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Louisiana Association of Public Employees’
Retirement Systems
Alternative Assets:
Educational Primer and Portfolio Impact
September 23, 2008
Rhett Humphreys, CFA
Partner & Senior Consultant
NEPC, LLC
5113 Piper Station Drive, Suite 205, Charlotte, NC 28277 Tel: 617-374-1300 Fax: 617-374-1313 www.nepc.com
CAMBRIDGE I CHARLOTTE | DETROIT I LAS VEGAS I SAN FRANCISCO
Absolute Return Fund Basics
General Terms
• Hedge Fund: A private partnership where the GP receives
management and/or incentive fees in exchange for
investment performance
• Long position: Owning a security – buy low, sell high (up is good)
• Short position: Selling a security – sell high, buy low (down is good)
• Arbitrage: The simultaneous purchase and sale of an asset in order
to profit from a difference in the price
• Gross Exposure: Aggregate of long and short investment positions in
relation to the Net Asset Value (NAV)
• Net Exposure: Difference between the long and short positions
• Alpha: The value added or subtracted by a fund manager.
Usually calculated with reference to a benchmark.
• Beta: Market driven performance
• Leverage: Increasing exposure to markets (both long and short) by
borrowing or use of derivatives.
3
AR Funds Have More Tools
Mutual Funds: AR Funds:
• market dependent • skill based
• focus on growing assets • focus on performance
• buy stocks and/or bonds • shorts, leverage, derivatives
• long bias • flexible market exposure
• strict style constraints • broad style constraints
• frequent liquidity • restricted liquidity
• scalable • capacity constrained
4
Benefits of Absolute Return Strategies
Source: NEPC, LLC
5
AR Fund Returns – Comparison
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont HF Index 10.7% 7.5% 13.8% 0.75
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
6
Direct Investments vs. Fund of Funds
• Direct Investments
Investor controls allocations more precisely
Select individual managers (more manager risk)
More oversight/time required
Pro: Better customization to unique client needs
Con: Very time consuming – “the tail wagging the dog”
• Funds-of-Funds
Effective diversification tool, but result is “average” returns
Potential access to top hedge funds
Extra layer of fees
Pros: Relative ease of implementation, a good place to start, diversification
Con: More expensive “cookie cutter” solution
7
Absolute Return Strategies
AR Strategies
Relative Value Equity Hedge Tactical
Multi-Strategy Event-Driven
(Credit-Linked) (Equity-Linked) (Derivatives)
Convertible Long/Short Distressed
Global Macro
Arbitrage Equity Securities
Fixed Income Equity Merger
Managed Futures
Arbitrage Arbitrage Arbitrage
Short Volatility Special
Other Credit
Bias Strategies Situations
Emerging Emerging Synthetic Multi-Strategy
Markets Markets Strategies Event-Driven
8
Strategy Description – Relative Value
• Relative Value strategies attempt to profit from related securities or
similar financial instruments that are mispriced
Search for securities that deviate from fair value
• Emphasis is on “market neutral” investing
Exposure to other risks may be hedged (e.g. interest rates,
stock market, credit, cap size, sector)
• Use leverage to enhance return
• Focus on risk management techniques
• Liquidity of underlying securities is important
• Leverage provider is key to these strategies
9
Relative Value – Convertible Arbitrage
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont Convertible Arb 8.0% 4.9% 12.0% 0.61
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
10
Strategy Description – Equity Linked
• Public market equity selection funds that take long and short positions
Systematic – An implementation of quantitative models employing a variety of numerical and
statically inputs
Fundamental – Ideas are generated through the use of bottom-up analysis to create an
information edge
Macro/Thematic – Global economic or geopolitical views expressed industry and/or country
direction bets
• Specific sub-strategies include:
Market Neutral equity Long/short
Funds containing primarily long undervalued equities offset by overvalued short positions
Returns are generated by the return spread between the long and short positions plus the short
interest carry
Sector Specific Long/Short Strategies
Financials, Healthcare, Japan, etc…
Long-biased equity funds
Funds containing long undervalued equities; short selling used sparingly
Both long and short positions are alpha generators
Returns tend to be more correlated with broad market movements due to less hedging
Short-biased equity funds
Funds containing long and short equities with the ability to be net short overall
Returns tend to be negatively correlated with broad market movements
11
Equity Linked – Long Short Equity
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont Long Short Equity 11.7% 9.8% 15.0% 0.68
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
12
Strategy Description – Event Driven
• Discipline concentrates on companies that are, or may be, subject to corporate events such
as restructurings, takeovers, mergers, liquidations, bankruptcies or other special situations.
