ASSET ALLOCATION ROUNDTABLE

BROADENING HORIZONS IN THE QUEST FOR RETURNS

Photograph Jason Leader / Dreamstime.com, supplied September 2011.

Participants
ROBERT BROWN, chairman of Towers Watsons Global Investment Committee MARCUS GRUBB, managing director of investment, World Gold Council FREDRIK NERBRAND, global head of asset allocation, HSBC Bank NEILL NUTTALL, managing director, chief investment officer and head of the Global Multi-Asset Group (GMAG), JP Morgan COLIN OSHEA, head of commodities, Hermes PHIL TINDALL, senior investment consultant, Towers Watson

Supported by:

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WHOS WHO

ROBERT BROWN, chairman of Towers Watsons Global Investment Committee

Robert joined Towers Watson in 2002 having spent 18 years in the asset management industry. Robert is a senior investment consultant and chairman of Towers Watsons Global Investment Committee, the group `responsible for all the firms capital market assumptions and views. Robert also advises a small number of our largest clients and as such has a particular understanding of issues facing such schemes. Before joining Towers Watson, Robert spent seven years at First Quadrant where he was involved in managing equity market neutral and GTAA strategies and latterly headed its European operations. Prior to that he spent eleven years at NatWest Investment Management (now Gartmore) where he was a director in charge of their structured equities group. Robert is a graduate of the University of London and holds BSc and MSc degrees in economics. He is a member of the Securities Institute and an Affiliate Member of the Institute of Actuaries.

MARCUS GRUBB, managing director of investment, World Gold Council

Marcus Grubb joined the World Gold Council in June 2008; he leads investment, marketing gold as an asset class with partners such as ETF Securities and has overall responsibility for product innovation including the development of BullionVault. Marcus has over 20 years experience of the global investment banking industry, in particular in equities, swaps and derivative products. Prior to joining the World Gold Council he was the founder Chief Executive of Swapstream, which was the largest inter-bank dealing exchange for interest rate swaps, now owned by the Chicago Mercantile Exchange. As Global Head of Equities at Rabobank, Marcus built and ran the global primary and secondary equities business. Prior to Rabobank, Marcus was a top-rated senior investment strategist at UBS, Salomon Brothers and SBC Warburg. Marcus received an honours degree in Modern History & Economics from the Queens College Oxford University.

FREDRIK NERBRAND, global head of asset allocation, HSBC Bank

Fredrik Nerbrand joined HSBC in 2005 and, before moving to Global Research in 2010, he was Head of Global Strategy at HSBC Private Bank. He has worked as an equity and asset allocation strategist, and has been a columnist for the financial press. Fredrik has a BSc and MSc in Economics and Business Administration from Lund University, Sweden.

NEILL NUTTALL, managing director, chief investment officer and head of the Global Multi-Asset Group (GMAG), JP Morgan
Neill Nuttall is based in London, with particular responsibility for global tactical asset allocation, total return and convertible bond portfolios. He is a member of the Global Strategy Team, responsible for deciding asset allocation for the GMAG's balanced portfolios. An employee since 1984, prior to joining the GMAG he worked for Jardine Fleming in Hong Kong as head of currency, Asian fixed income and convertible bond management, and more recently as a qualitative portfolio manager in the Currency Group in London. Previously, he worked for Standard Chartered Bank in Hong Kong and Thailand. Neill obtained a BA (Hons) in Politics from the University of Exeter.

COLIN OSHEA, head of commodities, Hermes

Colin joined the firm in April 2008. He is responsible for managing the Hermes suite of commodity strategies and for driving the business forward into the third-party asset management space. He has also implemented a commodity hedge fund manager program for the BT Pension Scheme. Prior to Hermes, Colin worked as an Investment Manager with Railpen Investments (investment manager to the Railways Pension Scheme) and joined the firm in 2005. He was involved in setting the strategic asset allocation for the Scheme and one of the main tasks was the recommendation of a commodity program. Prior to joining Railpen, Colin worked at Mellon as an Investment Consultant. He began his career at HSBC Actuaries & Consultants Ltd where he worked in pensions consultancy. Colin is a Fellow of the Institute of Actuaries. He studied Actuarial Mathematics & Statistics at Heriot-Watt University, Edinburgh and graduated with 1st Class Honours. Colin is also a Trustee Director of the Hermes Group Pension Scheme. Colin has spoken at a number of industry conferences and is widely quoted in the press on commodity investing.

PHIL TINDALL, senior investment consultant, Towers Watson

Phil joined Towers Watson in 2007 and is a senior consultant in the Investment Strategy team. He chairs the firms Beta Portfolio Group which is responsible for developing beta ideas and portfolios. He is also a member of our Portfolio Construction Group which builds portfolios, including active management portfolios. Phil has 20 years experience in the investment consulting industry, including 14 years with Towers Perrin and 4 years as head of investments for IBMs European investment consulting group. As well as investment strategy work, Phils experience includes manager research and liability driven investment.

