Asset Allocation Santa Barbara County Employees Retirement System - - PowerPoint PPT Presentation
September 28, 2016 Asset Allocation Santa Barbara County Employees Retirement System Table of Contents Page Asset Allocation Research 1 Asset Allocation Process 4 Asset Allocation Study 8 Appendix Custom Assumption Definitions
Santa Barbara County Employees’ Retirement System
September 28, 2016
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September 20, 2016
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the long run.
cannot make up for a poorly diversified and/or inefficient allocation.
concluded that asset allocation “drives” portfolio return.
100% of Return Amount Over Time
unsuccessful in adding significant value by engaging in timing and/or manager selection.
90% of Return Variability Over Time
target policy fluctuation.
Source: Ibbotson, Roger G. and Paul D. Kaplan, 2000. “Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?” Financial Analysts Journal. January/February 2000, Vol.56, No.1, pp.26-33.
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All portfolios start with $2 billion. After 20 years:
Years Portfolio 1 Portfolio 2 Portfolio 3 1 5.0% 0.0%
2 5.0% 10.0% 15.0% 3 5.0% 0.0%
4 5.0% 10.0% 15.0% 5 5.0% 0.0%
6 5.0% 10.0% 15.0% 7 5.0% 0.0%
8 5.0% 10.0% 15.0% 9 5.0% 0.0%
10 5.0% 10.0% 15.0% 11 5.0% 0.0%
12 5.0% 10.0% 15.0% 13 5.0% 0.0%
14 5.0% 10.0% 15.0% 15 5.0% 0.0%
16 5.0% 10.0% 15.0% 17 5.0% 0.0%
18 5.0% 10.0% 15.0% 19 5.0% 0.0%
20 5.0% 10.0% 15.0% Average 5.0% 5.0% 5.0%
0.0% 5.1% 10.3% Compound Return 5.0% 4.9% 4.5%
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Using inputs of expected return, volatility, and correlation, MVO enables investors to identify combinations
focus from individual manager selection to long-term and strategic asset allocation decisions.
MVO Benefits
risk in a small subset of assets or asset classes, especially closely related (highly-correlated) ones.
MVO Shortcomings
gains versus losses (i.e., do losses matter more than gains?)
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Assumptions Do Not Assume Manager Alpha
a slightly different, but related approach.
is more reliable during the portfolio construction process.
Inflation Assumption
Annual US Inflation Return
Chart Source: Ibbotson Associates (2016)
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asset allocation than to manager evaluation.
judgments about magnitude and patterns of future returns and risk.
forward-looking capital markets research, provides a structured approach to assisting with asset allocation decisions.
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RVK Asset Allocation Framework.
Current Asset Classes Current Target RVK Asset Classes Current Target U.S. Equity 23% Broad US Equity 23% Developed Market Non-U.S. Equity 9% Developed Market Non-U.S. Equity 9% Emerging Market Equity 10% Frontier Market Equity 1% Investment Grade Bonds 10% Foreign Bonds 4% TIPS 7% Emerging Market Bonds 3% High Yield Fixed Income 4% Bank Loans 2% Commodities 3% Natural Resources Public 2% Natural Resources Private 3% Infrastructure Public 2% Infrastructure Private 2% Private Real Estate 6% REITs 2% Private Equity Private Equity 7% Private Equity 7% 9% Custom Real Estate 8% Emerging Market Equity 11% Equity Fixed Income Real Assets Real Estate Custom Real Return 12% Custom Investment Grade Fixed Income 21% Custom Non-Investment Grade Fixed Income
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Return/Risk Assumptions Correlations
Broad US Equity Dev'd Market Non-US Equity Emerging Market Equity Custom IG Fixed Income Custom Non-IG Fixed Income Custom Real Return Custom Real Estate Private Equity Broad US Equity
1.00 0.84 0.75 0.01 0.74 0.83 0.11 0.76
Dev'd Market Non-US Equity
0.84 1.00 0.81 0.15 0.76 0.79 0.10 0.75
Emerging Market Equity
0.75 0.81 1.00 0.18 0.83 0.84 0.05 0.67
Custom IG Fixed Income
0.01 0.15 0.18 1.00 0.36 0.03 0.11 0.27
Custom Non-IG Fixed Income
0.74 0.76 0.83 0.36 1.00 0.76 0.06 0.55
Custom Real Return
0.83 0.79 0.84 0.03 0.76 1.00 0.20 0.78
Custom Real Estate
0.11 0.10 0.05 0.11 0.06 0.20 1.00 0.45
Private Equity
0.76 0.75 0.67 0.27 0.55 0.78 0.45 1.00 Arithmetic Return Assumption Standard Deviation Assumption Compound Return Assumption Return/Risk Ratio RVK Liquidity Metric Thematic Bucket Broad US Equity 7.05 17.80 5.60 0.40 95 Capital Appreciation Dev'd Market Non-US Equity 8.25 19.00 6.62 0.43 90 Capital Appreciation Emerging Markets Equity 11.00 29.00 7.40 0.38 85 Capital Appreciation Custom IG Fixed Income 3.44 5.82 3.28 0.59 82 Capital Preservation Custom Non-IG Fixed Income 6.00 11.08 5.43 0.54 50 Capital Appreciation Custom Real Return 7.03 13.22 6.22 0.53 48 Inflation Custom Real Estate 7.67 15.29 6.60 0.50 17 Inflation Private Equity 10.25 25.50 7.41 0.40 5 Capital Appreciation
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Summary of SBCERS Current Exposures 1. U.S. Equity allocation is in line with the benchmark and SACRS peers 2. Significant underweight to Developed International Equity, relative to the benchmark and SACRS peers 3. Significant overweight to Emerging Markets (including Frontier) Equity, relative to the benchmark and SACRS peers
SBCERS allocation data is based on current asset allocation targets. MSCI Index allocation data as of 6/30/2016. SACRS allocation data is based on the RVK SACRS Public Fund Universe Analysis as of 6/30/2015.