• Due to the binary nature of the strategy, either the event happens or it does not happen,
returns are not normally distributed.
• Managers have expertise on evaluating the likelihood and impact of an event.
• Specific sub-strategies include:
Merger Arbitrage
– Merger arbitrage, Corporate restructuring, Reg. D or Private Placement
arbitrage, Capital Structure arbitrage
Distressed Debt
– Purchasing securities of companies in financial stress or distress
– Highly cyclical strategy
Bankruptcy
– Funds that invest in securities of companies operating under Chapter 11
Event-Multi-Strategy
– Combination of any or all of the above
13
Event Driven – Merger Arbitrage
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont Risk Arb 7.8% 4.1% 7.6% 0.66
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
14
Strategy Description – Tactical/Derivatives
• Also referred to as directional traders, invest opportunistically in long and short financial
and/or non-financial assets in US and non-US markets
• Managers try to capitalize on macroeconomic factors and events, ranging from currency
movements to foreign equity markets and interest rates
• Specific sub-strategies include:
Discretionary
– Funds invested in long or short markets based on qualitative/fundamental analysis, often
with technical input
Systematic (CTA)
– Funds invested in long or short markets based on trend-following or other quantitative
analysis
» Generally, these strategies are based on mean-reverting or pattern-recognition
trend following models
Currency Arbitrage
– Balanced or hedged long and short currency positions.
– Generally express a disparity in the relationship of currency prices to interest rates,
account balances, etc… in separate markets and sovereign countries.
15
Tactical/Derivatives – Global Macro
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont Global Macro 14.0% 10.4% 26.8% 0.85
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
16
Strategy Description – Multi-Strategy
• Several distinct strategies or alpha sources offered in a single fund
Generally, no one strategy represents more than 20% of the entire
portfolio
Like a FoF with greater capital mobility and just one layer of fees
• Advantages of strategy
Capital is allocated to most compelling areas
Flexibility to find new Alpha opportunities
Firmwide capital deployment and risk is managed at silo and portfolio
levels
• Cons
Single firm business risk
In many cases, lower quality investors vs. single strategy firms
17
Multi-Strategy – Performance
Annualized Statistics Jan 1994 through Dec 2007
CSFB/Tremont Multi-Strategy 9.3% 4.4% 7.1% 0.94
S&P 500 Index 12.6% 14.8% 44.7% 0.55
MSCI World 10.4% 16.3% 48.0% 0.39
Lehman Agg Bond 8.5% 5.8% 12.7% 0.59
* Maximum Drawdown
18
Reporting Examples
19
Reporting Examples
20
Reporting Examples
21
AR Strategies – The Good and the Bad
• The “Good”:
Potential for non-correlated returns to traditional asset classes
Potential to reduce overall portfolio volatility
Another way to close the funding gap
Access to some of the most brilliant minds on Wall Street
Rapidly evolving asset class with innovative ways to diversify returns
Incentive structure rewards those that find true “alpha”
22
AR Strategies – The Good and the Bad
• The “Bad”:
Complicated strategies
Complicated structures
Difficult to evaluate managers
Opacity (lack of transparency)
Infrequent liquidity
Expensive
Time drain
23
What is Portable Alpha?