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ASSET ALLOCATION ROUNDTABLE

Current approaches to asset allocation

FTSE GLOBAL MARKETS: In the aftermath of the financial crisis, what are the main considerations governing asset allocation strategies in your firm? ROBERT BROWN, CHAIRMAN OF TOWERS WATSONS GLOBAL INVESTMENT COMMITTEE: We have not changed our fundamental economic view for the long term, and continue to believe we are in a period of slow developed-world growth, robust emerging-world growth and sharp spikes in risk aversion. Growth risks have increased in the past month, which increases the reliance of investment returns on uncertain policy outcomes. In this environment we continue to emphasise that all investors must ensure portfolios are well diversified and stress-tested against a broad range of economic scenarios. In general, we support rebalancing of portfolios to strategic benchmarks, although this will be less attractive if the long-term trend in asset allocation is away from equities. For investors with a medium-term approach to asset allocation, recent moves have exposed some opportunities at the margin. While we emphasise the downside risks to growth, and expect market volatility to remain elevated, we view equity markets as moderately attractive on a threeyear view. The sharp falls witnessed in recent weeks appear to have outpaced the deterioration of economic fundamentals. We believe government bonds are moderately unattractive relative to cash on a short-term view. With a longer-term horizon, current depressed levels of yields are consistent with economic fundamentals. However, in the near-term, yields provide very limited upside, and nontrivial potential downside (if risk aversion fades for whatever reason). For short-term investors this return distribution is unattractive. FTSE GLOBAL MARKETS: What needs to happen for equities to reacquire their traditional appeal? NEILL NUTTALL, MANAGING DIRECTOR, CHIEF INVESTMENT OFFICER AND HEAD OF THE GLOBAL MULTI-ASSET GROUP (GMAG), JP MORGAN: The recent breakdown in equity markets leads us to question whether sufficient value has returned to justify a long-term commitment to the asset class. The case in favour lies in the rise in dividend yields across several markets; with the Eurostoxx index now offering a yield of 5.8% and the FTSE 100 3.8%. Using a simple metric originally employed by Arnott & Bernstein (A&B), a reasonable back-of-the-envelope estimate for forward-looking tenyear real returns is provided by the sum of the current dividend yield and the average per capita real GDP growth over the past ten years, less a dilution factor. Essentially this equates to the yield plus a proxy for real dividend growth, which A&B found to be relevant. While such an approach is highly imperfect, it suggests that the most attractive region is Europe, with an A&B prospective real return of about 5% per annum, followed by the UK at just

over 4% pa and the US at just under 3% pa. Although equities look appealing versus bonds, for which current real yields suggest poor real returns over the next decade, they are not yet sufficiently compelling given the macro and policy uncertainties. We should remember that equities are an essential component of the capital structure. As an asset class, equities may be experiencing a secular bear market, but this has happened before in the last 100 years or so: between 19071921, 19291942, and 19661982. The average of these bear phases is approximately 14 years, and assuming that the current bear market commenced in 2000 (or even with the 1997/8 Asian/LatAm/Russian/LTCM crisis), then the bear is closer to its end than its beginning. Equities will reacquire their traditional appeal, typically after the majority of investors have capitulated, at which point they will reemerge as the highest returning of the major asset classes. FREDRIK NERBRAND, GLOBAL HEAD OF ASSET ALLOCATION, HSBC BANK: In my view, structural equity markets are based on five main pillars: the first of which is low valuations. As a comparison, US equities are currently trading at 20.2x cyclically-adjusted price earnings (CAPE) according to Shiller data. Since 1881 the average CAPE for US equities has been 16.4. Actually, we have only seen CAPE higher than current levels 22% of the time since 1881. Second, we need high real interest rates. Virtually independent of whichever measure of real interest one looks at, rates are low. The flip side of the Asian savings glut is an outsized demand for western assets and bonds in particular. Coupled with a very challenging growth outlook, real rates are likely to stay low for some time. However, only once they have moved north should

Fredrik Nerbrand, global head of asset allocation, HSBC Bank. Photograph kindly supplied by HSBC Bank, September 2011.

