role in n Superannuation Funds

2

3 Contents Executive summary 4 Introduction 5 Diversified growth strategies: a brief history 6 Key features of diversified growth strategies 7 Benefits of diversified growth strategies for n institutional investors 10 To hedge or not to hedge? 18 Potential uses of diversified growth strategies for n Superannuation Funds 21 The Investec Diversified Growth Strategy 25 Conclusion 31 Appendix 32 Authors Michael Spinks, Co-Head of Multi-Asset, and Portfolio Manager of Investec Diversified Growth Fund (n) Atul Shinh, Multi-Asset Investment Specialist The views expressed in this document are those of the authors and reflective of the wider Investec Multi-Asset team. Investec Asset Management is a multi-specialist house and therefore the views expressed may or may not be held by our other specialist investment teams.

4 Executive summary Diversified growth strategies are multi-asset programmes that flexibly invest in a range of traditional and non-traditional return sources to seek a defined outcome. They were originally designed for UK Defined Benefit pension schemes in the mid-2000s but are now utilised by all types of institutional investor on an increasingly global basis. We believe n investors cannot rely on domestic assets alone These strategies can vary in approach, but typical features include a total return objective, a broad opportunity set, flexible asset allocation, enhanced diversification and the use of numerous implementation methods. We believe that the breadth of opportunity set, investment flexibility and active approach to currency management of diversified growth strategies should be particularly appealing to n Superannuation Funds, as in our view they cannot rely on domestic assets alone to meet their performance objectives. The role that diversified growth strategies can play for n investors will vary depending on the nature of the investor, but their potential as a liquid alternative solution, given their diversifying properties, stands out. Our historical modelling suggests that there would have been a clear portfolio benefit to including a diversified growth strategy in a typical n Superannuation portfolio. The modelled realised return was higher, the overall portfolio volatility lower and the result therefore was improved risk-adjusted returns. It should also be noted that the benefit was enhanced when substituting from n equities rather than International equities. For example, according to our modelling, a 15% allocation to a diversified growth strategy funded out of n equities would have added 1.5% per annum to the overall return of a typical Superannuation Fund, whilst lowering the volatility (see page 23 for methodology). Our historical modelling shows the potential benefits to Superannuation Funds of diversified growth strategies The Investec Diversified Growth Fund (n) was launched in May 2015, following the launch of the sterling denominated Investec Diversified Growth Strategy in Investec Asset Management has been successfully managing a broad range of multi-asset strategies, including those with total return profiles, for over 20 years. 4 Diversified growth strategies and their role in n Superannuation Funds

5 Introduction Multi-asset programmes that flexibly invest in a range of traditional and nontraditional return sources, focusing on both risk management as well as investment return generation have attracted significant interest from institutional investors in recent years, creating a new market segment known as diversified growth strategies. Although originally designed for UK Defined Benefit (DB) pension schemes, other investors (principally Defined Contribution schemes) from the UK and globally have recognised the role that diversified growth strategies can play in helping to meet their respective objectives. These strategies have attracted the growing interest of a number of n Superannuation Funds, which is of no surprise given their objectives are often aligned with those of diversified growth strategies. This paper provides some background behind diversified growth strategies, describes the important characteristics that define these strategies and explains their potential application to n Superannuation schemes. We conclude by offering a brief overview of the Investec Diversified Growth Strategy. Diversified growth strategies and their role in n Superannuation Funds 5

6 Diversified growth strategies: a brief history The concept of diversified growth strategies started in the UK following the dotcom crash in markets in the early 2000s. Some DB schemes, chastened by this poor experience and dissatisfied by the performance of traditional multi-asset balanced strategies over this period, started looking at alternative methods to help generate more sustained growth in returns. Thus, the concept of reducing the reliance on equities to generate growth in returns, by flexibly investing in a better diversified set of growth drivers was born. Additionally, regulatory pressure and the requirement to reflect pension deficits on the balance sheet of companies created a much greater focus on the volatility of returns realised and the risk that was being taken to generate returns. At the same time, new methods to access a much wider opportunity-set for investors were opening up and, following years where a buy-and-hold approach was richly rewarded, the bear market in the early 2000s highlighted the more negative consequences of this lack of asset allocation decision making. The global financial crisis (GFC), a few years later, provided the first major test to the validity of the broad diversified growth model. Already at this stage, there was a degree of variation in the approaches employed as participants in the space showed a tendency to anchor their diversified growth approach on some of the multi-asset methods they historically relied upon. This variation of approach resulted in a considerable range of outcomes over the course of the GFC, with some strategies demonstrating strong downside protection characteristics, whereas others performed little better than equities. Subsequently, these strategies have not only had to contend with generally strong returns from developed market equities, and credit, but also poor returns from strategies typically classified as diversifiers, notably commodities and emerging market debt. While volatility has generally trended lower as central banks have maintained their interventionist monetary policies, there have been some significant market episodes to challenge these multi-asset approaches and their ability to meet both the return and risk objectives post the GFC. Therefore, the investment environment and deviation in asset class performance has heightened attention on the approaches employed by diversified growth managers, specifically around portfolio construction, idea generation and implementation precision. Diversified growth strategies have been one of the most popular choices for new allocations from institutional investors in recent years, which in itself has attracted a swathe of new market participants. It is estimated that the size of this marketplace was c. AUD 230 billion as of March Source: Camradata, using GBP/AUD exchange range of Diversified growth strategies and their role in n Superannuation Funds

