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June 2015 Deepening diversification in trust portfolios with alternative investments Leo M. Zerilli, CIMA Head of Investments John Hancock Investments As banks embrace open architecture investing in earnest, alternative investments are playing a more prominent role in client trust portfolios. Key takeaways For more than 60 years, alternative investments have provided investors with differentiated sources of returns and risk management beyond those available through traditional stock and bond strategies. Until recently, many bank trust departments have managed client portfolios almost exclusively with proprietary equity and fixed-income offerings, a long-standing practice reinforced by a historically conservative culture. However, the market’s demand for open architecture has prompted many banks to tap the specialized expertise of external asset managers, particularly those proficient in alternative investments, for trust department and wealth management platforms. Today, when contemplating potential managers, bank trust departments first seek those that can adhere to a consistent investment philosophy, a prerequisite that we, as a manager of managers, share at John Hancock Investments. Executive summary Since the middle of the last century, what we now call alternative investments have provided capital market participants with unconventional sources of return along with risk management techniques beyond those available through stocks and bonds alone. Once exclusive to institutions and other accredited investors, alternative investment strategies have recently drawn a much broader following through liquid and easily accessible vehicles such as 1940 Act mutual funds. While university endowments and corporate defined benefit pension plans have made extensive use of alternatives for years, bank trust departments have historically emphasized proprietary products, which have tended to focus on more traditional equity and fixed-income investments. Still, the market for bank trust asset management services has grown more insistent upon open architecture arrangements since the financial crisis. In recent years, clients have sought more specialized, innovative styles of investing approaches that target specific portfolio goals. Bank trust officers have responded to the market’s demand and have increasingly embraced external managers that have demonstrated an ability to apply a consistent philosophy to alternative investing, a trait that becomes more important as the mandate becomes less conventional. If implemented properly, one can make a strong case for the merits of alternative investment exposure within trust portfolios. Indeed, bank trust officers are now incorporating liquid alternative investments into client portfolios to help address gaps in traditional asset allocation that fail to address current market challenges such as stock market volatility, low bond yields, and high correlations across investments of all types. History of alternative return sources, risk management techniques At the most basic descriptive level, alternative investments are strategies other than long-only stock and bond styles. The chief virtue of alternative investments is that they do not necessarily move in sync with the traditional assets that dominate most portfolios. Because they tend to behave differently than stocks and bonds, alternative investments are typically used to address a specific need, such as greater diversification. Some alternative investments have an explicit return-seeking mandate, designed to supercharge a portfolio’s performance. However, most of the alternative investment styles we’ll discuss in the context of bank trust portfolios actually seek to hedge or limit certain market risks and therefore emphasize volatility control and consistency of returns rather than attempting to amplify them. In pursuing the strategy of the tortoise rather than that of the hare, it’s this latter group that seeks success through the compounded effect of a consistent, albeit modest, return stream over time. Alternatives to long-only stock and bond investments are not new. The hedge fund traces its roots to 1949, when Alfred Winslow Jones formed an investment partnership that included leverage and short selling, techniques designed to generate returns while reducing market risk. Jones was ahead of his time; these types of private partnerships, which sought total return while hedging the risks of market declines, didn’t gain traction until the 1980s. Early adopters of alternative investments included charitable foundations, defined benefit pension plans, insurance companies, and other institutional investors. Already enthusiastic, university endowments’ appetites for alternatives grew even more voracious following the 2000 publication of Pioneering Portfolio Management, by David Swensen, Yale University’s chief investment officer. Swensen argued that an endowment fund—designed to support the scholars of today and tomorrow with intergenerational neutrality—has an inherent advantage over other types of investors. Endowments can invest with a time horizon extending into perpetuity. This makes it possible for Yale and its peers to fund large allocations to alternatives, including illiquid assets such as private equity, venture capital, and direct real estate. Such investments offer the potential to capture an illiquidity premium, which compensates an investor for holding an asset that lacks an active trading market. Investing in alternatives proved an enduring trend in higher education. Today, the average university endowment has the majority of its assets allocated to alternative strategies. Alternatives have displayed different patterns of returns than those of the broader market Rolling 12-month return 60% n S&P 500 Index n HFRI Macro Index 30 0 –30 –60 2 5/01 5/02 5/03 5/04 5/05 5/06 5/07 5/08 5/09 5/10 5/11 5/12 5/13 5/14 5/15 Source: Morningstar, as of 5/31/15. For illustrative purposes only. