Finsia, Innovations In Asset Allocation Presentations, Thursday 9 June

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Finsia, Innovations In Asset Allocation Presentations, Thursday 9 June

  1. 1. ADVANCECONNECTStrengthen
  2. 2. INNOVATIONS IN ASSET allocationAllocation strategy in a dynamic investmentenvironment
  3. 3. RISK – MANAGING IT AND DE-RISKINGportfoliosKej SomaiaPortfolio Manager, Multi Asset, Colonial First State Asset Management
  4. 4. Measuring, managing andreducing riskLeah Kelly & Kej Somaia7th & 9th June 2011
  5. 5. Risk
  6. 6. What is risk?6 Risk has a different definition depending on your objective – Uncertainty around expected returns? – Not beating benchmark? – Chance of not being able to meet liabilities when they fall due? – Chance of losing capital? – Probability of a negative return over certain periods? – Probability of an extreme event? Risk is the probability that investment objectives will not be met
  7. 7. Typical risks in a diversified portfolio7 Market – Interest rate moves, credit spread moves, inflation moves, equity market moves, currency moves, stock specific Credit – Typically, related to fixed income investments, it is the risk that the borrower will be unable to meet its payment obligations (coupons, repayment of principal for example) Liquidity – Typically, we define it as the risk that we will be unable to sell assets without having a significant impact on the market or without having to take a significant haircut in value Counterparty – Closely related to credit risk, counterparty risk is the risk that the one of the parties involved in an over-the-counter derivative is unable to meet its contractual obligations
  8. 8. Measuring risk
  9. 9. Recap on some key terms9 Total portfolio risk measures Non-normal distributions Mean / expected portfolio value Volatility (σ) describes the width of the modelled portfolio CVaR is the avg VaR is a point on region beyond the distribution σ VaR Portfolio value
  10. 10. Measuring market and credit risk10 Can be used to measure: Appropriate for: Risk Description Equity Interest Credit Default Inflation Skewed Fat tailed measure market rate risk spread risk risk distributions distribution risk risk Tracking •Measures the difference in Yes Yes Yes – but No No No No Error volatility between its benchmark only if no and the portfolio interest •Relies on normality assumptions rate risk •Point in time is •No probability included Beta •Measures the sensitivity of a Yes Yes Yes No No No No portfolio to a move in the relevant benchmark •Point in time •No probability Duration •Measures the sensitivity of a No Yes Yes No Yes No No portfolio to a move in the relevant yield, inflation expectations or credit spread curve •Point in time •No probability Volatility •Measures the variability around Yes Yes Yes No Yes No No the expected return •No directional indication •Returns must be symmetric
  11. 11. Measuring market and credit risk11 Can be used to measure: Appropriate for: Risk Description Equity Interest Credit Default Inflation Skewed Fat tailed measure market rate risk spread risk risk distributions distribution risk risk VaR •Specifies the minimum loss that Yes Yes Yes Yes – Yes Yes Yes could be incurred with a given but probability over a given period of typically time underest •Comparable across portfolios and imates different asset classes the risk •A shortcoming is that it does not provide an indication of the expected size of the loss beyond the VaR point CVaR •Calculated as the weighted Yes Yes Yes Yes Yes Yes Yes average loss exceeding the VaR •Includes the entire tail of the distribution •Comparable across portfolios and asset classes Draw •Refers to the decline in returns Yes Yes Yes Yes Yes Yes Yes down from a peak over a certain period •Provides a measure of the magnitude but not the likelihood •Not directly comparable