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Emerging Market Equities.
achieve a better return/risk ratio.
portfolio which generally reduces the portfolio’s sensitivity to publicly-traded equities.
deviation, which at the current exposure introduces substantial drawdown risk.
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Total International Equity cannot exceed Broad US Equity allocation. Custom Non-IG Fixed Income cannot exceed 2/3 Custom IG Fixed Income allocation. Emerging Markets Equity cannot exceed 2/3 Developed International Equity allocation.
relative to the market.
Min Max 1 2 3 4 5 6 7 8 9 10
Current Target Recommended Target Equity Market Weight
Broad US Equity 15 30 15 15 15 15 15 15 18 21 23 30 23 19 19 Dev'd Market Non-US Equity 10 30 10 10 10 10 10 10 11 12 14 20 9 11 14 Emerging Markets Equity 10 1 4 5 5 5 7 8 9 10 11 7 4 Custom IG Fixed Income 10 35 35 35 35 35 28 21 18 14 11 10 21 17 17 Custom Non-IG Fixed Income 15 15 10 6 1 7 14 12 10 7 9 11 11 Custom Real Return 15 15 15 15 15 15 15 15 15 15 10 12 15 15 Custom Real Estate 10 10 10 10 10 10 10 10 10 10 10 8 10 10 Private Equity 10 4 5 9 10 10 10 10 10 10 7 10 10 Total 100 100 100 100 100 100 100 100 100 100 100 100 100 Capital Appreciation 40 40 40 40 47 54 57 61 64 70 59 58 58 Capital Preservation 35 35 35 35 28 21 18 14 11 10 21 17 17 Alpha Inflation 25 25 25 25 25 25 25 25 25 20 20 25 25 Expected Return 5.81 6.02 6.23 6.44 6.65 6.86 7.07 7.28 7.49 7.70 7.01 7.11 7.03 Risk (Standard Deviation) 8.18 8.67 9.22 9.81 10.52 11.27 12.06 12.89 13.73 14.78 12.27 12.23 12.01 Return (Compound) 5.50 5.67 5.83 5.99 6.13 6.27 6.40 6.51 6.62 6.70 6.31 6.42 6.36 Return/Risk Ratio 0.71 0.69 0.68 0.66 0.63 0.61 0.59 0.56 0.55 0.52 0.57 0.58 0.59 RVK Expected Eq Beta 0.40 0.43 0.46 0.50 0.53 0.56 0.61 0.65 0.70 0.77 0.63 0.62 0.61 RVK Liquidity Metric 68 67 67 66 64 61 62 64 65 70 68 63 63
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Return (Annualized, %) Risk (Annualized Standard Deviation, %) 14
Time Period Percentile 1 2 3 4 5 6 7 8 9 10
Current Target Recommended Target Equity Market Weight
1st Percentile
5th Percentile
25th Percentile 0.68 0.47 0.18
50th Percentile 5.94 6.15 6.27 6.46 6.71 7.02 7.17 7.29 7.48 7.59 6.96 7.18 7.16 75th Percentile 11.35 11.86 12.46 13.05 13.58 14.14 14.85 15.60 16.41 17.37 15.01 15.02 14.77 95th Percentile 19.63 20.83 22.28 23.60 24.45 25.39 27.28 29.27 31.27 33.85 28.22 27.71 27.22 99th Percentile 25.55 27.36 29.60 31.61 32.77 34.06 36.74 39.75 42.58 46.36 38.39 37.41 36.33 1st Percentile
5th Percentile
25th Percentile 2.46 2.41 2.28 2.20 2.22 2.25 2.04 1.76 1.46 1.05 1.66 1.98 1.99 50th Percentile 5.73 5.87 5.98 6.10 6.33 6.52 6.59 6.70 6.79 6.80 6.44 6.61 6.58 75th Percentile 8.96 9.34 9.77 10.13 10.49 10.88 11.41 11.89 12.42 12.95 11.48 11.50 11.31 95th Percentile 13.79 14.50 15.39 16.18 16.75 17.38 18.46 19.60 20.68 22.18 19.03 18.70 18.42 99th Percentile 16.85 17.84 19.08 20.22 20.95 21.74 23.28 24.93 26.50 28.45 24.02 23.73 23.23 1st Percentile
5th Percentile
25th Percentile 3.08 3.08 2.99 2.96 3.02 3.06 2.87 2.65 2.44 2.07 2.54 2.80 2.83 50th Percentile 5.68 5.84 5.97 6.10 6.30 6.48 6.60 6.71 6.82 6.86 6.46 6.60 6.56 75th Percentile 8.23 8.57 8.91 9.25 9.57 9.87 10.29 10.71 11.13 11.60 10.33 10.38 10.27 95th Percentile 11.90 12.49 13.19 13.81 14.32 14.83 15.62 16.50 17.40 18.42 15.99 15.83 15.63 99th Percentile 14.30 15.15 16.12 16.99 17.67 18.44 19.61 20.81 22.02 23.51 20.15 19.85 19.43 1st Percentile
5th Percentile 0.55 0.50 0.28 0.09
25th Percentile 3.65 3.70 3.67 3.70 3.76 3.80 3.71 3.60 3.44 3.19 3.48 3.67 3.67 50th Percentile 5.57 5.71 5.87 6.01 6.19 6.36 6.49 6.57 6.67 6.70 6.34 6.49 6.44 75th Percentile 7.42 7.69 7.98 8.27 8.54 8.80 9.12 9.43 9.74 10.04 9.11 9.17 9.07 95th Percentile 9.92 10.39 10.92 11.42 11.84 12.27 12.89 13.53 14.16 14.89 13.07 13.03 12.80 99th Percentile 11.77 12.30 13.03 13.65 14.08 14.63 15.46 16.36 17.20 18.21 15.82 15.64 15.38 1 Year 3 Years 5 Years 10 Years
