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Diversified growth strategies and their role in Australian Superannuation Funds

Executive summary 4

Introduction 5

Diversified growth strategies: a brief history 6

Key features of diversified growth strategies 7

Benefits of diversified growth strategies for Australian institutional investors 10

To hedge or not to hedge? 18

Potential uses of diversified growth strategies for Australian Superannuation Funds 21

The Investec Diversified Growth Strategy 25

Conclusion 31

Appendix 32

The views expressed in this document are those of the authors and reflective of the wider Investec Multi-Asset team. Investec Asset Management is a multi-specialist house and therefore the views expressed may or may not be held by our other specialist investment teams.

Contents

Michael Spinks,

Co-Head of Multi-Asset, and Portfolio Manager of Investec Diversified Growth Fund (Australian)

Atul Shinh, Multi-Asset Investment Specialist

Authors

Executive summary

○ Diversified growth strategies are multi-asset programmes that flexibly invest in a range of traditional and non-traditional return sources to seek a defined outcome.

○ They were originally designed for UK Defined Benefit pension schemes in the mid-2000s but are now utilised by all types of institutional investor on an increasingly global basis.

○ These strategies can vary in approach, but typical features include a total return objective, a broad opportunity set, flexible asset allocation, enhanced diversification and the use of numerous implementation methods.

○ We believe that the breadth of opportunity set, investment flexibility and active approach to currency management of diversified growth strategies should be particularly appealing to Australian Superannuation Funds, as in our view they cannot rely on domestic assets alone to meet their performance objectives.

○ The role that diversified growth strategies can play for Australian investors will vary depending on the nature of the investor, but their potential as a liquid alternative solution, given their diversifying properties, stands out.

○ Our historical modelling suggests that there would have been a clear portfolio benefit to including a diversified growth strategy in a typical Australian Superannuation portfolio. The modelled realised return was higher, the overall portfolio volatility lower and the result therefore was improved risk-adjusted returns. It should also be noted that the benefit was enhanced when substituting from Australian equities rather than International equities. For example, according to our modelling, a 15% allocation to a diversified growth strategy funded out of Australian equities would have added 1.5% per annum to the overall return of a typical Superannuation Fund, whilst lowering the volatility (see page 23 for methodology).

○ The Investec Diversified Growth Fund (Australian) was launched in May 2015, following the launch of the sterling denominated Investec Diversified Growth Strategy in 2008. Investec Asset Management has been successfully managing a broad range of multi-asset strategies, including those with total return profiles, for over 20 years.

Introduction

Multi-asset programmes that flexibly invest in a range of traditional and non-traditional return sources, focusing on both risk management as well as investment return generation have attracted significant interest from institutional investors in recent years, creating a new market segment known as diversified growth strategies.

Although originally designed for UK Defined Benefit (DB) pension schemes, other investors (principally Defined Contribution schemes) from the UK and globally have recognised the role that diversified growth strategies can play in helping to meet their respective objectives. These strategies have attracted the growing interest of a number of Australian Superannuation Funds, which is of no surprise given their objectives are often aligned with those of diversified growth strategies.

This paper provides some background behind diversified growth strategies, describes the important characteristics that define these strategies and explains their potential application to Australian Superannuation schemes. We conclude by offering a brief overview of the Investec Diversified Growth Strategy.

We believe Australian investors cannot rely on domestic assets alone

Our historical modelling shows the potential benefits to Superannuation Funds of diversified growth strategies

Diversified growth strategies and their role in Australian Superannuation Funds4

Introduction

Multi-asset programmes that flexibly invest in a range of traditional and non-traditional return sources, focusing on both risk management as well as investment return generation have attracted significant interest from institutional investors in recent years, creating a new market segment known as diversified growth strategies.

Although originally designed for UK Defined Benefit (DB) pension schemes, other investors (principally Defined Contribution schemes) from the UK and globally have recognised the role that diversified growth strategies can play in helping to meet their respective objectives. These strategies have attracted the growing interest of a number of Australian Superannuation Funds, which is of no surprise given their objectives are often aligned with those of diversified growth strategies.

This paper provides some background behind diversified growth strategies, describes the important characteristics that define these strategies and explains their potential application to Australian Superannuation schemes. We conclude by offering a brief overview of the Investec Diversified Growth Strategy.

