CBIS Approach to Institutional Portfolio Management

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1 ORIGINAL PUBLICATION: JUNE 2012 CBIS Approach to Institutional Portfolio Management Summary Many institutions are best served by a traditional equity/bond portfolio incorporating judicious use of alternative strategies. CBIS portfolios offer exposure to the full spectrum of return drivers across global markets, with transparency and daily liquidity, and can be structured to meet most reasonable risk/return objectives. Trustees and Fiduciaries who oversee institutional portfolios face a bewildering range of investment choices in today s globalized markets. Domestic equities and bonds, international developed and emerging market equities and bonds, private equity, venture capital, real estate, commodities, hedge funds that utilize some or all of these asset classes, and myriad niche styles within these broad categories all present themselves for consideration. An institution s mission may be seen as its animating spirit, the idea that motivates all it does, while its financial portfolio provides the nourishment that brings that spirit to life. Getting portfolio composition right can mean the difference between success and failure for the institution and its financial officers entrusted with portfolio oversight. Combining Financial & Social Value delivering on this goal requires disciplined research and analysis to help us identify leading institutional managers and blend them together into a diverse range of portfolios to meet the ongoing challenges of today s global markets. Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 1

2 THE PERIL OF IMITATING PEERS Given such high stakes, it s no wonder that a first instinct is to imitate what peers are doing, particularly at larger institutions that have achieved prominence as thought leaders in the field. These institutions generally invest a high percentage of assets in alternative strategies such as hedge funds, private equity, venture capital and commodity investments with a reduced emphasis on bonds due to their lower returns. They embrace complex investment strategies with attendant illiquidity, opacity and high management fees. Yet for institutions with less than $200 million in portfolio assets, CBIS believes this approach can thwart more than promote investment success. The analytical resources needed for success here are considerable. Manager selection risk is far higher for complex strategies, where skill is hard to differentiate from luck and peer results show very wide dispersion. Complexity and lack of transparency can make performance reporting difficult, particularly when results disappoint and need to be explained to skeptical colleagues. Burgeoning competition among alternatives managers only amplifies selection risk and increases the size of the crowd seeking alpha opportunities, eroding average returns. Success is not impossible, but it is improbable for institutions without the analytical and financial clout needed to identify and access top managers with proven expertise. CBIS APPROACH Fortunately, smaller institutions don t need to mimic large institutional peers in order to succeed. Most can achieve any reasonable investment objective, largely with conventional, transparent long equity and bond strategies. CBIS standard model portfolio is weighted 90% to equities and bonds (in a traditional 60%/40% division) and to an absolute return multi-strategy Catholic CRI-compliant hedge fund with demonstrated historical low correlations to equity and bond returns. The success of this method, relative to a more complex portfolio using a heavy allocation to alternatives, is seen by comparing its results with endowment and foundation average returns: CBIS MODEL PORTFOLIO: Comparative Performance (Trailing Periods at June 30, 2012) 1 YEAR 3 YEARS 5 YEARS CBIS Model Portfolio* 2.7% 12.3% 2.6% Endowment & Foundation Average^ -0.3% 10.2% 1.1% * A diversified 60% equity/40% fixed-income portfolio using CBIS institutional funds to achieve style diversification within each broad asset class using the following overall portfolio weights: CUIT Core Equity Fund, 12%; CUIT Value Equity Fund, 12%; CUIT Growth Fund, 12%; CUIT Small Cap Fund, 9%; CUIT International Fund, 15%; CUIT Intermediate Diversified Bond Fund, 40%. The CBIS Model Portfolio results shown do not include an allocation to the Catholic CRI-compliant hedge fund, which CBIS recommends on a case by case basis depending on an institution s portfolio size and investment objectives, or the CUIT Opportunistic Bond Fund, which is currently in the launch stage. ^2012 NACUBO-Commonfund Study of Endowments, results released in February /All returns are shown net-of-fee and annualized. I. CBIS MODEL PORTFOLIO WEIGHTS ARE MODIFIED TO MEET CLIENT-SPECIFIC INVESTMENT OBJECTIVES BY ASSET CLASS BY INVESTMENT STYLE 40% 50% 13% 20% 7% 20% 50% EQUITY 40% FIXED-INCOME ABSOLUTE RETURN S&P 500 INDEX VALUE EQUITY GROWTH EQUITY 7% SMALL-CAP INDEX 13% INTERNATIONAL EQUITY 20% INTERMEDIATE BOND 20% OPPORTUNISTIC BOND ABSOLUTE RETURN STRATEGIES Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 2