  12. 12. Caveats around the risk measures12 – All of the quantitative risk measures rely on assumptions; the extent of which depends on the method used to calculate them – Beta and duration, typically only make sense for small changes in equity markets or yield curves and are not comparable across markets – That is, a duration of 5 that includes fixed income securities in two different currencies implies that those markets move together and by the same amount – VaR can underestimate the risk depending on the underlying asset classes because there is a technical flaw in its design
  13. 13. Measuring liquidity risk13 Liquidity is a function of the relevant market – It depends on such things as – The number of traders – The frequency and size of trades – The time it takes to execute – The bid-ask spread – How big your portfolio is! – A variety of approaches exist and there is NO consensus – Methods vary: – Add a liquidity factor to the risk measure of the portfolio – Assume properties of the bid ask spread – usually normally distributed
  14. 14. Measuring liquidity risk14 – “Know your portfolio” approach – VWAP for equities; takes into account the spread and the size of the portfolio relative to the market in which it is invested – No liquidity for any type of alternative – Look through into cash portfolios and all fixed income portfolios – Stress OTCs to see the impact of collateral calls – Stress Forward FX positions to see the funding impact on rolling the hedge
  15. 15. Measuring counterparty risk15 – Know or derive a credit rating of the counterparty – Only applied in practice to OTC derivatives, where the notional exposure is not a true indication of the size of the possible obligation – Many participants use a “potential exposure” number, which is calculated using some kind of volatility and/or distribution to estimate the potential size of the obligations (on both sides) – Different treatment of different types of OTC derivatives
  16. 16. Managing risk
  17. 17. Risk management strategies17 Relevant risk management strategies depend on your investment objective – Risk management also depends on the risk you are trying to manage – If tracking error, volatility, beta or duration are your relevant risk metric knowing the contributions to your total portfolio volatility, for example, helps – Portfolios can then be adjusted accordingly so that the risks you expect to be rewarded are the dominant risk factors
  18. 18. Risk management strategies18 – A Liability Mismatch – Asset portfolios should be constructed to evolve in line with liabilities – Note that liabilities evolve through time – This may be through duration, convexity matching, through credit spread matching, through cash flow matching – If tail risk, loss of capital are the focus: – Recognising that in extreme events all markets tend to move together though often at different rates; a number of strategies exist: • Volatility hedging through actively managed equity put options, VIX futures or some other volatility derivative • Credit default swap indices is also another way.
  19. 19. Risk management strategies19 – Credit risk: diversification is key. There is no upside in taking credit risk, the best you can hope for is that you get your principal plus interest back. – Lend a little to a lot – Know your position in the capital structure – Counterparty risk: – Vigilant monitoring of the financial strength of the counterparty – Diversification helps – Collateralisation (albeit carefully) – Strong documentation is critical – Strong record and settlement procedures are key • Note that a confirmation overrules a schedule overrules the ISDA Master agreement
  20. 20. Risk management strategies20 – Liquidity risk: – Know your portfolio! – Hold a buffer of cash and synthetically replicate your market exposure – Keep your methods of rebalancing a portfolio open – Manage your resets • Not all Forward FX rolling at the same time • Not all your derivatives resetting at the same time – If you have collateral agreements in place, maintain some flexibility in what you can post
  21. 21. Risk management strategies21 And finally: – STRESS TEST , STRESS TEST, STRESS TEST all of your assumptions
  22. 22. Practice is changing