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*SBCERS current actuarial assumed rate of return is 7.5%
Time Period Target Return 1 2 3 4 5 6 7 8 9 10
Current Target Recommended Target Equity Market Weight
Target 0% 78 77 76 75 75 75 73 72 71 70 72 73 73 Target 6% 50 51 51 52 53 54 54 54 54 54 53 54 54 Target 6.5% 47 48 49 50 51 52 52 53 53 53 52 52 52 Target 7% 45 46 47 48 49 50 51 51 51 52 50 51 51 Target 7.25% 44 45 46 47 48 49 50 50 51 51 49 50 50 Target 7.5% 43 44 45 46 47 48 49 49 50 50 48 49 49 Target 0% 88 87 86 85 85 84 83 82 80 79 82 83 83 Target 6% 48 49 50 51 52 53 54 54 54 54 52 54 53 Target 6.5% 43 45 46 48 49 50 51 51 51 52 50 51 50 Target 7% 39 41 43 44 46 47 48 48 49 49 47 48 48 Target 7.25% 38 39 41 42 44 45 46 47 48 48 45 47 46 Target 7.5% 36 37 39 41 42 44 45 46 47 47 44 45 45 Target 0% 91 91 90 90 89 89 88 86 85 84 86 87 87 Target 6% 47 48 50 51 52 54 54 55 55 55 53 54 54 Target 6.5% 41 43 45 47 48 50 51 51 52 52 50 51 50 Target 7% 36 38 40 42 44 46 47 48 49 49 46 47 47 Target 7.25% 33 36 38 40 42 44 45 46 47 48 44 46 45 Target 7.5% 31 33 36 38 40 42 43 45 46 46 43 44 43 Target 0% 96 96 96 95 95 94 93 92 91 89 92 93 93 Target 6% 44 46 48 50 52 54 55 55 55 55 53 55 54 Target 6.5% 37 40 42 44 46 48 50 51 51 51 48 50 49 Target 7% 30 33 36 39 41 43 45 46 47 48 44 45 45 Target 7.25% 27 30 33 36 38 41 43 44 45 46 41 43 42 Target 7.5% 24 27 30 33 36 38 40 42 43 44 39 40 40 1 Year 3 Years 5 Years 10 Years
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RVK Assumption Index 60.0% Intermediate Duration Fixed Income Barclays US Agg Bond 25.0% TIPS Barclays US Trsy: US TIPS 15.0% Non-US Dev'd Sovereign Fixed Income UH Citi Non-US World Gov't Bond 100.0% RVK Assumption Index 33.3% High Yield Barclays US Corp: High Yield 33.3% EMD Blend 50 Local/50 Hard 50% JPM GBI EM Global Diversified/50% JPM EMBI Global Diversified 33.3% Bank Loans CS Leveraged Loan 100.0% RVK Assumption Index 33.3% Infrastructure S&P Global Infrastructure 33.3% Commodities Bloomberg Commodity 33.3% Custom Natural Resources Blend 45% Alerian MLP/39% NCREIF Farmland/16% Cambridge NR 100.0% RVK Assumption Index 61.0% Core Real Estate NCREIF ODCE (Gross) (AWA) 39.0% Non-Core Real Estate NCREIF Closed-End Value Added (NFI-CEVA) 100.0% SBCERS Target Structure SBCERS Target Structure SBCERS Target Structure Custom Real Estate Custom Real Return Custom IG Fixed Income Custom Non-IG Fixed Income SBCERS Target Structure 18
Asset Class Target Allocation (%) Target Range (%) US Equity 19 15 - 23 Developed Market non-U.S. Equity 11 8 - 14 Emerging Market Equity 7 4 - 10 Investment Grade Fixed Income 17 14 - 20 Non-Investment Grade Fixed Income 11 8 - 14 Real Return 15 8 - 22 Real Estate 10 5 - 15 Private Equity 10 5 - 15 Cash 0 - 2
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Current Asset Classes Current MV Current Target Transition Dollars RVK Asset Classes Post-transition MV Recom. Target U.S. Equity 602,815,571 $ 23% ($108,727,241) Broad US Equity 494,088,330 $ 19% Developed Market Non-U.S. Equity 224,990,985 $ 9% $61,060,153 Developed Market Non-U.S. Equity 286,051,138 $ 11% Emerging Market Equity 232,974,091 $ 10% Frontier Market Equity 23,548,727 $ 1% Investment Grade Bonds 347,391,769 $ 10% Foreign Bonds 102,014,946 $ 4% TIPS 183,007,479 $ 7% Emerging Market Bonds 66,354,562 $ 3% High Yield Fixed Income 96,235,419 $ 4% Bank Loans 46,559,761 $ 2% Commodities 68,877,105 $ 3% Natural Resources Public 69,723,055 $ 2% Natural Resources Private 12,161,334 $ 3% Infrastructure Public 76,993,464 $ 2% Infrastructure Private 14,642,493 $ 2% Private Real Estate 194,886,417 $ 6% REITs 31,852,779 $ 2% Private Equity Private Equity 184,600,218 $ 7% $75,446,271 Private Equity 260,046,489 $ 10% Cash Cash Equivalents 20,834,719 $ 0% ($20,834,719) Cash Equivalents