We believe Australian investors cannot rely on domestic assets alone

Diversified growth strategies and their role in Australian Superannuation Funds 5

Diversified growth strategies: a brief history

The concept of diversified growth strategies started in the UK following the ‘dotcom’ crash in equity markets in the early 2000s. Some DB schemes, chastened by this poor equity experience and dissatisfied by the performance of traditional multi-asset balanced strategies over this period, started looking at alternative methods to help generate more sustained growth in returns. Thus, the concept of reducing the reliance on equities to generate growth in returns, by flexibly investing in a better diversified set of growth drivers was born.

Additionally, regulatory pressure and the requirement to reflect pension deficits on the balance sheet of companies created a much greater focus on the volatility of returns realised and the risk that was being taken to generate returns. At the same time, new methods to access a much wider opportunity-set for investors were opening up and, following years where a ‘buy-and-hold’ approach was richly rewarded, the bear market in the early 2000s highlighted the more negative consequences of this lack of asset allocation decision making.

The global financial crisis (GFC), a few years later, provided the first major test to the validity of the broad diversified growth model. Already at this stage, there was a degree of variation in the approaches employed as participants in the space showed a tendency to anchor their diversified growth approach on some of the multi-asset methods they historically relied upon. This variation of approach resulted in a considerable range of outcomes over the course of the GFC, with some strategies demonstrating strong downside protection characteristics, whereas others performed little better than equities.

Subsequently, these strategies have not only had to contend with generally strong returns from developed market equities, bonds and credit, but also poor returns from strategies typically classified as ‘diversifiers’, notably commodities and emerging market debt. While volatility has generally trended lower as central banks have maintained their interventionist monetary policies, there have been some significant market episodes to challenge these multi-asset approaches and their ability to meet both the return and risk objectives post the GFC. Therefore, the investment environment and deviation in asset class performance has heightened attention on the approaches employed by diversified growth managers, specifically around portfolio construction, idea generation and implementation precision.

Diversified growth strategies have been one of the most popular choices for new allocations from institutional investors in recent years, which in itself has attracted a swathe of new market participants. It is estimated that the size of this marketplace was c. AUD 230 billion as of March 20151.

1Source: Camradata, using GBP/AUD exchange range of 1.95


Key features of diversified growth strategies

To date the diversified growth space has been characterised by significant variation in the underlying approaches employed. However, there are areas of commonality that we can point to in describing a ‘typical’ diversified growth investment model, which we detail below.

‘Outcome-based’ objectivesThe objective of achieving growth while limiting volatility is typically expressed through a ‘total return’ target (normally a return premium over inflation or the rate of cash), as opposed to a return target relative to a market based benchmark. A volatility target or risk objective is also present.

This outcome-based approach ties in with the objectives of many Superannuation funds, which normally look for returns from their assets in excess of inflation. Further, as schemes have been using diversified growth strategies as a diversifier or as a growth asset substitute, there is an expectation that their performance and the path of their performance will deviate from broad market indices.

Breadth of opportunity setHistorically, balanced ‘multi-asset’ strategies tended to be focused on traditional assets, such as equities and government bonds related to the local domestic market of the investment manager. Diversified growth strategies, on the other hand, access a much broader opportunity set, covering both traditional and alternative sources of return, with a global perspective.

The range of asset exposures that may be included in diversified growth strategies therefore includes, amongst others, global equities, emerging market equities, developed market government bonds, emerging market bonds, inflation-linked bonds, high yield bonds, investment grade bonds, property, private equity, commodities, volatility strategies, hedge funds, infrastructure, reinsurance and active currency positions.

By expanding the number of investment opportunities available and the type of returns that can be accessed, diversified growth strategies have more return ‘levers’ to exploit over the course of the market cycle, and opportunities to manage risk. This should increase their ability to achieve more consistent returns, and reduce the reliance on returns from individual markets.

Enhanced diversificationAs its name would suggest, the diversification of exposures is a key component of the diversified growth concept. Diversification, if applied correctly, can help achieve the desired outcome of these strategies by achieving long-term growth, but with an improved certainty of outcomes than would otherwise be the case by solely focusing on assets such as equities. Clearly, following from above, a broad opportunity set can be an important starting point in achieving diversification.

