Building an Unconstrained Sleeve

Building an
Unconstrained Sleeve
Traditional and Non-Traditional Assets &
Strategies
July 2017
Newfound Research LLC
425 Boylston Street, 3rd Floor
Boston, MA 02116
p: +1.617.531.9773 | w: thinknewfound.com Newfound Case ID: 5975123

Newfound Research was founded in August 2008 to offer quantitative
investment research.
Over time, our capabilities evolved to include the design of custom mandate
portfolios, the development of tactical overlay solutions, and sub-advisory
services.
In December 2013, we began offering discretionary asset management
services with portfolios directly advised by Newfound.
In all of our capabilities, we are dedicated to helping clients achieve their
long-term goals with research-driven, quantitatively-managed portfolios, while
simultaneously acknowledging that the quality of the journey is just as
important as the destination.
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About Newfound
Newfound was awarded 2016 ETF Strategist of the Year by ETF.com.

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About Newfound Research
Portfolio Management
Services
Investment Research
Publications
• Offer solutions for institutional and retail
investors
• Capabilities include the design of:
• Custom mandate portfolios
• Tactical overlay solutions
• Sub-advisory services
• Access to discretionary asset management
services through portfolios directly advised by
Newfound
• SMA/UMA strategies available on a
number of TAMPs
• Family of open-end mutual funds
• Model allocation portfolios (including
Newfound mutual funds and 3rd party
products)
• Firm began by providing quantitative
investment research in 2008
• Currently provide content on a variety of
topics, including:
• Asset allocation
• Alternatives
• Behavioral finance
• Risk premium
• Risk management
• Research is delivered through a wide range of
media as well as directly to individual readers

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Fundamental Elements of our Process
While there are many elements necessary for successful investing, Quantitative
and Behavioral are our foundational elements.
QuQUANTITATIVE
BeBEHAVIORAL
We believe in a research-driven,
systematic approach to investing.
We believe the optimal
investment plan is first and
foremost the the one we can
stick with.

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Investment Team
Justin Sibears
Managing Director
• Frequent speaker on industry panels and contributor to ETF Trends.
• Prior to joining Newfound, structured and traded derivatives at J.P. Morgan and Deutsche
Bank
• MS Computational Finance, Carnegie Mellon University
• MBA, Carnegie Mellon University
• BS Finance and Mathematics, Notre Dame University
Nathan Faber
Vice President
• Prior to joining Newfound, worked as a chemical engineer at URS.
• BS Chemical Engineering, Case Western Reserve University
Corey Hoffstein
Chief Investment Officer
• Frequent speaker on industry panels and contributor to ETF.com, ETF Trends, and Forbes
Great Speculations blog.
• Named ETF All Star in 2014 by ETF Report.
• BS Computer Science, Cornell University

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Global Research Readership
Readership stats
• ~50 publications per year
• ~3200 subscribers
• ~160k article views in 2016
• Channels represented:
• Pensions
• Insurance Companies
• Superannuation Funds
• Family Offices
• Wealth Advisory
Audiences across the globe regularly utilize our data-driven investment research to help make
portfolio management decisions within institutional mandates

QUANTITATIVE
ExEXPECTATIONS
Understanding what we are seeking to achieve
with an unconstrained or tactical sleeve.

It is important to define what we are looking for:
what role does the sleeve serve in the portfolio?
• A hedge to equity exposure: explicitly offsetting
equity losses?
• Equity-like, but with downside protection?
• Absolute return?
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Reasonable Expectations

Anecdotally, what we often hear:
“60-80% of the upside, 25-50% of the downside.”
Our take:
• If the market is the benchmark, meaningful up-
capture will require meaningful equity beta.
• Greater upside participation requires stomaching
more short-term volatility.
• “Upside” and “downside” are horizon-dependent
measures.
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𝑰𝑹 = 𝑰𝑪 𝑵
𝑰𝑹 is “Skill”: How effective are your tactical calls?
𝑰𝑪 is “Depth”: How accurate are your signals?
𝑵 is “Breadth”: How many signals do you have?
Probably easier to increase breadth than depth; i.e.
combine different approaches and benefit from
process diversification.
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Two Ways of Doing It

