The Rise of Alternatives

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1 Market Commentary January 015 Trends in Asset Management by Keith C. Crawford, Chief Financial Officer and Global Head of Strategy The Rise of The rapid growth and rising popularity of alternative investments, which we define as assets that aren t correlated to the broader capital markets, continues to be an important global storyline. State Street Global Advisors (SSGA) is committed to meeting the strong demand we continue to see from institutional investors, and increasingly their retail counterparts, for these non-traditional strategies. In the following commentary, SSGA CFO and Global Head of Strategy Keith Crawford takes a closer look at alternatives, exploring some of the major trends driving their growth and pondering what the future could hold both for the asset class and the industry at large. Over the past decade, the forces that traditionally drive global markets forward, in our view, have acted unlike anything we have witnessed in the preceding 0 years. As a result, most of the world s capital markets have experienced liquidity and credit crises; coupling implications; excessive government deficits and debt; anemic interest rates; underfunded pension plans; and limited advancement and growth of emerging markets. In combination, these factors have had a profound effect globally on the ability of investors to earn respectable yields on their investable assets and overall wealth and we believe this fundamental shift is prompting both institutional and retail investors to rethink their overall investment framework. As part of this changing mindset, we are seeing greater adoption of a diverse set of investment strategies known as alternatives. Some of the more common alternative investments include hedge funds, private equity, real estate, infrastructure and commodities. These assets can further be categorized as liquid or illiquid depending on their ability to price assets daily. Hedge funds are among the most visible and prominent alternative asset types, with many offering long/short, market neutral, managed futures, commodity trading, debt and volatility arbitrage, event-driven, global macro, currency, multi-strategy or fund of funds approaches. Liquidity varies, with some hedge funds offering higher degrees of liquidity than others. equity and real estate, on the other hand, tend to fall in the illiquid bucket. These investments provide diversification and offer investors a longer return stream along with the ability and capacity to more effectively match long-term liabilities with these assets. Figure 1: Ability of Assets Held by Global Defined Benefit Plans to Cover Liabilities Index Change Since 18 (%) Source: Towers Watson 01 Global Pension Assets Study. 75. Why are more and more investors turning to alternatives? For starters, a new paradigm may be emerging with respect to traditional portfolio construction. Investors are increasingly focusing on outcomes rather than managing to traditional long-only strategies and benchmarks, and many are confronting the reality that traditional assets alone i.e., stocks and bonds will not offer downside protection or generate enough alpha to help them achieve their desired investment objectives. As Figure 1 illustrates, this is particularly true for global defined benefit plans, where current asset bases are falling short in Figure : Emerging Allocation Legacy Allocation Hedge Fund Allocation Real Estate Credit Cash Emerging Allocation Illiquid Investments Liquid Alpha (opportunistic) Real Assest Credit Cash Distressed Global Macro Market Neutral Real Estate Commodities Long-Short Long-Only Long-Short Credit Core Plus High-Yield Source: Casey Quirk; Valores Capital Partners, Asset Management Sector Expertise, February 01.