Diversified growth strategies access a broad, global opportunity set, covering traditional and alternative sources of return


However, although ‘diversification’ is not new to multi-asset strategies, the experience of the GFC, where many ‘diversified’ portfolios did not perform as expected, has contributed to a better understanding of what it takes to achieve more effective diversification. As such, just owning lots of different assets is not always enough; it is important to understand the fundamental drivers of assets, how assets are likely to behave and the role they can play. The design of diversified growth strategies enables them to better achieve superior diversification compared to many traditional multi-asset strategies and this crucially links back to the focus on risk management in these strategies.

Flexible asset allocationThe ability and willingness to allocate between and within different asset classes is an important characteristic of diversified growth strategies. Although the frequency and magnitude of these decisions will vary from approach to approach, the flexibility to both take advantage of market opportunities and to protect against market risks is beneficial to the strategies in achieving their long-term objectives.

In contrast, the managers of traditional multi-asset strategies have either been constrained in their ability to deviate beyond a narrow range of allocations, or have been unwilling to express high conviction asset allocation positions.

Evolved implementation techniquesDiversified growth strategies use a number of methods to implement investment views. As well as using internally managed programmes and direct investments, diversified growth managers are increasingly using other methods, such as relative value positions (i.e. taking a relative view of one asset or market compared to a related asset or market) or bespoke baskets (i.e. hand picking a number of holdings to reflect the required investment idea) to express views.

By largely removing market directionality from the position, relative value holdings can provide uncorrelated exposures to a strategy. The use of these positions can thereby further expand the opportunity set available to the strategy, as they provide a potential additional source of return. Other long / short overlays that exhibit clearer directionality can also play a useful role in isolating a market risk factor, for example the small-cap equity premium. Bespoke baskets, on the other hand, can ensure there is greater precision around the view being expressed.

These types of exposure become more important in environments where positive market beta effects are less prevalent.

Risk management/downside protectionDiversified growth strategies are ever more focused on the evaluation of what could go wrong and truly understanding all the risks affecting the portfolio. In practice, this means the consideration of risk implications as part of the investment decision process, regular independent monitoring of the risks facing the portfolio, evaluating the impact on the portfolio of different potential market stresses and implementing positions that are specifically designed to provide the portfolio with a degree of downside protection in adverse environments.

Intrinsic to many diversified growth strategies is a focus on risk management.

Diversified growth strategies use a number of methods to implement views.


A strong risk management discipline, combined with effective portfolio diversification as described above, can improve the ‘worst case’ outcome for investors and reduce uncertainty about achieving the performance objectives.

Base currency focusedOne of the key advantages of a diversified growth approach is that it is structured with the base currency liabilities (such as domestic inflation or cash related) of investors in mind. In other words, these strategies provide access to a global opportunity set, but from the starting point of a domestic investor and their needs. Clearly there are potential benefits from accessing assets denominated in an overseas currency, from either a risk reduction or return enhancement perspective, but the decision of whether to hedge this exposure or not should be an active decision relative to the starting point of the investors’ base currency.


Benefits of diversified growth strategies for Australian institutional investors

Having detailed the typical characteristics of diversified growth strategies, we will now explore the potential benefits that these strategies provide for Australian institutional investors. Specifically, we will explore how these strategies should be well placed to meet real growth return objectives while providing investors with increased certainty about achieving this outcome.

Firstly, we will explain why Australian institutional investors should not rely on domestic assets alone to provide certainty around achieving a real return (in this instance, equivalent to domestic Inflation +5% i.e. a ‘real’ return of 5% on an annualised basis). We will then discuss why a broader opportunity set, in terms of both geographic and asset exposures, provides the return potential to achieve the return objective. We then describe the role that diversification can play in helping to reduce the range of possible outcomes of a portfolio. Finally, we conclude by explaining the important role that an active approach to currency management plays for an Australian investor.

How reliable are domestic Australian assets for achieving the required return?

With the proportion invested in domestic Australian assets by Superannuation funds typically ranging from 40-50%2, it is clear that despite the ongoing move to internationalise Australian Superannuation fund portfolios, there is still a significant reliance on domestic assets to achieve the required returns for these schemes.

An analysis of the historical returns achieved from these assets, however, shows that an investor could have achieved better returns by taking a more global approach in the past. To illustrate this, Figure 1 shows the annualised real returns of Australian equities, Australian bonds and Australian cash, over a number of discrete 10 year periods from 1900 to 2010, including the best and worst returning 10 year periods. We have compared these returns to the performance target of a 5% annualised real return.