• Portable alpha is packaging:
– A beta exposure, as represented by an index (i.e., S&P 500)
– With uncorrelated alpha
• Index exposure is typically obtained with derivatives
– The exposure can be obtained with a small commitment of capital
• Capital not committed to index exposures is used to generate
uncorrelated alpha
– Returns in excess of cash are alpha
• Sounds easy, but;
– Derivative exposures and product structures are legally complex
– Many alpha strategies are complex
– Most strategies have high fees
• Where possible, NEPC is driving certain solutions
– Bundled, ERISA friendly vehicles
– Transparency and liquidity
– Reasonable fees
24
Customized Portable Alpha Overlay
Total Return vs. Risk – 5 Year ending 03/31/08
20
16 Overlaid S&P 500
Annualized Return (%)
12 Median HF
S&P 500
8
Portable Alpha Plan
4
0
-4
-8
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
Risk (Standard Deviation in % )
Annualized Return Standard Deviation
Value Value
Overlaid S&P 500 14.0 12.2
Portable Alpha Plan 8.7 2.9
Median Hedge Fund 10.1 5.7
S&P 500 11.3 11.1
25
Private Equity
Categorization of Private Equity Strategies
Private Equity
US focused
International
Global
Venture Growth Equity Buyouts Mezzanine Distressed Secondary Special Situations
Debt Control Energy
Small Venture & Buyout
Seed/Early Pre-revenue Non-Control
Mid Funds that are
Middle Post-Revenue Venture Project Financing
Large generally
Later Expansion Lending & Leasing Restructuring
Mega 3-5 years old
Buyout Focused Bankruptcy Direct Investments
Industrial
Technology Business Services
Telecommunications Manufacturing
Life Sciences Healthcare
Media &
Entertainment
27
Strategy Definitions
• Venture Capital
– Venture Capital implies early stage financing of rapidly growing companies with an innovative/disruptive
business idea for a product or service that is proprietary.
• Growth Equity
– Growth Equity bridges the gap between venture and buyouts. Companies are generally generating revenue,
but need additional capital and/or guidance to ramp up production and enter new markets.
• Buyouts (Leveraged Buyouts, LBOs, Management Buyouts, MBOs)
– Buyout investing provides leveraged capital and business development capital to enable the restructuring of
existing business and industries.
• Mezzanine
– An investment strategy involving subordinated debt, (the level of financing senior to equity and below senior
debt). Capital supplied by mezzanine financing is used for various situations such as facilitating changes in
ownership through leveraged buyouts or recapitalizations, financing acquisitions, or enabling growth. Venture
lending and leasing is a subset of mezzanine financing that targets venture backed companies.
• Distressed
– Distressed securities are defined as a security with a current yield of 10% above comparable U.S. Treasury
bonds. Investment instruments include publicly traded debt securities, private debt, trade claims, mortgage
debt, common and preferred stock and commercial paper. Investments also include turnaround situations and
companies with poorly organized capital structures. Long and short positions are commonly used as a
technique to lock in profit or reduce risk.
• Secondaries
– Private equity interests are generally purchased at a discount from valuation from motivated owners of private
equity interests. The interests purchased are generally venture and buyout interests with limited exposure to
unfunded capital commitments.
• Special Situations
– Special situations generally have an open-ended investment objective and are seeking to capitalize on
opportunities in a wide variety of sectors. Investments may include energy, project financing and bridge
transactions.
28
Strategy Characteristics
Time Horizon to DPI
Strategy Sources of Returns IRR Range
Liquidity Multiple
Venture Capital Appreciation 5 - 7 years 15% - 25% 2.5X
Growth Capital Appreciation 5 - 7 years 10% - 20% 2.0X
Capital Appreciation, Dividends and
Buyouts 4 - 5 years 15% 1.75X
Recapitalizations
Current Income with limited Capital
Mezzanine 1 – 2 Years 10% 1.50X
Appreciation
Current Income with limited Capital
Venture Lending 2 – 3 Years 10% - 20% 1.75X
Appreciation
Secondaries Capital Appreciation 1 – 2 Years 15% - 25% 1.50X