0% Equity Fixed Income Real Assets Real Estate ($74,490,275) ($190,335,162) $76,901,396 $147,672,283 $33,307,293 11% Custom Real Estate 10% Emerging Market Equity 7% Custom Real Return 15% Custom Investment Grade Fixed Income 17% Custom Non-Investment Grade Fixed Income 182,032,543 $ 442,079,032 $ 286,051,138 $ 390,069,734 $ 260,046,489 $
in order to align with the recommended target.
transition to the recommended target will likely take a few years, with funds being sold from public equity to fund capital calls as they are issued.
Current MV represents allocations as of 7/31/2016.
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Scenario Current Target Recommended Target Equity Market Weight 1987: Black Monday
1997: Asian Crisis
1998: Russian Crisis
2001: NASDAQ Crash
2001: WTC Attack
2002: Market Downturn
2007: August Crisis
2008: January Crisis
2008: Sept-Oct Crisis
25 Oil Decrease
25 Oil Increase 2.49% 2.39% 2.50%
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Santa Barbara County Employees' Retirement System Asset Allocation Study September 28, 2016 Introduction The selection of the asset allocation is one of the most important decisions that Santa Barbara County Employees' Retirement System can make. It is the major determinant of both the long-term rates of return and the volatility of asset
considered and selection of the alternative allocation that best meets the investment objectives. The identification of alternative asset allocations begins with estimating the probable future performance of the various asset classes. Using these projections, we can identify the most desirable alternative allocations (potential portfolios) and evaluate them in light
The structure of this report follows the process described above. First, we present our return and risk expectations for each asset class, along with a brief explanation of their relevance to asset allocation. Next, the report will address the creation of the asset allocation alternatives. A description of how the alternatives were identified accompanies a table detailing their composition. Asset Class Expectations To create asset allocation alternatives, it is necessary to estimate, for each asset class to be employed, its probable return, risk, and behavior relative to other asset classes. The expected returns are our best estimates of the average annual percentage increases in the values of each asset class over a prospective long period of time. The expected returns and risks (as measured by standard deviation of returns) are listed on the left side of Figure 1 (next page), and the historical risks and returns of each asset class, as measured by comparable indexes, are listed on the right side of Figure 1 (next page).
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Figure 1 - RVK Assumptions vs. Longest Historical Time Frame
Statistics are calculated based on monthly periodicity, except where noted by a (Q) for quarterly periodicity.
Asset Class Arithmetic Return Assumption Standard Deviation Assumption Broad US Equity 7.05 17.80 Dev'd Market Non-US Equity 8.25 19.00 Emerging Markets Equity 11.00 29.00 Custom IG Fixed Income 3.44 5.82 Custom Non-IG Fixed Income 6.00 11.08 Custom Real Return 7.03 13.22 Custom Real Estate 7.67 15.29 Private Equity 10.25 25.50 Index Longest Historical Time Frame Annualized Arithmetic Return Annualized Standard Deviation Russell 3000 Jan 1979 - Dec 2015 12.31 15.40 MSCI EAFE (Gross) Jan 1970 - Dec 2015 10.52 17.03 MSCI Emg Mkts (Gross) Jan 1988 - Dec 2015 12.79 23.23 Custom SBCERS IG Fixed Income Mar 1997 - Dec 2015 5.25 4.09 Custom SBCERS Non-IG Fixed Income Jan 2003 - Dec 2015 7.18 7.70 Custom SBCERS Real Return Mar 2002 - Dec 2015 26.52 22.99 Custom SBCERS Real Estate Dec 1988 - Mar 2015 21.70 11.33 Cambridge US Private Equity Index Jul 1986 - Jun 2015 (Q) 13.43 9.46
*See appendix for custom index definitions. The table on the left represents the asset class return and standard deviation assumptions used as inputs for the study. The table on the right represents the historical return and standard deviation for the indexes used to represent these asset classes.