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The HFRI Macro Index is a benchmark designed to reflect macro hedge fund industry performance by constructing equally weighted composites of constituent funds, as reported by the hedge fund managers listed within HFR Database. Macro investment managers trade a broad range of strategies in which the investment process is p redicated on movements in underlying economic variables and the impact these have on equity, fixed-income, hard currency, and commodity markets. Managers employ a variety of techniques, both d iscretionary and systematic analysis, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods. It is not possible to invest directly in an index. Past performance does not guarantee future results. replaced HFRI data w/new file June 2015 Endowment fund asset allocation in 2014 The rise of liquid alternatives Survey of 831 universities As we know from 2008, traditional stock and bond asset allocation has not always provided investors with sufficient insulation against market volatility. During the global financial crisis, correlations—measurements that show the relationship of one asset’s price movement to another’s—across the capital spectrum surged as all but the safest investments declined en masse. The breadth, scale, and speed of wealth destruction prompted many investors to question age-old assumptions about diversification. While 2008 may have been an anomaly, taking a multidecade view of the market’s behavior reveals that big moves within a single trading session have been on the rise for some time. 100% 80 58% Alternative strategies 60 40 17% International equities 20 13% Domestic equities 7% Fixed income 0 5% Short-term securities Source: National Association of College and University Business Officers, 2014. Unlike a university endowment, the average person has a finite investment horizon, and a prolonged lockup period is not a viable option for most individual investors. Fortunately, not all alternative investments rely on an illiquidity premium to drive their returns. Opportunities to introduce alternative investments into the portfolios of individual investors have expanded in recent years with the migration of high-quality managers from the hedge fund arena to that of the 1940 Act mutual fund. Elevated volatility during and after the crisis has made it more difficult for the average investor to stick with an investment plan. Studies have shown that long-term investors respond to sharp market drops by switching portfolio holdings. Emotion often dominates investor behavior, and research suggests that the fear of further losses often motivates investors to sell near market bottoms, an impulse that can turn a temporary bout of market volatility into a permanent portfolio loss. Fund researcher DALBAR, Inc., publishes an annual study that puts the average holding period for stock and bond mutual funds at little more than three years. The result of all this gratuitous, ill-timed trading is that investors, on average, underperformed broad market indexes. Recognizing an unfulfilled need for risk-reducing strategies in the wake of the global financial crisis, a number of talented hedge fund managers and mutual fund families began working in partnership to offer alternative investments to individual investors. Today, many liquid versions of strategies that were Traditional vs. alternative investments: some generalizations for bank trust portfolios Traditional investments Alternative investments Limited to long stock and bond positions Can include derivatives, short sales, and leverage Deliver a wide range of possible results Aim for a target range of outcomes Return oriented Risk managed Underscore the magnitude of returns Emphasize consistency of returns Market return dominates the result Manager skill dominates the result 3 Stock market volatility has become more prevalent in recent years Number of trading days per year with returns +/– 2% (S&P 500 Index), 1950–2014 80 70 60 Trading days 50 40 30 Volatility regimes increasing Global economic dislocations and greater connections between markets around the world have led to more trading days with big market swings. 20 10 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2014 Source: Morningstar Direct, 2014. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results. successful within hedge fund structures are now available to a broader audience of investors through 1940 Act mutual funds. Managers of these liquid alternative investments are able to execute hedge fund-like strategies without many of the risks inherent in hedge funds, such as lockup periods, a lack of transparency, little regulatory oversight, excessive leverage, and illiquid holdings. Alternative styles that lend themselves well to mutual funds include those with a volatility-dampening aim such as absolute return, currency management, global macro, long/short equity, listed infrastructure, and multi-alternative allocation strategies. As U.S. equity market valuation measures look fuller with each new record high, and with 2008 still a vivid memory, mutual fund investors are taking notice. In fact, the alternatives category is the fastest-growing segment of the mutual fund market today, with several hundred unique alternative investment offerings now available. In 2008, alternative mutual fund asset levels were negligible; today, liquid alternatives are approaching an aggregate $300 billion in assets across the alternative categories that Morningstar tracks.1 Morningstar estimates that net inflows to alternatives totaled more than $20 billion in 2014 alone.2 4 Industry researchers Cerulli Associates and Strategic Insight predict substantial growth in liquid alternative assets over the next several years. According to Strategic Insight, liquid alternatives may reach $490 billion by 2018. Cerulli’s estimates suggest alternative mutual funds may represent 10% of the industry’s assets before the end of the decade, up from the current 3%.3 Growth of liquid alternative funds over three decades Number of alternative mutual fund offerings 500 400 300 200 100 0 1985 1988 1992 1996 2000 2004 2008 Source: Strategic Insight, Forward, and Morningstar, as of 6/30/14. 2012 2014 June 2015 Mutual fund vs. hedge fund structures Structure Mutual funds Limited partnership hedge fund Liquidity Daily Varies—lockups are common Typical fees 1%–2% 2% + performance incentive Transparency High Low to none Regulation High Low Investment minimums Low Often high Accredited investor No Yes Lower Unrestricted Form 1099 Schedule K-1 Leverage Taxes Conservative culture, proprietary offerings yield to open architecture Despite their growing accessibility and prevalence, alternative investments have lacked a strong presence in the market for bank trust asset management services. Steeped in tradition and approaching change carefully, private banks have been cautious in adopting alternative strategies, instead relying primarily on the diversification potential of long-only stock and bond holdings for client portfolios. Until recently, many bank trust departments constructed client portfolios almost exclusively with proprietary offerings—generally limited to traditional equity and fixedincome styles—managed by an affiliated fund family or by the bank’s own internal investment staff. This long-standing practice has been reinforced by the historically conservative culture shared by most banks in the trust business. However, growing competition from registered investment advisors with a wide range of wealth management services has put pressure on the bank trust channel. Additionally, according to a Morningstar study of industry data conducted for the New York Times, the majority “of the funds run by each of the four largest banks in the business … have underperformed their basic benchmarks over the last 10 years,” making an exclusively proprietary approach to trust asset management less tenable still.4 It’s hard for one investment firm to be good at all things, and the market’s demand for a greater range of choice has prompted many private banks to engage the specialized expertise of unaffiliated external asset managers, particularly those proficient in alternative investments. According to Cerulli Associates, bank trust departments “have increasingly adopted open architecture to offer their clients more products and services and to maintain their fiduciary status.”5 As banks embrace open architecture investing in earnest, alternative investments are playing a more prominent role in client trust portfolios. Cerulli’s research suggests that more than 80% of bank trust executives expect to increase engagement with third-party asset managers during the next 3 years. While 27% of banks still maintain a largely closed architecture arrangement, even those “use external managers for selective needs, such as gaining exposure to alternative investments.”5 In essence, many banks are beginning to acknowledge that meeting the needs of today’s high-net-worth investors via trusts can be accomplished through other channels as well; being a bank trust organization is no longer a relevant differentiator in and of itself. As banks grow more comfortable with open architecture, they’re also gaining comfort with more complex investments, including alternatives. 5 Bank trust approaches to third-party asset managers 36% 36% 27% n C ompletely open architecture n L argely closed architecture, but using external managers for selective needs n M ix of open and closed architecture traits of alternative mutual funds may merit a higher fee. For example, when contemplating an alternative exposure for a trust portfolio, bank trust officers might consider the likelihood of the investment helping the portfolio achieve one or more of a number of specific goals, including: Lowering a portfolio’s correlation to the stock market Improving portfolio performance potential in a rising-interest-rate environment Reducing manager concentration risk by diversifying beyond the bank’s proprietary funds Source: Cerulli Associates, 2013. Numbers are rounded and may not total 100%. Weathering macroeconomic or geopolitical shocks with resilience Like any good fiduciary, bank trust officers owe portfolio beneficiaries the duty of loyalty, acting with the care, skill, and diligence of a prudent expert. This includes incorporating a broad range of different