7 Key features of diversified growth strategies To date the diversified growth space has been characterised by significant variation in the underlying approaches employed. However, there are areas of commonality that we can point to in describing a typical diversified growth investment model, which we detail below. Outcome-based objectives The objective of achieving growth while limiting volatility is typically expressed through a total return target (normally a return premium over inflation or the rate of cash), as opposed to a return target relative to a market based benchmark. A volatility target or risk objective is also present. This outcome-based approach ties in with the objectives of many Superannuation funds, which normally look for returns from their assets in excess of inflation. Further, as schemes have been using diversified growth strategies as a diversifier or as a growth asset substitute, there is an expectation that their performance and the path of their performance will deviate from broad market indices. Breadth of opportunity set Historically, balanced multi-asset strategies tended to be focused on traditional assets, such as equities and government related to the local domestic market of the investment manager. Diversified growth strategies, on the other hand, access a much broader opportunity set, covering both traditional and alternative sources of return, with a global perspective. The range of asset exposures that may be included in diversified growth strategies therefore includes, amongst others, global equities, emerging market equities, developed market government, emerging market, inflationlinked, high yield, investment grade, property, private, commodities, volatility strategies, hedge funds, infrastructure, reinsurance and active currency positions. Diversified growth strategies access a broad, global opportunity set, covering traditional and alternative sources of return By expanding the number of investment opportunities available and the type of returns that can be accessed, diversified growth strategies have more return levers to exploit over the course of the market cycle, and opportunities to manage risk. This should increase their ability to achieve more consistent returns, and reduce the reliance on returns from individual markets. Enhanced diversification As its name would suggest, the diversification of exposures is a key component of the diversified growth concept. Diversification, if applied correctly, can help achieve the desired outcome of these strategies by achieving long-term growth, but with an improved certainty of outcomes than would otherwise be the case by solely focusing on assets such as equities. Clearly, following from above, a broad opportunity set can be an important starting point in achieving diversification. Diversified growth strategies and their role in n Superannuation Funds 7

8 However, although diversification is not new to multi-asset strategies, the experience of the GFC, where many diversified portfolios did not perform as expected, has contributed to a better understanding of what it takes to achieve more effective diversification. As such, just owning lots of different assets is not always enough; it is important to understand the fundamental drivers of assets, how assets are likely to behave and the role they can play. The design of diversified growth strategies enables them to better achieve superior diversification compared to many traditional multi-asset strategies and this crucially links back to the focus on risk management in these strategies. Flexible asset allocation The ability and willingness to allocate between and within different asset classes is an important characteristic of diversified growth strategies. Although the frequency and magnitude of these decisions will vary from approach to approach, the flexibility to both take advantage of market opportunities and to protect against market risks is beneficial to the strategies in achieving their long-term objectives. Intrinsic to many diversified growth strategies is a focus on risk management. In contrast, the managers of traditional multi-asset strategies have either been constrained in their ability to deviate beyond a narrow range of allocations, or have been unwilling to express high conviction asset allocation positions. Evolved implementation techniques Diversified growth strategies use a number of methods to implement investment views. As well as using internally managed programmes and direct investments, diversified growth managers are increasingly using other methods, such as relative value positions (i.e. taking a relative view of one asset or market compared to a related asset or market) or bespoke baskets (i.e. hand picking a number of holdings to reflect the required investment idea) to express views. By largely removing market directionality from the position, relative value holdings can provide uncorrelated exposures to a strategy. The use of these positions can thereby further expand the opportunity set available to the strategy, as they provide a potential additional source of return. Other long / short overlays that exhibit clearer directionality can also play a useful role in isolating a market risk factor, for example the small-cap premium. Bespoke baskets, on the other hand, can ensure there is greater precision around the view being expressed. Diversified growth strategies use a number of methods to implement views. These types of exposure become more important in environments where positive market beta effects are less prevalent. Risk management/downside protection Diversified growth strategies are ever more focused on the evaluation of what could go wrong and truly understanding all the risks affecting the portfolio. In practice, this means the consideration of risk implications as part of the investment decision process, regular independent monitoring of the risks facing the portfolio, evaluating the impact on the portfolio of different potential market stresses and implementing positions that are specifically designed to provide the portfolio with a degree of downside protection in adverse environments. 8 Diversified growth strategies and their role in n Superannuation Funds