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risk assetssuch as equitiesfind more support from falling discount rates. The next pillar is low leverage. The global economy is still highly leveraged despite some recent consumer deleveraging. Only once balance sheets have hit a more solid footing can a sustainable growth in leverage take hold. Let us just hope that policy makers have realised that more debt added to an existing debt problem is not a solution. Four, a strong demographic outlook is also helpful. A protracted period of limited birth rates and ageing population has made much of the West appear more and more like Japan. For example, Western Europe currently has 3.8 potential workers per pensioner. This ratio will drop to 1.9 by 2040 according to US Census Bureau estimates. By comparison, Japans labour-topensioner ratio is currently 1.8, down from a peak of 5.1 in 1990. Finally, we need to see the potential for deregulation. Given that policy makers are fretting about how to regulate our way out of a recession, this route for productivity gains appears shut. We live in a world of born-again regulators. In summary, the pillars are not in place for a structural equity market. That said there will be plenty of trading opportunities going forward as markets deal with the prospect of more persistent permafrost than first envisioned. FTSE GLOBAL MARKETS: As investors increasingly look towards emerging markets and ever more alternative asset classes, is there a limit to what can justifiably be called an investible asset class? MARCUS GRUBB, MANAGING DIRECTOR OF INVESTMENT, WORLD GOLD COUNCIL: By grouping a very disparate range of assets together under the alternatives label we often risk masking the very different risk and return profiles they each represent and the different investment objectives they may fulfill. From an allocation perspective, and beyond any regulatory constraints, an asset or asset class under consideration should be examined in terms of its key drivers and its impact on the broader portfolio over time. However, in light of what we have hopefully learnt from the recent past, allocators are also increasingly sensitive to the liquidity, transparency and stability characteristics of assets being considered for inclusion in a portfolio. Investor concern regarding the counterparty risk inherent in many derivative products has also never been higher. Many so-called alternatives have been found to be lacking in one or more of these properties, leading them to be judged as overly risky in that regard and therefore less investable. The reason we have such confidence in our arguments that gold should be seen as a basic portfolio building blockwhat we term a foundation assetis that it can be proven to have beneficial attributes in addressing most of the risks that cause investors to hesitate when considering alternatives. FTSE GLOBAL MARKETS: What comes first, asset allocation or fund selection? NEILL NUTTALL: In general, as we were reminded in the 2002 report by Lord Myners, market beta, and therefore
Phil Tindall, senior investment consultant, Towers Watson. Photograph kindly supplied by Towers Watson, September 2011.

strategic asset allocation, typically drives 90% of performance returns. As such, it should be the first consideration in portfolio construction. We would caveat this with the fact that it is important to ensure a full review of your opportunity set, to ensure that you have a way to invest in each of the asset classes represented in your strategic allocation; otherwise, fund selection could be problematic and implicitly determine the asset allocation. We believe that allocating to an asset class that provides diversification and helps the portfolio to meet risk and reward objectives is essential, even if this must be done by investing through a sub-optimal managerwhile alpha may detract from performance, beta could be beneficial. In addition, it is important to remember that in seeking to introduce diversification at every level of the portfolio construction process, fund selection (manager research, style and process) is an important component of any portfolio. MARCUS GRUBB: Many asset managers are aware of the robust body of evidence, for example, from Brinsons landmark studies and Ibbotsons more recent work, that asset allocation is by far the major determinant of portfolio returns over the longer term. However, the degree to which this evidence has been translated into practice is far less clear. There is, perhaps, a simple behavioural aspect to thisan understandable reluctance to put statistics above direct relationships. However, the existing research appears fairly conclusive; asset allocation strategy is the fundamental driver of returns over time. One of the key issues here may be that there are relatively few asset classes or funds or, indeed, fund managers,

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and represented skill, which was (and still is) expensive. Over the last few years, academia has turned the spotlight on hedge fund returns, once regarded as the ultimate in pure alpha. Research suggests that a decent proportion of hedge fund returns can be reproduced with relatively straightforward trading strategies, many of which have been captured in a new wave of indices, such as reinsurance, currency carry and volatility indices. These funds are more liquid and much less expensive than traditional hedge funds making diversity potentially cheaper and more readily accessible for lower governance funds. If properly constructed, these new betas should have a strong diversifying effect on a funds portfolio, but critically at the right price. The risks of an equity-focused strategy are high, especially given the economic uncertainty we face going forward. While the theory of diversification has been put to the test over the last couple of years, we believe it is more important than ever, particularly over the medium to longer term. New beta opportunities can help institutional funds to build a more diversified portfolio to improve investment efficiency, but investors need to assess how much governance they have and are prepared to commit as well as the costs involved if they are to make the effort worthwhile.
Robert Brown, chairman of Towers Watsons global investment committee. Photograph kindly supplied by Towers Watson, September 2011.

that can be relied upon to deliver counter-cyclical performance to the benefit of the broader portfolio. There are many assets and fundswhether mainstream or exotic that can be pursued for specific periods for their return potential. There are, however, relatively few that exhibit sufficient counter-cyclical characteristics that they can reliably function as longer-term portfolio insurance assets, offering balance and protection during market stress and asset convergence. These are the assets, such as gold, generally independent of the tendencies of the wider market, which we believe are most valuable in offering stability to asset allocation strategies, and such strategies will then underpin the fund selection process. FTSE GLOBAL MARKETS: Does the trend towards greater diversity require improved governance? PHIL TINDALL, SENIOR INVESTMENT CONSULTANT, TOWERS WATSON: Investors should not ignore the potential high costs and governance associated with active management and illiquid, less price-transparent asset classes. In fact, they should be self-critical when considering their governance competencies before committing heavily to diversity strategies. However, the trend towards greater diversity should not preclude lower governance funds from either outsourcing to specialists, using diversified pooled funds or using better, cheaper beta. Not long ago, portfolio returns were broken down into either beta or alpha. Beta was associated with market returns on basic asset classes such as equities and bonds. Alpha was anything that could not be explained by these index returns,

