Rathmore NOV Letter from the Manager 2019

Delivering Equity-Like Returns with -Like Risk for over a Decade

The 12-year period since Lazard Rathmore launched has been punctuated by defining economic and market events, including the Global Financial Crisis of 2008, the European sovereign and banking crises of 2010–2012, the oil market collapse of 2014–2016, and the Turkish currency and debt crisis of 2018, among others. We believe the performance of the strategy over the past 12 years is a testament to its ability to not only withstand challenging market conditions but also to prosper when risk assets fare well. Lazard Rathmore—a hedged convertible bond strategy—offers investors the potential to monetise market volatility and protect Multiple Drivers of Return capital during down markets without having to forgo participation The Lazard Rathmore strategy launched to the upside. The strategy seeks to capitalise on the traditional on 1 June 2007, with the objective characteristics of a convertible bond but with the added benefits of providing superior risk-adjusted, that come with hedging these securities. Pairing long convertible absolute returns across varying market bond positions with short stock positions in the same company cycles. hedges against the issuer’s credit exposure and further reduces risk The strategy draws from three sources in down markets. Hedges not only offer principal protection, they of returns—hedged credit, equity can also provide income (from the short stock rebate) and a source volatility, and special situation trades— of returns during volatile market conditions (volatility yield). to deliver equity-like returns, with The more frequent, and the larger the move of the underlying bond-like risk. stock (i.e., the more volatile), the greater the profit that hedged convertible bond arbitrage strategies can extract. • Hedged credit: provides income and principal protection Uniquely, the Lazard Rathmore strategy draws on three • Equity volatility: seeks to monetise interrelated sources of returns—hedged credit, equity volatility, periods of market volatility and special situation trades—which diversifies the strategy’s returns relative to traditional asset classes. For instance, over the • Special situations: offers an long term, the strategy’s performance has remained negatively uncorrelated stream of alpha correlated to grade credit and has maintained a low Together, these differing sources of correlation to equities. returns have allowed the strategy to We evaluate the strategy’s performance since inception relative outperform almost all major equity and indices, with a fraction to other asset classes through different market environments, and of the volatility, since the strategy’s explain which characteristics have underpinned the patterns of inception. performance.

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Performance during Risk-Off Periods Performance during Risk-On Periods The fixed income characteristics of a convertible bond, the active The Rathmore strategy has shown that over time it can also use of portfolio and position-level hedging, and the ability to generate steady positive returns during risk-on periods—which monetise market volatility, has allowed the Rathmore strategy tend to be characterised by strong equity performance, tightening to provide superior downside protection during risk-off market credit spreads, and a strong bid for risk assets. In 2019, equity periods. Markets in 2018 exemplified risk-off conditions, markets generated strong positive returns in six out of the first characterised by relatively long periods of benign market activity, eight months of the year2. Over this period, equities generated punctuated with shorter periods of widespread volatility. positive percentage returns (Exhibit 2), credit spreads tightened Between January 2018 and February 2018, volatility—as (from LIBOR+520 to LIBOR+480), while rates rallied strongly. measured by the CBOE Volatility Index—increased by 400%, from 12% to 48% on an intra-week basis1. During the fourth quarter of the year, the S&P 500 Index lost over 20%, briefly Exhibit 2 putting it in bear market territory. Lazard Rathmore Participates in Up Markets, with Significantly Lower Volatility

The Rathmore strategy demonstrated that it was able to protect Returns (%) Volatility (%) to the downside, and outperform all of the major investable 25 15 asset classes over this period, at a time when equities, credit, and commodities produced negative total returns for the year (Exhibit 1). The strategy achieved this by capitalising on 20 12 its short stock hedges (which benefitted during the multiple instances of weak equity market performance over the period) 15 9 and its long volatility exposures (which gained as the value of the conversion option associated with convertible bonds increased). Although “the basis” (the difference between the 10 6 long convertible bond and the short stock hedge) widened modestly during this period, as would be expected in a risk-off 5 3 environment, this dynamic ultimately provided an improved risk-reward for investors. Furthermore, this “cheapening” was offset by increased volatility trading and consequently a higher 0 0 2019 YTD volatility yield during the period. Lazard Rathmore (Net) Bloomberg Barclays US Treasury Index S&P 500 Index Bloomberg Commodities Index US High Yield Index Volatility [RHS]

