Global Equity Portfolio Construction Fall 2012
INTRODUCTION Investors should thoughtfully construct an equity portfolio by: Identifying the objective Taking a global approach Expanding away from long only equities Private equity help enhance returns Hedged equity help manage risk and seek alpha Focusing on implementation Strategic biases Value Small Cap Emerging Markets Effective use of active management Size einvestments appropriately Employ active asset allocation 1
OBJECTIVE The primary role of an equity portfolio is total return Asset Categories Role Risk Global Equity (stocks, private equity, long/short hedge funds) Total Return Stock Market Declines Global Fixed Income and Credit (bonds, bank loans, credit hedge funds) Deflation Protection and Total Return Rising Rates and/or Credit Downgrades Real Assets Inflation Protection Deflation (real estate, natural resources,commodities) and Total Return Diversifying Strategies (absolute return hedge funds, trading strategies) Diversification and Total Return Active Management Sample Equity Portfolio Construction Objectives Role Absolute Relative Global Equity Total Return >5 7% Real Return Return > MSCI ACWI* with less volatility Public Total Return >5% Real Return Return >MSCI ACWI Private Total Return >8% Real Return Return >MSCI ACWI + 3% Hedged Total Return + Volatility Reduction + Alpha >5% Real Return Return >MSCI ACWI with 2/3 of the volatility * MSCI All Country World Index For Illustrative Purposes Only 2
OBJECTIVE The primary risk to an equity portfolio, regardless of equity asset category, is a substantial stock market decline that impairs capital Equities can experience periods of high correlations Rolling 5 year Correlations to the MSCI All Country World Index (ACWI) 1.0 08 0.8 0.6 0.4 0.2 S&P 500 Russell 2000 Russell 3000 Growth Russell 3000 Value MSCI EAFE MSCI Emerging Markets HFRI Equity Hedge (Total) Private Equity 0.0 0.2 Sources: PerTrac, MSCI, Hedge Fund Research, Venture Economics 3
OBJECTIVE Many investors incorporate three elements to meet their total return objectives Low fee, beta exposure Passive allocations that help generate total returns and equity beta equal to a broad index of public equities Maximize performance Portfolio tilts and allocations to private equity to help generate higher total returns by increasing the portfolio s equity beta Risk controlled performance Allocations to hedged equity to reduce the portfolio s equity beta, add alpha through active management, and help improve risk adjusted returns 4
GLOBAL Taking a global approach A global portfolio increases the opportunities for investment 5
GLOBAL Despite recent high correlations bt between equity markets, kt there is risk to concentrated allocations to individual countries Over long horizons, investors would have experienced significantly less severe worst cases by investing with a global perspective versus maintaining a home country bias Source: AQR Capital Management. Analysis from 1/1950 through 8/2009. Average Worst Returns for Local and Global Portfolios (1950 2008) Cumulative Rea al Returns 20% 0% 20% 40% 60% Average Global Returns During Worst Local Returns Events Average Worst Global Return Average Worst Local Returns 80% 0 12 24 36 48 60 72 84 96 108 120 Source: AQR Capital Management Months 6
PRIVATE EQUITY Expanding away from long only equities Private equity can provide key benefits including: Potential for premium returns to the public markets capture an illiquidity premium added value from active management Broader investment opportunity set Performance as of March h31, 2012 5 years 10 years 15 years 20 years All Buyouts 5.7% 12.8% 12.1% 13.4% Russell 3000 Index 2.2 4.7 6.5 8.7 Illiquidity Premium 3.5 8.1 5.6 4.7 All Venture Capital 5.6 13.6 14.1 15.2 Russell 2000 Index 3.0 7.9 9.4 10.8 Illiquidity Premium 2.6 5.7 4.7 4.3 Sources: Venture Economics and Lipper 7