investments when constructing and maintaining a portfolio for a diversified investment mandate. Conservative banking culture has historically fostered an attempt to judge the merit of a particular holding on a stand-alone basis; however, rather than evaluating an asset in a vacuum, fiduciaries need to consider each investment in context, in light of its role within the portfolio as a whole. This more holistic view supports the inclusion of alternatives in the universe of potential investments; indeed, because of their complementary features, alternative investments may actually reduce a trust portfolio’s aggregate level of risk. Higher expenses for access to special investments that can smooth returns in uncertain markets may be worth it; ultimately, it’s the net result of the trust portfolio’s performance that matters to the beneficiary. Alternatives offer trust officers more tools to meet fiduciary responsibilities Fiduciaries have broad latitude in selecting, removing, and replacing investments for discretionary trust portfolio mandates. The main requirement for bank trust officers is to select investment options through a prudent process that applies in prevailing investment industry practices. Alternative investments have been a part of the prevailing practice in other channels for years, if not decades. With the growth of liquid alternatives, the prevailing industry practices are now changing for trusts and individual investors as well. In acting solely in the interest of a client, a fiduciary has a clear obligation to mind the costs of implementing an investment program. While liquid alternatives tend to carry higher fees than traditional mutual fund investments, certain distinguishing 6 Consistent philosophy is key When searching for external investment talent, professional manager research teams across the bank wealth management channel look for portfolio teams with consistent investment philosophies. A commitment to style purity is another crucial factor. Over the years, through an exchange of best practices with manager research professionals at banks across the country, we’ve learned that most bank trust departments expect their third-party managers to generate patterns of performance consistent with their mandates, a core tenet of our investment model at John Hancock Investments as well. Indeed, with a unique manager-of-managers approach to investing since 1988, John Hancock Investments is structured for manager research and oversight, and our lineup covers a range of traditional and alternative asset classes, with 104 investment strategies managed by 72 portfolio teams at 27 different asset managers around the world. With the insight and resources of a diverse asset management network and a commitment to financial stewardship, we manage nearly $130 billion for bank trusts, individuals, and institutional clients of all types—more than $15 billion of which is invested in goal-specific alternative and specialty investment mandates. June 2015 In selecting managers, we outline an appropriate set of characteristics we call a performance blueprint—an objective, measurable template for the patterns of risk and return that we expect from a fund through different market conditions. A key part of building that performance blueprint is isolating the attributes that matter most. For example, when we analyze an investment manager’s performance, we look at the underlying factors that have driven those returns. We also examine how a portfolio’s composition has changed over time and how the manager’s allocation decisions have affected performance. This kind of attribution analysis helps us gain deeper insight into the strengths and weaknesses of a particular manager, which, in turn, helps us understand what’s driving the results. However, past performance, no matter how rigorously it’s evaluated, is no guarantee of future returns, and relying too heavily on historical data can cause one to overlook skilled managers. Similarly, if we rush to replace managers for weak short-term performance, there is a good chance we will miss some long-term opportunities. We are likely to stick with investment managers when they have periods of weak performance if we understand the reasons for those results. However, we have replaced managers whose patterns of performance— good or bad—proved inconsistent with their mandates. In our efforts to serve the best interests of our fund shareholders over the long term, we conduct direct, in-person meetings with portfolio managers and seek to understand the risks they take in order to achieve results. Face-to-face meetings with senior decision makers help us assess critical items such as investment process and culture and, by extension, judge the potential for repeatability of past performance. Specifically, we work to determine whether a manager’s strong historical returns are simply a result of chance or if there is something else in place, be it a superior philosophy, a winning team dynamic, or a proprietary edge in the investment process that competitors don’t have. Case studies in alternative manager selection If alternative investments serve an important role in deepening diversification of a portfolio, what is the best way for a trust portfolio to benefit from them? We think an examination of our approach to alternatives might be instructive. Using a lternative and specialty investment strategies in asset allocation portfolios for more than 15 years, John Hancock