Do we have to do anything?
A 60/40 portfolio is a pretty good starting point:
• Positive returns from bonds means up-capture is
likely >60%
• “Flight-to-safety” quality of bonds means that
down-capture is likely <60% in a crisis.
• Rebalancing can allow an investor to benefit
both from short-term momentum and long-term
mean-reversion.
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QUANTITATIVE
StSTRATEGIES
Different approaches that are commonly applied
when building an unconstrained sleeve.

Equity - Trend strategies use time-series momentum approaches that seek to invest during
positively trending market environments and retreat to safety (e.g. short-term U.S. Treasuries)
otherwise.
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Equity – Trend
Source: MSCI, St. Louis Federal Reserve. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not a guarantee of
future results. Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Equity – Trend strategy is rebalanced
monthly. The strategy invests in the MSCI World index when it is above its 10-month moving average and in a 1-year constant maturity U.S. Treasury index when it is below.
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Equity - Trend Equity - MSCI World

Equity - Minimum Volatility strategies seek to exploit the low-volatility phenomenon, whereby
lower risk securities exhibit an excess risk-adjusted return. They typically invest in securities
exhibiting lower volatility and beta.
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Equity – Minimum Volatility
Source: MSCI. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not a guarantee of future results. Performance is
gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Equity – Minimum Volatility strategy is the MSCI World Minimum
Volatility Index.
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Equity - Minimum Volatility Equity - MSCI World

Macro – Trend strategies apply long/short trend-following techniques to equities, rates,
currencies, and commodities. Historically, their dynamic nature has made them an excellent
hedge during a variety of different crisis periods.
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Macro – Trend
Source: MSCI, Salient. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not a guarantee of future results.
Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Macro – Trend strategy is the Salient Trend Index.
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Macro - Trend Equity - MSCI World

Macro - Risk Parity strategies seek to exploit diversification opportunities by using leverage to
allow all asset classes to contribute an equivalent amount of risk to the portfolio.
Empirical evidence suggests that this approach exploits the multi-asset low volatility
phenomenon, where low volatility assets exhibit an excess risk-adjusted return.
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Macro – Risk Parity
Source: MSCI, Salient. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not a guarantee of future results.
Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Macro – Risk Parity strategy is the Salient Risk Parity
Index.
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Macro - Risk Parity Equity - MSCI World

Macro - Contrarian strategies seek to exploit the long-term mean-reversionary behavior
exhibited by asset classes through either valuation or price-reversal measurements. By their
nature, they tend to be fearful when others are greedy, and greedy when others are fearful.
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Macro – Contrarian
future results. Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Macro – Contrarian strategy is
rebalanced monthly and invests 30% in the MSCI World Index, 30% in the Vanguard Total Bond Market fund (VBMFX), and 40% in a contrarian sleeve. The contrarian sleeve
ranks the MSCI World and the Vanguard Total Bond Fund based on trailing 12-60 month returns and invests in highest ranking asset class. The contrarian sleeve is rebalanced
annually using 12 overlapping portfolios.
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Macro - Contrarian Equity - MSCI World

Macro – Income strategies are non-traditional bond strategies, investing across the globe in
both traditional (e.g. sovereign debt) and non-traditional (e.g. corporate bonds and asset-
backed securities) fixed income.
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Macro – Income
Source: MSCI, HFRI, St. Louis Federal Reserve. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not a guarantee
of future results. Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Macro – Income strategy is
rebalanced monthly and invests 80% in the HFRI Relative Value Fixed-Income Corporate Index and 20% in a 7-Year Constant Maturity U.S. Treasury Index.
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Macro - Income Equity - MSCI World