Exhibit 1 As at 30 September 2019 Lazard Rathmore Defends Well in Down Markets Source: Lazard, Bank of America Merrill Lynch, Bloomberg, S&P Returns (%) Volatility (%) 2 -2 0 Overall, the “basis” (the difference between the long convertible 0 2 bond and the short stock hedge) improved over the period, as one might expect in a risk-on environment. In addition, the -2 4 heightened uncertainty around a number of issues offered ample 6 -4 volatility trading opportunities, particularly around news flow 8 pertaining to trade tariffs, central bank policy decisions, and -6 10 highly anticipated macroeconomic releases given the concerns around global growth. This resulted in the strategy generating a 12 -8 volatility yield consistent with its LIBOR+400 to LIBOR+600 14 return target. -10 16

-12 18 2018 Lazard Rathmore (Net) Bloomberg Barclays US Treasury Index S&P 500 Index Bloomberg Commodities Index US High Yield Index Volatility [RHS - axis inverted]

As at 31 December 2018 Source: Lazard, Bank of America Merrill Lynch, Bloomberg, S&P 3

Performance during Benign Periods Equity-Like Returns, with Bond-Like In relatively benign market periods—which tend to be Risk characterised by positively trending risk markets—the returns Lazard’s Rathmore strategy draws on the characteristics of generated from special situations and events have proven traditional convertible bonds in order to participate in equity particularly meaningful to the Rathmore strategy. In this respect, upside through the bond’s equity option during rising markets 2017 is a good frame of reference, as equity markets showed an and benefit from the principal protection associated with almost continuous upward trajectory for the entire year. In fact, the bond’s fixed-income features during down markets, with the S&P 500 Index recorded its lowest annual “peak-to-trough” additional levers at its disposal to accentuate these benefits for level on record in 2017 (measuring less than 300 basis points investors. for the year). In addition, equity volatility, a primary source of returns for the Rathmore strategy, was also at its lowest level on The strategy’s three main sources of differentiated returns—hedged record during this period. credit, equity volatility, and special situation trades—have allowed the strategy to outperform almost all major equity and fixed The strategy’s net return, from hedged credit and equity volatility, income indices, with a fraction of the volatility, since inception was +500 basis points above LIBOR over the year. However, (Exhibit 4). In aggregate, the features of the strategy offer investors importantly, a high number of special situation trades were the potential to monetise market volatility and protect capital additive, and accounted for +398 basis points of additional during down markets without having to forgo participation to the performance (and alpha, given the nature of these negotiated upside, making it an all-weather approach, in our view, capable of trades) over this period. The special situations component of enduring varying market conditions and cycles. the portfolio, which involves exiting convertible bond positions back to the issuer through non-traditional, negotiated outcomes, Furthermore, the ability to benefit from increased market provides an uncorrelated stream of alpha. The rationale behind volatility accounts for much of the diversification benefits of this is largely associated with issuers’ boards and key executives hedged convertible securities over other asset classes. The Lazard striving to optimise their capital structures during these relatively Rathmore strategy’s differentiated approach of focusing on benign periods. For this reason, there were a higher number of special situation and event-driven trades is often uncorrelated special situation trades than would be expected in more volatile to opportunities in traditional credit markets and also helps periods. This highlights how the Rathmore strategy can continue it maintain a low correlation to equity markets and negative to deliver high single-digit returns, even during trending markets correlation to investment grade credit (Exhibit 5). (Exhibit 3).