Distressed Capital Appreciation 1 – 2 Years 17% 1.75X
Current Income with limited Capital
Energy 1 – 2 Years 15% 1.75X
Appreciation
29
Historical Returns for Private Equity
ANNUALIZED INTERNAL RATES OF RETURN, (IRR)
THROUGH DECEMBER 31, 2007
US VENTURE CAPITAL US BUYOUTS
Vintage Max Upper Median Lower Min Max Upper Median Lower Min
Year Quartile Quartile Quartile Quartile
1992 116.3% 38.9% 14.1% 11.3% -47.2% 60.0% 29.8% 18.4% 10.7% -23.5%
1993 98.6% 38.8% 12.7% 0.2% -25.0% 57.0% 25.9% 16.0% 7.8% 0.2%
1994 112.9% 41.1% 15.6% 3.6% -47.9% 91.3% 21.6% 12.0% 0.6% -6.9%
1995 247.8% 64.9% 21.3% 3.4% -29.8% 48.0% 12.3% 5.8% 0.2% -10.0%
1996 454.9% 113.9% 31.0% 1.5% -17.7% 81.4% 9.9% 5.6% -0.8% -10.7%
1997 296.0% 59.7% 20.2% -0.8% -31.6% 65.3% 11.3% 3.0% -0.9% -17.3%
1998 721.0% 11.9% 2.0% -4.0% -44.8% 36.5% 10.7% 5.6% -2.5% -22.1%
1999 140.1% 0.9% -6.9% -15.0% -100.0% 62.0% 14.2% 2.7% -2.5% -22.6%
2000 31.1% 3.0% -2.4% -7.6% -24.2% 112.1% 21.7% 7.4% -0.9% -18.0%
2001 29.0% 11.3% 2.6% -3.5% -25.6% 72.1% 17.9% 8.5% -3.1% -14.3%
2002 28.9% 3.6% -0.6% -2.4% -13.5% 80.2% 29.6% 9.1% 0.0% -22.1%
2003 34.4% 15.7% 0.9% -1.6% -5.9% 51.2% 29.1% 15.1% 4.2% -0.1%
2004 39.1% 11.8% -1.0% -7.8% -16.2% 69.9% 24.4% 12.9% 0.2% -20.4%
2005 34.0% 12.0% 0.0% -2.9% -17.0% 25.1% 12.1% 7.5% -5.1% -31.8%
2006 167.5% 1.4% -12.7% -20.2% -35.2% 13.7% -3.1% -9.1% -14.7% -25.6%
2007 115.6% -22.7% -28.2% -48.1% -95.5% 15.0% -8.0% -48.3% -85.1% -94.9%
Source: TFSD Venture Economics
Observations: US Buyout funds outperformed US Venture funds during eleven of the last sixteen vintage years.
US Venture funds generally had higher returns for the 1994 through 1997 vintage years when compared to US
Buyout funds for the same vintage years.
30
Building a Private Equity Program
• Investment Considerations
– Vintage Year diversification is critical to the program’s success
– Manager selection has a dramatic impact upon returns
– Investors make a commitment to fund capital over a period of
years
– “J-Curve” impact
• Management fees are charged on commitments not on the amounts
funded
• Strategy diversification will mitigate the “J-Curve”
– Size of the private equity commitments will impact the
investment vehicle decision – fund of funds versus direct funds
31
J-Curve Impact
• Cash flow pattern of investing in
private equity Projected Cash Flows for a $10 Million Commitment
– In Years 1-3 returns are negative, $15,000,000
little income is generated,
management fees are collected on
committed (not invested) base, $10,000,000
additionally there are some early
investments which fail;
– Years 3-5 returns flatten out and $5,000,000
gradually turn positive as values are
written up to reflect transactions and
some income is received; $0
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year
10
– Years 5-10 returns spike as assets
are sold and accumulated increases -$5,000,000
in value are reflected, and income is
received as businesses become
profitable; -$10,000,000
– All combined leads to what has been Drawdown Distribution Cumulative Net Cash Flow J Curve
termed the “J-Curve.”
32
Fund-of-Funds vs. Single Strategy Funds
• Individual investments
– Can select best in class
– Can control allocations more precisely
– More individual manager risk
– More oversight/time required
– Pro: Better customization to unique client needs
– Con: Very time consuming – “the tail wagging the dog”
• Funds-of-Funds
– Effective diversification tool, but more “average” returns
– Potentially better access to top firms
– Extra layer of fees
– Pros: Relative ease of implementation, a good place to start
– Con: More expensive “cookie cutter” solution
33
Real Estate
Real Estate As An Investment
• Several types of investments
– Public / Private
– Debt / Equity
• Two major ways to participate
– Direct ownership through limited partnerships, joint
ventures or direct purchases
– Indirect ownership through commingled funds, real
estate investment trusts
• Real property assets can provide rental income as well as
value appreciation
35
Real Estate Investment Vehicles
• Private Equity Real Estate
– Open-end Commingled Vehicles
• Usually Insurance Company Separate Accounts or Private REITS that allow ERISA plans
and other institutional investors to commingle their capital.