HEDGED EQUITY Expanding away from long only equities Hedged equity can help reduce or eliminate many of the constraints imposed on traditional long only equity investors, allowing for more definitive active management Over the last 20 years, the HFRI Equity Hedge Index* outperformed the S&P 500 Index and MSCI ACWI on both an absolute and risk adjusted basis Since 1990, the HFRI Equity Hedge Index outperformed the S&P 500 Index in 83% of the rolling 5 year periods Rolling 5 Year Relative Performance HFRI Equity Hedge minus S&P 500 Index formance e Points Relative Perf Percentage 15% 10% 5% 0% 5% Hedged Equity Outperforms S&P 500 Outperforms 10% 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: HFRI Standard & Poors * A composite of hedged equity managers 8
HEDGED EQUITY Hedged equity managers must be able to add alpha in addition to reducing risk, otherwise there are less costly and more efficient means to reducing equity risk The results of a study conducted by Roger Ibbotson et al. showed certain categories of hd hedged dstrategies, including three equity oriented strategies, produced dmeaningfully positive alphas 9
STRATEGIC BIASES Strategic portfolio tilts can provide a return premium Small Cap Public equity small cap stocks outperformed large cap stocks 69% of the rolling 10 year periods Private equity small buyouts outperformed mega buyouts by nearly 4 percentage points annualized over the last 20 years Per rcentage Points Small Cap vs. Large Cap 30 Rolling 10 year Excess Return 20 Average Excess Return: 3.3 percentage points 10 0 10 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 Source: Ibbotson Performance as of March 31, 2012 5 years 10 years 15 years 20 years Small Buyouts 10.9% 14.1% 13.6% 15.9% Mega Buyouts 5.3 12.7 11.4 12.0 Size Premium 5.6 1.4 2.2 3.9 Source: Venture Economics 10
STRATEGIC BIASES Strategic portfolio tilts can provide a return premium Value Large cap value stocks outperformed large cap growth stocks 78% of the rolling 10 year periods Small cap value stocks outperformed small cap growth stocks 91% of the rolling 10 year periods Large Cap Value vs. Large Cap Growth 20 Rolling 10 year Excess Return Average Excess Return: 3.2 percentage points Small Cap Value vs. Small Cap Growth 20 Rolling 10 year Excess Return Average Excess Return: 5.6 percentage points Perc centage Points 10 0 Perc centage Points 10 0 10 19 936 19 941 19 946 Source: Ibbotson 19 951 19 956 19 961 19 966 19 971 19 976 19 981 19 986 19 991 19 996 20 001 20 006 20 011 10 19 936 19 941 19 946 Source: Ibbotson 19 951 19 956 19 961 19 966 19 971 19 976 19 981 19 986 19 991 19 996 20 001 20 006 20 011 11
STRATEGIC BIASES Emerging Markets Debt, demographics, and expected economic growth rates are more favorable for emerging markets versus the developed markets Average Debt to GDP 100% 80% 79.5% 60% 40% 20% 0% 49.8% Emerging Markets Developed Markets Source: CIA World Factbook Percentage of Population Ages 65 and Older 20% 15% 10% 5% Developed Markets Frontier Markets Emerging Markets 0% Source: The World Bank Source: International Monetary Fund 12
ACTIVE MANAGEMENT Effective use of active management A passive allocation or fundamental indexing is suitable to efficiently gain market exposure at little cost $ Invested Index Funds Long Only Developed Public Equity Emerging Markets Potential Value Added Hedged Equity Venture Capital Opportunities, however, exist for managers to add value through: Expert knowledge, better use of information, and access to unique opportunities A valuation oriented, contrarian approach 0 Unconstrained mandates More Efficient Source: Fund Evaluation Group Performance Difference between Top and Bottom Quartile 10 Years ending December 31, 2011 Percentag ge Points 25 20 15 10 5 1.6 2.1 2.2 U.S. Large Cap U.S. All Cap U.S. Small Cap 2.8 3.1 Emerging Markets Sources: Lipper, HFRI, Thomson Venture Economics, PerTrac Less Efficient Global 15.3 Long/Short Equity 19.5 Venture Capital 13
