Dynamic Asset Allocation Best Practice Re-visited

1. Dynamic Asset AllocationBest Practice Re-visited Asset allocation in uncertain times Cass Business School Alan J Brown, FSIP Senior Adviser 2nd July, 2012 July 2012 | For professional advisers only. Not suitable for private customers

2. Dynamic Asset Allocation Today's model re-visited Our risk appetite never changes! Asset/Liability Modelling Forecasting Dynamic Asset Allocation • Risk appetite = fn(ex-ante risk premia, wealth) • Corner solutions De-risking • Not what you might expect! Dynamic Asset Allocation| July 2012

3. Today’s best practice Model • Current institutional best practice can be characterised by the following five stage process: • Conduct an asset/liability study based on very long-run equilibrium return assumptions • Choose a strategic benchmark • Create an implementation plan with a mix of active and passive managers • Select and fund investment managers • Monitor performance • Repeat every three to five years Dynamic Asset Allocation| July 2012

4. Two key weaknesses • 80:20 rule round the wrong way! • Majority of governance spent on controlling risks to benchmark - small • Risks from benchmark to liability only managed intermittently - large • Forecasted returns nearly useless! • Equilibrium returns to infinity barely change • Error term swamps the forecast Dynamic Asset Allocation| July 2012

5. Expect the Unexpected Forecast and actual total real returns on the S&P 500 Source: Schroders, Shiller/Yale, Global Investment Returns year book, DataStream Method: Actual returns were calculated by taking the total change in the real total return index and annualising. The forecasts are based on the Gordon Growth model Dynamic Asset Allocation| July 2012

6. But we can’t time markets can we? It is time in the markets that counts – isn’t it? Source: Datastream, Schroders, Nominal terms, no dividends. Data to November 2011. Dynamic Asset Allocation| July 2012

7. Forecasting Occam’s Razor – Reversion to the mean Source: Bogle (1995), Schroders, Datastream Dynamic Asset Allocation| July 2012

8. Forecasting (Cont.) US Median P/E Ratios within inflation bands: 1968 to 2008 Source: Schroders, Datastream Dynamic Asset Allocation| July 2012

9. Governance and utility • Should our risk appetite really be static in the presence of: • Changing funding ratios • Changing risk premia • Funding ratios generally have an inverse relationship with risk premia • Funding ratios rise when risky assets outperform liabilities (bonds) • When risky assets outperform (PEs rising) future returns fall • Strength of sponsor covenant may determine utility function Dynamic Asset Allocation| July 2012

10. Dynamic Asset Allocation – What is it? • Dynamic Asset Allocation is NOT Tactical Asset Allocation • Dynamic Asset Allocation is about the tails of over- or under-valuation • Japanese equities late 1980’s • Technology Media and Telecom stocks late 1990’s • Credit late 2008 • Government bond duration now! • Dynamic Asset Allocation predicated on the belief that: • Risk appetite = fn(ex-ante risk premia, wealth) Dynamic Asset Allocation| July 2012

11. Risk Preferences Exploring the Corners Risk Premia Low High Corner 1 Risk Premia High Wealth High Corner 2 Risk Premia Low Wealth High Corner 3 Risk Premia Low Wealth Low Corner 4 Risk Premia High Wealth Low 4 1 High Wealth 3 2 Low Source: Schroders Dynamic Asset Allocation| July 2012

12. Corners 2 and 3 – When Risk Premia are low • Risk appetite “should” be low irrespective of wealth • But • Watch out for behavioural biases • Impact of regulation/accounting on economic decisions • Discount rates Dynamic Asset Allocation| July 2012

13. Corner 1 – When Risk Premia and Wealth are high • An opportunity to de-risk or to earn further wealth? • Factors to consider: • Size of the fund in relation to the sponsoring organisation • Financial health and risk preferences of the sponsor • Maturity of the fund • The potential to flex contribution rates • For DC, members approaching retirement vs. members starting out Dynamic Asset Allocation| July 2012

14. Corner 4 – Risk Premia are high and Wealth is low Bottom of the Bear Market Scenario • Regulatory/Accounting environment • Insurance/solvency rules • Portfolio insurance/put option – implied costs • The case of the Chubb and St Paul Insurance companies • Financial health and risk preferences of the sponsor • British Airways • Schroders? Dynamic Asset Allocation| July 2012

15. De-risking Conventional Wisdom could be costly! • De-risking LDI style • Hedging out the sensitivity of liabilities to nominal (and real?) interest rates • A glide path or one way ratchet, always increasing hedges • Strategy views liabilities in isolation of assets • A return to business as usual implies a sharp rise in interest/discount rates • No benefit if liabilities hedged • Nightmare scenario of positive correlation between equities and bonds • Result - Funding ratios under pressure all over again! Dynamic Asset Allocation| July 2012

16. Path dependency – The money weighted problem Impact of contributions and investment returns as members age Source: Schroders. 40 Year contributions at base contribution rate of 9% of salary, indexed at 3%p.a. Annualised earning base rate 8%p.a. Dynamic Asset Allocation| July 2012

17. 40 Year Savings Outcomes Impact of contributions and investment returns as members age End Benefit as a Multiple of Salary 40 Year Average Rate of Return Source: Why SAA is Flawed, Schroders, April 2012 Dynamic Asset Allocation| July 2012

18. Challenges for the Industry • Consultant led Strategic Asset Allocation model: • Firms organised in specialised silos • Limited multi-asset skills • Component providers • Benchmark relative • Dynamic asset allocation • Holistic fund management • Multi-asset in nature • Outcome oriented Dynamic Asset Allocation| July 2012

19. A Sea Change • Major changes for asset managers, consultants and clients: • Dynamic risk appetite (utility functions) • Taking a view on asset class returns • Dynamic asset allocation • Outcome, not benchmark oriented • Who’s going to do what? • The role of the consultant • Advice to the institutional client • Advice to the retail client • Keeping everyone honest! Dynamic Asset Allocation| July 2012

20. Important Information For professional advisers. This material is not suitable for private customers Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. The forecasts included in this presentation should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. The data contained in this document has been sourced by Schroders and should be independently verified before further publication or use. Schroders have expressed their own views and these may change. Issued in April 2012 by Schroder Investments Limited31 Gresham Street, London EC2V 7QARegistered No: 2015527 EnglandAuthorised and regulated by the Financial Services Authority Dynamic Asset Allocation| July 2012