MAKING IT WORK

Factor Pathways

Smart Beta provides a rules-based, transparent way for investors to capture the well-documented factor premia across equities and fixed income. The following case study illustrates recent State Street Global Advisors (SSGA) engagements with global institutional clients. This example describes how restructuring equity and bond exposures with Smart Beta helped clients achieve more capital-efficient portfolios.

CASE STUDY

FUND REGION AUM EXISTING EQUITY ALLOCATION Large Non-Profit Organization’s Endowment

US $2 billion Multiple active managers

vs. Multiple Active ManagersSMART BETA

ChallengeA US non-profit with assets invested by a number of active managers asked SSGA to conduct a risk-based analysis of its public equity portfolio to understand the drivers of active return.

Portfolios that use multiple active strategies may suffer from over-diversification, with managers’ particular styles cancelling each other out. While a single active strategy may demonstrate high tracking error or active share, adding diverse strategies may lead to an overall portfolio that is costly and features little stock-specific risk. Further, the tracking error that remains may often be explained by a small number of common risk factors that can be accessed with greater transparency and cost efficiency via Smart Beta strategies.

EngagementWe evaluated the client’s portfolio-level holdings using the MSCI All Country World Index1 as the benchmark. Upon analyzing the aggregate portfolio, SSGA determined:

• Although the investor was paying fees to a range of active managers, the overall active risk of the aggregate portfoliowas low, at 1.05%.

• Of that risk, factor risk accounted for 67%; stock-specificrisk was only 33%.

• The factor risk was tilted toward small size. Also, there was a high exposure to volatile equities and negative exposure to value, meaning that the portfolio favored expensive stocks.

SolutionSSGA discussed alternative ways for the client to construct its equity portfolio, replicating the factor risk provided in aggregate by its active managers, while maintaining allocations to those active managers who were providing truly idiosyncratic returns. The recommendation was to reallocate a portion of the active portfolio to Smart Beta strategies that provide certain desirable factor exposures that may not be reflected in the portfolio of active managers, such as value and low volatility. This structural design allows for potentially higher active risk, greater flexibility, more control and simplicity.

Hypothetical Risk Statistics3

Portfolio Total Risk (%) 9.18

Benchmark Total Risk (%) 9.33

Beta 0.98

Active Risk 1.05

Factor Risk (%) 67

Specific Risk (%) 33

Source: SSGA, Axioma, as of September 30, 2014.

Analysis of Investor’s Equity PortfolioActive Style Factor Exposures2

-0.10 -0.15 -0.05 0.00 0.05 0.10 0.15

Short-Term Momentum

Exchange Rate Sensitivity

Growth

Liquidity

Medium-Term Momentum

Volatility

Size

Value

Leverage

67%

FACTOR RISK

33%

SPECIFIC RISK

1 MSCI All Country World Index is a free-float weighted equity index. It includes developed world markets, and does not include emerging markets.

2 Factor Exposures are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

3 Predicted risk statistics are estimates based on certain assumptions and analysis. There is no guarantee that the estimates will be achieved; please see appendix for risk terms.

Making it Work: Factor Pathways 2

Factor investing is grounded in years of academic research and covers a wide spectrum of approaches and applications. They can be implemented in a variety of ways to help achieve specific risk, return and portfolio diversification objectives. For more examples of factor solutions, visit ssga.com.

Making it Work: Factor Pathways 3

GLOSSARY

BETA is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

ACTIVE RISK is a type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the benchmark against which it is compared.

On page 2, Factor Risk and Specific Risk refer to the amount of Active Risk that is due to factor exposures or stock-specific risk.

For public use.