• Most of these vehicles are very large ($2-10 billion of net assets; hundreds of properties) and
focus on core and/or value added strategies.
• Lock-up periods of 1-2 years are common and redemptions are usually permitted with 90
days notice.
– Closed-end Vehicles (e.g., Limited Partnerships, LLC’s)
• Usually smaller in size ($100 - $500 million) with a 7 – 10 year term. They tend to focus on
non-core investments and niche strategies (value added, opportunistic, sector focused)
where the manager has an expertise.
• These are typically illiquid investments with limited investor rights. They frequently include a
provision to share profits above a preferred return with the manager.
• Publicly Traded Real Estate
– REITs
• There are both public and private REITs. Public REITs are registered with the SEC and
traded on public exchanges whereas private REITs are not traded on any exchange.
• REITs pursue many strategies and can be either large or small, concentrated or diverse.
Public REITs are freely tradeable and liquid.
• Both public and private REITs must by law distribute 95% of their net income to shareholders
each year.
36
Market Overview - Size
Market Overview - Size
• Estimates of the Global Investment
Other Stocks
22% 25%
Universe total $120.7 trillion.
• The US portion of the universe is
$56.6 trillion, or 47%.
• Commercial Real Estate
represents approximately 9.3% of
the US investment universe, or
about $5.3 trillion (of that, $1.8
Real Estate
13%
trillion is “institutional” in quality).
Bonds
40%
Sources: PricewaterhouseCoopers, Merrill Lynch, New York Stock Exchange,
Prudential Real Estate Investors, “The Language & Culture of the Pension
Real Estate Investment Market” Institutional Real Estate, Inc.
37
Market Overview - Geography and Property Sectors
Geographic Categories Property Types
• Office
– Office Market Rents tend to move with
supply and not demand. The Main Risk
in Office Property Investment is periodic
overbuilding that is unrelated to
economic demand.
• Apartments (Multi-Family Dwellings)
– Tend to be the most stable of all
sectors. Major risks include higher than
expected home ownership rates and
temporary overbuilding.
• Industrial
– Include many types of properties, such
as warehouses and R&D facilities. The
Four Major NCREIF Regions: main risks are functional and locational
-East obsolescence.
-South • Retail
-Midwest – Include regional mega-malls, local
-West shopping centers, and other retail
space. Risks include macro-economic
trends affecting consumer strength,
periodic overbuilding, and changing
demographic patterns.
38
Real Estate Risk vs. Return
Income-Oriented Appreciation-Oriented
Opportunistic
Value-Added
Core
Income
Risk
39
Styles of Real Estate Investment
There are four major styles of institutional investment:
– Income-focused
• These tend to be publicly traded investments in the form of either Mortgage Backed Securities or
Mortgage Loans. Usually, credit analysis is more important than property management or property type.
These managers operate more like a fixed income advisors than property advisors.
– Core
• The most common private-equity, real estate investment strategy. Most large, open-end commingled
funds can be characterized as Core. They tend to be diversified by geography and sector while
possessing strong income-generating properties in economically diversified metro areas. They shun
development or operating risk by focusing on existing well-leased and well located properties. Generally,
returns have a strong income component with modest to moderate additional return from appreciation.
– Value Added
• These managers take on additional operating and leasing risk by focusing on physically renovating
and/or re-tenanting properties that suffer from some type of obscelecence. As a result, a majority of the
portfolio’s total return comes from value appreciation, with less from current income. Vehicles include
closed-end commingled funds as well as some large, open-end commingled products.
– Opportunistic
• These portfolios take on the most risk, including entitlement, development, leasing, and operational risk.
The income component of the total return is usually insignificant or non-existent since much or all of the
total return is sought from capital appreciation. Often, these are small limited partnerships focusing on a
specific region or sector that is currently out-of-favor. Investors can expect erratic cash flows that
experience a J-Curve, similar to what an investor experiences in venture capital investing.
