Asset Classes 2

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Investment Consulting PracticeFor Internal Purposes Only

Introduction to Asset Classes

Shalin VyasMarch 2013


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Asset Classes

Risk

Return

Cash

Gilts

Corporate bonds

Hedge funds

UK equity

Global equity

Private equity

Emerging market

equity

Infrastructure

Commodities

High yield/

EM debtProperty


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Components of asset return

AssetReturn

Risk-FreeRate

ActiveReturn

MarketExposure

+ +

excess return,

over the risk free rate,

of each asset class

index

excess return over

the asset class

index achieved by

skilled investment

management

return on risk-free

bonds

(beta) (alpha)Rf


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Cash


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Cash What are they?

UK Base rates

0

1

2

3

4

5

6

7

Jan

2007

May

2007

Sep

2007

Jan

2008

May

2008

Sep

2008

Jan

2009

May

2009

Sep

2009

Jan

2010

May

2010

Sep

2010

Jan

2011

May

2011

UK CLEARING BANKS BASE RATE UK LIBOR 3 Month

Cash or highly liquid holdings

Income variable

Historically: perceived as no risk!

Actually: lower risk & lower return

Risk from inflation eroding the real value of the investment

Advantages

Liquid

Low risk

Simple

Disadvantages

Low return

Really cash?


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Equities


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Equities What Are They?

Share of ownership of a company

Voting rights

Returns gained from:

Dividends from company profits

Capital growth in share price

Why do pension funds hold equities?

Expect greater return than bonds in the long-term

Expected to outperform liabilities

Provide diversification versus other assets

However, equities are also higher risk Volatile capital values

Dealing costs higher than bonds


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Equities Typical Features

Passive managers aim to match index returns

Enhanced passive aim to outperform an index benchmark by between 0.5% -

1% p.a.

Core Active managers aim to outperform an index benchmark by between 1 -

2.5% p.a.

Unconstrained managers portfolio is built without direct reference to a market

index. Relative returns are less relevant with managers focusing more on

absolute returns


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Equities Advantages and Disadvantages

Superior long term performance (historically)

Equity returns have consistently stayedahead of inflation

Provides diversification versus other assets

Expected to outperform liabilities

Very volatile

Overseas equity bring additional risk

Dealing costs higher than bonds


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Bonds


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Bonds What are they?

Bonds basically IOUs, i.e. a loan

You might agree to lend me 100 today

In exchange for 10 every year (usually paid 5 every 6 months)

And the return of your 100 after 10 years

Not really different to a bank loan

A bond pays a Coupon rate on its face orPrincipal value

Yield is the annual return on a bond if held to maturity

Price of a bond changes with market yields

Here the coupon (per 100 nominal lent) is 10% and maturity is in 10 years

110

10

-100

10 10 10 10 10 10 10 10

0 1 2 3 4 5 6 7 8 9 10Years

's

Cash Flow


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Gilts

Issued by the Government, essentially considered to have no default risk

Advantages

low risk

Liability matching (fixed)

Liability matching (inflation)

Disadvantages

Low expected returns

Often residual interest rate risk due to duration mismatch between pooled funds and

liabilities

Perceived currently to be over priced due to demand for high quality bonds


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Corporate Bonds risk over gilts

The additional risk within a corporate bond contains

a default premium

a liquidity premium

AAA:Exceptionallystrong

AA: Very strong

A: Strong

BBB: Reasonably strong

BB: Adequate

B: Balance sheet stretched

CCC: Vulnerable

CC: Highly vulnerable

C: A bankruptcy petition may have been filed

D: Default on interest payments to bond holders

Sub investment

grade/High yield /

Junk

Investment grade


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BondsRelationship between price and yield of a bond

Yield Price

Yield Price


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Property


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Property What are they?

Return: Capital Growth + Rental Income

Comprises of a number of main sub-sectors

Traditionally pension schemes invested in retail, office and industrial in the UK

Schemes now considering investing to a small extent in other sectors, such as residential, hotels and

leisure, long lease property

RetailOffice

Industrial

FisheriesSuper-markets

HealthcareRetirement

HomesFarms

Vineyards

ForestsSelf

StorageGardenCentres

StudentHousing

MainstreamResidential

RestaurantCinemas

GymsBingo Halls Service

Stations

Hotels

DataCentres

LEISURE -RESIDENTIAL AGRICULTURAL

MAINSTREAM ALTERNATIVESource: ING


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Property Typical Features

Benchmark/target

Relative return

Absolute return

Style of investment

Value/Growth Gearing

Direct investment:

Active management

requirement

Index replication impossible

Passive approach is not

possible

Core-plus

Income producing

with active

managementpotentialCore

Fully leased

property

Re

turn

Risk

Value-added

Repositioning,

moderate

redevelopment

Opportunistic

Distressed sellers,

development,

financial

engineering,

emerging sectors


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Property Advantages and Disadvantages

High yielding Stable and diverse income stream

Competitive historical returns

Low correlation with other asset classes

Tangible not paper investments

Inefficient market

Alpha potential through asset management

Expensive to trade and manage Valuations are subjective, imprecise,

irregular, unreliable

Illiquidity

Large lot sizes


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Hedge Funds


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Hedge Funds What are they?

An asset manager . . .

Accessing the same markets as others . . .

But is unconstrained. . .

And is incentivised . . .

