The Chemistry of Asset Allocation

Are Traditional Asset Classes the Right Building Blocks for Portfolio Diversification?
2011 Callan IAG National Conference

September 2011

Callan Associates 101 California Street Suite 3500 San Francisco, CA 94111

Mark Andersen
Vice President 415-274-3023 direct Andersen@callan.com

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Agenda

Overview of traditional approaches

Benefits and shortfalls Implementation

Introduction to factor-based allocation

Classifying factors Combining factors Implementation

A hybrid approach to asset allocation

Economic Scenario Buckets

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Why the Interest in Factors?

Traditionally portfolios are built with asset classes such as equity, fixed income,
real estate, etc.

Ideally portfolios would be made up of many components, each independently

risky, and each compensated with return for taking risk.

It is possible to break down asset classes into building blocks, or factors, which
explain the majority of their return and risk characteristics.

Asset classes are an indirect way to invest in factors, but it is possible to invest
directly in certain factors.

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The Basics

Why the Interest in Factors?

Asset classes are bundles of exposures divided into categories such as

equities, bonds, real assets, etc.

Asset classes should be as independent as possible (minimal overlap) and in

aggregate should cover the investment universe (minimal gaps).

Correlations among asset classes are driven by many common factor

exposures.

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The Basics

Distinction Between Asset Classes and Sub-Asset Classes

The finer the distinctions between various asset classes, the higher the resulting
correlations.

Typical asset allocation relies on sub-asset classes (such as large cap or small cap
U.S. equity or non-U.S. developed equity).

Asset Class

Equity
U.S. NonU.S.
Developed Emerging

Debt
U.S.
Investment Grade High Yield

NonU.S.
Developed Emerging

Sub-Asset Class
Large Small

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The Basics

Mean Variance Optimization

The output of a mean-variance optimizer is a frontier composed of efficient

portfolios. Portfolios are classified as efficient if they provide the greatest expected return for a given level of expected risk.

Optimization, and efficient portfolios, rely heavily on the quality of the inputs
Capital market forecasts are the basis of this type of model.

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Traditional Approach
10% 24% U.S. Equity 13% Non-U.S. Equity 5% Emerging Markets 48% Fixed Income 7% Real Estate 3% Private Equity E(r) = 6.6%, E() = 10%

Classic Efficient Frontier

8%

Non-U.S. Equity U.S. Equity Real Estate

Private Equity Emerging Markets Equity

Expected Return

6%

4%

U.S. Fixed Income Cash

2%

0% 0% 5% 10% 15% 20% Expected Risk (Standard Deviation) 25% 30% 35%

The frontier is composed of efficient portfolios across the risk spectrum. Less than 100% correlation among asset classes lead to diversification benefits which efficient portfolios maximize.
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Traditional Approach

Some Limitations

While many portfolios appear to be well diversified, equity-like risk tends to dominate.

Alternatives Real Estate Private Equity Cash Global Fixed Income Non-U.S. Equity U.S. Fixed Income U.S. Equity Equity Credit Equity Equity

Global Equity

Credit

Equity

Source: Diversified portfolio based on 2011 P&I average Top 200 corporate DB plan allocations (2/7/2011).

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Traditional Approach

Some Limitations

Correlations across asset classes can be high because many asset classes are exposed to similar or common risk factors. For example, U.S. equity and U.S. corporate bonds share some common exposures, as do
private equity and public equity.

U.S. Equity

U.S. Corporate Bonds

GDP Growth

Volatility

Inflation

Capital Structure

Volatility

Currency

Value

Liquidity

Currency

Real Rates

Liquidity

Momentum

Size

Inflation

Default Risk

Duration

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What Are Factors?

If asset classes are molecules, then factors are atoms.

Those factors aggregate into the risk return characteristics of asset classes.

We are interested in identifying and classifying various factors and exploring

how they can be used to allocate assets.

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Classifying Factors
Periodic Table of Factors
Macroeconomic Regional Sovereign Exposure

A Sampling

Equity

Fixed Income

Other

GDP Growth

Size

Duration

Liquidity

Productivity

Currency

Value

Convexity

Leverage

Real Interest Rates

Emerging Markets (Institutions + Transparency)

Momentum

Credit Spread

Real Estate

Inflation

Default Risk

Commodities

Volatility

Capital Structure

Private Markets

Factors are the basic exposures which make up investments.

They can be thought of as building blocks or risk premiums.

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Risk Factors

How can one get exposure?