9 A strong risk management discipline, combined with effective portfolio diversification as described above, can improve the worst case outcome for investors and reduce uncertainty about achieving the performance objectives. Base currency focused One of the key advantages of a diversified growth approach is that it is structured with the base currency liabilities (such as domestic inflation or cash related) of investors in mind. In other words, these strategies provide access to a global opportunity set, but from the starting point of a domestic investor and their needs. Clearly there are potential benefits from accessing assets denominated in an overseas currency, from either a risk reduction or return enhancement perspective, but the decision of whether to hedge this exposure or not should be an active decision relative to the starting point of the investors base currency. Diversified growth strategies and their role in n Superannuation Funds 9

10 Benefits of diversified growth strategies for n institutional investors Having detailed the typical characteristics of diversified growth strategies, we will now explore the potential benefits that these strategies provide for n institutional investors. Specifically, we will explore how these strategies should be well placed to meet real growth return objectives while providing investors with increased certainty about achieving this outcome. Firstly, we will explain why n institutional investors should not rely on domestic assets alone to provide certainty around achieving a real return (in this instance, equivalent to domestic Inflation +5% i.e. a real return of 5% on an annualised basis). We will then discuss why a broader opportunity set, in terms of both geographic and asset exposures, provides the return potential to achieve the return objective. We then describe the role that diversification can play in helping to reduce the range of possible outcomes of a portfolio. Finally, we conclude by explaining the important role that an active approach to currency management plays for an n investor. There is still a significant reliance by Superannuation Funds on domestic assets. How reliable are domestic n assets for achieving the required return? With the proportion invested in domestic n assets by Superannuation funds typically ranging from 40-50% 2, it is clear that despite the ongoing move to internationalise n Superannuation fund portfolios, there is still a significant reliance on domestic assets to achieve the required returns for these schemes. An analysis of the historical returns achieved from these assets, however, shows that an investor could have achieved better returns by taking a more global approach in the past. To illustrate this, Figure 1 shows the annualised real returns of n equities, n and n cash, over a number of discrete 10 year periods from 1900 to 2010, including the best and worst returning 10 year periods. We have compared these returns to the performance target of a 5% annualised real return. Figure 1: n asset classes through the decades ( ) 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% Equities Bonds Cash Target Best 10 years Worst 10 years Average Average of 10 year periods -10% Source: Credit Suisse Investment Returns Sourcebook Source: Rainmaker Information - December Diversified growth strategies and their role in n Superannuation Funds

11 Over the time period of , although n equities exceeded the performance objective, it was achieved with a high volatility, indicating a significant variability of return and therefore a high degree of unreliability in achieving a consistent return profile. n and cash, on the other hand, both significantly underperformed the objective over this extended period, demonstrating they have not been effective in generating the required return. We do recognise, however, that the impact of the franking tax credit on dividends results in enhanced domestic returns for many n investors, thereby increasing their attraction relative to global markets. However, we believe the dynamics of the domestic market (with a small market relative to the global opportunity set and a reliance on financial sector companies) should encourage investors to look beyond this potential franking benefit when assessing the attractiveness of the market. Our forward-looking view on the prospects of these assets does not change our opinion about the reliability of n assets to generate the return target either. We believe that most n Superannuation Funds are over exposed to domestic assets and should target a broader global opportunity set to give them a better chance of meeting their performance objectives. The next section provides further justification for our views. Breadth of opportunity set Diversified growth strategies access a broad opportunity set, covering both traditional and alternative sources of return, and with a global geographical perspective. By expanding the number of investment opportunities available and the type of returns that can be accessed, diversified growth strategies have more return levers to exploit over the course of the market cycle. This should increase the ability to achieve more consistent returns, and reduce the reliance on individual market returns. Diversified growth strategies have many return levers to exploit through a market cycle. We will evidence the benefit that accessing a broader opportunity set can provide by assessing the historical returns of a wide range of assets and geographies in comparison to domestic n assets. In this analysis, for simplicity, we have focused on the local market returns of the respective assets in question. We will show later that the decision of whether to hedge non-n dollar exposure makes a significant difference to the returns that investors receive. Figure 2 overleaf shows the calendar year returns of a number of different markets from the past 10 years. Within each calendar year, we have ranked the markets from the highest returning to the lowest returning, showing the percentage return achieved for all assets. Diversified growth strategies and their role in n Superannuation Funds 11