40
Why Invest in Real Estate
• Potential to improve risk/adjusted return
• Diversification Benefits
– Low correlation with other asset classes
• Attractive Income Characteristics
• Inflation hedge (real assets vs. financial assets)
• Meaningful portion of investable universe
41
Risks In Real Estate Investing
• Less liquid than financial assets
• No continuous pricing mechanism, therefore quoted prices might not
reflect a property’s current value
• May be difficult to find buyers and sellers (if investment is direct)
• Real Estate market is segmented, making acquiring information more
difficult than financial assets
• Diversification more difficult to achieve, owing to size of individual
investment
• Returns can vary greatly between geographic regions and property
types
42
Excellent Diversifier: Low to Negative Correlations
• The NCREIF Index has exhibited low to negative correlations against all
major indices (i.e., S&P 500, Russell 2000, and the LB Aggregate) over
the last five and ten year time periods (i.e., through 3/31/2008).
Last 5 years
S&P 500 R 2000(R) Leh. Agg. NCREIF NAREIT
S&P 500 1.00
R 2000(R) 0.89 1.00
Leh. Agg. (0.09) (0.12) 1.00
NCREIF 0.11 0.03 (0.12) 1.00
NAREIT 0.52 0.69 0.30 (0.03) 1.00
REITs show high correlation
Last 10 years to small cap stocks
S&P 500 R 2000(R) Leh. Agg. NCREIF NAREIT
S&P 500 1.00
R 2000(R) 0.89 1.00
Leh. Agg. (0.55) (0.54) 1.00
NCREIF 0.22 0.05 (0.13) 1.00
NAREIT 0.33 0.58 (0.01) 0.00 1.00
As of 3/31/2008
43
Healthy Historical Returns
• In seven of the past twelve years, NCREIF has delivered returns falling
between the S&P 500 and the LB Aggregate.
NCREIF NAREIT S & P 500 Leh. Agg.
1995 7.5% 18.3% 37.5% 18.5%
1996 10.3% 35.8% 23.0% 3.6%
1997 13.9% 18.9% 33.4% 9.7%
1998 16.2% (18.8%) 28.6% 8.7%
1999 11.4% (6.5%) 21.0% (0.8%)
2000 12.2% 25.9% (9.1%) 11.6%
2001 7.3% 15.5% (11.9%) 8.4%
2002 6.7% 5.2% (22.1%) 10.3%
2003 9.0% 38.5% 28.7% 4.1%
2004 14.5% 30.4% 10.9% 4.3%
2005 20.1% 8.3% 4.9% 2.4%
2006 16.6% 34.4% 15.8% 4.3%
2007 13.6% (19.8%) (5.1%) 7.7%
44
Real Estate as an Inflation Hedge
NCREIF Returns vs. CPI
25.0
20.0
15.0
Calendar Year Return (%)
10.0
5.0
0.0
-5.0
-10.0
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
NCREIF Total Return NCREIF Income Only CPI
45
Summary: Implementation Considerations
• Any plan sponsor making an allocation to Real Estate
should insure that their portfolio is fully diversified, with
due consideration given to the following :
1) Style: Core vs. Value-added / Opportunistic
2) Geography: National vs. Regional
3) Property Type: Office, Multifamily, Retail, Industrial, Hotel
• Investing in a Real Estate portfolio that is concentrated in
one strategy can result in additional risk to the investor
• Leverage decision is important
• Liquidity requirements must be considered
46
Impact of Alternatives
Supporting Asset Allocation: 10.0% Risk Level
Traditional Stocks and Bonds: the 1980’s
Large Cap Equities Core Fixed Income
56.0% 44.0%
Equity 56.0% Fixed Income 44.0%
Diversified Asset Classes: the 1990’s
Int’l Int’l Small Cap Core Fixed Long
Emerging Global Emerging
Equity Small Large Cap Equities Equities Income Bonds High Yield
Equities Bonds Debt
10.0% 5.0% 5.0% 25.0% 6.0% 9.0% 15.0% 10.0% 10.0% 5.0%
Equity 51.0% Fixed Income 49.0%
Emerging Alternative Asset Classes: the 2000’s
Int’l
Int’l Equities Small Cap Long Emerging Real Private Hedge
Equity Large Cap Equities Equities GAA TIPS
Small Bonds Debt Estate Equity Funds
Portable Alpha 15%
10.0% 5.0% 5.0% 15.0% 5.0% 15.0% 20.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Direct Equity 40.0% Fixed Income 30.0% Alt. 15.0%
48
Theoretical Return/ Risk Frontier: The 2000’s
14
13 Private Equity
12 Small Cap Stocks
9.0% Return
11 Int'l Stocks
10
Large Cap Stocks
Return
8.5% Return
9
7.5% Return
8
Real Estate
7
Hedge Funds High Yield Bonds Efficient frontier with domestic stocks and bonds only
6 Frontier with diversifying asset classes,
Core Bonds w/o Alternative Assets
5 Frontier using Alternative Assets: the 2000’s
4
0 5 10 15 20 25 30
Risk
Stocks/Bonds Only Diversification w/o Alternatives Diversification w/ Alternatives
Note: Risk and return estimates exclude the impact of active management.