2 Figure : Global Investable Assets North America $5.T #1 Pensions $18.T #1 Insurance $7.T # Banks $6.6T Middle East $.7T Europe $.6T #6 Pension $5.6T # Insurance $.6T #5 Banks $5.7T Asia-Pacific $16.5T #7 Pension $5.1T #8 Insurance $.7T #10 SWF $.6T # Banks $.8T Other $.6T $8T Institutional Pensions $0T Insurance $T E&Fs $T SWFs $6T Banks/HNW $18T Family Offices $.5T Source: Brown Brothers Harriman, Strategic Insight, en Vogue: Designing the Next Blockbuster Fund, 01. meeting liabilities. Because of this and other trends, more investors (see Figure ) are seeking strategies that can provide both pure alpha and return stream diversification within their core portfolio allocation. re-deployed into alternatives. In our view, investors may need to rethink their portfolios in order to keep costs in line, and increased replication of active core equity and fixed-income strategies will be sourced by lower-fee passive strategies. As a result, many investors are turning to alternatives and the industry is growing quickly. Assets in alternative vehicles totaled more than $6 trillion at the end of 01, up more than $0 billion from year-end For more context, alternatives today account for approximately 10% of global assets under management up from 6% in 00 with hedge funds ($ trillion) representing the lion s share. Market Size and Key Trends Figure provides an estimate of total global investable assets, categorized by investor type and geography. According to the latest data available, global investable assets were estimated to be $8 trillion through September 01, up approximately 8% from year-end 01. Figure : Global AUM by Product $7.5T 5%, $1.T %, $8.T %, $0.6T 66%, $.8T $7.T 8%, $.T %, $10.8T %, $1.T 5%, $8.1T $6.T 10%, $6.0T %, $15.1T %, $.5T %, $0.T As the figure shows, nearly 75% of the world s total investable assets are owned by institutional investors, while 5% is attributable to individual investors. As for alternatives, this asset class has doubled from 5% to 10% (Figure ) of the overall global AUM pool. However, as part of the global net revenue pool, alternatives are expected to generate the largest share of net revenues by 016 (Figure 5), which is indicative both of expected demand for alternative products and the higher fees alternatives will command going forward. Additionally, while investors remain focused on minimizing portfolio expenses and adding diversification in order to lower volatility it is likely that increased allocations to index products will continue to rise, with fee savings supporting the growth of allocation to alternatives. Figure 6 projects that investors can gain % in fee savings by moving from active to passive strategies, with those savings potentially being 5%, $.0T %, $.T Active Specialties Solutions LDIs Active Core 5 1%, $7.T 01 Passive/ETFs CAGR (%) Source: Valores Capital Partners, Asset Management Sector Expertise, February 01; Strategic Insight; BCG Analysis. Note: ETFs = exchange-traded funds; LDIs = Liability-driven investments. Any apparent discrepancies in totals are due to rounding. 1 Includes hedge, private-equity, real estate, infrastructure, and commodity funds. Includes equity specialties (foreign, global, emerging markets, small and mid caps, and sector) and fixed-income specialties (credit, emerging markets, global, high yield, and convertibles) Includes absolute-return, target date, global asset-allocation, flexible, income, and volatility funds, and LDIs. Includes active domestic large-cap equity, active government fixed-income, money market, and traditional balanced and structured products. State Street Global Advisors

3 Figure 5: Global Net Revenue by Product Industry Revenues ($B) 00 +7% Estimated Revenues CAGR (%) Figure 6: Active Shift Industry Fees ($M) A Portion of Fee Savings From Moving to /0 Passive/Active Mix Can Be Reallocated to 0 68 Active Core Active Specialties Source: Boston Consulting Group Projected Global Asset Management Net Revenue Pool Money Market Passive Solutions Parallels to the Early Days of Exchange-Traded Funds Alternative investment strategies have historically been the exclusive domain of institutions and other sophisticated investors. However, alternative managers in recent years have sought greater access to the global retail market. Within the US, for example, alternatives are growing through 10 Act ( 0 Act) mutual funds and ETFs and in Europe, these strategies are being more broadly dispersed to investors through collective investment funds, including UCITS.* Currently, the biggest non-traditional and alternative funds manage close to $0 billion in assets through these vehicles and almost all of these funds offer daily liquidity. It is interesting to note that asset growth trends in the European UCITS market appear to correlate with growth patterns in the US, with both markets generating compounded annual growth rates of 11.0% and 11.