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Asset Allocation Solutions for Pension & Insurance Companies John McLaughlin Head of Multi Asset Solutions The Great Court at the British Museum May 2010 | For professional investors only. This material is not suitable for retail clients Getting the balance right Is a traditional balanced approach the answer? 1. Diversification is limited to 2 or 3 asset classes 2. Benchmark is not aligned to the client’s ultimate objective 3. Focus is greatest where the opportunity is least 4. Asset allocation is slow moving and lacks conviction 5. Risk management amounts to monitoring a tracking error 6. Liabilities are difficult to match using bonds and are not particularly capital efficient Liabilities Bonds 1 Equities Static diversification is not enough You must also rebalance dynamically Simple static diversification provides protection as the tech bubble collapses June 2000 – April 2006 Simple static diversification offers little protection in the current down turn April 2006 – June 2009 140 140 130 130 120 120 110 110 100 100 90 90 80 80 70 70 60 60 50 Jun 00 50 May 06 Jun 01 Jun 02 Jun 03 Jun 04 MSCI AC World £ hedged Diversified Index £ hedged Jun 05 May 07 May 08 Schroder Diversified Growth Acc £ MSCI AC World £ hedged Diversified Inex £ hedged *Diversified Index: 50% MSCI AC World TR $,10% HFRI Fund of Funds Composite TR $, 7% JPM EMBI Global Composite TR $, 10% ML Global High Yield TR $, 10% FTSE EPRA/NAREIT Developed TR $, 3% LPX50 TR $, 10%DJ UBS Future Commodity Index ER $. Rebalanced on monthly basis. Source: Thomson DataStream, Schroders. Updated 30 th June 2009. 2 May 09 Dynamic multi-asset investing Say ‘No’ to the traditional approach No Benchmark Target an absolute risk/return outcome No Limits Asset type Broad diversification by Risk source Investment vehicle Equity Cash Private Equity Equity Property Infrastructure Illiquidity High Yield Term Commodities Hedge Funds Credit Volatility Currency Skill No Fear No Surprises High conviction asset allocation: Construct portfolios based on risk weighting, not trade weighting • Capital rotation through the market cycle • Taking advantage of valuation opportunities Observe and control the portfolio through different risk lenses e.g. VaR, factor risk, liquidity risk • Realising investment themes Use customised, quantitative risk management tools Easy to say, not so easy to do ….. successfully Schroders asset allocation model Asset allocation is hard to do well Fund Managers & Analysts Equity Fixed Income 163 53 Alternatives 67 Quarterly Monthly Daily Cyclical Market Forum Global Asset Allocation Committee Fund Management & Analysis 40+ Senior 5 Independent 22 Fund Managers and Fund Managers / Analysts Multi-Asset Specialists Analysts Gather Information Determine Investment Policy Construct Portfolios – Outlook for asset classes – Asset class preferences – Sizing positions – Specialist views – Conviction & Accountability – Fund / Vehicle selection – Discuss economic scenarios – Set stop-loss/take-profit – Monitor risk & return Investment Strategy Risk Management 5 macro economists 16 quants and derivative experts Models & economic cycle analysis Specialist resources are necessary - lots of them Source: Schroders, 31 December 2009 *Team of 30 includes portfolio management, quant analysis, research, trading and support 4 Optimisation, risk analysis, hedging Asset allocation in practice Getting ideas into the portfolio – the Schroders way − − Global asset allocation committee members sponsor and co-sponsor ideas Challenged by colleagues Alan Brown, Keith Wade, Johanna Kyrklund, Simon Doyle and Richard Coghlan Sponsor Co-Sponsor Long High Yield Debt vs. Cash Cash Johanna Kyrklund Alan Brown Long Investment Grade vs. US Government Government Bonds Bonds Keith Wade Johanna Kyrklund − All ideas structured as long/short positions − Analysis to ensure risk control and diversification − Implemented quickly, to take advantage of market conditions Short Long Equities Equities vs. Cash Cash − Accountable and transparent process Long LongPacific Can $ vs. Basin Equities Australian US Equities$ Richard Coghlan Simon Doyle Long Emerging Market Currencies G3 G3 Currencies Currencies Johanna Kyrklund Keith Wade Source: Schroders, for illustration only 5 5 Voting Members GlobalAsset AssetAllocation Allocation Global Committee Committee (monthly) vs. Keith Wade Richard Coghlan Implementing your ideas efficiently – Active or Passive funds ? Getting “Bang for your Buck” Efficient (Passive) – Some benchmarks are much harder to beat than others – Focus on selecting actively managed strategies only in inefficient asset classes where high probability of achieving positive alpha exists – Avoid paying active management fees where probability of positive alpha is low by selecting low cost passive funds Inefficient (Active) Source: Lipper Hindsight, February 2010 Percentage of funds outperforming benchmark +1% 1 2 +2% +3% European Money market Swiss Equities European Govt Bonds Japanese Small Caps UK Equities US Agg Bonds Emerging Market Debt Index 5 12 15 16 20 21 23 10 16 9 4 6 8 5 3 3 3 4 2 Emerging Market Equity 24 13 8 5 Japanese Equities 24 18 13 9 European Corp