Figure 1: Australian asset classes through the decades (1900-2014)

-10%

-5%

0%

5%

10%

15%

20%

-10%

-5%

0%

5%

10%

15%

20%

1900

-191

0

1910

-192

0

1920

-193

0

1930

-194

0

1940

-195

0

1950

-196

0

1960

-197

0

1970

-198

0

1980

-199

0

1990

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2000

-201

0

Bes

t 10

year

s

Wor

st 1

0 ye

ars

Ave

rage

Ave

rage

of

10

year

per

iods

Equities Bonds Cash Target

Source: Credit Suisse Global Investment Returns Sourcebook 2015

There is still a significant reliance by Superannuation Funds on domestic assets.

2Source: Rainmaker Information - December 2014


Over the time period of 1900-2014, although Australian equities exceeded the performance objective, it was achieved with a high volatility, indicating a significant variability of return and therefore a high degree of unreliability in achieving a consistent return profile. Australian bonds and cash, on the other hand, both significantly underperformed the objective over this extended period, demonstrating they have not been effective in generating the required return.

We do recognise, however, that the impact of the franking tax credit on dividends results in enhanced domestic equity returns for many Australian investors, thereby increasing their attraction relative to global markets. However, we believe the dynamics of the domestic equity market (with a small market relative to the global equity opportunity set and a reliance on financial sector companies) should encourage investors to look beyond this potential franking benefit when assessing the attractiveness of the market.

Our forward-looking view on the prospects of these assets does not change our opinion about the reliability of Australian assets to generate the return target either. We believe that most Australian Superannuation Funds are over exposed to domestic assets and should target a broader global opportunity set to give them a better chance of meeting their performance objectives. The next section provides further justification for our views.

Breadth of opportunity set

Diversified growth strategies access a broad opportunity set, covering both traditional and alternative sources of return, and with a global geographical perspective. By expanding the number of investment opportunities available and the type of returns that can be accessed, diversified growth strategies have more return ‘levers’ to exploit over the course of the market cycle. This should increase the ability to achieve more consistent returns, and reduce the reliance on individual market returns.

We will evidence the benefit that accessing a broader opportunity set can provide by assessing the historical returns of a wide range of assets and geographies in comparison to domestic Australian assets. In this analysis, for simplicity, we have focused on the local market returns of the respective assets in question. We will show later that the decision of whether to hedge non-Australian dollar exposure makes a significant difference to the returns that investors receive.

Figure 2 overleaf shows the calendar year returns of a number of different markets from the past 10 years. Within each calendar year, we have ranked the markets from the highest returning to the lowest returning, showing the percentage return achieved for all assets.

Diversified growth strategies have many return ‘levers’ to exploit through a market cycle.


2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Japan equity (45.2%)

Emerging Market equity (32.1%)

Emerging Market equity

(39.4%)

Global government

bonds (39.7%)


(78.5%)

Emerging Market equity (18.9%)

Australia government

bonds (14.2%)



Global Corporate

bonds (12.8%)


(34.0%)

Europe equity (18.5%)

EM Debt Local (18.1%)


bonds (20.2%)

Australia equity

(30.8%)

Commodities (16.7%)

Australia Corporate

bonds (10.0%)


(18.2%)

US equity (29.6%)

US equity (11.4%)


Australia equity (18.3%)


Global Corporate

bonds (15.5%)

EM Debt Hard (29.8%)


EM Debt Hard (7.3%)

Global HY (17.8%)

Global HY (25.3%)


bonds (11.1%)

UK equity (20.8%)


Commodities (11.1%)

Australia Corporate

bonds (11.6%)

UK equity (27.3%)

US equity (12.8%)

Global government bonds (6.8%)




Australia equity

(20.3%)

UK equity (14.4%)

Hedge Funds (10.3%)

EM Debt Local (-5.2%)

Global HY (25.6%)

UK equity (12.6%)

Global Corporate

bonds (4.5%)


UK equity (18.7%)

Global government bonds (9.5%)

Commodities (17.5%)

US equity (13.6%)

UK equity (7.4%)

Global HY (-9.2%)



Global HY (2.6%)


Global Corporate

bonds (16.2%)

Global HY (9.2%)


Hedge Funds (10.4%)

EM Debt Hard (6.2%)

EM Debt Hard (-12.0%)

US equity (23.5%)

Australia Corporate

bonds (7.5%)

US equity (0.0%)