Ironically, even though risk factors are the basic building blocks of investments,
there is no natural way of investing in many of them directly. Most risk factors can be accessed through derivatives or long/short positions.

Simple examples:
Inflation: Nominal Treasuries less TIPS Real Interest Rates: TIPS Volatility: VIX futures

More complex examples:

Value: Long Developed Equity Value, Short Developed Equity Growth Size: Long Developed Equity Small Cap, Short Developed Equity Large Cap Credit Spread: Long U.S. High Quality Credit, Short U.S. Treasury/Government Duration: Long U.S. Treasury 10+ Year, Short US Treasury 1-3 Year Emerging Markets: Long Emerging Equity, Short Developed Equity

Not exactly possible:

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GDP Growth, Productivity, Momentum, Leverage

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Risk Factors

Return, Volatility, and Correlation Historical Experience

Based on 10 Years of Monthly Data ending 12/31/2010 Factor Risk and Return
Factor Exposure Equity Value Size EM HY Spread Default Duration Real Rates Inflation Volatility Long Position MSCI World MSCI World Value MSCI World Small Cap MSCI Emerging Markets BC High Yield BC Aaa BC 20+ Year Treasuries BC TIPS BC Treasuries CBOE VIX Short Position MSCI World Growth MSCI World Large Cap MSCI World BC Intermediate Credit (IG) BC BBB BC 1-3 Year Treasuries BC TIPS Historical Return Risk 3.20% 17.58% 1.07% 6.31% 8.80% 8.22% 13.69% 11.47% 2.57% 9.97% 1.22% 5.08% 2.51% 11.95% 7.03% 6.86% -1.74% 5.05% -4.05% 66.54%

Factor Correlations
Equity Value Size EM HY Spread Default Duration Real Rates Inflation Volatility Equity 1.00 0.07 0.39 0.43 0.69 0.54 -0.18 0.09 -0.43 -0.69 Value 1.00 0.15 -0.14 0.06 0.03 0.12 -0.04 0.12 0.04 Size EM HY Spread Default Duration Real Rates Inflation Volatility

1.00 0.42 0.40 0.38 0.07 0.32 -0.41 -0.22

1.00 0.41 0.34 -0.04 0.19 -0.35 -0.32

1.00 0.74 -0.38 -0.02 -0.49 -0.49

1.00 -0.28 0.21 -0.60 -0.40

1.00 0.57 0.12 0.15

1.00 -0.67 -0.03

1.00 0.32

1.00

Correlation < -0.3

Correlation between 0.4 and 0.6

Correlation > 0.6

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Factor Assumptions

Notes on the Historical Experience

Factor returns (or premiums) are fairly low, most have returned less than 5% over
the past decade.

Factor characteristics are extremely time sensitive, so varying the data horizon
can materially impact relationships.

Factor standard deviations range widely between 5% to 66% (for the VIX). Correlations among factors are low, typically ranging from -0.5 to +0.6.
Relatively highly correlated factors include Equity vs. High Yield and High Yield vs. Default. The average correlation for the 10 factors on the previous page is 0.03.

This is significantly less than many asset class correlations which range from 0.15 to more than +0.90. Sub-asset classes like U.S. Small Cap vs. U.S. Large Cap are the most correlated while relatively unrelated pairings such as U.S. 1-3 Year Treasuries vs. Private Equity are also the least correlated.

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Traditional vs. Factor

Traditional 60/40 Portfolio

Portfolio comparison

Based on 10 Years of Monthly Data ending 12/31/2010 Factor Portfolio

Volatility 40% BC Aggregate 40% Russell 3000 Inflation Equity Value

vs.
20% MSCI ACWI ex-US

Real Rates Duration HY Default Spread

Size

EM

Historical Return: Historical Risk:

5.16% 11.16%

5.66% 5.75%

Equal weighting 10 sample factors into a portfolio with monthly rebalancing results in historical equity-like returns with considerably less risk. Even with this simple weighting scheme, the factor portfolio exhibits relatively low volatility vs. a typical 60/40 portfolio. Both portfolios have a very low correlation with each other (-0.18).

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Simple vs. Optimized

Portfolio Comparison

Based on 10 Years of Monthly Data ending 12/31/2010 Optimized Factor Portfolio Simple Factor Portfolio
Volatility Inflation Equity Value Real Rates Size Volatility Value

Real Rates

Size

vs.