  23. 23. How has practice changed?23 – Certainly there is a focus from regulators, advisor networks, superannuation firms regarding DB and DC risk – More and more conversations are focusing on portfolio design that has meeting investor objectives as a key – Furthermore, investors are focussing on the total risk of their portfolios, rather than just one metric – Increased focus on education of Boards and Trustees with regards to communicating risks of investment options
  24. 24. Disclaimer24 Product Disclosure Statements (PDS) and Information Memoranda (IM) for the funds issued by Colonial First State Investments Limited ABN 98 002 348 352, Commonwealth Managed Investments Limited ABN 33 084 098 180, and CFS Managed Property Limited ABN 13 006 464 428 (collectively CFS) are available from Colonial First State Global Asset Management. Investors should consider the relevant PDS or IM before making an investment decision. Past performance should not be taken as a reliable indication of future performance. Information in this presentation is confidential. No part of this material may be reproduced or transmitted in any form or by any means without prior written consent of Colonial First State Asset Management (Australia) Limited ABN 89 114 194 311 (CFSAMAL). This material contains or is based upon information that we believe to be accurate and reliable. While every effort has been made to ensure its accuracy, none of CFS or CFSAMAL offers any warranty that it contains no factual errors. We would like to be told of any such errors in order to correct them. This material has been prepared for general information. You should not rely on the contents. To the fullest extent allowed by law, CFS and CFSAMAL exclude all liability (whether arising in contract, from negligence or otherwise) in respect of all and each part of the material, including without limitation, any errors or omissions. This material is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render specific advice. It is not an offer document, and does not constitute a recommendation of any securities offered by any of the CFS or CFSAMAL. No person should act on the basis of any matter contained in this material without obtaining specific professional advice. CFS and CFSAMAL are wholly owned subsidiaries of Commonwealth Bank of Australia. The Bank and its subsidiaries do not guarantee the performance of any funds invested in by clients of CFS and CFSAMAL or the repayment of capital. Investments are not deposits or other liabilities of the Bank or its subsidiaries and are subject to investment risk including loss of income and capital invested. Colonial First State Global Asset management is the consolidated asset management division of the Commonwealth Bank of Australia ABN 48 123 123 124 Copyright © Colonial First State Group Limited 2011 All rights reserved
  25. 25. INNOVATIONS IN ASSET allocationAllocation strategy in a dynamic investmentenvironment
  26. 26. LIFECYCLE INVESTING strategiesProfessor Michael Drew SF FinManaging Director, Lifecycle Strategies, QIC
  27. 27. Innovations in Asset AllocationAllocation strategy in adynamic investment environmentFinsia workshopsJune 2011
  28. 28. DisclaimerQIC Limited ACN 130 539 123 (“QIC”) is a wholesale funds manager and itsproducts and services are not directly available to retail investors. QIC is a companygovernment owned corporation constituted under the Queensland InvestmentCorporation Act 1991 (Qld). QIC is regulated by State Government legislationpertaining to government owned corporations in addition to the Corporations Act2001 (“Corporations Act”). QIC does not hold an Australian financial services(“AFS”) licence and certain provisions (including the financial product disclosureprovisions) of the Corporations Act do not apply to QIC. Please note however thatsome wholly owned subsidiaries of QIC have been issued with an AFS licence andare required to comply with the Corporations Act. QIC Lifecycle Strategies is abusiness division of QIC.QIC, its subsidiaries, associated entities, their directors, employees andrepresentatives (“the QIC Parties”) do not warrant the accuracy or completeness ofthe