Bonds 28 14 4 European Equity 32 22 14 13 Global Equities 35 30 24 18 Global Energy 40 16 9 European Small Caps 46 36 32 27 European Financials 50 23 21 19 US Small Caps UK Agg Bonds 53 57 45 25 36 9 29 2 Portfolio construction The right tools also make a big difference SMART (Schroders Multi-Asset Risk Tool) Quantitative framework Cyclical model1 Expansion Recession Recession Valuation 4 3 2 1 0 -1 -2 -3 Estimated US Output Gap Baseline forecast model2 Equities cheap Normalised over 10 years +/- 1 SD Equities expensive 90 92 94 96 98 00 02 04 06 08 10 Momentum model3 40 BUY equities 20 Equity total return Y-on-Y % 0 -20 Sell equities -40 -60 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 1 Source: Congressional Budget Office (CBO), Thomson DataStream, Schroders Source: Thomson Datastream. Normalised Earnings yield minus bond yield 3 Source: Thomson Datastream. Equity year on year return 2 Multi-Asset Portfolio Construction • Risk Reporting and Decomposition • Portfolio Simulations • … and much much more Slowdown 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 60 • Recovery 4 2 0 -2 -4 -6 -8 -10 Solution 1: Global Asset Allocation Proof that the processes and the resources work! Investment Features 125 – Aims to provide absolute returns which are uncorrelated with other asset classes 120 – Performance target of 10% above cash gross of fees over rolling 12 months 115 Ann. strategy return: Ann. strategy volatility: Ann. LIBOR return: Ann. excess return: 9.80% 6.41% 2.93% 6.87% – Volatility target of 10-15% p.a. 110 Benefits – Almost all positions implemented through derivatives, keeping transaction costs low 105 – Fund uses Schroder’s proprietary risk software to optimise allocations and manage risks 100 – More liquid and transparent than many macro funds Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar 08 08 08 08 08 08 09 09 09 09 09 09 10 10 Global Tactical Asset Allocation – Diversifying within portfolio Source: Schroders. Chart shows monthly performance for the Global Tactical Asset Allocation portfolio. The Strategy was operating on a live basis in a managed account with £4 million of Schroder seed capital from January 2008 until April 2009. Performance shown is past performance. Past performance is not necessarily a guide to future performance. The value of investment can go down as well as up and is not guaranteed. 8 3 month £ LIBOR Solution 2: Diversified Growth Fund Equity like returns with 2/3 the risk of equities Equities 44% A smoother path of returns over time 170 Em. Market Debt 11% 160 High Yield Bonds 9% Schroder ISF Global High Yield 6% Bluebay High Yield Fund 3% 130 Infrastructure 3% 120 Absolute Return 2% Private Equity 2% Schroder ISF Asia Pacific Property Securities 3% Invista Foundation Property Trust REIT 1% International Public Partnerships 2% HSBC Infrastructure Company Ltd Ordinary1% JP Morgan Highbridge Statistical Market Neutral Fund 2% Private Equity* 2% Schroder ISF EURO Corporate Bond 3% Vanguard Inv Grade Credit Fund 3% Tactical Inv. Grade Bonds 6% 100 Strategic Schroder AS Commodity Fund 4% Schroder ISF Global Energy 4% ETFS Gold 2% Property 4% 110 Schroder ISF Emerging Market Debt Absolute Return 6% PIMCO Emerging Market Bond Fund 5% Commodities 10% 150 140 Schroder ISF US Small & Mid Cap 9% Schroder ISF QEP Global Quality 7% Schroder ISF QEP Global Active Value 6% Schroder ISF European Special Situations 3% Schroder ISF Emerging Markets 3% Schroder ISF Asian Equity Yield 3% Schroder ISF European Equity Alpha 2% Schroder ISF European Allocation1% Passive Equity Derivatives 10% Time Convertibles 4% CPI +5% Global Equities Cash 8% Schroder ISF Global Convertible Bond 4% Cash 8% Diversified Growth Fund Source: Schroders as at 26 February 2010. Please note that this is indicative exposure only and may change, subject to market conditions and outlook *Private Equity includes allocation to Schroder PEFOF IV plus 1 listed externally managed fund. Total may not sum to 100 due to rounding 9 Externally Sourced Solution 3: Diversified Completion Fund Fully managed access to alternative investments Designed specifically to ‘complete’ a growth portfolio of equities Asset Allocation as at 1 March 2010 Targets cash + 4% p.a. over rolling 5 year periods Maintains a beta of less than 0.5 to equities Full ongoing governance responsibility – Manager selection – New asset classes as appropriate Transparent fees Return from Dec 07 to Dec 09: +5.8% p.a. Source: Schroders, as at 1 March 2010 10 High Yield Debt 19% Commodities 14% Hedge Funds 11% Emerging Market Debt 11% Infrastructure 7% Catastrophe Risk 6% Property 6% Leveraged Loans 4% Private Equity 3% Active Currency 2% Convertible Debt 2% Cash 15% Solution 4: Global Dynamic Balanced Fund Limiting the downside Schroder Global Dynamic Balanced Fund Calendar Year Performance Return % – Like the Diversified Growth Fund, but with a systematic overlay that exits the market during a downturn 40 30 20 10 – Aims to limit drawdowns to -10% in the worst years for risk assets – Active allocation to risk assets, between 0% and 60% 0 -10 -20 Avoiding bursting of tech bubble -30 -40 Avoiding worst of credit crunch Strategy Source: Schroders, Datastream as at 31st December 