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Please reference the RVK Capital Market Assumptions white paper for details of the analysis undergone in developing the assumptions for each asset class. Also, note that the relationship between the asset classes (their positioning in the graph relative to one another) is much more important for investment decision-making than the absolute expected return level of each asset class. It is important to understand that these expectations are assumptions of long-term future performance and are, therefore, subject to uncertainty. The risk, or volatility, of each asset class reflects this uncertainty, which is quantified by the statistic known as standard deviation of returns. The standard deviation for each asset class is listed in Figure 1. The standard deviation of returns measures the volatility ("risk") of an asset class by assigning probabilities to a range of different possible returns. If asset returns are normally distributed (bell-shaped curve) then two-thirds (67%) of all returns are expected to lie within one standard deviation on either side of the mean. For example, we expect Broad US Equity to return, annually on average, 7.05% with a standard deviation of 17.80%, meaning that for a normal distribution two-thirds
we expect 95% of all return outcomes to lie within two standard deviations of the mean return, implying only a
(next page) provides the expected range of single year returns in each asset class using the above methodology, and also uses a bell-shaped (normal distribution) diagram to illustrate the above example.
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Figure 2 - Annual Volatility of Return Assumptions
Expected Return +1 St Dev +2 St Dev +3 St Dev
Broad US Equity
7.05 24.85 42.65 60.45 Dev'd Market Non-US Equity
8.25 27.25 46.25 65.25 Emerging Markets Equity
11.00 40.00 69.00 98.00 Custom IG Fixed Income
3.44 9.45 15.46 21.47 Custom Non-IG Fixed Income
6.00 17.16 28.32 39.48 Custom Real Return
7.03 20.25 33.47 46.69 Custom Real Estate
7.67 22.96 38.25 53.54 Private Equity
10.25 35.75 61.25 86.75
7.05% 24.85% 42.65%
0% 20% 40% 60% 80% Expected Annual Return +2 Standard Deviations
Deviations
Deviation
Deviations +3 Standard Deviations +1 Standard Deviation
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Correlation Creating a diversified portfolio of asset classes enables the investor to achieve a high rate of return while minimizing volatility of the portfolio. Diversification exists because the returns of different asset classes do not always move in the same direction, at the same time, or with the same magnitude. Varied investment environments cause some asset classes to rise in value while others fall, and correlation is the measure that quantifies the degree to which asset classes do not move in tandem. Correlation can take on values between 1.00 and -1.00. If returns of two asset classes rise or fall at the same time they are said to be perfectly correlated and have a correlation value of 1.00. Conversely, two asset classes that simultaneously move in opposite directions are said to be perfectly negatively correlated and have a correlation value of -1.00. A correlation of 0 indicates no relationship between the returns. It is imperfect correlations between asset classes that enable an investor to create efficient portfolios; that is, those with the highest amount of return at a given level of risk. The correlations for the asset classes used in this study are shown in Table 1 (next page). The fact that the correlations shown in the table are nearly all positive does not imply that these asset classes do not diversify one another. Their correlations are significantly less than 1.00, meaning we expect a measurable number of instances when the underperformance of one or more of the asset classes will be offset by the outperformance of others.
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Table 1 - Correlation Matrix
Broad US Equity Dev'd Market Non-US Equity Emerging Markets Equity Custom IG Fixed Income Custom Non-IG Fixed Income Custom Real Return Custom Real Estate Private Equity Broad US Equity 1.00 0.84 0.75 0.01 0.74 0.83 0.11 0.76 Dev'd Market Non-US Equity 0.84 1.00 0.81
0.76 0.79 0.10 0.75 Emerging Markets Equity 0.75 0.81 1.00
0.83 0.84
0.67 Custom IG Fixed Income 0.01
1.00 0.36
Custom Non-IG Fixed Income 0.74 0.76 0.83 0.36 1.00 0.76
0.55 Custom Real Return 0.83 0.79 0.84
0.76 1.00 0.20 0.78 Custom Real Estate 0.11 0.10
0.20 1.00 0.45 Private Equity 0.76 0.75 0.67
0.55 0.78 0.45 1.00
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Asset Allocation Alternatives The expected returns, risks and correlations described in the previous section are the primary inputs for the model that constructs the asset allocation alternatives. The model uses this information to build many portfolios with different proportions of each, subject to whatever constraints are placed upon it. The model then determines which of these hypothetical portfolios are most "efficient" – that is, those that achieve the best combination of return and risk. Allocations achieving a given rate of return at the least amount of risk, or the highest amount of return at a specific level of risk, are known as "efficient" or "optimal" portfolios. We constrain the model to take into account reasonable minimum or maximum allocations to each asset class or groups of asset classes. It is worth noting that the model determines optimal portfolios by considering not only the return and volatility of all asset classes individually, but also the correlations between the asset classes. Because correlation amongst asset classes is what determines the efficiency of a portfolio, another way of describing the process of minimizing volatility is maximizing diversification.