information contained in this document (“the Information”). To the extentpermitted by law, the QIC Parties disclaim all responsibility and liability for any lossor damage of any nature whatsoever which may be suffered by any person directlyor indirectly through relying on the Information, whether that loss or damage iscaused by any fault or negligence of the QIC Parties or otherwise. The Informationis not intended to constitute advice and persons should seek professional advicebefore relying on the Information.Copyright QIC Limited, Australia 2011. All rights are reserved. Do not copy,disseminate or use, except in accordance with the prior written consent of QIC. 28
  29. 29. QIC Lifecycle Strategies QIC Lifecycle Strategies works with superannuation funds to develop and manage sophisticated investment solutions and lifecycle programs for the sole purpose of improving the retirement outcomes of defined contribution (DC) members. Our customised solutions allow trustees to deliver tailored outcomes for their members based on their investment horizon. 29
  30. 30. Lifecycle Strategies key beliefs 30
  31. 31. The problem (1) –Members aren’t always long-term investors• Investing for the long term does not reduce the probability of experiencing a loss in any one year• Therefore, the probable range of outcomes widens as a member’s investment horizon shortens. 31
  32. 32. The problem (1) –History isn’t kind when timeframes are finite• History shows that, in their final year, a 40-year investor has a: • 42% chance of not achieving a 7.5% return • 24% chance of falling short of CPI+3% • 14% chance of a negative return Source: QIC Lifecycle Strategies• This is interesting, but doesn’t factor in the dollars (portfolio size) against this return. 32
  33. 33. The problem (1) illustrated• One version of reality … a 25% drawdown five years from retirement destroys up to 1.5 times a member’s lifetime contributions to superannuation and reduces their annuity income by one-third. This situation was the lived experience for some super fund members in 2008/09. $2,000,000 $1,493,608 $1,500,000 $1,000,000 $500,000 $1,071,515 (-28% impact) $0 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 -$500,000 -$1,000,000 -$1,500,000 -$2,000,000 Base case - Accumulation (7.5% p.a.) Base case - Decumulation (4.5% p.a.) Drawdown 1 - Accumulation (-25%, year 35) Drawdown 1 - Decumulation (-25%, year 35) 33
  34. 34. The problem (2) –The portfolio size effect• It’s what you do when the largest amount of money is at risk that matters• Due to this size effect, a member’s final investment outcomes become more sensitive to asset allocation in later years relative to early years• Switching to less volatile assets before retirement can lessen the impact of severe stock market downturns • can be justified only when the accumulation at the point of switch exceeds the target set by the Fund Source: Basu, A. and Drew, M.E. (2009) Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds, Journal of Portfolio Management, 35:3, 61-72. 34
  35. 35. So, are target date funds the solution? Stylised asset alloction of XYZ Target Date Fund 100% 90% Cash 80% 70% Bonds 60% 50% 40% 30% Equities 20% 10% 0% 40 35 30 25 20 15 10 5 0 5 10 15 20 25 30 Years to Retirement Years Post Retirement 35
  36. 36. Issues with 1st generation target date funds• The proponents of 1st generation target date strategies cite the convenience to members of putting their investing activities on autopilot• However, the GFC has reminded us that: - whats safe and what’s risky changes as you move through life - sequencing risk impacts differently in savings years versus spending years - negative compounding matters!• Unlike the ‘auto-pilot’ or static approach, QICs approach to lifecycle investing is dynamic: - The riskiness (or otherwise) of the glidepath is informed (among other things) by the extent to which the members retirement wealth accumulation objective has been achieved 36