12 Figure 2: n assets versus global assets over the past decade Japan (45.2%) Emerging Market (32.1%) Emerging Market (39.4%) government (39.7%) Emerging Market (78.5%) Emerging Market (18.9%) government (14.2%) Japan (20.9%) Japan (54.4%) (12.8%) Emerging Market (34.0%) Europe (18.5%) Local (18.1%) government (20.2%) (30.8%) Commodities (16.7%) (10.0%) Emerging Market (18.2%) US (29.6%) US (11.4%) Europe (24.6%) (18.3%) (12.2%) (15.5%) Hard (29.8%) Local (15.7%) Hard (7.3%) HY (17.8%) HY (25.3%) government (11.1%) UK (20.8%) Local (15.2%) Commodities (11.1%) (11.6%) UK (27.3%) US (12.8%) government (6.8%) Hard (17.4%) Europe (19.2%) Japan (10.3%) (20.3%) UK (14.4%) Hedge Funds (10.3%) Local (-5.2%) HY (25.6%) UK (12.6%) (4.5%) Local (16.8%) UK (18.7%) government (9.5%) Commodities (17.5%) US (13.6%) UK (7.4%) HY (-9.2%) Europe (24.6%) Hard (12.2%) HY (2.6%) Europe (15.8%) (16.2%) HY (9.2%) Hard (10.2%) Hedge Funds (10.4%) Hard (6.2%) Hard (-12.0%) US (23.5%) (7.5%) US (0.0%) (14.9%) (15.7%) (8.6%) HY (8.4%) Hard (9.9%) government (3.7%) Hedge Funds (-21.4%) Local (22.0%) Europe (5.9%) Local (-1.8%) US (13.4%) government (11.0%) Hard (7.4%) Hedge Funds (7.5%) HY (5.6%) US (3.5%) UK (-28.3%) Commodities (18.7%) Hedge Funds (5.7%) UK (-2.2%) (11.5%) Hedge Funds (9.0%) Europe (4.2%) Local (6.3%) (3.7%) Europe (3.0%) Commodities (-36.6%) Hedge Funds (11.5%) government (5.2%) Hedge Funds (-5.7%) UK (10.0%) (4.8%) Hedge Funds (3.4%) (6.1%) Japan (3.0%) (2.5%) US (-38.5%) Japan (7.6%) Japan (1.0%) Commodities (-13.4%) (9.7%) government (0.1%) (1.1%) government (5.7%) government (2.1%) government (-0.6%) (-39.9%) (6.3%) HY (-0.1%) (-14.9%) government (5.5%) Emerging Market (-2.6%) UK (0.7%) (3.6%) (-0.3%) (-3.7%) Japan (-40.6%) government (-2.7%) (-3.5%) Europe (-14.9%) Hedge Funds (4.8%) Hard (-5.3%) Emerging Market (-2.2%) US (3.0%) Government (-1.1%) HY (-7.5%) Europe (-44.4%) (-7.6%) (-7.0%) Japan (-17.0%) Government (0.5%) Local (-9.0%) Local (-5.7%) Government (-0.1%) Commodities (-2.7%) Japan (-11.1%) Emerging Market (-53.3%) Government (-20.7%) Government (-7.3%) Emerging Market (-18.4%) Commodities (-1.1%) Commodities (-9.6%) Commodities (-17.0%) Source: Bloomberg (list of markets in Appendix) 12 Diversified growth strategies and their role in n Superannuation Funds

13 It can be seen that over this period there has been significant dispersion between the highest and lowest returning assets and that the ranking of n assets compared to other assets within each calendar year has varied significantly. This table therefore evidences the opportunity cost from just focusing on n assets, given the returns that have been available from other markets. We should not only focus on the return that would have been missed from a narrow focus on n assets. Investing in a broader set of assets would have also reduced the variability experienced by an investor compared to just focusing on domestic assets, which in turn would have likely led to a lower volatility profile. Figure 2 also helps us to highlight the potential benefits from taking an active and high conviction approach to dynamic asset allocation across different assets. For example, an allocation to Japanese equities on a currency hedged basis in 2012 would have had very beneficial results for an overall portfolio through to the end of Conversely, avoiding commodities over this period would have proved beneficial too. Finally, the presence of negative returning markets in certain periods shows that investors should not just think in the one dimension of which assets will go up. Paying attention to which assets might go down as well adds another potential stream of returns, either by taking direct short positions or through the construction of the aforementioned relative value positions. Paying attention to which assets might go down is important and adds another potential return source. Benefits of diversification The correlation between two assets can be a useful measure to help determine the extent of diversification possible, by providing information on how assets have behaved in different environments historically. For example, assets with a tendency of exhibiting a negative correlation to equities can play a useful role in providing protection in the event of significant falls in markets. It is important to note though that correlations vary over time, and assets that may have behaved in a certain way in the past will not necessarily behave in the same way in the future. To illustrate this point, we show a series of charts overleaf displaying the historical correlations between n equities and a range of global and domestic assets as well as the stability of these relationships. Given that our starting point is the belief that n investors should be looking to diversify away from n assets, and equities in particular, it follows that we believe those assets with either favourable correlations and/or return potential would be useful additions in constructing a portfolio to meet the return objectives. Further detail on our methodology relating to Figures 3-8 is set out in the Appendix. It is important to note that correlations vary over time. Diversified growth strategies and their role in n Superannuation Funds 13