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Efficient Allocations The table below shows the range of possible optimal allocations given the selected asset classes and constraints listed under "Min" and "Max." This range illustrates the tradeoff between return and risk; additional return can only be achieved by undertaking additional risk. Frontier 1 Min Max 1 2 3 4 5 6 7 8 9 10
Current Target Recommended Target Equity Market Weight
Broad US Equity 15 30 15 15 15 15 15 15 18 21 23 30 23 19 19 Dev'd Market Non-US Equity 10 30 10 10 10 10 10 10 11 12 14 20 9 11 14 Emerging Markets Equity 10 1 4 5 5 5 7 8 9 10 11 7 4 Custom IG Fixed Income 10 35 35 35 35 35 28 21 18 14 11 10 21 17 17 Custom Non-IG Fixed Income 15 15 10 6 1 7 14 12 10 7 9 11 11 Custom Real Return 15 15 15 15 15 15 15 15 15 15 10 12 15 15 Custom Real Estate 10 10 10 10 10 10 10 10 10 10 10 8 10 10 Private Equity 10 4 5 9 10 10 10 10 10 10 7 10 10 Total 100 100 100 100 100 100 100 100 100 100 100 100 100 Capital Appreciation 40 40 40 40 47 54 57 61 64 70 59 58 58 Capital Preservation 35 35 35 35 28 21 18 14 11 10 21 17 17 Alpha Inflation 25 25 25 25 25 25 25 25 25 20 20 25 25 Expected Return 5.81 6.02 6.23 6.44 6.65 6.86 7.07 7.28 7.49 7.70 7.01 7.11 7.03 Risk (Standard Deviation) 8.18 8.67 9.22 9.81 10.52 11.27 12.06 12.89 13.73 14.78 12.27 12.23 12.01 Return (Compound) 5.50 5.67 5.83 5.99 6.13 6.27 6.40 6.51 6.62 6.70 6.31 6.42 6.36 Return/Risk Ratio 0.71 0.69 0.68 0.66 0.63 0.61 0.59 0.56 0.55 0.52 0.57 0.58 0.59 RVK Expected Eq Beta (LCUS Eq = 1) 0.40 0.43 0.46 0.50 0.53 0.56 0.61 0.65 0.70 0.77 0.63 0.62 0.61 RVK Liquidity Metric (T-Bills = 100) 68 67 67 66 64 61 62 64 65 70 68 63 63
Total International Equity cannot exceed Broad US Equity allocation. Custom Non-IG Fixed Income cannot exceed 2/3 Custom IG Fixed Income allocation. Emerging Markets Equity cannot exceed 2/3 Developed International Equity allocation. Please see the Glossary for statistics descriptions.
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Efficient Frontier The figure below illustrates the relationship between risk and return. The risk of each alternative allocation is plotted against the horizontal axis, while the return is measured on the vertical axis. The line connecting the points represents all the optimal portfolios subject to the given constraints and is known as the "efficient frontier." The upward slope of the efficient frontier indicates the direct relationship between return and risk. Frontier 1
5.50 6.00 6.50 7.00 7.50 8.00
Return (Annualized, %)
8.00 9.00 10.00 11.00 12.00 13.00 14.00 15.00 16.00
Risk (Annualized Standard Deviation, %)
1 2 3 4 5 6 7 8 9 10
Current Target Recommended Target Equity Market Weight 31
Monte Carlo Simulation Monte Carlo simulation uses a random sampling of asset class returns, based on the probability distribution implied by the empirical returns, to create several thousand estimates of portfolio performance. Undergoing a Monte Carlo simulation provides insight into the performance of the asset allocation by examining many randomly sampled return outcomes. An asset allocation study allows for the construction of an "efficient," or return-maximizing, portfolio of asset class investments at each given level of portfolio volatility. These calculations are based on expected return, risk, and correlations for each asset class. The asset allocation process provides a snapshot of portfolio performance that is highly dependent on the mean return expectations. A Monte Carlo simulation process "stress tests" these assumptions and asset allocation recommendations that stem from them through thousands of independent samplings of portfolio returns, based on the assumptions and indicated asset allocations. Through the Monte Carlo simulation process, we are better able to ascertain the real-world probability of achieving various return targets over time. Our Monte Carlo simulation model assumes a non-normal (downside log-stable (DLS), or "fat-tailed") distribution of returns, which we believe provides a more realistic representation of historical market experience than the typically used normal or log-normal (LN)
can estimate the potential return for a given portfolio over the indicated time period. The charts below illustrate the differences between the above mentioned distributions. It is important to note that the output that follows refers to geometric (compound) return, rather than the arithmetic return assumptions used in the asset allocation analysis. The geometric return of a portfolio will be less than (or equal to) its arithmetic return over time, because geometric return accounts for the dampening effect of volatility on the portfolio's compound returns.
20 40 60 80 100 120 140
4 12 20 28 36 44 52 60
Distributions Comparison: S&P500 Simulated 1 YR Data
LN 1 Yr Normal 1 Yr DLS 1 Yr The DLS distribution shows a bump in the far left portion of the tail 1 2 3 4 5 6 7
ENLARGED LEFT-TAIL Distributions Comparison : S&P500 Simulated 1 YR Data
LN 1 Yr Normal 1 Yr DLS 1 Yr
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The table below shows the expected return by percentile for each portfolio on Frontier 1 for the 1, 3, 5, and 10 year periods.