  37. 37. So, is switching between MIC options the solution?• Superannuation funds already have ‘target risk’ member investment choice (MIC) options available for members• Some funds already have a ‘partial lifecycle’ strategy that moves members from one MIC option to another at set birthdays• Our modelling shows that these strategies have the potential to expose members to unintended risks - essentially require the planets to perfectly align 2, 3 or 4 times in a members’ life, at the exact time de-risking takes place• Most funds employ active managers and dynamic asset allocation strategies, so why be deterministic in designing a glidepath? 37
  38. 38. The solution 38
  39. 39. The solution 39
  40. 40. Our solution – The Lifecycle Completion Portfolio• The QIC Lifecycle Completion Portfolio takes the form of an overlay• This allows the superannuation/pension fund to manage (or complete) the competing investment horizons of: - the superannuation fund’s long-term investment portfolio, and - the finite investment horizons of members• QIC Lifecycle Strategies analyses the investment objectives set for every member cohort by the trustees to identify the most appropriate glidepath from a return, risk, and constraint perspective• This frees the CEO/CIO (and their advisers) from the burden of managing competing retirement horizons of members - concentrates their efforts on constructing and managing the core investment portfolio over a long-time horizon 40
  41. 41. The Completion Portfolio in practice 41
  42. 42. Lifecycle Strategies investment process 42
  43. 43. Lifecycle Strategies glidepath design 43
  44. 44. Implementation Implementation via ... QIC Lifecycle Completion Completion Strategies Portfolio Portfolio construction management Optimal Multiple implementation Performance glidepath paths and risk To design monitoring phase Client Glidepath to Receive client/ data or delegate Performance delegate reporting to client 44
  45. 45. Dynamic lifecycle solutionsKey steps:• Analyse membership cohorts• In consultation with the Trustees - determine objectives appropriate to membership• Design customised asset allocation glide path: • Take account of portfolio size effect, market conditions, and objectives • Incorporate downside protection as relevant• Manage asset allocation dynamically• Review glide path periodically (e.g. monthly) versus objectives and adjust as necessary 45
  46. 46. Case study excerpt – results comparison R a n kin g s (1-9) W eig h ted W eig h ted W eig h ted W eig h ted W eig h tin g DL C2050 S c ore T DF 2050 S c ore B a la n c ed S c ore 100% E q u ities S c oreR etirem en t W ea lth R a tioMean 5% 6 0.3 3 0.2 3 0.2 7 0.4Median 18% 6 1.1 3 0.5 3 0.5 7 1.3Maximum 1% 6 0.1 3 0.0 3 0.0 7 0.1Minimum 1% 3 0.0 7 0.1 6 0.1 3 0.0Quartile 1 5% 6 0.3 3 0.2 3 0.2 3 0.2Quartile 3 5% 6 0.3 3 0.2 3 0.2 3 0.2Coefficient of Variation 5% 3 0.2 6 0.3 6 0.3 2 0.1Interquartile range ratio 5% 3 0.2 6 0.3 6 0.3 2 0.1 T OT A L 45% 2.4 1.7 1.7 2.2Down s id e R isk a n d P erform a n c e M ea su resLPM0 (Probability of Shortfall) 17% 6 1.0 2 0.3 2 0.3 5 0.9LPM1 (Expected Shortfall) 20% 7 1.4 3 0.6 2 0.4 5 1.0LPM2 (Downside Semi-variance) 1% 6 0.1 5 0.1 3 0.0 2 0.0Sortino Ratio (SR) 1% 6 0.1 3 0.0 3 0.0 7 0.1Upside Potential Ratio (UPR) 1% 6 0.1 3 0.0 3 0.0 7 0.1 T OT A L 40% 2.6 1.1 0.8 2.0T a il R isk E stim a tesValue-at-Risk (VaR) 10% 8 0.8 4 0.4 3 0.3 5 0.5Expected Tail Loss (ETL) 5% 6 0.3 7 0.4 5 0.3 2 0.1 T OT A L 15% 1.1 0.8 0.6 0.6Defa u lt Op tion S u ita b ility Ra tin g * 6.1 3.5 3.1 4.8 *Maximum Score = 9.0 DL C2050 T DF 2050 B a la n c ed 100% E q u ities R ec om m en d 46
  47. 47. Comparing alternative default designs Target Risk Age-based Target Date Dynamic (with DAA) MIC Switch Fund Lifecycle Strategy Ability to take account of assets outside of super û û û û Provide adequate retirement savings if market conditions are generally bad û û û û Age / time to retirement asset allocation considered in û ü ü ü Market conditions considered before a change to asset allocation ü û û ü Protection strategies offered during transition phase û û û ü Strategy customised to the characteristics of the funds cohort membership û û û ü 47
  48. 48. Thanks .....Questions?