49
28
Concentration In Equities
Portfolio Dollar Weights Portfolio Risk Impact
Nominal
Infrastructure
Bonds
Nominal
Bonds
Equities
Equities
Drawdowns
Portfolio Equity Component of Portfolio
0%
-10%
-20%
-30%
-40%
-50%
-60%
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
50
Commitment to Alternatives 2Q04 vs. 2Q07
% of Fund in Alternatives
2004 2007 Change
Corporate 14.9 26.6 +11.7
County 5.0 27.2 +22.2
City 10.3 14.0 +3.7
State 7.0 11.1 +4.1
Taft-Hartley 6.9 18.3 +11.4
ICC Median 5.0 8.0 +3.0
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Actual Results: Fully Diversified Portfolios
Int’l Equity Domestic Equity NEPC Client Fixed Income
Portable Portable Alpha Portable Alpha
Alpha
Alternatives Absolute
Long Bonds TIPS HY EMD
SC Dev’l SC Mid Large (Illiquid) Return
EM
Cap Cap
10% 3% 8% 3% 5% 8% 20% 11% 26% 3% 3%
Equity 37% Fixed Income 32%
Average Large Corporate Plan* Cash
Int’l Equity Domestic Equity Fixed Income
2% 18% 8% 3% 29% 9% 6% 18% 2% 3% 2%
Equity 60% Fixed Income 25%
Average Large Public Plan*
Int’l Equity Domestic Equity Fixed Income
2% 15% 7% 4% 33% 2%2% 29% 2%2%2%
Equity 61% Fixed Income 35%
*Average allocations are from Large Corporate/Public Plans with total plan assets over $1 Billion.
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Total Funds – 5 Year Risk/Return
Total Funds – Total Return vs. Risk
5 Years Ending 3/31/08
Total Illiquid.
Total Liquid.
Overall Comp.
S&P 500
LB Aggregate
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NEPC Client Performance with Alternative Investments
Average Returns by Commitment to Alternatives
As of March 31, 2008
10.0%
9.0%
8.0%
7.0%
Annualized Return (%)
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1 Year 2 Years 3 Years 4 Years
ICC Median No Alternatives More than 0% More than 5% More than 10% More than 15% More than 20%
Note: Includes all current NEPC clients (regardless of hire date) with DB, Endowment and Foundation plans that had the specified commitment to alternatives during each
of the years presented. Alternative Investments include hedge funds, private equity and miscellaneous investments (e.g. timber etc) but not Real Estate.
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Risk & Return Impact Conclusions
• Structural changes resulting from inclusion of
alternatives
– Materially diversify traditional “stock: bond” investment programs
• Returns enhanced from inclusion of new asset classes
• Risk reduced from reduction in traditional equity commitments
• A “better beta”
– Independence of portable alpha from benchmark influences
• Maintains returns in markets adverse to stocks and bonds
• A “better alpha”
• Ultimate goals of higher returns, more consistent
returns better realized than with traditional, bundled
approaches
55
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