3 The stronger CBIS returns reflect the endowment and foundation average s heavy alternatives weight (at approximately 50% of assets, where results have been disappointing for many institutions since the 2008/2009 financial crisis) and CBIS much higher exposure to bonds, often shunned by endowments and foundations. The data do not imply that all institutions who have embraced these strategies have fared badly, only that the average portfolio, for all its complexity, has not kept pace with a more straightforward 60/40 portfolio. The results illustrate what we believe is a high bar for success when venturing into alternative investments. CBIS MODEL PORTFOLIO BROAD THEMES Despite its apparent simplicity, the CBIS Model Portfolio is carefully structured to provide complete diversification across global equity and bond investment styles, geographical regions, and exposure to the range of factors that determine asset class returns. Because CBIS is a manager of managers, we: Determine whether each distinct style exposure is best captured by an indexed or active approach, Identify and hire best-in-class managers to execute the desired investment style, Combine two or more managers with unique and complementary approaches in most actively managed funds to augment diversification, and Monitor and evaluate manager performance over time. Figure 1 and the callout box display the Model Portfolio s asset classes, styles and weights (which are altered to meet client-specific risk/return objectives). Several themes and beliefs shape our overall approach. CBIS MODEL PORTFOLIO Styles, Managers, Benchmarks Core Equity Index RhumbLine Advisers; S&P 500 Value Equity Aronson, Johnson, Ortiz (50%); Dodge & Cox (50%); Russell 1000 Value Growth Equity Los Angeles Capital Management (50%); Wellington Management (50%); Russell 1000 Growth Small-Cap Equity Index RhumbLine Advisers; Russell 2000 International Equity Causeway Capital (50%); Principal Global Investors (50%); MSCI EAFE Intermediate Diversified Bond Dodge & Cox (20%), Jennison Associates (40%), Reams Asset Management (40%); Barclays Capital Aggregate Index Opportunistic Bond Longfellow Asset Management (50%), Reams Asset Management (50%); Barclays 1-5 Year U.S. Government Credit Index Absolute Return Catholic CRI-compliant hedge fund using event-driven, long/short equity and global fixed-income arbitrage strategies; please inquire for additional information Exposures Equity Allocation: U.S., global developed markets, global emerging markets, large-cap, mid-cap, small-cap Bond Allocation: U.S. investment-grade and high-yield Diversification Eight equity strategies, five bond strategies, ten sub-advisors Approximately 2,800 individual equity securities across long equity programs Approximately 750 individual debt securities across intermediate diversified bond programs Catholic CRI Proprietary stock screens for violence and militarism, life ethics, tobacco, pornography Shareholder advocacy across a range of environmental, social justice and corporate governance-related issues Proxy voting for more than 3,600 domestic and international portfolio companies Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 3

4 II. LARGE-CAP STOCKS DOMINATE MARKET INDICES Composition by Constituent Company Market Capitalization III. BONDS STILL OFFER HEDGE ON DEFLATION & EQUITY LOSSES Moody s Aaa Bond Yields (Jan Jan. 2013) 100% 75% 50% 25% 0% S&P 500 Russell 3000 Wilshire 5000 Large Cap (>$15B) Mid Cap ($2B-$15B) Small Cap (>$2B) Source: Wilshire 18% 16% 14% 12% 8% 6% 4% 2% 0% Jan-19 Jan-34 Jan-49 Jan-64 Jan-79 Jan-94 Jan-09 Source: U.S. Federal Reserve IV. INTERNATIONAL EXPOSURE THROUGH THE S&P 500 S&P 500 International Revenue (% of Total) V. MIND THE CORRELATIONS Hedge Fund of Funds & Wilshire 5000 (Dec Dec. 2012) 100% 80% 60% 40% 20% 0% Source: Standard & Poor s Jan-34 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Source: Wilshire Compass U.S. Dollar Emphasis Most CBIS participants liabilities, whether retirement benefits, foundation grants or operational expenses, are dollar-denominated. Substantial foreign exposure entails considerable currency risk and the risk that these liabilities will not be met. Developed and emerging markets offer attractive companies for investment and diversification opportunities for U.S. investors. Yet the U.S. still offers the world s deepest, most liquid capital markets and the political stability, economic strength and entrepreneurial energy that creates the best environment for wealth creation. The portfolio s 13% international allocation is sizeable enough to take advantage of valuation inefficiencies outside of U.S. markets. Large-Cap Emphasis As shown in Table II, the investable U.S. equity universe is dominated by liquid, large-cap companies, with modest mid-cap exposure. There are good opportunities in the mid- and small-cap areas, but most companies are too small and illiquid to be viable institutional investments. The portfolio s 8% small-cap allocation is higher than pure capitalization alone might indicate, but reflects the sheer number of opportunities here. We use an indexed small-cap exposure to help reduce fees while capturing the return potential from this market segment. Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 4