Exhibit 4 Lazard Rathmore Outperforms Many Traditional Asset Classes

Annualised Returna (%) 12 Exhibit 3 Lazard Rathmore Features Hold Firm Even in Benign Market Conditions Rathmore S&P 500 Index Returns (%) Volatility (%) 8 25 10 BofA ML US High Yield Index Russell 2000 Index BofA ML Global 300 Index Barclays US Aggregate Bond Index 20 8 4

15 6 0

10 4 HFRX Convertible Arbitrage Index

-4 0 5 10 15 20 25 30 5 2 Annualised Volatilityb (%)

As at 30 September 2019 0 0 All data in USD. 2017 a Inception for the Lazard Rathmore strategy is 1 June 2007. Performance is presented net of fees, including a 1.5% management fee and 20% incentive Lazard Rathmore (Net) Bloomberg Barclays US Treasury Index fee. The performance quoted represents past performance. Past performance S&P 500 Index Bloomberg Commodities Index is not a reliable indicator of future results. US High Yield Index Volatility [RHS] b Based on daily returns. Annualised volatility since inception for the Lazard Rathmore strategy based on monthly returns is 6.9%, yielding a Sharpe ratio As at 31 December 2017 of 1.0. Source: Lazard, Bank of America Merrill Lynch, Bloomberg, S&P Source: Lazard, Bloomberg 4

Exhibit 5 Lazard Rathmore is a Strong Diversifier

HFRX Convertible Barclays US BofA ML US BofA ML Arbitrage Aggregate HY Master II Global 300 Russell 2000 Correlation Matrixa Lazard Rathmore Index Bond Index Index Index S&P 500 Index Index Lazard Rathmoreb 1.00 HFRX Convertible Arbitrage Index 0.37 1.00 Barclays US Aggregate Bond Index -0.08 0.03 1.00 BofA ML US HY Master II Index 0.53 0.40 0.03 1.00 BofA ML Global 300 Index 0.40 0.10 -0.19 0.53 1.00 S&P 500 Index 0.25 -0.09 -0.31 0.31 0.80 1.00 Russell 2000 Index 0.22 -0.11 -0.30 0.27 0.77 0.92 1.00

As at 30 September 2019 a Inception for the Lazard Rathmore strategy is 1 June 2007. Performance is presented net of fees, including a 1.5% management fee and 20% incentive fee. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. b Based on daily returns. Annualised volatility since inception for the Lazard Rathmore strategy based on monthly returns is 6.9%, yielding a Sharpe ratio of 1.0. Source: Lazard, Bloomberg

This builds a solid argument to invest in the strategy, in our view, while current market conditions also present a tactical opportunity. Equity valuations are extended in some developed markets regions (e.g., in the United States) following the longest bull run in history while credit spreads are not far from decade lows, as investors’ hunt for yield has led them to riskier areas of the fixed income market against the backdrop of historically low risk-free rates. Meanwhile, the global economic backdrop is also challenged as growth in Europe and China has faltered. With equity, credit, and markets stretched, downside risks significantly outweigh upside potential. For investors seeking to protect their portfolio against these downside risks without having to forgo gains on the upside, we believe that hedged convertible bonds present an attractive solution. Letter from the Manager

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Notes 1 Source: The Chicago Board Options Exchange 2 Source: S&P Dow Jones

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Emerging markets can face significant political, economic, or structural challenges. The portfolio may experience delays in buying, selling, and claiming ownership of and there is an increased risk that the portfolio may not get back the money invested. Yields from bonds reflect in part the risk rating of the bond issuer. Investment in lower-rated bonds increases the risk of default on repayment and the risk to capital of the fund. High-yielding assets such as certain fixed interest securities may carry a greater risk of capital values falling or have limited prospects of capital growth or recovery. Investment in high yield securities involves a high degree of risk to both capital and income. The strategy uses financial derivative instruments (“FDIs”). While the use of FDIs can be beneficial, they also involve risks different from, and in certain cases, greater than, the risks presented by more traditional investments. 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