%, respectively, from 11 to 011. The projected growth in the US Alternative 10 Act space (see Figure 7) will be driven by an institutional shift from private to public vehicles, along with increased adoption by retail investors. As for the projected growth in UCITS-type vehicles, foreign managers have the ease and flexibility to create funds under this structure and we believe many are looking to create liquid alternatives within this framework to meet future retail demand. Greater adoption of alternatives going forward should help alleviate the asset concentration we currently see at the top of the alternatives field. While there are approximately,000 alternative and non-traditional mutual funds and collective trusts, the top 1% of funds account for almost 100% of total annual flows. 5 The recent strong growth of alternatives driven primarily by absolute return-oriented, multi-asset *Undertakings for Collective Investment in Transferable Securities Directives Fees-Today Savings Fees-Future Fees-Today Savings Source: Goldman Sachs, Retail Liquid : The Next Frontier, December 6, 01. Fees-Future class vehicles and non-traditional bond strategies has generated this high concentration amongst just a few managers. As a result, while awareness and acceptance is climbing, most investors are still unfamiliar with the many types of alternative strategies available to them and they are choosing those managers that are most well-known, thereby erpetuating this top-heavy concentration. Like traditional investment strategies, alternatives are not immune to the critical consideration of capacity. Therefore, concentration in top managers may ultimately succumb to new entrants and wider competition as capacity is consumed. Interestingly, this current phenomena in alternatives bears a striking resemblance to the early days of exchange-traded funds (ETFs), when there was significant concentration in relatively few managers and offerings. 6 Expansion of the overall ETF industry and its products grew significantly over time as Figure 7: Outlook for Alternative UCITS & 0 Act Funds Alternative 0 Act & UCITS Funds ($) $17B % $B $B % $55B Retail Audience to Purchase Hedge Funds (%) $B 71% E 1E 15E 16E $1.5T 17E Source: Citi, The Rise of Liquid & the Changing Dynamics of Alternative Product Manufacturing and Distribution, May State Street Global Advisors

4 retail intermediaries were educated on the underlying benefits, uses and risks of ETFs. Similarly, increased education around alternatives could spur meaningful adoption and a flood of new entrants, thus fueling growth and manager expansion for years to come. Convergence on the Rise The success of long-only volatility/momentum, non-traditional bond and diversified hedge funds is a main driver behind the convergence trend we re seeing among traditional and non-traditional asset managers. Over the past several years, alternative asset managers have increasingly joined forces with traditional managers to expand into new segments in response to both market opportunities and regulatory changes. On one side of the industry, many mutual fund companies are struggling as they continue to lose market share to low-cost ETFs, and are therefore considering liquid alternative products as a way to stop the bleeding. On the other side, dedicated alternative asset managers are looking to tap into the lucrative retail investor market to help boost their returns. 7 Figure 8 illustrates this growing overlap. In the US, AQR Capital Management is a prime example of a hedge fund that turned to the 0 Act mutual fund industry to access a new and expanded customer base. In just five years, Figure 8: Convergence Liquidity Liquid Illiquid High Public Funds Passive ETF & Index Funds Benchmarked Long Only Traditional Asset Managers Hedge Fund Managers Public & Overlap Funds Convergence Unconstrained Long Hedged Long & Actively ManagedFutures (Altermative Beta) Liquid Long/Short More Liquid Asset Managers, Hedge Funds & Firms Transparency Long/Short Opportunistic Firms Real Assets & Long Duration Less Liquid Low Source: Citi, The Rise of Liquid & the Changing Dynamics of Alternative Product Manufacturing and Distribution, May 01. Figure : Emerging Business Models for Breadth of Investment Capabilities Multi-Alternative Mega Firm Blackstone KKR the quantitative-focused firm has built up a diversified family of alternative and long-only volatility/momentum-based mutual funds. This business has grown to $1 billion in assets under management, including diversified arbitrage, managed futures, multi-strategy and risk-parity mutual funds. 