FTSE GLOBAL MARKETS: If your firm runs a TAA strategy in-house: what are the critical components of a good asset allocation model? FREDRIK NERBRAND: Our dynamic asset allocation process is based on three main drivers: economic momentum, relative valuations and financial conditions. We have constructed a series of proprietary global leading economic indicators, which aim to forecast the industrial, consumer and trade cycle. In our view, most indicators are still focused on geographies. This makes limited sense as the global cycle is increasingly more integrated. There is no holy grail with regards to relative valuations but we tend to focus on implied discount rates for our cross-asset views. Finally, we run a number of financial conditions indicators such as the HSBC Clog index. In addition, we run aggregate real bank lending data in order to assess inflationary/deflationary pressures coming from money supply. NEILL NUTTALL: Diversification across asset classes, models and factors is key in the construction of a robust tactical asset allocation (TAA) model. Historically, TAA models have focused on the directional decisions, namely stock versus bond, and bond duration. In addition, the information captured has typically centred on valuation which, although an important component of any TAA model, is heavily influenced by time horizon and operates better over an intermediate period. Furthermore, the asset classes addressed have typically been the major, developed, equity and bond markets (as this is where there is the best historical data). While valuation should be taken into account, other factors such as momentum and the business cycle are also important. Momentum/technical factors tend to work better over a shorter-term horizon (say, less than 12 months). The

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opportunity set should be widened to address as many asset classes and sectors as possible. In addition, increasing weight should be given to relative value decisions within asset classes, to avoid the limited concentration of decisions across asset classes. Risk is another important consideration: to be aware of position sizing and the calibration of the risk contribution from each position is essential to long-term success. In our view, when people have experienced disappointing performance in TAA programmes the processes have been too narrowly focused.

Allocations to commodities
FTSE GLOBAL MARKETS: What roles can gold play in your portfolio? FREDRIK NERBRAND: The traditionalist view of gold is for one of value storage and as a hedge to tail risks. Gold should do well in both an inflationary period, or indeed in a world of deflation and increased default risks. Similarly, the opportunity cost for holding gold is minimal given the prevailing, low, real interest rates. While all of these issues are likely to persist, our main reason for holding gold is as a diversifier. In an investment world which is dominated by risk-on and risk-off, any asset that offers uncorrelated returns should remain well bid. Almost independently of the period used for estimating the cross-asset correlation, matrix gold offers just that. For example, if we apply a twocriteria acid test for how much gold to have in a 50/50 equity bond portfolio: one, by adding gold we reduce volatility; two, by adding gold we do not want to add tracking error of say more than 1%. A balanced portfolio should then have roughly 5% in gold. If we compare this with the weight that invested gold has in comparison to global bonds and equities, the current weight in gold is only 0.21%. Hence, there is ample scope for a reweighting in global asset markets. MARCUS GRUBB: Gold has been the star performing asset over the last decade and gold market fundamentals and the macro environment are both highly conducive to a continued bullish outlook. However, this should not blind investors to its primary appeal as a strategically significant asset; that is, its long-term diversification benefits and its hedging abilities in various circumstances and conditions. To put it more simply, gold functions as portfolio insurance and is typically at its most valuable when most needed. These benefits can be proven statistically and historically, and are very much in evidence now. FTSE GLOBAL MARKETS: How effective is gold as a longterm inflation hedge? NEILL NUTTALL: We note that gold has been a store of value for over 2,500 years. There are short periods when this has not been the case (such as 1982-2002), but we lean very much in favour of the evidence of the longer-term history. Gold tends to have low correlation to many other asset classes and even other commodities, and is typically considered a hedge against inflation. In contrast to other

Marcus Grubb, managing director of investments, World Gold Council. Photograph kindly supplied by the World Gold Council, September 2011.

commodities, gold does not perish, tarnish or corrode, which makes it attractive as a long-term store of value. It is also considered to be a currency hedge, particularly against the US dollar, to which is it negatively correlated. Investor activity in the gold market, as reported by the World Gold Council, continued to be robust in the second quarter of this year, with strong flows into exchangetraded funds and also purchases of gold bars and coins, particularly in Asia and Europe. Interestingly, demand in India as a result of rising inflation and an increase in personal wealth has led to a surge in the launch of goldbacked savings and investment vehicles. Gold is considered a safe haven as an asset that maintains an intrinsic value, particularly in an environment with falling risk appetite and a lack of conviction in the economy and banking system. Cynics point out that there is no central bank for gold, which can act to debase its currency. Historically, gold has posted strong real returns during periods of high inflation, and lesser returns during periods of low and moderate inflation. Over a long-term investment horizon, gold has clear diversification benefits. Over the shorter term, investment in gold can help against interim increases in inflation but does not tend to perform as strongly as other assets. As gold is not an income producing asset unless it is leased out, it becomes more a store of wealth in a zero interest rate environment. There is an old anecdote that a sovereign coin (just under a quarter of an ounce) has always been worth enough to pay for a meal for two at the Savoy. Using pricing as at today, this seems a reasonable indicator of the price of goldand if gold keeps rallying, the quality of the bottle of wine accompanying the meal can be improved!