POSITION SIZING LONG ONLY EQUITY NUMBER OF MANAGERS USED BY ASSET CLASS Avoid overlap, excess diversification, and unnecessarily small positions Exposure to geographies, capitalizations, and sectors can be achieved with as few as 3 5 strategies If more equity strategies are used or needed, consider allocating to concentrated, unique strategies and ensure active management fees are not paid for the total equity portfolio to provide market like exposure U.S. Portfolio Construction Considerations Multiple strategies within one style may overlap and provide minimal added value (e.g., two diversified large cap growth managers) All cap strategies can provide broad exposure with fewer managers Non U.S. Developed Markets Similar considerations as U.S. equity A small cap and value tilt can add value to a broad international equity mandate Emerging Markets Similar considerations as U.S. and Non U.S. developed markets A strategic overweight to emerging markets can provide more exposure to a faster growing part of the world Global/ Opportunistic A global manager can take the place of multiple focused managers and have a greater opportunity set to add value Niche manager (country, sector, frontier markets, etc.) may add value 14
POSITION SIZING PRIVATE EQUITY The number of strategies and commitment size is dependent upon whether an investor uses a fund of funds approach or invests direct Direct investments: commitment size guideline of 1 3% of the total portfolio per manager Fund of funds: commitment size guideline of 2 8% of the total portfolio per manager the underlying investments in a fund of funds provide sufficient diversification and fewer fund of funds investments are necessary The number of strategies should provide vintage year diversification to avoid excess exposure during weak exit markets and inadequate exposure during strong vintage years Considerations should be given to strategy and geographic diversification Private Equity Venture Capital/Growth Equity Sample Guideline: Global Buyout Sample Guideline: 30% 50% 30% 50% Special Situations Sample Guideline: 10% 30% 15
POSITION SIZING HEDGED EQUITY Focused Position Size Guideline: 1 3% Core Strategies Broad mandate and skill set Invest across the equity spectrum Actively manage gross and net exposures Opportunistically invest in non equity positions Core Focused Position Size Guideline: 1 3% Position Size Guideline: 3 5% Focused Position Size Guideline: 1 3% Focused Strategies Niche managers Less efficient markets Small/micro cap Emerging markets Sector specialists More concentrated Direct investments: position size guideline of 1 5% of the total portfolio per manager Fund offunds: funds: position size guideline of 5 10% of the total portfolio per manager the underlying investments in a fund of funds provide sufficient diversification and fewer fund of funds investments are necessary 16
ACTIVE ASSET ALLOCATION Investment opportunities or themes may arise, allowing nimble investors the ability to add value by shifting allocations Portfolio changes should be based primarily on valuation Can help lower a portfolio s risk by building in a margin of safety Value investing often necessitates a contrarian position, which is frequently required to achieve superior long term performance HISTORICAL VALUATIONS: U.S. PRICE/10 YEAR NORMALIZED EARNINGS S&P 500, 1950 Present zed) Price / Earnin ngs (Real 10 Year Normaliz 50x 45x 40x 35x 30x 25x 20x 15x 10x 5x S&P 500 P/E10 Average P/E10 0x 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Robert Shiller and Standard & Poor s 21.9x 18.7x HISTORICAL VALUATIONS: INTERNATIONAL PRICE/10 YEAR NORMALIZED EARNINGS MSCI EUROPE, 1982 PRESENT Price / Earnin ngs (Nominal 10 Year Norm malized) 50x 45x 40x 35x 30x 25x 20x 15x 10x 5x MSCI Europe P/E10 Average P/E10 0x 1980 1985 1990 1995 2000 2005 2010 Source: MSCI 21.2x 13.5x 17
GLOBAL EQUITY PORTFOLIO PERFORMANCE Of the three portfolios discussed earlier, the integration of tilts and hedged equity added to performance versus a low fee, bt beta portfolio in nearly every rolling 5 year period Rolling 5 year Annualized Returns 25% 20% 15% 10% Max performance portfolio 5% 0% 5% Low fee, beta portfolio Risk controlled performance portfolio 10% 1999 2001 2003 2005 2007 2009 2011 Sources: PerTrac, HFRI, Venture Economics Portfolio allocations included in the appendix 18
