Can Absolute Return Strategies Protect Against a Comeback in Volatility?

National Conference on Public Employee Retirement Systems

NCPERS 2018 Annual Conference & Exhibition May 13 – 16 New York, NY

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Agenda

I. Current market environment

II. Can absolute return strategies protect against the comeback of volatility?

III. Why equities for absolute return

IV. Appendix

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I. Current market environment

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Increased risk may be required to maintain returns

Source: “Increasing Volatility and Complexity,” Ball, R. and Wymouth, B., Callan Associates, 2016.

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Historical bull markets

• Historically, the average bull run lasts 61 months with a cumulative return of 175%. • The current bull market has lasted 106 months with a cumulative return of nearly 300%. Source: Strategas Research Partners and Factset.

5 National Conference on Public Employee Retirement Systems Calendar‐year drawdown As of March 31, 2018

• 2017 was a year of unusually low volatility based on historical observations. • Typically drawdowns are approximately 5x larger in magnitude in a year of average volatility. Source: FactSet. Data presented reflects past performance, which is no guarantee of future results. Returns include the reinvestment of dividends and other earnings.

6 National Conference on Public Employee Retirement Systems Historical market performance following low volatility periods As of March 31, 2018

• On average, market performance tends to moderate following low volatility years with an increase in the magnitude of drawdowns.

Source: Strategas Research Partners.

7 National Conference on Public Employee Retirement Systems Equity market stress monitor As of March 31, 2018 Percentile Ranks Higher Risk Higher Risk

CAPITAL CONCENTRATION

0% 20% 40%Median 60% 80% 100% Small Cap Concentration Large Cap Concentration

C ORRELATIO N OF RETURNS

0% 20% 40%Median 60% 80% 100% More Idiosyncratic Risk More Systematic Risk

DISPERSIO N OF RETURNS

0% 20% 40%Median 60% 80% 100% High Convergence High Divergence

INDEX EFFICIENCY

0% 20% 40%Median 60% 80% 100% Risk of Low Beta Exposure Risk of High Beta Exposure

SKEWNESS OF RETURNS

0% 20% 40%Median 60% 80% 100% Extreme Bearishness Extreme Bullishness

MSCI World MSCI EAFE S&P 500 MSCI Europe MSCI Emerging Markets Source: Intech. Chart reflects the percentile rank as of date shown for each dashboard component against available history for the index. The risk metrics presented are intended to be general in nature and do not constitute investment advice or recommendations by Intech. This information is being provided for informational purposes only, and is not an offer or recommendation of any security or investment product, or a prediction of future results or events. It should not be used as the sole basis for investment decisions. There are numerous other factors related to the markets in general that should be considered before making any investment decision. 8 National Conference on Public Employee Retirement Systems

II. Can absolute return strategies protect against the comeback of volatility?

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Common expectations for absolute return strategies

• Risk in absolute return strategies is mostly idiosyncratic. • Some general measures of risk and return can be considered when looking at absolute return strategies.

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A framework for categorizing absolute return strategies

11 National Conference on Public Employee Retirement Systems Absolute return: Wide range of outcomes 20 years ending December 31, 2017

Source: HFRI and Factset. Data reflects past performance and is not indicative of future results. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information. 12 National Conference on Public Employee Retirement Systems Correlation benefits Correlation of various asset classes with MSCI All Country World Index 20 Years ending December 31, 2017

• Correlations tend to be higher for growth‐oriented absolute return strategies and lower for diversifying absolute return strategies. Source: Factset. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information.

13 National Conference on Public Employee Retirement Systems Correlation ranges vary greatly over time Range of rolling 36‐month correlation of absolute returns vs. MSCI All Country World Index 20 Years ending December 31, 2017

• While correlations can vary across strategies over time, it is important to look at the corresponding impact on volatility. Source: Factset. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information.

14 National Conference on Public Employee Retirement Systems Volatility ranges vary greatly over time Range of rolling 36‐month standard deviation of absolute returns 20 Years ending December 31, 2017

• A beneficial absolute return strategy should offer potential for significant volatility reduction and downside protection through a variety of risk regimes. Source: Factset. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information.

15 National Conference on Public Employee Retirement Systems Are returns always positive? Annualized returns over various time periods

• Returns may not always be positive over the short term, but should compensate for the risk taken.

Source: Factset. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information.

16 National Conference on Public Employee Retirement Systems Risk‐adjusted returns

• Accounting for the risk taken to generate returns is an important consideration.

17 National Conference on Public Employee Retirement Systems Historical Sharpe ratio rankings by asset class 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2.30 2.84 7.40 3.47 1.13 4.14 4.11 2.34 0.51 Equity Equity 8.78 1 Relative Relative Global Relative Event- Relative Macro Market Market ACWI Value Value Bonds Value Driven Value Neutral Neutral • By offering attractive 7.02 2.55 3.70 0.60 2.27 6.78 0.32 0.02 2.09 2.00 FI FI Equity FI FI Hedge 2 Global Relative Event- Relative Convert. Convert. Market Convert. Convert. Fund Bonds Value Driven Value correlation characteristics and Arbitrage Arbitrage Neutral Arbitrage Arbitrage Composite

1.97 3.27 reduced volatility, absolute 4.51 2.08 0.26 1.92 5.99 -1.16 -0.40 FI FI 1.70 3 Event- Event- Quant. Event- Quant. Commod. ACWI Convert. Convert. Macro Driven Driven Directl. Driven Directl. Arbitrage Arbitrage return strategies tend to

-1.65 3.36 1.65 1.80 0.95 1.29 4.50 -0.49 2.80 -0.11 generate better risk‐adjusted Equity Hedge Hedge Equity Hedge Hedge FI 4 Event- Relative Relative Market Fund Fund Market Fund Fund Convert. Driven Value Value Neutral Composite Composite Neutral Composite Composite Arbitrage returns than traditional asset