5 Role of Bonds Despite strong returns over a 30-year bull market dating from the early 1980s, high-quality bonds continue to offer an effective hedge on deflation risk and weak equity market returns. Depression-era results illustrate this. As shown in Chart III, bond yields fell below today s level in 1934 and declined for 16 more years, reaching 2.6% in While not shown in the chart, a review of high-quality bond yields back to the 19th century shows they generally remained under 3% from 1872 until World War I. CBIS also utilizes the new CUIT Opportunistic Bond Fund (OBF) to address the longer-term risk of inflation and rising rates within the portfolio s fixed-income allocation. S&P 500 International Exposure U.S. investors gain considerable exposure to global economic growth through the S&P 500 and other domestic companies. As shown in Chart IV, over 40% of S&P 500 sales are generated outside the U.S. Role of Alternative Strategies Chart V illustrates a theme that has bitten some institutions who have embraced alternatives correlation failure. The chart shows rolling 36-month correlations between the Wilshire 5000 domestic equity market index and the HFRI Fund of Funds Index (an index of a diverse group of hedge fund of funds). Many hedge fund strategies, as well as venture capital and private equity results, are highly correlated with equity market returns. Private equity and venture capital are particularly reliant on strong equity markets to accommodate investor exit strategies, whether a sale or initial public offering (IPO). CBIS believes smaller institutions should use alternatives carefully, primarily to hedge equity and bond weakness, and only when the strategies used demonstrate a clear low correlation with historical stock and bond returns. CBIS MODEL PORTFOLIO STRUCTURE AND DIVERSIFICATION The CBIS Model Portfolio offers prudent exposures to the full range of factors driving returns across global markets, diversified across eight equity strategies, five bond strategies and ten separate and distinct sub-advisors. We expect our managers to apply their expertise to take advantage of valuation opportunities within their style mandate, con-strained by our broad guidelines imposed for risk control. For example, emerging market exposure (EM) is held to 15% of assets in the CUIT International Fund, where the two individual managers have discretion to manage EM weight as valuations change. In the CUIT Intermediate Diversified Bond Fund, high-yield exposure is held to of Fund assets. The Fund s three sub-advisors each have discretion to use high-yield under guidelines set by CBIS. These niche allocations are incorporated within the existing Funds to manage costs while taking advantage of our sub-advisers expertise. Separate specialist managers would add to fees while offering little additional analytical capability. While not the primary consideration, the impact of fees is an important consideration in portfolio structure. Broad asset class weights are based on a 50% equity/40% bond/ hedge benchmark portfolio. Style weights are derived from analysis of historical returns and correlations as well as capital market return assumptions looking out over a 10 to 20 year period, although all weights are adjusted to meet client-specific risk/return objectives. In addition to asset class diversification, style diversification within asset classes and strategy diversification within styles, the model portfolio provides security-level diversification across more than 2,800 individual domestic and international equities and 750 individual bonds. CBIS does not advocate attempting to time the market through tactical asset allocation strategies. Successful market timing usually involves far more luck than skill, and the required analytical resources and decision-making speed would overwhelm the mandate and abilities of most finance committees. Instead, we suggest that participants respond to market volatility with a disciplined rebalancing program, typically bringing allocations back to policy portfolio weights when they shift away by five or more percentage points. Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 5

6 WORKING WITH CBIS The discussion above presents our overall approach to portfolio management, yet equally important is our ability to customize this approach to meet each participant s specific needs. All participants are assigned a CBIS Investment Advisor (IA), a highly experienced investment professional with a unique understanding of the needs of Catholic institutional investors. The IA can review your institution s governing documents, asset pool structure, investment policy statement (or help you create or update yours if needed), anticipated receipts and outlays, and your short- and longterm financial goals. The IA will then take these insights and combine them with a spending and portfolio optimization analysis to develop asset class and style weights that best match your financial objectives. He or she can work with you and your finance committee colleagues to foster a comfort level across your organization with portfolio strategy, return objectives and risk tolerance. The IA will also develop a service plan that meets your needs and expectations on an ongoing basis. Service can include reporting on trends and developments in financial markets, analyzing quarterly portfolio performance and individual fund results, and reviewing CBIS socially responsible investing program news and developments. Important Information The CUIT Funds are exempt from registration with the Securities and Exchange Commission and therefore are exempt from regulatory requirements applicable to registered mutual funds. All performance (including that of the comparative indices) is reported net of any fees and expenses, but inclusive of dividends and interest. Past performance is not indicative of future performance. The return and principal value of the Fund(s) will fluctuate and, upon redemption, shares in the Fund(s) may be worth less than their original cost. Complete information regarding each of the Funds, including certain restrictions regarding redemptions, is contained in disclosure documents which can be obtained by calling Shares in the CUIT Funds are offered exclusively through CBIS Financial Services, Inc., a broker-dealer subsidiary of CBIS. Christian Brothers Investment Services, Inc. n info@cbisonline.com PAGE 6