  49. 49. CASE STUDY: ASSET ALLOCATION – APRACTICAL examplePaul Chin F FinSenior Investment Analyst, Investment Strategy and Research Group,Vanguard Investments Australia
  50. 50. FINSIA Conference: Innovations in Asset AllocationCurrent reflections on Asset Allocation (including a Case Study)Sydney, Australia: Tuesday 7th June 2011Melbourne, Australia: Thursday 9th June 2011Paul W. ChinSenior Investment AnalystInvestment Strategy & Research GroupInvestments Team (Asia-Pacific)
  51. 51. Agenda 1. Constructing portfolios: topical issues 2. Asset Allocation: revisiting key themes 3. A Case Study: n Vanguard Diversified Funds’ asset allocation> 51 Confidential
  52. 52. 1. Constructing portfolios: topical issues> 52 Confidential
  53. 53. Individual Investors: - Investor behaviour: left to their own devices (U.S.) Rolling 12-month excess returns: Dow Jones U.S. Total Stock Market Index versus Barclays Capital Aggregate Bond Index 50% 2009 Equities: $40b outflows 40% Stocks outperform 2006–2007 Equities: $464b inflows Bonds: $398b inflows Bonds: $182b inflows 30% 20% 10% 0% -10% 1999 Equities: $160b inflows 2001 -20% Bonds: $2b inflows Equities: $70b inflows 2000 Bonds: $81b inflows -30% Equities: $262b inflows 2002 Bonds: $48b outflows Equities: $37b inflows -40% Bonds: $148b inflows Bonds outperform -50% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Date label as of 31 December for each year. Stock returns use the Dow Jones U.S. Total Stock Market Index from 1990 through April 22, 2005 and the MSCI US Broad Market Index thereafter. Bonds consist of the Barclays Capital U.S. Aggregate Bond Index. Sources: Vanguard Investment Strategy Group and Strategic Insight.> 53 Confidential
  54. 54. Financial Planning (intermediated advice): - A value chain under pressure Financial Advice Industry Margins Regulators Total costs need to reduce Investors in area of 0.5 – 1.0% Investment Dealer Advice Platforms Managers Groups Businesses Value proposition changes; impacts to portfolio construction> 54 Confidential
  55. 55. Some other major Asset Allocation trends - Portfolio construction challenges still exist “May you live in interesting times…” n Defined Benefit challenges (e.g. GFC & impact on funding levels, regulatory): – é to FI, ê in EQ allocations – Rise of alternative investments & riskier n A rise in the number of Asset assets: PE/VC, commodities, Classes used infrastructure, absolute return, structured, alternative/systematic betas n A focus on liabilities n A growth in types (and n Intermediated/Individual: ‘value for services’ top complexity) of derivatives of mind: – Use of indexing in portfolios – Rapid growth of ETFs> 55 Confidential
  56. 56. Building policy portfolios… - Perspectives of different investorsFocus: AA is tailored to meet liabilities & maximise Focus: earning the highest level of return for a giventhe surplus given acceptable risk level acceptable risk level Surplus, given - Cash n Define investor’s acceptable risk level - Bonds return requirement - Listed Property - Bonds n Identify current - Intl Equities wealth position - Listed Property n List investment - Intl Equities constraints - Aus Equities - Aus Equities Modelled Strategic Strategic Liabilities Asset Asset Allocation Allocation Source: Vanguard (stylised) > 56 Confidential
  57. 57. Common issues in investing/Asset Allocation (AA) - Expecting a perfect AA leads to disappointment Are you succumbing to the effects of behavioural finance? n The temptation to respond to Pleasure market dynamics is high – Regret minimisation – Overconfidence – Aversion to ambiguity – Loss Aversion -$50 Loss Gain +$50 PainSource: Kahneman and Tversky (1979)> 57 Confidential
  58. 58. Core Portfolio Construction principles haven’t changed Be mindful of constantly responding to short-term market dynamics n Perhaps a ‘New Normal’ in economic terms n Strategic Asset Allocation ≠ “buy & hold” or “set & forget” n The underlying premises of portfolio construction remains highly relevant – Expectations in return, risk, correlation periodically – Funding needs/liabilities may have changed – Risk management is gaining prominence – Rebalancing within tolerances – Taxation, costs and fees> 58 Confidential
  59. 59. 2. Asset Allocation: revisiting key themes> 59 Confidential