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FTSE GLOBAL MARKETS: Commodities are also often seen as an inflation hedge. Does this tend to overshadow the other benefits of commodities? COLIN OSHEA, HEAD OF COMMODITIES, HERMES: Many of the developed market central banks raison dtre is low inflation. However, in light of the global recession the central banks policy bias is now towards more inflation to create nominal GDP growth and employment. Similarly, developed governments now saddled with substantial debt as a result of credit crisis bailouts prefer inflation and nominal growth over deflation and stagnate growth. It is not surprising then that inflation has edged higher and pension funds are increasingly wary of inflation effects on future pensions. Just as compound interest is the eighth wonder of the world and crucial for wealth creation, inflation has the opposite compound effect and can lead to wealth destruction. While many defined benefit pensions include a promise to index benefits within their liability portfolio, it is difficult to include inflation explicitly within the strategic asset allocation of pensions investment portfolio. Thus inflations potential impact can be under-estimated for many pensions. Commodity futures are a good inflation hedge for two reasons. Commodity spot prices capture unexpected jumps in inflation, in particular jumps driven by input cost (i.e. energy and food). The cash collateral of commodity futures captures the short-term trend inflation through the return on cash and its exposure to short-term interest rates. On the other hand, gold has appreciated considerably over the last five years, not due to inflation over that time but rather due to golds safe haven identity amidst systemic risks. While institutional investors cite diversification and inflation hedging as the most important reasons to invest in commodities, commodity returns, especially in comparison to equity returns, have been overlooked.
Asset class risk, return & premia vs. 10 year government
Total returns Risk Premia

as a means of access to emerging market growth and may therefore be drawn more to the corresponding potential returns. In the case of gold, viewing it primarily as part of the commodities complex means investors are likely to be adopting a somewhat one-dimensional view and are therefore potentially blinkered to its wider attributes, beyond its inflation protection benefits. Earlier in the year we undertook some research, published as Gold: a commodity like no other, which showed that gold, which is typically less volatile than most commodities, and less correlated to equity markets during recessions, offers portfolio diversification and risk reduction benefits that cannot be duplicated through investment in commodity baskets. However, that is not to say we underestimate golds appeal as an inflation hedge. We recently commissioned independent research from the highly respected consultants at Oxford Economics modelling the impact of various inflationary scenarios on portfolios and golds optimal allocation within them. In the context of higher inflation outlooks, golds allocations were seen to increase, reinforcing the substantial body of evidence supporting golds reputation as a reliable and enduring store of value. FTSE GLOBAL MARKETS: When investing in commodities how should investors choose between direct physical investment, a portfolio of commodity-related stocks or commodity futures? Does this vary between different types of commodities? NEILL NUTTALL: The first consideration around investment in commodities within a portfolio would be the investment instruments permitted within client guidelines. Direct physical investment provides the purest exposure to commodities in that the performance is not impacted by investor behaviour. However, physical commodities have the obvious disadvantage of the need for storage, which can be difficult as conditions need to be appropriate to avoid devaluation of the commodity. In addition, the potential environmental impact of storage must be considered, together with the cost of insuring these tangible assets. Investment through derivatives provides an easier way of accessing the commodity market, although by nature of the market, price fluctuations through investors buying and selling the instrument and levels of liquidity will impact performance (through the backwardation or contango in the futures market), rather than this purely reflecting the supply and demand of the underlying commodity. Investment through ETFs can provide broad index exposure and simplify transactions, although it is important for investors to understand the differences in exposure within these products. For example, the Goldman Sachs Commodity Index has a heavy bias towards energy, while exposure in the UBS Dow Jones index is more diversified across broad sectors. While performance of commodity stocks can often move in line with the underlying commodity price, fundamentally these are equities and therefore are subject to added risk/return from general operations, labour costs, political risk within many regions in which they operate (for

25% 20% Return/Risk 15% 10% 5% 0% Commodities Equities

10.1% 9.7% 7.8% 4.9% 2.1% 1.7% 0.0% 20% 15%

Liabilities (10yr govt)

The chart above highlights that over the past 40 years commodity futures have yield returns similar to equities and in this case slightly exceeded commodities. This trend is similar over shorter time periods such as five and ten years. Commodities while acting as a suitable and robust inflation hedge can also over the long-term add returns to a diverse investment portfolio. Source: Hermes, Barclays Capital, MSCI, and Hermes, supplied September 2011.

MARCUS GRUBB: Many investors are undoubtedly drawn to commodities because they are perceived, on aggregate, they provide inflation-hedging potential. Alternatively, however, some investors see commodity exposure