14 Figure 3: and regional equities vs n equities (hedged) Variability of correlation (%) EM equities 40 US equities Europe equities 30 UK equities 20 Japan equities Correlation to n equities (%) Figure 4: and regional vs n equities (hedged) Variability of correlation (%) GB 40 HY 30 GB Correlation to n equities (%) Figure 5: Alternatives vs n equities (hedged) Variability of correlation (%) Hedge funds 40 Commodities EM LC 30 EM HC Correlation to n equities (%) Historical correlations on a hedged basis Figure 3 shows that on a hedged basis, the main markets under consideration have demonstrated a fairly high correlation to n equities, with Japanese equities showing a lower but still noteworthy level of correlation. The variability of correlations for these markets are reasonably low, indicating that these fairly high correlations have been persistent over time. Figure 4 shows that on a hedged basis, n bond markets have provided the potential for strong diversification benefits, with domestic government and domestic corporate exhibiting uncorrelated returns to n equities. It should be noted that n government in particular have exhibited a high variability of correlation though, indicating that they could not have always been relied upon to provide diversified returns to equities. bond markets have exhibited mixed behaviours, with global government providing an uncorrelated source of returns to n equities, but with investment grade, and high yield in particular demonstrating a reasonable degree of correlation with low correlation variability. This suggests their diversification properties were muted. Figure 5 shows that on a hedged basis, various alternatives have only provided a limited degree of diversification over time, with reasonably low variability of correlation. Emerging market debt, in particular, has exhibited a modest level of correlation to n equities. Source: Bloomberg, see appendix for details 14 Diversified growth strategies and their role in n Superannuation Funds

15 Figure 6: and regional equities vs n equities (unhedged) Variability of correlation (%) EM equities 40 US equities Europe equities 30 UK equities 20 Japan equities Correlation to n equities (%) Figure 7: and regional vs n equities (unhedged) Variability of correlation (%) GB 40 HY 30 GB Correlation to n equities (%) Figure 8: Alternatives vs n equities (unhedged) Variability of correlation (%) Hedge funds 40 Commodities 30 EM LC EM HC Historical correlations on an unhedged basis Figure 6 shows that on an unhedged basis, there has been a range in the correlations between the main markets under consideration and n equities, with some markets such as Japan demonstrating a fairly low correlation. On the whole, these markets have exhibited greater variability of correlation on an unhedged basis compared to on a hedged basis, but still at a fairly low level of variability overall. Figure 7 shows that on an unhedged basis, global have exhibited strong diversification benefits, with global government and investment grade showing material negative correlations, and high yield showing negligible correlation. The correlation variability of global government and investment grade has been fairly low, indicating their historical diversification effectiveness has been reliable. Finally, Figure 8 shows that on an unhedged basis, various alternatives have provided a good degree of diversification over time, with their returns more or less uncorrelated with n equities over time. The variability of correlations of emerging market debt and hedge funds suggests, however, this diversification benefit has not been stable over time Correlation to n equities (%) Source: Bloomberg, see appendix for details Diversified growth strategies and their role in n Superannuation Funds 15

16 A few conclusions can be made based on the above correlation and return analysis: On the whole, most markets have historically only provided limited diversification benefits to n equities, but they can provide significant additional return potential as illustrated in Figure 2. As a result, a broader set of market exposures can be beneficial to the overall risk-adjusted returns of a portfolio. n have historically provided a powerful diversification benefit to n equities, although the relationship has proved to be variable. This suggests that they could not always be relied upon for diversification and that a flexible allocation approach to investing in these assets would be sensible. government have also historically provided a strong diversification benefit to n equities, although again with a reasonable degree of variability. This supports the argument for a flexible allocation approach to investing in these assets. high yield, on a hedged basis, have exhibited poor diversification characteristics with n equities, although have provided significant additional return over certain periods (as illustrated in Figure 2). The usefulness in terms of diversification benefits and the return generation potential of alternative investments have varied considerably depending on the asset in question. This suggests that although certain alternative assets can play an important role in both the generation of returns and in the control of volatility, this sub-set is not homogenous in its behaviour. It is evident that most of the asset correlations vary significantly depending on whether the returns are calculated on a hedged or unhedged basis. This suggests that the treatment of foreign currency exposures for different assets has a significant impact on the role they can play in a portfolio and the subsequent level of diversification that can be achieved. This result highlights the risky nature of the n dollar as a base currency and the potential diversification benefits of other currencies, most notably the US dollar. Managing the appropriate level of base currency exposure and carefully selecting other exposures is therefore a critical decision. To further emphasise the last couple of points, in Figures 9 and 10 we have restated and consolidated the same charts to show the clusters of correlations for equities, and alternatives on both a hedged and an unhedged basis. A broader set of market exposures can be beneficial to the overall risk-adjusted returns of a portfolio Treatment of foreign currency exposures for different assets has a significant impact on the role they can play in a portfolio 16 Diversified growth strategies and their role in n Superannuation Funds