Due to their perceived safety and liquidity, Intermediate-Term U.S. Treasuries have historically
exhibited a “flight-to-safety” premium during equity market collapses. The instantaneous
nature of this premium has made U.S. Treasuries an excellent hedge, regardless of whether
equity losses are sudden or prolonged.
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Bond – Intermediate-Term U.S. Treasury
future results. Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions. The Intermediate-Term U.S. Treasuries
index is a 7-Year Constant Maturity U.S. Treasury Index.
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Intermediate-Term U.S. Treasuries Equity - MSCI World

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Historical Capture Ratios
Quintiles of Monthly U.S. Equity Market Returns
Bottom
Quintile
2nd
Quintile
3rd
Quintile
4th
Quintile
Top
Quintile
Equity – Trend 41% 75% 75% 91% 63%
Equity – Min. Volatility 59% 32% 70% 77% 76%
Macro – Trend -12% 38% 45% 67% 25%
Macro – Risk Parity 22% 71% 55% 62% 50%
Macro – Contrarian 33% 34% 65% 65% 55%
Macro – Income 9% -23% 66% 39% 26%
Bond – Int. U.S. Treasury -26% -19% 18% 20% 3%
Source: MSCI, HFRI, Salient, and St. Louis Federal Reserve. Calculations by Newfound Research. Performance is backtested and purely hypothetical. Past performance is not
a guarantee of future results. Performance is gross of all fees. Returns include the reinvestment of dividends, capital gains, and other distributions.

QUANTITATIVE
HgHEDGE
Portfolios designed in effort to offset significant
equity losses.

Run a simulation-based optimization that explicitly seeks to minimize downside capture to the
MSCI World Index.
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Equity Hedge
Source: MSCI, HFRI, St. Louis Federal Reserve. Calculations by Newfound Research.
Performance is backtested and purely hypothetical. Past performance is not a guarantee of
future results. Performance is gross of all fees. Returns include the reinvestment of dividends,
capital gains, and other distributions.
Bond -
Intermediate-
Term U.S.
Treasuries
65%
Macro -
Income
2%
Macro -
Trend
33%
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Hedge MSCI World Equity Index

Run a simulation-based optimization that explicitly seeks to minimize downside capture to the
MSCI World Index.
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Equity Hedge (No Bonds)
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Hedge (No Bonds) MSCI World Equity Index
Macro -
Trend
93%
Macro - Risk
Parity
7%

To offset equity losses, strategies with negative correlations
are required.
Historically, this has meant exposures like U.S. Treasuries
and Macro – Trend.
These positions diversify each other well, both having
historically exhibited crisis alpha, but with U.S. Treasuries
potentially reacting more quickly than Macro – Trend.
In the backtest, both portfolios exhibit positive returns in
2000, 2001, 2002 and 2008.
Uncorrelated behavior can lead to frustrating returns: in
2009, when the MSCI World Index returned 29.9%, the
Hedge and Hedge (No Bond) strategies returned -3.3% and
2.5% respectively.
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Takeaways

QUANTITATIVE
EqEQUITY-LIKE
Portfolios designed in effort to capture a
significant equity upside with reduced downside.

Run a simulation-based optimization that explicitly seeks to maximize up-capture to the MSCI
World Index, with the constraint that the relative “Ulcer Index” of the strategy is 25% or
less than that of the MSCI World Index.
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Equity-Like
Bond -
Intermediate-
Term U.S.
Treasuries
2%
Equity -
Minimum
Volatility
22%
Equity -
Trend
31%
Macro -
Income
10%
Macro - Risk
Parity
8%
Macro -
Trend
4%
Macro -
Value
23%
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Equity-Like MSCI World Equity Index

To gain equity-like exposure, significant equity beta
must be present.
Equity – Trend and Equity – Minimum Volatility both
have the potential for an asymmetric risk profile.
Nearly 50% of the portfolio contains other exposures,
highlighting the benefits of process diversification.
Maintaining equity beta may increase drawdowns. In
the backtest, the strategy had a maximum drawdown
of -19%.
Diversification makes keeping up in a bubble, like the
late 1990s, near impossible.
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Takeaways

QUANTITATIVE
ArABSOLUTE RETURN
Portfolios designed in effort to create a stable an
consistent return stream in all environments.