To be a skill based investor . . .

but with fewer constraints

but with theirchoice of equities, bonds, currency

and commodities

so can use leverage, short selling and derivatives

so performance related fees

allowing investors to access some of the best talent

in money management


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Hedge Funds Typical Features

Single Hedge Fund

Good

Access the best managers for each strategy

Ability to create a bespoke portfolio

Ability to identify closely the source of return

One layer of fees

Not so good

Concentration risk if only a few managers

Monitoring burden as number of managers

increases

Greater investment judgement required

Fund of Hedge Funds

Good

Access to a large number of hedge funds

Diversifies manager risk across several types

of hedge funds

Reduced monitoring and due diligence burden

for Trustees

High levels of manager expertise in finding

good quality hedge funds

Not so good

More difficult to identify sources of return

Diversification of managers could lower

overall FoHF expected return Extra layer of fees


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Hedge Funds Advantages and Disadvantages

Can offer attractive risk reduction

Returns not typically correlated with themarket

Cover a variety of instruments and markets

Attract top investment talent

Managers aligned with clients, often have

own money at stake

Success is measured by great performance,not asset gathering

High management and performance fees

Lock-ups, notice periods and infrequentdealing

Capacity constrained

Lack of transparency

Light regulation

Use of leverage can magnify losses

Additional governance and legal fees


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Emerging Market Equities


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Investment Consulting Practice

For Internal Purposes Only

Emerging Market Equities (EME) What are they?

There is no set economic or geographical region or area that defines emerging markets.

Investing in emerging market equity involves investment in the equity of companies

domiciled in emerging economies.

Emerging market economies include rapidly growing countries such as Brazil, Russia,

India, and China also known as BRIC countries

. but can also include countries as diverse as Thailand, South Africa, South Korea,

Chile or Bulgaria.


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EME Geographical Spread

Source: MSCI

Developed markets in pink

Emerging markets in blue


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EME Opportunities

Emerging economies continue to drive global growth

Changing global economic balance of power wealth transfer to emergingmarkets

Increasing importance of trade between emerging market blocs

Low household debt, strong corporate balance sheets, stronger fiscal position

Ongoing structural shifts in emerging markets driving growth forward

Population effects demographic dividend

Infrastructure demand to meet growth and replace obsolete equipment

Power investment critical to facilitate ongoing economic growth

Rise of the consumer growth of the middle class and increasing income

Resource intensive convergence of resource intensity per capita


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EME Advantages and Disadvantages

Economic strength

Wider opportunity set

Expected outperformance of developedmarkets

Volatile returns

Slowdown in global growth

Country specific risks

Flight to quality

Currency risk

Current uncertainty over equity markets ingeneral


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Diversified Growth Funds


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Diversified Growth Funds (DGFs) What Are They?

A DGF is a balanced fund which typically invests in multiple asset classes

Aim to deliver close to "equity-type" returns over the medium term

Aim to have significantly lower volatility than equities

Managers aim to achieve their objective by creating diversified portfolios, which

aim to generate returns by combining good asset allocation decisions with strong

stock selection (or manager selection) in each asset class.


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Equity

39%

Convertible Bonds

4%

Commodities

7%

Property

2%

Cash

4%

Absolute Return

5%Private Equity

2%Infrastructure

2%

Corporate Bonds

35%

DGF Typical Features

The chart to the right shows an example asset

allocation mix of a DGF.

Most funds typically hold a high percentage of

equities. This explains why most DGFs target

a similar return to equities.

DGFs have the ability to adjust these

allocations as the economic environment

changes.

They tend to be measured against cash or

inflation indices, plus an outperformance target

(e.g. LIBOR +3-5%).

DGFs are not immune to market downturns,

however should provide better protected then

long only equity funds.


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DGF Advantages and Disadvantages

Reduces the need to have in depth knowledgeof all asset classes

Allow access to asset classes where a directholding may not be possible

Dynamic asset allocation, if successful, can

produce positive returns in all markets

Delegation of underlying fund selection atasset class level

Range of options or portfolios to consider

Asset allocation decisions are not in the controlof the investor

May have additional fees

Unlikely to have strong capability in all theunderlying asset classes

Funds tend to have relatively short track recordof around 3-4 years

May be allocations to illiquid assets and thiscan mean less regular dealing frequencies


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Private Equity


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Private Equity What are they?

Equity investment in an asset, in which the equity is not freely traded on the public stockexchange

Important source of capital for start-up and young companies, for firms in financial

distress and those seeking growth or buyout financing


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Private Equity Sectors

Venture Capital Special Situations

Seed

Early

Expansion

Late

Growth Equity

Mezzanine

Distressed Debt

Secondaries

Royalty

Sector-Focused (i.e.

Clean Technology andEnergy)

Buyouts

Small

Medium

Large

Mega


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Private Equity Typical Features

Private Equity Characteristics

Lock-up / Liquidity Fund term 10-12 years

Secondary market for partnership interests

inefficient

Structure Limited partnership structure

Complex legal documents negotiated with side

letters

Cash Flows Commitment drawdown over 3-4 years

Capital calls have 10 days notice

Fee Structure c2% investment fee

c20% carried interest (incentive fee) with c8%

preferred return hurdle

Leverage Venture capital: none

Growth equity: none to low

Buyout: 50-70% debt/total capitalization,

depending on strategy

10704 Private Equity April 2011


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Private Equity Advantages and Disadvantages

Attractive long-term returns in the past

Opportunities for talented managers to addsignificant value over the long term

Diversification from quoted equity markets

Opportunity to invest in companies beforetheir potential value is realised through saleor flotation on a recognised stock exchange

Very wide dispersion in returns (survivorshipbias impacts PE indices)

Tend to be heavily leveraged, potentiallyexposed to interest rates

Liquidity on investment/disinvestment

Commitment to an investment will lead tocash calls on the fund potentially at shortnotice

Funds are committed, exiting can be hardtherefore causing liquidity issues

Performance measurement is very difficultand subjective

Fees are very high


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Questions


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Asset Classes 2

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