Investments manages over $15 billion in alternative assets today. One of the benefits of our model is that we can scour the globe to find managers with the skills to manage a particular strategy. As a manager of managers, we can go anywhere in the world to find proven portfolio teams, an approach that now resonates with more bank trust advisors as they seek to fulfill their fiduciary obligations to their clients. For example, our search for a uniquely qualified absolute return manager led us to Standard Life Investments, based in Edinburgh, Scotland. Standard Life Investments developed its flagship absolute return investment strategy in 2005, and the firm is one of the few absolute return managers with experience managing the full range of market environments of the last decade. Emphasizing risk management, the team can use a variety of strategies designed to maintain a consistent performance target through both up and down markets. This experience and record in managing absolute return strategies were key factors in our decision to select Standard Life to run John Hancock Global Absolute Return Strategies Fund, which we launched in December 2011. The fund combines traditional sources of expected returns such as broad market beta and security selection with more advanced relative value and directional strategies, which have the rare potential to make money in down markets. We expect the fund to target positive returns over all market cycles with significantly less volatility than global equities. For investors seeking instant diversification across alternative asset classes and investment strategies, John Hancock Alternative Asset Allocation Fund is a bundled approach within one portfolio. The industry-leading asset allocation team we’ve hired at John Hancock Asset Management invests with 16 underlying managers—including Standard Life Investments—specializing in alternative markets, alternative investment approaches, and absolute return strategies. For return enhancement potential, alternative markets such as those in global real estate or commodities provide exposure to drivers of performance often unrelated to traditional stock and bond holdings. For risk-reduction potential, alternative investment approaches such as long/short equity or multi-sector income use unconstrained, opportunistic strategies that can tactically alter market-level exposure. And, as we’ve seen, absolute return strategies offer diversification potential and are designed to generate consistently positive returns in a variety of environments. 7 Conclusion Alternative investments have provided unconventional sources of return and unique ways to manage risk beyond those available through the traditional trust portfolio staples of stocks, bonds, and cash. Once primarily limited to institutions, alternative strategies have become popular with individual investors through liquid vehicles, such as 1940 Act mutual funds. While initially slow to adopt alternatives, bank trust officers are beginning to turn to them for help in carrying out their fiduciary responsibilities to trust beneficiaries. The global financial crisis of 2008 and the migration of talented hedge fund managers into the mutual fund world have made bank trust officers more open to refining their recommendations by incorporating alternatives into client portfolios. In our view, the most appropriate way to approach alternative investments is with an asset allocation mindset. 1 Josh Charney, alternative investments analyst at Morningstar, Ignites exclusive interview, 6/19/14. 2 “Morningstar Direct U.S. Asset Flows Update,” Morningstar Direct, 1/14/15. 3 “Alts to Move From Fringe to Core, Fueling Growth: Cerulli,” Ignites, 5/14/14. 4 ”Wall Street Banks’ Mutual Funds Can Lag on Returns,” the New York Times, 4/12/15. 5 The Cerulli Edge, U.S. Asset Management edition, October 2013. Diversification does not guarantee a profit or eliminate the risk of a loss. Portfolios that have a greater percentage of alternatives may have greater risks. The fund’s performance depends on the advisor’s skill in determining asset class allocations, the mix of underlying funds, and the performance of those underlying funds. The fund is subject to the same risks as the underlying funds and exchange-traded funds in which it invests: Stocks and bonds can decline due to adverse issuer, market, regulatory, or economic developments; foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability; the securities of small companies are subject to higher volatility than those of larger, more established companies; and high-yield bonds are subject to additional risks, such as increased risk of default. Certain market conditions, including reduced trading volume, heightened volatility, and rising interest rates, may impair liquidity, the ability of the fund to sell securities or close derivative positions at advantageous prices. Currency transactions are affected by fluctuations in exchange rates. The fund’s losses could exceed the amount invested in its currency instruments. Please see the fund’s prospectus for additional risks. A fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money. Connect with John Hancock Investments: @JH_Investments | jhinvestmentsblog.com John Hancock Funds, LLC Member FINRA, SIPC 601 Congress Street Boston, MA 02210-2805 800-225-5291 jhinvestments.com NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. NOT INSURED BY ANY GOVERNMENT AGENCY. MF234061 ALTSBTWP 6/15