  60. 60. What do you see in this picture?> 60 Confidential
  61. 61. Interpreting the same data - A range of views on the same data US wealth management recommended Asset Allocations: (moderate-risk) Box & Whisker Plot (at March 2011) 70% 60% 50% 40% 30% 20% 10% Equities Fixed Interest US Fixed InterestSource: Vanguard Investments Australia calculations using data from Barrons, March 2011> 61 Confidential
  62. 62. Dynamic Asset Allocation - Getting the timing, magnitude & direction right…Fixed Interest Fixed Interest…strategies range from reducing World’s largest bond investor PIMCO dumps U.S. Treasuries …strategies range from reducinglongest-dated holdings and shifting longest-dated holdings and shifting - The Guardian UK, 11 April 2011to higher-yielding corporate debt, to higher-yielding corporate debt,to investing in stocks, commodities to investing in stocks, commodities& non-U.S. bonds... Fidelity says yields may stay low, conflicting with PIMCO & non-U.S. bonds... - Bloomberg, 12 May 2011Global Equities Global Equities…the average super fund on Ratings houses silent on Japan fund fallout …the average super fund onMorningstar’s database had aa Morningstar’s database had - Financial Standard, 15 March 201123.2% weighting to Japan (vs aa 23.2% weighting to Japan (vsFeb-11 index weight of 10.4%). Feb-11 index weight of 10.4%).Currencies & Commodities Currencies & Commodities…head of Toscafund hedge fund Aussie dollar will rise further, expert predicts …head of Toscafund hedge fundDr Savouri predicts the AUD could Dr Savouri predicts the AUD could - Financial Standard, 13 May 2011keep climbing, reaching $US1.30 keep climbing, reaching $US1.30by 2013 & $US1.70 by 2014. by 2013 & $US1.70 by 2014. RBA dismisses commodity price bubble talk - The Age, 26 May 2011> 62 Confidential
  63. 63. The body of notable research on Asset Allocation Effect on differences in Effect on Total Ave Total Returns Return Variability: Policy Return / Ave across funds: Researcher Data Set Period Ave time series R2 Actual Return cross sectional R2Brinson et al. (1986) 91 Pension Funds 1974-1983 93.6% 112% n.a.Brinson et al. (1991) 82 Pension Funds 1978-1987 91.5% 101% n.a. 58 Pension Funds 1993-1997 88.0% 99% 35%Ibbotson & Kaplan(1991) 94 US Balanced Funds 1988-1998 81.4% 104% 40%Drobetz & Kohler 51 German & Swiss 1995-2001 82.9% 134% 65%(2002) balanced funds 420 US Balanced Funds 1962-2001 76.6% 114% n.a.Vanguard (2003) 66 US Balanced Funds Bear markets 69.4% 100% n.a.Vanguard 227 US Balanced funds 1966-2003 81.6% 122% 19%Tokat et al. (2006)Vanguard 189 US Balanced funds 1966-2006 82.1% 108% 20%Davis et al. (2007) > 63 Confidential
  64. 64. Some forthcoming Vanguard research (2011) n In Australia… n Over 80% of the variability of monthly returns can be explained by the variability of the fund’s policy benchmark n Funds detracted from their performance and increased their volatility relative to their Asset Allocation policies n The distribution of alpha is highly skewed: only a small number of funds have been able to generate statistically positive alpha> 64 Confidential
  65. 65. 3. A Case Study: Vanguard Diversified Funds> 65 Confidential
  66. 66. Building a Strategic Asset Allocation n Maintain an appropriate policy portfolio n Diversify to the maximum possible extent n Hold investment costs to the bare bones minimum n Be realistic with your return expectations> 66 Confidential
  67. 67. Building a Strategic Asset Allocation: - International Equity hedging considerations Diversification benefits from unhedged International Equity allocation10% Level of hedging needs to consider overall risk minimisation objective – no y = 0.48x + 0.004 one clear strategy for equities (unlike R 2 = 0.4 5% global bonds) 0% Local market return Scatter plot of monthly local market returns and return to hedging shows -5% positive relationship-10% When local returns are negative, the-15% AUD return has tended to be also negative ⇒ mitigates unhedged AUD AUD Hedge Impact return Index-20% -20% -15% -10% -5% 0% 5% 10% 15%Source: Vanguard team analysis> 67 Confidential