Australia Corporate

bonds(8.6%)

Global HY (8.4%)

EM Debt Hard (9.9%)

Australia government bonds (3.7%)

Hedge Funds (-21.4%)




US equity (13.4%)

Global government

bonds (11.0%)

EM Debt Hard (7.4%)

Hedge Funds (7.5%)

Global HY (5.6%)

US equity (3.5%)

UK equity (-28.3%)

Commodities (18.7%)

Hedge Funds (5.7%)

UK equity (-2.2%)

Australia Corporate

bonds (11.5%)

Hedge Funds (9.0%)



Australia Corporate

bonds

(3.7%)


Commodities (-36.6%)

Hedge Funds (11.5%)


Hedge Funds (-5.7%)

UK equity (10.0%)

Australia Corporate

bonds (4.8%)

Hedge Funds (3.4%)

Australia Corporate

bonds (6.1%)

Japan equity (3.0%)

Australia Corporate

bonds (2.5%)

US equity (-38.5%)

Japan equity (7.6%)

Japan equity (1.0%)


Global Corporate

bonds (9.7%)





Global government

bonds (-0.6%)

Australia equity

(-39.9%)

Australia Corporate

bonds(6.3%)

Global HY (-0.1%)

Australia equity

(-14.9%)


Emerging Market equity (-2.6%)

UK equity (0.7%)

Global Corporate

bonds (3.6%)

Global Corporate

bonds (-0.3%)

Global Corporate

bonds (-3.7%)

Japan equity (-40.6%)


bonds (-2.7%)

Australia equity (-3.5%)

Europe equity

(-14.9%)

Hedge Funds (4.8%)

EM Debt Hard (-5.3%)

Emerging Market equity (-2.2%)

US equity (3.0%)

Global Government bonds (-1.1%)

Global HY (-7.5%)

Europe equity

(-44.4%)

Global Corporate

bonds (-7.6%)

Global Corporate

bonds (-7.0%)


Global Government bonds (0.5%)



Global Government

bonds (-0.1%)

Commodities (-2.7%)



(-53.3%)

Global Government

bonds (-20.7%)

Global Government bonds (-7.3%)


(-18.4%)

Commodities (-1.1%)

Commodities (-9.6%)


Figure 2: Australian assets versus global assets over the past decade

Source: Bloomberg (list of markets in Appendix)


It can be seen that over this period there has been significant dispersion between the highest and lowest returning assets and that the ranking of Australian assets compared to other assets within each calendar year has varied significantly. This table therefore evidences the opportunity cost from just focusing on Australian assets, given the returns that have been available from other markets.

We should not only focus on the return that would have been missed from a narrow focus on Australian assets. Investing in a broader set of assets would have also reduced the variability experienced by an investor compared to just focusing on domestic assets, which in turn would have likely led to a lower volatility profile. Figure 2 also helps us to highlight the potential benefits from taking an active and high conviction approach to dynamic asset allocation across different assets. For example, an allocation to Japanese equities on a currency hedged basis in 2012 would have had very beneficial results for an overall portfolio through to the end of 2014. Conversely, avoiding commodities over this period would have proved beneficial too. Finally, the presence of negative returning markets in certain periods shows that investors should not just think in the one dimension of which assets will go up. Paying attention to which assets might go down as well adds another potential stream of returns, either by taking direct ‘short’ positions or through the construction of the aforementioned relative value positions.

Benefits of diversification

The correlation between two assets can be a useful measure to help determine the extent of diversification possible, by providing information on how assets have behaved in different environments historically. For example, assets with a tendency of exhibiting a negative correlation to equities can play a useful role in providing protection in the event of significant falls in equity markets. It is important to note though that correlations vary over time, and assets that may have behaved in a certain way in the past will not necessarily behave in the same way in the future.

To illustrate this point, we show a series of charts overleaf displaying the historical correlations between Australian equities and a range of global and domestic assets as well as the stability of these relationships. Given that our starting point is the belief that Australian investors should be looking to diversify away from Australian assets, and equities in particular, it follows that we believe those assets with either favourable correlations and/or return potential would be useful additions in constructing a portfolio to meet the return objectives. Further detail on our methodology relating to Figures 3-8 is set out in the Appendix.

Paying attention to which assets might go down is important and adds another potential return source.

It is important to note that correlations vary over time.