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example, Africa and Asia) and regulatory changes (for example, within mining, or oil exploration). Such stocks are likely to move downwards in a broad market sell-off and may therefore be less diversifying than other means of investing in commodities. MARCUS GRUBB: While we can only comment on gold with any authority, I think there is an increased motivation among investors to seek investment vehicles backed by physical holdings of real assets. This is, essentially, driven by a need for stability and security in uncertain times and a corresponding demand for greater transparency and reduced counterparty risk. For example, in the gold ETF market, we have seen investors clearly prefer physicallybacked products that allow no derivative component, as distinct from synthetic-based ETFs, because they are seeking to minimize counterparty risk. Many of the investment vehicles you mention will have risk-return profiles that diverge considerably from the value of associated physical assets. Investment in commodity-related equities and sector funds, for example, will undoubtedly increase exposure to idiosyncratic company risk (although this may also offer more upside potential) and the traditional route to commodity investment for many institutional investors, through a basket of collateralised futures, involves a completely different set of risks, including the ability of counterparties to successfully implement strategies to counter issues such as negative roll yield. COLIN OSHEA: Today, commodity investors have many more ways to invest in commodities than even two or three years ago. The plethora of exchange-traded products has opened the door to exposure in exotic, rare earth metals such as rhodium to vanilla exposure in gold. As investors address the question why invest in commodities (see diagram in the next page), the answer will lead them to the next question: how to invest in commodities? Physical commodity exposure is more akin to private equity with long lock-ups and a high dependence on local know-how. For example, purchasing farm land in Brazil might highlight bottlenecks in bringing the crop to market, the countrys shipping infrastructure down to the microeconomics of local labour productivity and relevant labour laws. Equity commodities typically exhibit a higher relationship with equity markets than with underlying commodity prices. For example, a basket of the top diversified oil majors has a beta of 0.7 or higher with MSCI All World but less than 0.3 to the price of crude oil. In other words the global equity market explains a substantially higher proportion of the oil majors returns than the price of crude oil. Equity valuation includes a large proportion of expectations over the long run. On the other hand, commodity futures represent the current clearing price for the supply and demand of the commodity in question. A basket of commodity futures provides the portfolio diversification investors seek. Per Barclays Capital annual investor survey the most compelling reason for commodity exposure among institutional investors is diversification;

Neill Nuttall, managing director, chief investment officer and head of Global Multi-Asset Group (GMAG), JP Morgan. Photograph kindly supplied by JP Morgan, September 2011.

over 40% cite diversification more than any other reason to invest in commodities. Historically, the basket of commodity futures across various sectors (such as industrial metals, energy and agriculture) has exhibited low correlation with equities and bonds. FTSE GLOBAL MARKETS: Scarce resource management is focusing investors on strategic commodities. How much does the growing scarcity of resource figure in your approach to investing in commodities? FREDRIK NERBRAND: As the world looks set to remain in a subdued growth environment for the foreseeable future we believe investors will focus on two things. Productivity gains (wherever they can be found) and resource constraints. On our estimates, iron ore, copper, coal and platinum demand are all likely to outpace supply in coming years. Hence, we believe these should have a relatively large weighting in an asset allocation. In our portfolio our strategic weight to industrial, energy and agricultural commodities is 15% (on top of the 10% in gold). However, due to the deteriorating economic outlook we prefer to underweight commodities at the moment to 9% while keeping gold at 10%. FTSE GLOBAL MARKETS: How can you capitalise on the growth outlook for commodities? COLIN OSHEA: Some academics have thrown into the question the relationship between strong GDP growth and equity valuations. Through further share issuance and or

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technological innovation, macro-economic growth may translate into higher overall wealth but not necessarily higher equity earnings per share. Commodity futures represent the current clearing price or supply and demand of a particular market whereas commodity equities represent anything from the present value of discounted expected earnings over many years to the capital structure of that particular company. For these reasons, commodity futures rather than commodity equities exhibit a stronger relationship to the commodity supply and demand in major emerging market economies. For example, China continues to invest in its infrastructure requiring significant amounts of copper, so much that China is the largest consumer of global copper, representing over 45% of global copper consumption. Similarly, densely-populated emerging economies such as India and China are experiencing three development trends which all lead to higher agricultural imports: one, less rural and higher urban population leading to less and a more expensive rural labour force; two, urban sprawl and higher car usage reducing arable land; three, a higher protein diet of beef and pork further up the food chain thereby requiring more grains for feedstock and leading to higher consumption per capita. Finally incremental increases in energy demand continue unabated in non-Organisation for Economic Co-operation and Development (OECD) countries, in particular emerging Asia. Today the global economy is utilising more barrels of crude oil than ever before, over 89m barrels a day. Of this demand, the non-OECD represent 48%. While the OECD countries demand has declined by 2m barrels a day over the last two years the non-OECD demand has more than compensated for this drop in demand. Emerging market equities GDP growth rates may not be as important to companys earnings per share and therefore equity investors. However higher growth rates translate directly into higher demand for commodities and therefore higher clearing prices and higher returns for commodity investors.
Why invest in commodities? Why Commodities? Diversification Inflation protection Event risk insurance Positive risk premium What? Index or Active Benchmark (DJ-UBS, GSCI, RICI) Collateral (Cash, Credit, TIPs)