17 Figure 9: Correlation clusters for equities,, alternatives on a hedged basis Variability of correlation (%) Equity Bonds Alternatives Correlation to n equities (%) Figure 10: Correlation clusters for equities,, alternatives on an unhedged basis Variability of correlation (%) Equity Bonds Alternatives Correlation to n equities (%) Source: Bloomberg, see Appendix for details It can clearly be seen that the general effect of leaving foreign currency exposures unhedged has been to significantly reduce the correlations of assets to n equities. Does this mean we should be advocating a fully unhedged approach for a multi-asset fund that is targeting a return in excess of CPI? We explore the importance of active currency management in the next section. Diversified growth strategies and their role in n Superannuation Funds 17

18 To hedge or not to hedge? The decision of whether to hedge foreign currency exposures as an nbased investor can make a significant difference to the overall outcome experienced it not only affects the return achieved of individual assets but also impacts their interaction with other assets. Given the return objectives of diversified growth strategies are typically structured with the specific domestic liabilities of the investor in mind (e.g. n CPI +5% for n investors), it therefore follows that the starting point for the strategy s currency exposure should also be domestically skewed. In other words, the base position for a diversified growth strategy should involve the full hedging of overseas assets back into the base currency. Every currency exposure deviation away from that starting point is then a deliberate and conscious decision based on the views about different currencies, the roles they can play in a portfolio and how they interact with one another. As we explain later on the paper in the section about the Investec Diversified Growth Strategy, different currencies exhibit different characteristics and can play varying roles in a portfolio, e.g. as a return generator, as a risk reducer, or as an uncorrelated stream of returns. However, in order to understand the roles that different currencies can play in a diversified growth portfolio, it is first of all important to understand the characteristics of the base currency in question, as this will influence the manner in which other currencies interact relative to it. Different currencies exhibit different characteristics and can play varying roles in a portfolio. We would categorise the n dollar as a Growth currency given that its performance and behaviour is linked to global drivers of economic growth. Figure 11 shows the rolling 36 month correlations between the S&P 500 (in USD terms) and the return from n dollar vs US dollar. Figure 11 supports our view that the currency exhibits growth properties and is particularly sensitive to market crises (as its correlation to equities has spiked over these periods, i.e. the n dollar has tended to depreciate when markets have been falling). Figure 11: Rolling 36 month correlation of S&P 500 (USD) to AUD/USD Source: Bloomberg, 31 March Diversified growth strategies and their role in n Superannuation Funds

19 As well as looking at historical relationships to help determine the expected behaviour of the n dollar, we also try to understand why the relationships exist and therefore whether they are likely to persist. For the n dollar, we believe the role of China as a key export partner for s commodity products, notably iron ore, has significantly increased the relationship between the currency and global risk assets. This Growth characteristic of the n dollar goes some way to explaining why the correlation of unhedged returns has been lower than for hedged returns. Foreign assets gain value from an n investors perspective when the n dollar depreciates (and vice versa), which has recently typically occurred in global market sell-offs, meaning that the currency effect acts somewhat as a counterbalance to the negative returns that would otherwise be achieved. Understanding the Growth characteristic of the n dollar is very important. However, it is not as simple as just concluding that all foreign asset exposures should be left unhedged. When calculating the impact from the hedging of foreign asset exposures, the interest rate differentials between the foreign country and the domestic country needs to be factored in. n investors have benefited, particularly in the last few years, from the interest rate differential being in their favour (i.e. the interest rate in has been higher than in other developed countries), which has meant, for example, that a fully hedged exposure has generated a positive carry. Figure 12 shows just this it decomposes the return that an n investor would have received from fully hedging an allocation to the S&P 500 index into the component relating to the underlying index return in USD and the component relating to the hedging benefit. Figure 12: US equities (AUD hedged) return decomposed: US equities local return and interest rate differential benefit % US Equities (USD) - LHS Interest rate differential benefit - LHS US Equities (AUD Hedged) - RHS % Source: Bloomberg, 31 December 2014 Diversified growth strategies and their role in n Superannuation Funds 19