1 Year 1 2 3 4 5 6 7 8 9 10 Current Target Recommended Target Equity Market Weight
1st Percentile
5th Percentile
25th Percentile 0.68 0.47 0.18
50th Percentile 5.94 6.15 6.27 6.46 6.71 7.02 7.17 7.29 7.48 7.59 6.96 7.18 7.16 75th Percentile 11.35 11.86 12.46 13.05 13.58 14.14 14.85 15.60 16.41 17.37 15.01 15.02 14.77 95th Percentile 19.63 20.83 22.28 23.60 24.45 25.39 27.28 29.27 31.27 33.85 28.22 27.71 27.22 99th Percentile 25.55 27.36 29.60 31.61 32.77 34.06 36.74 39.75 42.58 46.36 38.39 37.41 36.33 3 Years . . . . . . . . . . . . . 1st Percentile
5th Percentile
25th Percentile 2.46 2.41 2.28 2.20 2.22 2.25 2.04 1.76 1.46 1.05 1.66 1.98 1.99 50th Percentile 5.73 5.87 5.98 6.10 6.33 6.52 6.59 6.70 6.79 6.80 6.44 6.61 6.58 75th Percentile 8.96 9.34 9.77 10.13 10.49 10.88 11.41 11.89 12.42 12.95 11.48 11.50 11.31 95th Percentile 13.79 14.50 15.39 16.18 16.75 17.38 18.46 19.60 20.68 22.18 19.03 18.70 18.42 99th Percentile 16.85 17.84 19.08 20.22 20.95 21.74 23.28 24.93 26.50 28.45 24.02 23.73 23.23 5 Years . . . . . . . . . . . . . 1st Percentile
5th Percentile
25th Percentile 3.08 3.08 2.99 2.96 3.02 3.06 2.87 2.65 2.44 2.07 2.54 2.80 2.83 50th Percentile 5.68 5.84 5.97 6.10 6.30 6.48 6.60 6.71 6.82 6.86 6.46 6.60 6.56 75th Percentile 8.23 8.57 8.91 9.25 9.57 9.87 10.29 10.71 11.13 11.60 10.33 10.38 10.27 95th Percentile 11.90 12.49 13.19 13.81 14.32 14.83 15.62 16.50 17.40 18.42 15.99 15.83 15.63 99th Percentile 14.30 15.15 16.12 16.99 17.67 18.44 19.61 20.81 22.02 23.51 20.15 19.85 19.43 10 Years . . . . . . . . . . . . . 1st Percentile
5th Percentile 0.55 0.50 0.28 0.09
25th Percentile 3.65 3.70 3.67 3.70 3.76 3.80 3.71 3.60 3.44 3.19 3.48 3.67 3.67 50th Percentile 5.57 5.71 5.87 6.01 6.19 6.36 6.49 6.57 6.67 6.70 6.34 6.49 6.44 75th Percentile 7.42 7.69 7.98 8.27 8.54 8.80 9.12 9.43 9.74 10.04 9.11 9.17 9.07 95th Percentile 9.92 10.39 10.92 11.42 11.84 12.27 12.89 13.53 14.16 14.89 13.07 13.03 12.80 99th Percentile 11.77 12.30 13.03 13.65 14.08 14.63 15.46 16.36 17.20 18.21 15.82 15.64 15.38
Please see the Monte Carlo introduction for more information about assumed distribution.
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The table below shows the percentage chance of achieving or exceeding the given return for each portfolio on Frontier 1 for the 1, 3, 5, and 10 year periods.
1 Year 1 2 3 4 5 6 7 8 9 10 Current Target Recommended Target Equity Market Weight
Target 0% 78 77 76 75 75 75 73 72 71 70 72 73 73 Target 6% 50 51 51 52 53 54 54 54 54 54 53 54 54 Target 6.5% 47 48 49 50 51 52 52 53 53 53 52 52 52 Target 7% 45 46 47 48 49 50 51 51 51 52 50 51 51 Target 7.25% 44 45 46 47 48 49 50 50 51 51 49 50 50 Target 7.5% 43 44 45 46 47 48 49 49 50 50 48 49 49 3 Years . . . . . . . . . . . . . Target 0% 88 87 86 85 85 84 83 82 80 79 82 83 83 Target 6% 48 49 50 51 52 53 54 54 54 54 52 54 53 Target 6.5% 43 45 46 48 49 50 51 51 51 52 50 51 50 Target 7% 39 41 43 44 46 47 48 48 49 49 47 48 48 Target 7.25% 38 39 41 42 44 45 46 47 48 48 45 47 46 Target 7.5% 36 37 39 41 42 44 45 46 47 47 44 45 45 5 Years . . . . . . . . . . . . . Target 0% 91 91 90 90 89 89 88 86 85 84 86 87 87 Target 6% 47 48 50 51 52 54 54 55 55 55 53 54 54 Target 6.5% 41 43 45 47 48 50 51 51 52 52 50 51 50 Target 7% 36 38 40 42 44 46 47 48 49 49 46 47 47 Target 7.25% 33 36 38 40 42 44 45 46 47 48 44 46 45 Target 7.5% 31 33 36 38 40 42 43 45 46 46 43 44 43 10 Years . . . . . . . . . . . . . Target 0% 96 96 96 95 95 94 93 92 91 89 92 93 93 Target 6% 44 46 48 50 52 54 55 55 55 55 53 55 54 Target 6.5% 37 40 42 44 46 48 50 51 51 51 48 50 49 Target 7% 30 33 36 39 41 43 45 46 47 48 44 45 45 Target 7.25% 27 30 33 36 38 41 43 44 45 46 41 43 42 Target 7.5% 24 27 30 33 36 38 40 42 43 44 39 40 40
Please see the Monte Carlo introduction for more information about assumed distribution.