Risk and returns

FTSE GLOBAL MARKETS: How must portfolios be constructed to prepare for extreme or Black Swan events. MARCUS GRUBB: We examined this very question in a recent report entitled Gold: hedging against tail risk, looking specifically at the impact that an allocation to gold would have on a portfolios in the event of a tail riski.e. market behaviour outside normal statistical probability. Through analysing different portfolio compositions and variants around a benchmark portfolio, we assessed the long-term risk profile of these combined assets in previous periods of extreme market stress, both when gold was included and when it was absent. The research found that for three quarters (18 out of 24) of the tail risk scenarios analysed (from a period between 1987 and 2010), portfolios which included gold consistently outperformed those which did not. Thus, small allocations to gold (ranging, for example, from 2% to 10%) can increase risk-adjusted returns and help reduce the weekly 1% and 2.5% VaR of a portfolio by up to 18.5%. In summary, we found a modest strategic holding of gold consistently reduces the probability of significant portfolio losses during extreme market events and, moreover, the downside protection on offer does not hinder potential upside. This research supports our other analyses of optimal portfolio composition that have repeatedly shown that in multiple market conditions an allocation to gold can reduce the volatility of a diversified investment portfolio without sacrificing expected returns. FTSE GLOBAL MARKETS: When selecting funds and managers, what are some of the red flags and irregularities to note? NEILL NUTTALL: The key factors that we consider in selecting managers in our fund of fund portfolios are riskadjusted performance and consistency of alpha generation, people and process. Some investors tend to focus heavily on performance, but, of course, past performance is no guarantee of future results. An understanding of process can often be more helpful in portfolio construction, enabling diversification across investment processes, which can lead to a portfolio that is more resilient to shorter-term cycles and performance shocks. In terms of underperformance of managers, this would not automatically be a red flag, but underperformance in a period in which the process should be outperforming (for example, a value-biased manager in a period in which value is performing strongly) and in which the manager expects to be outperforming is cause for concern and alarm. This would be one indication of a major red flag, namely style drift. If the investment process is more qualitatively driven, any disruption in the portfolio management team can be a challenge. If the process takes more of a quantitative approach, the reliance on a single portfolio manager may be less evident and therefore less significant when there are portfolio management changes.

How? Swaps Futures Exchange-traded fund Equities Physical

Who? Fiduciary (Fund, Pension) Investment Bank Hedge fund In house

Source: Hermes, September 2011.

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ASSET ALLOCATION ROUNDTABLE

the cornerstone of modern portfolio theory. Yet, even though the theory is half a century old and familiar to most investment professionals, implementing it in practice still seems problematic for many. So much so, in fact, that we frequently hear fund managers suggesting that, in view of globalisation and the experience of the financial crisis, the concept of diversification is primarily of academic interest rather than practical value. We suggest this argument is based on a somewhat superficial view of diversification, often due to the fact that the co-variance properties of many assets are not fully understood, possibly because their values are often studied in isolation or without sufficient examination of the underlying market fundamentals. For example, to date, professional investment in so-called alternatives has largely consisted of hedge funds, private equity and real estate, all of which proved to be highly correlated in the financial crisis because of the close relationship of their drivers to macroeconomic factors. Your question describes real estate as an uncorrelated asset but it was dragged down with most other assets during the crisis, and, significantly, has continued to be vulnerable to prevailing market conditions and recessionary pressures. Golds lack of correlation, by contrast, is underpinned by its very diverse set of drivers and can be proven to hold across markets, geographies and time.
Colin OShea, head of commodities, Hermes. Photograph kindly supplied by Hermes, September 2011.

The investment outlook

FTSE GLOBAL MARKETS: What are the next frontier markets for investors? NEILL NUTTALL: We believe that frontier markets are the next wave of emerging market investing, and that the last frontier region is Africa, and more specifically, subSaharan Africa. Africa is clearly very diverse and individual countries are at different stages of development within their capital markets. One of the greatest challenges for the sub-Saharan region is the development of infrastructure, which is being aided by overseas investment. China, for example, has become a leading sponsor of infrastructure projects in Africa, including hydropower and railroad projects in sub-Saharan Africa. As these sub-Saharan markets (for example, Nigeria and Kenya) develop, they should offer higher returns to investors, but this will not come without elevated levels of risk. When investing into inefficient markets, it is crucial to opt for an active portfolio manager with deep knowledge of countries and industries and a comprehensive understanding of the specific risks associated with each frontier market. Africas status as the last remaining frontier region means it offers many exciting opportunities for long-term investors as its economies and markets play catch-up with the rest of the world. Strong GDP growth (between 2004 and 2008 real GDP growth in sub-Saharan Africa has averaged 6.5%, according to the IMF) is testament to the dramatic structural changes that are transforming the continent. Notably, the continents demographics are supportive. According to the UN, population growth in Africa through 2015 is forecast to rise faster

FTSE GLOBAL MARKETS: How do TAAs work in practice? NEILL NUTTALL: A well-formulated tactical asset allocation strategy provides a framework for incorporating consistent market views aimed at generating a high quality alpha stream. They do so by systematically shifting asset weights relative to a benchmark to take advantage of market inefficiencies and opportunities. As such, a broad opportunity set is desirable. At the same time, an effective TAA framework has the capability to manage the incremental risk (tracking error) associated with movements away from a strategic benchmark. The means of implementation of shorter-term views is likely be dictated by the specifics of individual client guidelines. The most efficient way of implementing tactical decisions is through the use of derivatives. This is the quickest, most capital efficient and most precise method of implementation. Where investment guidelines prevent the use of such instruments, it is still possible to implement through physical holdings, although this comes with some limitations. While the benefits of TAA are perhaps greatest in low-return/high-risk markets, those strategies capable of targeting tracking error while maximizing excess returns are well positioned to be customised to meet specific risk/return objectives across a range of investments and market environments. FTSE GLOBAL MARKETS: How can investing in non-correlated assets such as gold or real estate help hedge against a fall in an overall investment portfolio? MARCUS GRUBB: The concept of a portfolio diversification relies upon the notion of non-correlated assets and is

