Change the Measure: Measure the Change : Are We Incenting Managers Properly?

1. Change the Measure: Measure the Change: Are We Incenting Managers Properly? ”Institutional investors will return to the basics over the next 10 years, says a report from McKinsey & Co. It predicts investors will move away from a focus on beating benchmarks and maximizing alpha regardless of market conditions to one that emphasizes meeting fundamental investment objectives. ‘The Best of Times and the Worst of Times for Institutional Investors’ found that among the major shifts investors need to make in order to adapt to the new market landscape is to adopt a more forward looking investment approach involving more communication with managers on their objectives and strategies.”

2. Typical regional asset allocation approach will have different risk implications than when it was implemented in the 90’s MSCI EAFE S&P 500 TSX Bonds • Hire specialists in each silo • Reward them for beating their benchmark • Control risk through low asset correlation

3. Globalization is a Reality • Globalization has led to a much more integrated economy • World Bank & Central Bankers share and cooperate to a much higher degree • Multilateral and bilateral trade agreements have increased market links • Euro zone has imposed • Fiscal & Monetary constraints • A single currency • One labour pool • Inflation, interest rates, have moved in the same direction in most developed markets

4. Over the past 15 years correlations have moved from 36% to over 85% between North American markets and the rest of the Globe1 Importantly market corrections are largely occurring together Recent Corrections in the S&P/TSX vs. the S&P 500 and MSCI EAFE Global Markets Have Arrived Source: Bloomberg

5. The Pattern of Market Returns is Not Helpful • If higher correlations are the new norm, then this pattern is likely to represent your whole equity portfolio • Perhaps this structure and the measurement are not appropriate • As Managers, if staff achieve a goal ten times in ten, but the company is put into distress four times in ten, would you change your metric?

6. As at June 30, 2007 60% S&P/TSX & 40% MSCI World Consumer Discretionary 7.69 Consumer Staples 4.77 Energy 20.15 Financials 28.65 Health Care 3.93 Industrials 7.93 Information Technology 6.50 Materials 12.54 Telecommunication Services 5.28 Utilities 2.55 Total 100.00 “Sometimes the Way we Look at the Problem is the Problem”Stephen R. Covey Typical Balanced Portfolio – June 30, 2007 Typical Equity Portfolio 23% Financial Exposure 28% Financial Exposure • An index does a reasonable job of defining the choice of companies available, but maybe not the characteristics of the right companies to invest in to fund a Pension Plan

7. 100% Equity Correlation from 15 Years Ago • An index portfolio 15 years ago versus the last 5 years • Higher correlations imply higher volatility with no return enhancement • Approaches that control “tracking error risk” will see total portfolio risk increase Correlation in the last 5 Years 100% Bond Source: Zephyr StyleADVISOR

8. Can we restore diversification? • Bottom up portfolio construction still seems to offer diversification opportunity • Broader mandates with fewer restrictions

9. Sectors offer better diversification than markets Correlation average of 0.69 versus 0.85 for regional markets MSCI Cons Cons Health Info Telecom World Energy Materials Industrials Disc Staples Care Financials Tech Services Utilities MSCI World 1.00 Cons Disc 0.87 1.00 Cons Staples 0.81 0.74 1.00 Energy 0.73 0.51 0.51 1.00 Financials 0.88 0.86 0.77 0.51 1.00 Health Care 0.78 0.69 0.74 0.44 0.69 1.00 Industrials 0.92 0.90 0.75 0.63 0.87 0.72 1.00 Info Tech 0.82 0.80 0.57 0.50 0.67 0.65 0.77 1.00 Materials 0.87 0.74 0.67 0.79 0.70 0.60 0.80 0.67 1.00 Telecom Services 0.81 0.72 0.66 0.56 0.68 0.68 0.74 0.75 0.68 1.00 Utilities 0.70 0.52 0.64 0.64 0.53 0.58 0.57 0.50 0.59 0.64 1.00 10 Years as at September 30, 2011 • Securities are less correlated than sectors

10. 100% Equity Correlation from 15 Years Ago • Control Risk through security selection and sector exposure not market weightings • A security and sector driven approach has the opportunity to restore some diversification and mute volatility. Correlation in the last 5 Years Addressing diversification with sector and security exposure can reduce risk levels 100% Bond Source: Zephyr StyleADVISOR

11. Heisenberg Uncertainty Principle“The Presence of the Observer Changes the Nature of the Observed” • In investment management, the measurement changes the behaviour of the measured • Closet indexers exist as a result of measurement to a market benchmark • One third of active fund strategies studied were judged to be “closet indexers” All Equity Mutual Funds in the U.S. 1992 - 2003 • If the incentive goal is not changed, the portfolio construction will likely not change

12. Decide on a Goal that Serves Your Plan’s Need • For most pension investors, an absolute goal of CPI + 5% for the equity portion is likely of better service to the plan than to outperform amarket portfolio • The greater the consistency, the better • The pattern of return matters • Loss of capital has greater repercussions than outsized gains • Pension plans have difficulty storing surplus • Long-term results for the S&P indicate approximately a 9% return • Would you trade potential upside for stability? • Much evidence suggests there may be no return loss for the greater return stability

13. Risk & Reward in Equities May Not Be Positively Correlated Blitz, van Vliet 1986 – 2006 (global) Source:Blitz, David and Van Vliet, Pim, The Volatility Effect: Lower Risk Without Lower Return (April 2007). Journal of Portfolio Management, pp. 102-113, Fall 2007

14. Client, consultant manager interaction needs to be broad and in depth to achieve the results Plan’s need • Mandates should be broad and flexible enough to allow managers to use the breadth of economic sectors and the depth of companies to access the diversification available • Benchmarks should be more focused on what the plan needs to achieve • Benchmarks should be focused on risk adjusted return, not simply value add