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Appendix Definition of terms used in this analysis:
Asset Allocation is a systematic analysis of the properties of specified asset classes to determine the allocation of those assets that meet the return targets of a portfolio. Correlation is a statistical measure of the relationship between asset class returns. A value of 1.00 is a perfect correlation; that is, the asset classes always move in the same direction. A value of –1.00 indicates a perfect negative correlation, in which the asset classes always move in
Correlation calculations only consider the direction of changes relative to two variables and not the magnitude of those changes. The Efficient Frontier is the set of portfolios that minimizes risk at given target levels of return. This process takes into account the risk, return and correlation of the asset classes to arrive at the most efficient set of portfolios. Expected Equity Beta is a measure of the sensitivity of a portfolio to movements in the Large/Mid Cap US Equity market. It is a measure of a portfolio's non-diversifiable or systematic risk. Performance Expectation is the best estimate of the average annual percentage increase in the value of an asset class over the next ten years. Risk is quantified by the standard deviation of returns. Also known as the volatility of returns, it provides a statistical range of performance relative to the average expectations. With this measure, we can establish a level of "confidence" about the expected range of returns for the portfolios. RVK Liquidity Metric is a qualitative method for determining the relative amount of liquidity in a portfolio. The characteristics considered when determining relative liquidity include trading volume, gates for redemption, leverage, nature of transactions, and pricing mechanisms. The RVK Liquidity Metric is calculated using investment weights applied to each corresponding asset class liquidity rating. See next page for more details. Thematic Classification - Represents dedicated manager allocations; as such, thematic allocations are approximations. RVK categorizes asset classes as Alpha, Capital Appreciation, Capital Preservation, and Inflation as displayed in the table on the next page.
Custom Index Definitions:
Custom Investment Grade (IG) Fixed Income Index = 60% Barclays US Aggregate Bond Index + 25% Barclays US TIPS Index + 15% Citi Non-US World Gov't Bond Index. Custom Non-Investment Grade (IG) Fixed Income Index = 1/3 Barclays US Corporate High Yield Index + 1/3 Emerging Market Debt Blend Index + 1/3 Credit Suisse Leveraged Loan Index Custom Real Return Index = 1/3 S&P Global Infrastructure Index + 1/3 Bloomberg Commodity Index + 1/3 Custom Natural Resources Blend (45% Alerian MLP/39% NCREIF Farmland/16% Cambridge NR Index) Custom Real Estate Index = 61% NCREIF ODCE (AWA) + 39% NCREIF Closed-End Value Added (CEVA) 35
Asset Class Thematic Bucket Liquidity Bucket RVK Liquidity Metric Broad US Equity Capital Appreciation Liquid 95 Large/Mid Cap US Equity Capital Appreciation Liquid 95 Broad International Equity Capital Appreciation Liquid 90 Dev'd Market Non-US Equity Capital Appreciation Liquid 90 Global Equity Capital Appreciation Liquid 90 Dev'd Small Cap Int'l Equity Capital Appreciation Liquid 85 Emerging Markets Equity Capital Appreciation Liquid 85 Small Cap US Equity Capital Appreciation Liquid 85 Convertibles Capital Appreciation Liquid 80 Distressed Debt Capital Appreciation Less Liquid 50 Emerging Markets Debt (Local and Hard) Capital Appreciation Less Liquid 50 High Yield Fixed Income Capital Appreciation Less Liquid 50 Non-Core Real Estate Capital Appreciation Not Liquid 5 Private Equity Capital Appreciation Not Liquid 5 T-Bills and Treasurys Capital Preservation Liquid 100 Cash Equivalents Capital Preservation Liquid 98
Capital Preservation Liquid 85 Long Duration Fixed Income Capital Preservation Liquid 85 Low Duration Fixed Income Capital Preservation Liquid 85 Stable Value Capital Preservation Less Liquid 50 Non-US Dev'd Sovereign Fixed Income UH Capital Preservation Less Liquid 50 GTAA Alpha Liquid 88 Diversified Hedge Funds Alpha Less Liquid 35 Equity Market Neutral Alpha Less Liquid 35 Long-Biased Long/Short Equity Alpha Less Liquid 35 Managed Futures FoF Alpha Less Liquid 35 Commodities Inflation Liquid 98 TIPS Inflation Liquid 95 Diversified Inflation Strategies Inflation Liquid 93 Global REITs/MLPs Inflation Liquid 85 Bank Loans Inflation Less Liquid 50 Core Real Estate Inflation Not Liquid 25 Infrastructure Inflation Not Liquid 5 Timber Inflation Not Liquid 5
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