Duration HY Default Spread

EM EM

Historical Return: Historical Risk:

5.66% 5.75%

10.25% 5.75%

Optimizing a factor portfolio using historical risk, return, and correlations results in a bestfit portfolio tuned for the 10 year data sample. This portfolio was selected from the efficient frontier based on its 5.75% expected risk. This example is meant to illustrate that optimization with factors is possible, but high quality forward-looking inputs are necessary.

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Portfolio Construction
Which factors to include? How to weight factors?

Factor Portfolios Present Notable Challenges

Factor portfolios must be implemented using long and short exposures, often
via derivatives allocations.

Active high frequency rebalancing among a large number of risk factors is

necessary to maintain the desired exposure.

Factor portfolios resemble certain styles of hedge funds and risk parity
approaches (sans leverage).

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A Hybrid Approach

Can We Still Apply Factors to Traditional Methods?

Examine asset classes through a factor lens and group like asset classes together under macroeconomic scenarios.

Inflation Low or Falling Growth High or Rising Inflation Economic Growth Inflation Linked Bonds (TIPS) Commodities Infrastructure High Growth High Inflation Real Assets: Real Estate, Timberland, Farmland, Energy, MLPs

Low Growth Low Inflation or Deflation Cash Government Bonds

High Growth Low Inflation Equity Corporate Debt

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Economic Scenarios

What Roles do Asset Classes Play?

Bucketing asset classes based on their response to macroeconomic scenarios combines the transparency of investing with asset classes with the granularity of factor-based approaches. Sample Groupings:

Capital Growth: Grow assets through relatively high long-term returns

Global equity Private equity

Income / Flight to Quality: Provide current income and protect capital in times
of market uncertainty
Global fixed income Cash equivalents

Volatility Hedge: Earn returns between stocks and bond while attempting to
protect capital and temper market volatility
Diversified hedge funds

Real Assets: Support the purchasing power of assets

Real estate TIPS Commodities Natural Resource Equities
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Economic Scenarios

Working Within the Mean Variance Optimizer

Asset Class Risk-Reward Optimization Set: 2011 ESB Pvt 10%

Private Equity

8% Expected Return

Capital Growth

Real Estate

6%

Volatility Hedge Real Assets

4%
Cash

Income

2% 0% 5% 10% 15% 20% Expected Volatility 25% 30% 35%

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Economic Scenarios

The Building Blocks

Asset Class Risk-Reward Optimization Set: 2011 ESB Pvt 10%

Private Equity

8% Expected Return

Global Ex-US Equity Broad Domestic Equity Natural Resources Real Estate REITs

6%

Volatility Hedge High Yield

4%
Cash

Domestic Fixed TIPS Non US Fixed

Commodities

2% 0% 5% 10% 15% 20% Expected Volatility 25% 30% 35%

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Economic Scenarios

A Hybrid Example

This is how one large plan combines factors and asset classes:
pp re cia ti tio De on n fla Pro tio te Pr n/C ctio o n r Ca tec isis t i pi ta on Pu l P rc res ha er s Pr ing vat io e In se Po n co rv w m ati er e o G n en Di ve er rs at io ific n a Al t io ph n a In fla

Factor Asset Class Cash Interest Rates U.S. Government Bonds International Government Bonds Company Exposure Global Credit Global Equity Private Equity Real Assets Real Estate Infrastructure TIPS Special Opportunities Absolute Return Real Return Distressed Debt Mezzanine Debt Structured Credit Other

Target Allocation 2% 6% 4% 2% 53% 11% 36% 6% 18% 12% 3% 3% 21% 6% 7% 1% 1% 1% 5%

Ca pi ta

Source: Adapted from the Alaska Permanent Fund Corporations Investment Policy Statement dated 12/1/2010.
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Next Steps in Asset Allocation

What Does the Future Hold?

Practitioners will place increased emphasis on understanding how different

portfolios react to specific economic and capital market outcomes.

Asset classes will be increasingly defined by their expected reactions to these

different economic environments.

Liquidity will be an explicit consideration both in strategic policy development

and implementation.

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Conclusion
Building portfolios of factors is challenging, but using factors to understand
traditionally constructed portfolios is very useful.

Limitations, including basic investability, preclude most market participants

from solely investing along factor lines. However, factors provide a useful way to group traditional asset classes in macroeconomic buckets.

Several multi asset class managers can engineer strategies with specific
factor exposures; these can be used to augment existing frameworks.

Some factor exposures are explicitly incorporated within manager structure

analysis (such as liquidity, leverage, duration, currency, size, momentum, etc.).

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