  68. 68. Building a Strategic Asset Allocation: - Were the changes worthwhile? 5yr rolling: Sharpe Ratio differentials between original & current allocations0.25 Conservative (30/70) The Sharpe Ratio ends up higher than original Balanced (50/50)0.20 allocation, so changes Growth (70/30) were worthwhile0.15 High Growth (90/10) The positive difference in Sharpe0.10 Ratio means greater return per unit of risk0.050.00-0.05 Jun-04 Jun-06 Jun-03 Dec-03 Dec-04 Jun-05 Dec-05 Dec-06 Jun-07 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Dec-00 Jun-02 Dec-02 Dec-07 Jun-08 Dec-99 Jun-00 Jun-01 Dec-01 The difference in Sharpe Ratio declined Source: Vanguard team analysis during the GFC as returns dropped rapidly > 68 Confidential and total risk increased
  69. 69. Relative performance> 69 Confidential
  70. 70. In summary n Don’t forget the (high) hurdles of costs, taxes and market impacts in assessing investment approaches n A highly dynamic investing environment: regulatory development, instrument evolution, investor awareness n Asset Allocation remains important; fundamental investment principles still hold n Strategic Asset Allocation ≠ “buy & hold” or “set & forget”> 70 Confidential
  71. 71. Disclosures - General advice warning Connect with Vanguard® > www.vanguard.com.au > 1300 655 102 This presentation contains general information and is intended to assist you. We have not taken anybodys circumstances into account so the information may not be applicable to your circumstances. Before making an investment decision, you should consider your circumstances, whether the information is applicable your situation, and our Product Disclosure Statement (PDS) You can access our PDS at www.vanguard.com.au or by calling 1300 655 102 Past performance is not an indication of future performance. Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263 / RSE Licence L0001335) (“Vanguard”) is the product issuer. This publication was prepared in good faith and we accept no liability for any errors or omissions. We are the trustee of Vanguard® Personal Superannuation Plan ABN 81 550 468 553. ‘Vanguard’, ‘Vanguard Investments’ and the ship logo are the trademarks of The Vanguard Group, Inc. © 2011 Vanguard Investments Australia. All rights reserved.> 71 Confidential
  72. 72. In summary
  73. 73. The Vanguard Group “To be the world’s highest-value provider of investment products…” n Global strength: n In Australia: n The Vanguard Group began 1975 n Retail Investors, Advisers & n A pioneer in index management Institutional Clients n US$1.7 trillion under management* n 23 Managed Funds n ~44% of assets = actively managed n 7 Exchange Traded Funds n Mutually owned n A$82 billion under management* An unwavering focus on client value: n Client first As at March 2011 n Cost efficiency> 73 Confidential
  74. 74. Vanguard professional biographies Paul Chin, F Fin Senior Investment Analyst Investment Strategy & Research Group, Investments (Asia-Pacific) Paul is responsible for providing investment thought-leadership and research for Vanguard Investments as a member of the global investment research effort. He originally joined Vanguard to head the firm’s Research & Technical Services Group, overseeing the retail thought-leadership agenda, researcher and platform relationships and delivering portfolio construction analytics for advisers. Prior to joining Vanguard, Paul worked with Barclays Global Investors (now Blackrock) in San Francisco, USA for over 7 years, most recently as principal, portfolio manager. In this money management role, he managed asset allocation, global macro and currency hedged strategies. Before that, he worked with Advance FM (including fund manager incubator, Ascalon Capital Managers) and Colonial First State Investments in product development and institutional client-facing roles across Australia and Asia-Pacific. He has previously served as Director/Vice-President of the Australian-American Chamber of Commerce, played First Grade cricket in Victoria and represented Barclays in the 2004/05 Global Challenge Round the World Yacht Race. Paul holds a Masters in Applied Finance & Investments (Finsia) and a Bachelors of Commerce (Monash). He is a Fellow of the Financial Services Institute of Australasia, sits on the Finsia Regional Council for Vic/Tas and occasionally lectures in the Asia-Pacific region in the areas of portfolio management, traditional and alternative investments.> 74 Confidential

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