-0.52 1.66 1.49 0.89 1.04 4.20 -1.82 1.41 Equity 2.63 -0.14 classes. 5 Quant. Global Quant. Quant. Event- ACWI Macro Market ACWI ACWI Directl. Bonds Directl. Directl. Driven Neutral

1.20 1.36 2.59 0.64 -0.27 0.98 -1.97 3.46 1.54 Equity -0.72 Hedge Hedge FI Hedge Equity 6 Quant. Relative ACWI Market Commod. Fund Fund Convert. Fund Market Directl. Value Neutral Composite Composite Arbitrage Composite Neutral Sharpe Ratio Rank

(1 = (1 = Best, 12 = Worst) -2.02 2.56 1.09 -0.83 2.50 FI 1.19 1.29 0.55 -0.28 0.96 Equity 7 Quant. Quant. Quant. Convert. Commod. ACWI ACWI Macro Commod. Market Directl. Directl. Directl. Arbitrage Neutral

-0.85 -2.13 1.10 0.31 -0.71 2.48 0.88 0.91 Hedge -0.16 0.76 8 Relative Quant. Event- Event- Global Macro Commod. Fund Macro ACWI Value Directl. Driven Driven Bonds Composite

-2.24 0.85 0.86 -0.57 0.14 -1.08 0.26 Hedge -0.91 -0.03 0.50 9 Global Global Global Global Global Global Fund Macro Macro Macro Bonds Bonds Bonds Bonds Bonds Bonds Composite

0.74 -0.92 -2.52 Equity 0.67 FI -0.08 -1.11 -1.32 -1.68 0.20 0.16 10 Event- Market ACWI Convert. Commod. Commod. Commod. Commod. Macro Commod. Driven Neutral Arbitrage

Source: FactSet. Alternative asset classes reflect HFRI indexes. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information. 18 National Conference on Public Employee Retirement Systems

III. Why equities for absolute return

19 National Conference on Public Employee Retirement Systems Hidden betas Beta of various asset classes against MSCI All Country World Index 20 Years ending December 31, 2017

• All returns over cash require taking some risk. • Absolute return strategies have a wide range of sensitivities to global equities, the predominant driver of risk in a multi‐asset class portfolio. Source: Factset. All HRFI Index information shown is available only on a net‐of‐fee basis. Indexes are unmanaged and investors cannot invest directly in an index. See Simulations Disclaimer at the end of this presentation for additional information.

20 National Conference on Public Employee Retirement Systems Why equities for absolute return? LIQUIDITY • Exchange‐traded, highly liquid securities • Reduces need for gate provisions, lock‐up periods or other withdrawal limitations TRANSPARENCY • Know what you own • Easily understand performance drivers and future outlook • Ability to perform proper risk assessments of overall portfolio COST EFFICIENCY • Lack of dependency on exotic and illiquid instruments that are expensive and difficult to value • Increased capacity • Ability to provide similar outcomes more cost effectively

Source: 2015 Alternative Investments Survey, Observations for U.S. Institutional Investors, Callan Associates.

21 National Conference on Public Employee Retirement Systems Conclusion • Any asset in a portfolio should serve to improve risk‐adjusted returns.

• Investors typically seek the following attributes when considering absolute return strategies to meet this objective:

• When evaluating absolute return strategies, the emphasis should be on outcomes rather than labels.

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IV. Appendix

23 National Conference on Public Employee Retirement Systems Equity Market Stress Monitor: Risk metrics defined

CAPITAL CONCENTRATION: Do winners take all? • measures how capital is distributed among stocks within an index

CORRELATION OF RETURNS: How similar are stocks’ absolute returns? • measures the market‐weighted average pair‐wise correlation of stocks in an index

DISPERSION OF RETURNS: How different are stocks’ relative returns? • also known as cross‐sectional volatility, dispersion measures whether stocks’ returns relative to their benchmark are converging (low dispersion) or diverging (high dispersion).

INDEX EFFICIENCY: How much beta risk should you take? • measures the extent to which more or less market beta exposure is required to produce a more efficient portfolio than the index.

SKEWNESS OF RETURNS: How fat are the tails? • measures the asymmetry of index returns around the mean value.

24 National Conference on Public Employee Retirement Systems HFRI Index Definitions HFRI Equity Quantitative Directional Index Quantitative Directional strategies employ sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factor‐based and Statistical Arbitrage/Trading strategies. Factor‐ based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Quantitative Directional Strategies typically maintain varying levels of net long or short equity market exposure over various market cycles. HFRI Fund Weighted Composite Index The HFRI Fund Weighted Composite Index is a global, equal‐weighted index of over 1,500 single‐manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds. HFRI Event Driven Index Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure. HFRI Relative Value Index Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

25 National Conference on Public Employee Retirement Systems HFRI Index Definitions HFRI Fixed Income Convertible Arbitrage Index Fixed Income ‐ Convertible Arbitrage includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a convertible fixed income instrument. Strategies employ an investment process designed to isolate attractive opportunities between the price of a convertible security and the price of a non‐convertible security, typically of the same issuer. Convertible arbitrage positions maintain characteristic sensitivities to credit quality the issuer, implied and realized volatility of the underlying instruments, levels of interest rates and the valuation of the issuer's equity, among other more general market and idiosyncratic sensitivities. HFRI Equity Market Neutral Index Equity Market Neutral strategies employ sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factor‐based and Statistical Arbitrage/Trading strategies. Factor‐ based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. In many but not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Equity Market Neutral Strategies typically maintain characteristic net equity market exposure no greater than 10% long or short. HFRI Macro Index Investment Managers which trade a broad range of strategies in which the investment process is predicated 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 discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.