2009. Backtested performance until 31st December 2008, live performance from 1st January 2009. Live performance is gross of fees using NAV for I shares. The simulated results must be considered as no more than approximate representation of the strategy’s potential performance. They are the result of back-testing quantitative research results, which are based on a number of assumptions. There are a number of limitations on the retroactive reconstruction of any performance results based on simulations. Past performance is not a guarantee of future results 11 Equity Market 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 -50 New solutions: Real assets fund Durable goods % contribution to CPI- U y/y Rent of shelter 80% 60% 40% 20% 0% -20% -40% -60% Asset Strategic Current Weights Views DJ AIG CMCI Commodity Index 25% 28% 80% TIPS 20% 10% 60% 40% CS Leveraged Loans 10% 12% ELMI+ 10% 20% FTSE EPRA/NAREIT Global 10% 3% MSCI Energy 10% 10% 88 90 92 94 96 98 00 02 04 06 08 20% 0% -20% -40% -60% % contribution to CPI- U y/y Commodities* % contribution to CPI- U y/y The ‘real’ answer to future inflation? 88 90 92 94 96 98 00 02 04 06 08 30% 20% 10% 0% -10% MSCI Metal and Mining 10% 7% MSCI EM 5% 5% High dividend stocks n/a 5% -20% -30% 88 90 92 94 96 98 00 02 04 06 08 Source: Bureau of Labour Statistics, Data Stream, Schroders. *Food and beverages & non durables less food and beverages 12 New solutions: DC pensions market ‘Pension Plus’ – your retirement supplement Accumulation Period Drawdown Period Maximum allocation to growth assets No drawdown distribution Monthly drawdown payments from Year 11 to Year 25. Coupons are deducted from the NAV NAV Highest NAV 100% Inception Year 25 Protected Drawdown Bonus Payout* Payments set at 5% p.a. of highest recorded NAV during the accumulation period Final NAV is paid out to the investor. A proportion of the Bonus Payout will be incrementally protected if the NAV of the fund is high. * Subject to market conditions Source: Schroders 13 Year 10 Matching liabilities – bonds or swaps? A Comparison Bonds for liability coverage Swaps for liability coverage – Accuracy of liability matching is limited – Better accuracy of liability matching – Extent of coverage broadly limited to size of bond portfolio – Extent of coverage can be much larger than assets in LDI portfolio – Low expected return – Frees up assets to pursue growth strategies – However, longer dated gilt yields are higher than swap yields – Lower yields at longer maturities than gilts Liabilities Liability coverage Backing assets Liabilities Bonds Bonds Source: Schroders, for illustration only LDI Swaps Equities Swaps Growth assets Liability Driven Investment Reducing liability risks - using swaps rather than bonds Liabilities Key : Dynamic Allocation Portfolio Structure Swap Overlay Cash Cash Holdings Return Generating Assets Portfolio Management Interest rates fall / Inflation rises Interest rate and inflation swaps Cash Buffer 10% 5% Interest rates rise / Inflation falls Note: Percentages shown above for illustration only. Actual amounts depend on the structure of the hedge Source: Schroders, for illustration only Return Generating Assets 85% Schroders LDI – the third generation solution Platform structure and management Liabilities Portfolio structure Liability management Collateral Key : Dynamic Allocation Cash Holdings Return Generating Assets Portfolio management Cash movement Synthetic credit Cash Fund Longevity swaps Collateral IRS and inflation hedge Cash movement Return generating assets Conclusion – Diversification is your first defence against market uncertainty – But diversification by itself is not enough, it must also be dynamic – Your asset allocation is what matters most – so make it your main focus – Be obsessive about risk, and the returns will look after themselves – Risk and return objectives should be ‘real’, not ‘relative’ – Be capital efficient when matching your liabilities Say ‘No’ to a traditional balanced approach; say ‘Yes’ to dynamic asset allocation 17 Important information For Professional Investors only. Not Suitable for Retail Clients This presentation is for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Schroders has expressed its own views and opinions in this document and these may change. Information herein is believed to be reliable but Schroder Investment Management Ltd (SIM) does not warrant its completeness or accuracy. This does not exclude or restrict any duty or liability that SIM has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system The forecasts stated in the presentation are the result of statistical modelling, based on a number of assumptions. Forecasts are subject to a high level of uncertainty regarding future economic, and market factors that may affect actual future performance. The forecasts are provided to you for information purposes as at today's date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things, as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions, models or other matters change Issued in July 2009 by Schroder Investment Limited, 31 Gresham Street, London EC2V 7QA. Registration No 2015527 England Authorised and regulated by the Financial Services Authority 18