Run a simulation-based optimization that seeks an equal-risk contribution for each strategy
employed.
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Absolute Return
Bond -
Intermediate-
Term U.S.
Treasuries
25%
Equity -
Minimum
Volatility
8%
Equity -
Trend
9%
Macro -
Income
25%
Macro - Risk
Parity
9%
Macro -
Trend
12%
Macro -
Value
12%
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Approach #3 MSCI World

Run a simulation-based optimization that seeks an equal-risk contribution for each strategy
employed.
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Absolute Return (No Bonds)
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Absolute Return (No Bond) MSCI World Equity Index
Equity -
Minimum
Volatility
16%
Equity -
Trend
18%
Macro - Risk
Parity
19%
Macro -
Trend
23%
Macro -
Value
24%

Diversification is key. Balancing asset class and
process risk is paramount.
Balancing risks means that absolute return style
strategies will likely badly underperform equities
during strong bull markets.
Even absolute return-style strategies are not
immune to liquidity crises like 2008.
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Takeaways

Your mileage with unconstrained strategies will vary
depending on where you’re trying to go.
• Strategies that are historically effective at hedging in
downturns are often painfully random during the rest
of the cycle.
• To capture significant equity upside, you have to bear
equity risk. This means being subject to sudden,
significant losses.
• Diversification may help you achieve more consistent
returns, but can lead to significant underperformance.
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Takeaways

The optimization applied is a simulation-based, block-bootstrap
approach.
For each simulation, returns for each strategy are aligned by month. To
simulate 10 years of returns, 20 6-month chunks are randomly
selected.
The first 6-month chunk is randomly selected. Subsequent chunks are
selected by adding a random normal variable with location zero and
scale of 36 months to the starting point of the prior chunk.
Optimal portfolios under each simulation are averaged together.
Simulations are run until the solution converges (approximately
250).
We believe this approach helps capture many of the salient features
empirically evident in asset class returns, including autocorrelation,
auto-regressive and heteroskedastic volatility, and time-varying
cross asset class dynamics.
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Optimization

Certain information contained in this presentation constitutes “forward-looking statements,” which can be
identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,”
“project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations or
comparable terminology. Due to various risks and uncertainties, actual events or results or the actual
performance of an investment managed using any of the investment strategies or styles described in this
document may differ materially from those reflected in such forward-looking statements. The information in this
presentation is made available on an “as is,” without representation or warranty basis.
There can be no assurance that any investment strategy or style will achieve any level of performance, and
investment results may vary substantially from year to year or even from month to month. An investor could
lose all or substantially all of his or her investment. Both the use of a single adviser and the focus on a single
investment strategy could result in the lack of diversification and consequently, higher risk. The information
herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or
investment recommendations. You should consult your investment adviser, tax, legal, accounting or other
advisors about the matters discussed herein. These materials represent an assessment of the market
environment at specific points in time and are intended neither to be a guarantee of future events nor as a
primary basis for investment decisions. Past performance is not indicative of future performance and
investments in equity securities do present risk of loss.
Investors should understand that while performance results may show a general rising trend at times, there is
no assurance that any such trends will continue. If such trends are broken, then investors may experience real
losses. The information included in this presentation reflects the different assumptions, views and analytical
methods of Newfound as of the date of this presentation. This document contains the opinions of the
managers and such opinions are subject to change without notice. This document has been distributed for
informational purposes only and should not be considered as investment advice or a recommendation of any
particular security, strategy or investment product. This document does not reflect the actual performance
results of any Newfound investment strategy or index.
No part of this document may be reproduced in any form, or referred to in any other publication, without
express written permission from Newfound Research.
© Newfound Research LLC, 2017. All rights reserved.
37
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