8 Further, traditional managers have become more active in the alternatives/hedge fund space with firms like Old Mutual, TIAA-CREF, Franklin Templeton (with K Associates) and Wells Fargo (with Rock Creek) integrating more alternative capabilities into their offerings. These firms are also seeking to expand their alternatives expertise by combining their in-house knowledge and enhancing the gaps through sub-advisory arrangements, investments or acquisitions. As a result, a new alternatives ecosystem is taking shape with four successful business models emerging each with a unique value proposition and its own distinct advantages and disadvantages for growth. Figure provides the emerging constructs into which these blended asset managers may be categorized. Looking Ahead Specialist Platform Apax Partners OCH-ZIFF The Caryle Group Apollo Bridgewater Man Degree of Product Integration Diversified Asset Manager BlackRock Invesco J.P.Morgan PIMCO Single-Strategy Boutique CQS Maverick PERRY CAPITAL CAXTON Source: McKinsey & Company, McKinsey Alternative Investment Survey of Institutional Investors, June 01. Backed by ongoing demand, alternatives including liquid alternatives are on pace to grow attractively over the next several years and occupy an even larger slice of overall investable assets. However, the precise rate at which this projected growth occurs will likely depend on the following challenges and considerations: State Street Global Advisors

5 Capacity constraints and availability of high-quality investment managers Increased complexity both on the investment side and operationally, along with different/unique risk requirements Challenging and changing regulatory requirements (e.g., Dodd-Frank, Volcker) and increased scrutiny Ability to widely market/disclose alternative products in a clear and transparent manner Many of our clients continue to augment and enhance their portfolios to include more alternative investment strategies. SSGA offers capabilities in this growing asset class, and is committed to expanding its suite of alternative strategies to keep pace with the demand. For insitutional use only. Not for use with the public. 1 Preqin Investment Outlook, Alternative Assets, H1 01. Deutsche Bank Markets Prime Finance, Twelfth Annual Alternative Investment Survey, February 01. Brown Brothers Harriman, en Vogue: Designing the Next Blockbuster Fund, 01. Citi, The Rise of Liquid & the Changing Dynamics of Alternative Product Manufacturing and Distribution, May Brown Brothers Harriman, en Vogue: Designing the Next Blockbuster Fund, Goldman Sachs, Retail Liquid : The Next Frontier, December 6, PwC s Regulatory Brief, SEC sweep: Liquid alternative funds: Enter SEC (June 01). 8 Morningstar Direct, November 0, 01. McKinsey & Company, McKinsey Alternative Investment Survey of Institutional Investors, June 01. ssga.com State Street Global Advisors US and EMEA Entities Belgium: State Street Global Advisors Belgium, Chausse de La Hulpe 10, 1000 Brussels, Belgium. T: , F: SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 170 Near Dubai Mall & Burj Khalifa, P.O Box 688, Dubai, United Arab Emirates. 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T: F: United States: State Street Global Advisors, One Lincoln Street, Boston, MA T: Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries. Investing in futures is highly risky. Futures positions are considered highly leveraged because the initial margins are significantly smaller than the cash value of the contracts. The smaller the value of the margin in comparison to the cash value of wthe futures contract, the higher the leverage. There are a number of risks associated with futures investing including but not limited to counterparty credit risk, currency risk, derivatives risk, foreign issuer exposure risk, sector concentration risk, leveraging and liquidity risks. The views expressed in this material are the views of Keith Crawford through the period ended November 01 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Alternative investment funds are designed only for sophisticated investors who are able to bear the risk of the loss of their entire investment. An investment in an alternative investment fund should be viewed as illiquid and interests in alternative investment funds are generally not readily marketable and are generally not transferable. Investors should be prepared to bear the financial risks of an investment in an alternative investment funds for an indefinite period of time. An investment in an alternative investment fund is not intended to be a complete investment program, but rather is intended for investment as part of a diversified investment portfolio. Typically interests in an alternative investment fund are not registered under the US Securities Act of 1, as amended ( the Securities Act ), and the fund is not registered as an investment company under the US Investment Company Act of 10, as amended (the Investment Company Act ), and as such, investors will not be afforded the protections of those laws and regulations. A prospective investor should carefully review all offering materials associated with alternative investment funds, including the risk factors, and should consult his or her own legal counsel and/or financial advisor prior to considering an investment in an alternative investment fund. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investors particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. State Street Global Advisors 015 State Street Corporation. All Rights Reserved. ID-INST Exp. Date: 11/0/015