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than anywhere else in the world, at a rate of 2.2%. As a result, Africa is expected to house the largest youth population in the world, creating interesting investment opportunities as young workers spend their earnings. FTSE GLOBAL MARKETS: The European and US sovereign debt crisis looks to cross into the 2012 financial year: what impact will this have on your firms approach to asset allocation; particularly within the holding of assets based in advanced markets? NEILL NUTTALL: The debt crisis has an impact on several stages of the asset allocation process, including strategic asset allocation, intermediate views, cyclical views on the US and Europe and shorter-term tactical views. We believe that ongoing deleveraging in the developed world will be the dominant macro force for a number of years, and that this represents a structural headwind for markets. From a strategic perspective, the biggest impact will be on a risk basis and on our forward-looking view on volatility, particularly for sovereign bond markets. This also leads to a broader assessment of the relative risk between emerging and developed markets. Historically, the risk of default has always been a concern for emerging markets, with an associated risk premium for investing in developing markets. This recent shift in sovereign bond markets could lead to a levelling out of risk premium between developed and emerging markets. The impact of the sovereign debt crisis on asset allocation will be influenced by views on how long it will take to work through the process of resolution, and the impact across global markets. On an intermediate-term view, there are significant structural headwinds as the US and Europe deal with their debt burdens. There is also a question of how long the downward impact on global growth will lastwhether this will be a three-to-five-year pressure or a longer, structural change. Our interpretation of the price action in risk assets in August is that the market is coming to terms with the view that the headwinds will last for very much longer than had previously been expected. FTSE GLOBAL MARKETS: What is the inflation outlook for the US and Europe? What impact will this have on asset allocation? FREDRIK NERBRAND: The US and Europe increasingly resemble Japan in terms of the overall economic outlook. While policy makers are keen to boost activity through unorthodox policies the underlying deleveraging takes precedence. The main issue that markets face is the lack of impact from QE on domestic activity. Labour markets and GDP have seen little impact while emerging market growth has spurred inflation. In turn, this has muted real wages in the West, making the overall impact questionable. In a world where stagnation takes hold we believe bond yields will remain low and investment grade credit spreads reaching tightening

further. Emerging market local currency bonds are also likely to remain well bid while equities flounder with high volatility given the uncertain growth outlook. MARCUS GRUBB: Economic growth in the developed world still appears extremely sluggish and fragile and it can be argued we are still in grave danger of sliding into a deflationary trough. Certainly the outlook for 2012 is anything but rosy, but asset allocators need to look a little further than the next 12 months. Over the medium term, rational arguments can be made for a range of outlooks, from significant inflation, through disinflation to deflation. We commissioned the aforementioned research from Oxford Economics, with an eye on the next three to five years, in order to address these uncertainties and their impact on allocation decisions. Using their well-respected modelling techniques to define a number of macroeconomic scenarios, including inflation and deflation, the researchers then examined the impact of such scenarios on optimised portfolio allocations. The results indicated that an optimal allocation to gold rises in a more inflationary scenario, as well as for more risk-averse investors in a limited growth and lower inflation scenario. FTSE GLOBAL MARKETS: Is the time still right to begin investing in gold? MARCUS GRUBB: The question here is one of investment objectives. If the motivation for investing in gold is because it is the most potent diversification asset available then there is undoubtedly a compelling argument for adding gold to any portfolio that does not already include an allocation. If, however, the question is one of opportunitythat is, how robust is the outlook for golds continued rise in valuethen our initial response is that we are not allowed to engage in price forecasting. That said, we can confidently state that, even after a prolonged sequence of record highs, the underlying conditions that have driven the bull market thus far, both in terms of market fundamentals and the macroeconomic environment, remain very supportive of the trend. It is worth mentioning that, while golds price performance has now been very impressive for over a decade, outperforming virtually all other assets, this is not its primary benefit for long-hold investors. It is often difficult to get investors to look beyond price performance when considering an asset with an average annual price that has risen for ten consecutive years and when that price (at this time) is around 300% higher than on the same date five years ago and 550% higher than a decade ago.Yet even more compelling for asset allocators is the statistical evidence from portfolio optimisation research which consistently suggests there is an empirical case for holding gold in the context of a broader portfolio regardless of its immediate price profile, because over the long term its potency as a diversifier can be proven to enhance the overall risk-return balance of your investments.I

Disclaimer: All information here is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but no responsibility or liability can be accepted by Berlinguer Ltd or FTSE Group for any errors, omissions or for any loss arising from the use of this publication. This has been reprinted for the World Gold Council with the kind permission of Berlinguer Ltd. Copyright Berlinguer Ltd 2011. All rights reserved.

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