State Street Global Advisors Worldwide Entities

Australia: State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services Licence (AFSL Number 238276). Registered office: Level 17, 420 George Street, Sydney, NSW 2000, Australia Telephone: +612 9240-7600 • Facsimile: +612 9240-7611 Belgium: State Street Global Advisors Belgium, Chaussée de La Hulpe 120, 1000 Brussels, Belgium. Telephone: 32 2 663 2036, Facsimile: 32 2 672 2077. SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.Canada: State Street Global Advisors, Ltd., 770 Sherbrooke Street West, Suite 1200 Montreal, Quebec, H3A 1G1, T: +514 282 2400 and 30 Adelaide Street East Suite 500, Toronto, Ontario M5C 3G6. T: +647 775 5900. Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates. Telephone: +971 (0)4-4372800, Facsimile: +971 (0)4-4372818.France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number 412 052 680. Registered office: Immeuble Défense Plaza, 23-25 rue Delarivière-Lefoullon, 92064 Paris La Défense Cedex, France. Telephone: (+33) 1 44 45 40 00. Facsimile: (+33) 1 44 45 41 92. Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich. Telephone +49 (0)89-55878-400. Facsimile +49 (0)89-55878-440. Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong • Telephone: +852 2103-0288 • Facsimile: +852 2103-0200 Japan: State Street Global Advisors (Japan) Co., Ltd., Toranomon Hills Mori Tower 25F 1-23-1 Toranomon, Minato-ku, Tokyo 105-6325 Japan, Telephone +81-3-4530-7380 Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345) , Membership: Japan Investment Advisers Association, The Investment Trust Association, Japan, Japan Securities Dealers’ Association Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: 145221. Member of the Irish Association of Investment Managers. T: +353 (0)1 776 3000. F: +353 (0)1 776 3300. Italy: State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch of State Street Global Advisors Limited, a

company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), with a capital of GBP 71’650’000.00, and whose registered office is at 20 Churchill Place, London E14 5HJ. State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano), is registered in Italy with company number 06353340968 - R.E.A. 1887090 and VAT number 06353340968 and whose office is at Via dei Bossi, 4 - 20121 Milano, Italy • Telephone: 39 02 32066 100 • Facsimile: 39 02 32066 155. Netherlands: State Street Global Advisors Netherlands, Apollo Building, 7th floor Herikerbergweg 29 1101 CN Amsterdam Amsterdam, Netherlands. Telephone: 31 20 7181701. SSGA Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore 068912 (Company Reg. No: 200002719D, regulated by the Monetary Authority of Singapore) • Telephone: +65 6826-7555 • Facsimile: +65 6826-7501 • Web: www.SSGA.com Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. Telephone +41 (0)44 245 70 00. Facsimile Fax: +41 (0)44 245 70 16. United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 2509928. VAT No. 5776591 81. Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. Telephone: 020 3395 6000. Facsimile: 020 3395 6350. United States: State Street Global Advisors, One Lincoln Street, Boston, MA 02111-2900

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

Investing involves risk including the risk of loss of principal.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.

The information provided does not constitute investment advice and it should not be relied on

as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

Past performance is not a guarantee of future results.

Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.

Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.

Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Making it Work: Factor Pathways 4

This article is an excerpt from State Street Global Advisors’ publication

Q1&2 2016

Additional ArticlesFor more articles like this, please visit ssga.com/IQ.

© 2016 State Street Corporation. All Rights Reserved. ID6436-INST- 6741 0416 Exp. Date: 31/03/2017

IQAbout UsFor nearly four decades, State Street Global Advisors has been committed to helping our clients, and those who rely on them, achieve financial security. We partner with many of the world’s largest, most sophisticated investors and financial intermediaries to help them reach their goals through a rigorous, research-driven investment process spanning both indexing and active disciplines. With trillions* in assets, our scale and global reach offer clients access to markets, geographies and asset classes, and allow us to deliver thoughtful insights and innovative solutions.

State Street Global Advisors is the investment management arm of State Street Corporation (NYSE: STT), one of the world’s leading providers of financial services to institutional investors.

* Assets under management were $2.3 trillion as of March 31, 2016. AUM reflects approx. $32.6 billion (as of March 31, 2016) with respect to which State Street Global Markets, LLC (SSGM) serves as marketing agent; SSGM and State Street Global Advisors are affiliated.