GLOBAL EQUITY PORTFOLIO RISK The risk of a global equity portfolio can be measured relative to a broad global equity index, thus to hl help manage risk ikinvestors could target: t A portfolio beta A desired level of tracking error A targeted volatility A portfolio with an objective of maximizing performance was more volatile over nearly all rolling 5 year periods An equity portfolio incorporating hedged equity reduced volatility in every rolling 5 year period Rolling 5 year Standard Deviation 30% 25% 20% Max performance portfolio 15% 10% Low fee, beta portfolio 5% Risk controlled performance portfolio 0% 1999 2001 2003 2005 2007 2009 2011 Sources: PerTrac, HFRI, Venture Economics Portfolio allocations included in the appendix 19
GLOBAL EQUITY PORTFOLIO RISK Incorporating hedged equity can significantly reduce portfolio beta and the inclusion of private equity and strategic t tilts can increase portfolio bt beta Rolling 5 year Annualized Beta 1.4 Max performance portfolio 1.2 Lowfee, beta portfolio 1.0 0.8 Sources: PerTrac, HFRI, Venture Economics Portfolio allocations included in the appendix Risk controlled performance portfolio 0.6 1999 2001 2003 2005 2007 2009 2011 20
PORTFOLIO CONSTRUCTION QUESTIONS Equity portfolio construction is dependent upon the investment objectives Once the objective is defined, consideration should be given to the following questions to aid in constructing an equity portfolio Question Is the total equity portfolio global? Can the investor accept illiquidity? How important is managing volatility? Does the investor believe strategic tilts can add value? Is active or passive management most appropriate? How many strategies are needed? Are there opportunities to employ active asset allocation? Reason A global approach increases the investment opportunity set Higher probability to outperform the market when investing with top tier private equity managers Hedged equity strategies can provide equity market returns with less volatility through unconstrained management Overweight allocations to value, small cap, and emerging markets offer potential for higher returns Active management is more appropriate in less efficient areas where there is a higher probability to generate alpha Overlap and excess diversification can lead to paying active management fees for market like exposure Certain areas within equity may be more/less attractive based onvaluations 21
SUMMARY Successful equity portfolio construction requires investors to: Identify the investment objectives of the equity portfolio Take a global approach to help improve opportunities and risk mitigation Expand away from long only equities to help enhance returns and manage risk Focus on implementation establish strategic biases effective use of active management appropriate investment sizing opportunistic asset allocation 22
APPENDIX Low fee, beta portfolio low cost portfolio that helps generate total returns and equity beta exposure equal to a broad dindex of public equities 100% MSCI ACWI Index Max performance portfolio portfolio with allocations to private equity, portfolio tilts, and active management in an attempt to generate higher total returns by increasing equity beta exposure 17% S&P 500 Index 9% Russell 2000 Value Index 14% MSCI EAFE Index 9% MSCI EAFE Small Cap Index 23% MSCI Emerging Markets 28% Venture Economics Pooled Average (a micro cap substitute, CRSP Decile 10, was used for volatility and beta calculations) Risk controlled performance portfolio with allocations to hedged equity in an attempt to reduce equity beta exposure, add alpha through active management, and improve risk adjusted returns 83% MSCI ACWI Index 17% HFRI Equity Hedge (Total) Index 23
DISCLOSURES This was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directed to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202 Attention: Compliance Department. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information i provided dby third parties. The information i in this report is given as of the date indicated dand believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities. Past Performance is not indicative of future results. Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown. This report is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or those investors will not incur losses. 24
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