20 So should an investor be focused on the potential return uplift resulting from hedging overseas exposure or should they be focused on the correlation and portfolio construction benefits from leaving overseas exposure unhedged? The answer, of course, is not straightforward, and lies somewhere in between. There will be times when it is right to hedge overseas exposure for some assets but not for others. Conversely, there will be other times when it is right to leave more overseas exposure unhedged (e.g. in the event of market turmoil). This trade-off between increased carry versus volatility reduction is often a central theme in our investment debates around hedging strategies. From a diversified growth strategy perspective there is the further consideration of taking all positions relative to the base currency objective, as described earlier. The answer on whether to hedge or not hedge is not straightforward. Figure 13 demonstrates both of these points. It shows the difference between the monthly returns from a fully hedged allocation to the S&P 500 index and the monthly returns from an unhedged allocation to the S&P 500 index, from an n investors perspective. A positive figure indicates that the fully-hedged allocation has outperformed the unhedged allocation over a particular month, and vice versa. We have overlaid the chart with the cross rate between the n dollar and the US dollar. It can be seen that in periods of n dollar strength, it has been advantageous to fully hedge the overseas exposure. Conversely, in periods of n dollar weakness, it has been advantageous to leave overseas US dollar exposure unhedged. Figure 13: Monthly differential between S&P 500 AUD hedged and unhedged, and AUD/USD rate % % % % -0.05% % % % Feb 05 Feb 06 Feb 07 Feb 08 Feb 09 Feb 10 Feb 11 Feb 12 Feb 13 Feb 14 Mar 15 Difference (RHS) AUDUSD (LHS) Source: Bloomberg, 31 March 2015 The primary conclusion is that understanding and managing currency exposure is a vital component to integrate into the investment process, playing both a risk management and return enhancement role. Understanding and managing currency exposure is a vital component to integrate into the investment process 20 Diversified growth strategies and their role in n Superannuation Funds

21 Potential uses for of diversified growth strategies for n Superannuation Funds Having outlined the typical features of diversified growth strategies and the benefits they can provide above, it is clear that they can play an important role for n institutional investors. This is particularly the case given that equities are the key drivers of returns for most n Superannuation funds, large and small, DC or DB. This reliance on equities comes with a cost of short term volatility that can create uncertainty about returns that investors will achieve at any given point or over a particular time horizon. For DB schemes that are looking to meet their liabilities, this lack of certainty creates issues, particularly if they are in the path of de-risking assets. For DC schemes, volatility can unsettle members such that they lose faith in the concept of pension savings prompting a switch to lower returning safer assets. Below, we outline four potential uses that diversified growth strategies can play and assess the applicability of these uses for different types of institutional investors. We finish with an exploration of what the impact of including a diversified growth strategy in a typical n Superannuation Fund could have been. 1. One-stop shop Diversified growth strategies can play a variety of different roles for different types of institutional investor. As outlined earlier, the majority of diversified growth approaches offer investors exposure to a combination of traditional and alternative return sources, with the aim of achieving a stable and positive total return over time. Therefore in many respects, the multi-asset teams managing these strategies and the trustee boards managing their pension funds are not too different in what they are trying to do. Diversified growth strategies, in effect, offer investors a one-stop shop of exposures. Most pension funds would be unlikely to rely solely on one diversified growth strategy to achieve their goals, although experience in the UK has shown that DC schemes have often used one or two diversified growth strategies as the main component in their default range. 2. An option within the Superfunds structure With n Superannuation Funds increasingly looking at providing different risk/return options to their members, we think that diversified growth strategies can play an important role in this provision of options. For example, diversified growth strategies can provide an option of a return of inflation +5% with half the level of volatility of equities, in isolation, or can be combined with other assets such as equities and to provide additional options, with the risk/return objectives depending on the exact mix of assets. Diversified growth strategies and their role in n Superannuation Funds 21

22 3. Liquid alternatives solution We demonstrated above that a global opportunity set and an active approach to currency management can result in a set of return streams that are very different to domestic n returns, particularly to domestic equities. The risk management disciplines of diversified growth strategies, including explicit downside protection mechanisms, can also help to differentiate the return pattern of these strategies. Given the majority of diversified growth strategies are available to investors on a daily dealing basis, they can be regarded by investors as providing many of the characteristics of a liquid alternatives solution by offering an effective diversifier away from equities, while still providing the required return potential. 4. Outsourced CIO model As we explained above, most diversified growth approaches are flexible in their overall asset allocation, being able to react to changing market dynamics more quickly and nimbly than most pension funds, which are typically restricted by their governance arrangements. This asset allocation flexibility is important as it allows the strategy not only to benefit from significant return opportunities, but also to protect against significant market threats. As well as benefiting directly from this asset allocation expertise through an allocation to a diversified growth strategy, pension funds can also utilise these asset allocation insights to help them in the management of the overall pension fund portfolio too. This concept of idea sharing between the investment manager and the pension fund to influence the management of the pension fund portfolio is known as an outsourced CIO model. The roles that diversified growth strategies can play will depend on the nature of the investor. Different roles for different investors The roles that diversified growth strategies can play will depend on the nature of the investor. For example, a sophisticated pension fund with strong levels of governance will probably have less need for a diversified growth strategy as a diversifier in their portfolio, but may benefit from the outsourced CIO role it can play. The diagram below attempts to summarise the different roles diversified growth strategies can play for different investors. Greater relevance for schemes with strong governance One-stop shop Option within Superfund structure Liquid alternatives solution Outsourced CIO model Greater relevance for schemes with limited governance 22 Diversified growth strategies and their role in n Superannuation Funds

23 Modelling the benefit of diversified growth inclusion To illustrate the potential benefits from including an allocation to a diversified growth strategy, and to highlight its role as a diversifier away from equities in particular, we have conducted some analysis that models the impact on introducing a diversified growth strategy into a typical portfolio. We have chosen an initial strategic asset allocation based on what we consider to be broadly representative for an n Superannuation scheme, as follows: Figure 14: A representative n Superannuation scheme portfolio n cash 10.0% n equities 25.0% International developed market equities (ex ) 22.5% Emerging market equities 5.0% n 10.0% 7.5% n property 10.0% Infrastructure 10.0% Source: Investec Asset Management We have assumed a hypothetical portfolio, (which we refer to below as the typical portfolio) that rebalances on an annual basis, with a hedge ratio of 50% (i.e. foreign assets are 50% hedged back to n dollar). To represent the diversified growth strategy, we have used the track record of the Investec Diversified Growth Strategy. Given this track record is sterling based, we have calculated returns hedged back to n dollar. Further details around our methodology, including the assumptions and the proxy indices used, can be found in the Appendix. Figure 15 shows the impact on the return and volatility of returns for the portfolio, on an annualised basis from May 2008 (the inception of the track record) to end March 2015 given different sized allocations to the Investec Diversified Growth Strategy. Figure 15: Modelling the impact of introducing a diversified growth fund into a Superannuation fund PorTFolio return VolATIlITy SharPE Ratio Typical portfolio 5.2% 9.3% % in DGF (funded from n equities) 5.7% 8.9% % in DGF (funded from n equities) 6.2% 8.5% % in DGF (funded equally from n and International DM equities) 5.9% 8.6% % in DGF (funded from n equities) 6.7% 8.2% % in DGF (funded equally from n and International DM equities) 20% in DGF (funded with 15% from n equities and 5% from International DM equities) 6.4% 8.2% % 7.9% 0.37 Source: Bloomberg, 31 March 2015, see Appendix for details This modelling is not intended as advice or a recommendation but is intended as an illustrative example of the potential benefits an allocation to a diversified growth strategy could provide if included in a typical Superannuation portfolio. Diversified growth strategies and their role in n Superannuation Funds 23

24 It can be seen that in this exercise, there has been a clear portfolio benefit to including a diversified growth strategy (in this example ours) in a broader portfolio over the period modelled. The modelled realised return is higher, the overall portfolio volatility is lower and thus results in better risk-adjusted returns. It is noteworthy that the benefit is enhanced when substituting from n equities rather than International equities. 24 Diversified growth strategies and their role in n Superannuation Funds

25 The Investec Diversified Growth Strategy We launched an n vehicle within our Diversified Growth Strategy in May 2015, but we have been successfully managing multi-asset strategies for over 20 years and have managed the Investec Diversified Growth Strategy (with a sterling base currency and track record) since Objectives and performance The Investec Diversified Growth Fund (n) targets a return of n CPI +5% per annum, gross of fees, with half the level of volatility, over rolling 5 year periods. We judge the success of the Fund by achieving both the return and risk objectives. The performance of the sterling track record is shown in Figure 16 for reference. Figure 16: Illustrative performance of the Investec Diversified Growth Strategy composite* % Annualised (gross) performance in GBP 5 year historical volatility*** 11.9% % % 6.4% 7.0% 7.4% 7.4% 7.5% 5.6% Percentage (%) year 3 years p.a. 5 years p.a. Since inception p.a.** DGF Equities Diversified Growth GBP Inflation Plus UK CPI + 5% *Source: Investec Asset Management GIPS composite report. This is a representative track record for our sterling based Diversified Growth Strategy **Composite inception date is 30 April 2008, returns of less than a year are not annualised. ***MSCI World GBP Hedged, over 5 years Investment team Michael Spinks and Philip Saunders are the co-portfolio managers, and so therefore, the ultimate decision makers for the Investec Diversified Growth Strategy. Michael, who joined Investec Asset Management in 2012, has managed diversified growth strategies since 2006 and has 19 years of investment experience. Philip has managed the Investec Diversified Growth Strategy since its inception in 2008 and has spent the majority of his 34 years of experience managing multi-asset strategies at Investec Asset Management. Our investment team is research-driven and this is reflected in its structure. Managing multi-asset mandates, with the breadth of opportunity set available to us, requires significant resource, experience and specialist expertise. The Investec Diversified Growth Strategy therefore benefits from being managed Diversified growth strategies and their role in n Superannuation Funds 25