Figure 3: Global and regional equities vs Australian equities (hedged)

10

20

30

40

50

60

-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Var

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)

Correlation to Australian equities (%)

EM equities

US equities

Europe equities

UK equities

Japan equities

Figure 4: Global and regional bonds vs Australian equities (hedged)

10

20

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40

50

60

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-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Australia GB

Australia Corporate

Global Corporate

Global HY

Global GB

Figure 5: ‘Alternatives’ vs Australian equities (hedged)

10

20

30

40

50

60

Var

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of c

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n (%

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-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

EM HC

Commodities

EM LC

Hedge funds

Historical correlations on a hedged basis

Figure 3 shows that on a hedged basis, the main equity markets under consideration have demonstrated a fairly high correlation to Australian equities, with Japanese equities showing a lower but still noteworthy level of correlation. The variability of correlations for these markets are reasonably low, indicating that these fairly high correlations have been persistent over time.

Figure 4 shows that on a hedged basis, Australian bond markets have provided the potential for strong diversification benefits, with domestic government bonds and domestic corporate bonds exhibiting uncorrelated returns to Australian equities. It should be noted that Australian government bonds in particular have exhibited a high variability of correlation though, indicating that they could not have always been relied upon to provide diversified returns to equities. Global bond markets have exhibited mixed behaviours, with global government bonds providing an uncorrelated source of returns to Australian equities, but with investment grade, and high yield in particular demonstrating a reasonable degree of correlation with low correlation variability. This suggests their diversification properties were muted.

Figure 5 shows that on a hedged basis, various ‘alternatives’ have only provided a limited degree of diversification over time, with reasonably low variability of correlation. Emerging market debt, in particular, has exhibited a modest level of correlation to Australian equities.

Source: Bloomberg, see appendix for details


Figure 6: Global and regional equities vs Australian equities (unhedged)

10

20

30

40

50

60

-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Var

iabi

lity

of c

orre

latio

n (%

)


EM equities

US equities

Europe equities

UK equities

Japan equities

Figure 7: Global and regional bonds vs Australian equities (unhedged)

10

20

30

40

50

60

Var

iabi

lity

of c

orre

latio

n (%

)


-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Australia GB

Australia Corporate

Global Corporate

Global HY

Global GB

Figure 8: ‘Alternatives’ vs Australian equities (unhedged)

10

20

30

40

50

60

Var

iabi

lity

of c

orre

latio

n (%

)


-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

EM HC

Commodities

EM LC

Hedge funds

Historical correlations on an unhedged basis

Figure 6 shows that on an unhedged basis, there has been a range in the correlations between the main equity markets under consideration and Australian equities, with some markets such as Japan demonstrating a fairly low correlation. On the whole, these markets have exhibited greater variability of correlation on an unhedged basis compared to on a hedged basis, but still at a fairly low level of variability overall.

Figure 7 shows that on an unhedged basis, global bonds have exhibited strong diversification benefits, with global government bonds and investment grade bonds showing material negative correlations, and high yield showing negligible correlation. The correlation variability of global government bonds and investment grade bonds has been fairly low, indicating their historical diversification effectiveness has been reliable.

Finally, Figure 8 shows that on an unhedged basis, various ‘alternatives’ have provided a good degree of diversification over time, with their returns more or less uncorrelated with Australian equities over time. The variability of correlations of emerging market debt and hedge funds suggests, however, this diversification benefit has not been stable over time.

Source: Bloomberg, see appendix for details


A few conclusions can be made based on the above correlation and return analysis:

• On the whole, most equity markets have historically only provided limited diversification benefits to Australian equities, but they can provide significant additional return potential as illustrated in Figure 2. As a result, a broader set of equity market exposures can be beneficial to the overall risk-adjusted returns of a portfolio.

• Australian bonds have historically provided a powerful diversification benefit to Australian equities, although the relationship has proved to be variable. This suggests that they could not always be relied upon for diversification and that a flexible allocation approach to investing in these assets would be sensible.

• Global government bonds have also historically provided a strong diversification benefit to Australian equities, although again with a reasonable degree of variability. This supports the argument for a flexible allocation approach to investing in these assets.

• Global high yield bonds, on a hedged basis, have exhibited poor diversification characteristics with Australian equities, although have provided significant additional return over certain periods (as illustrated in Figure 2).

• The usefulness in terms of diversification benefits and the return generation potential of ‘alternative’ investments have varied considerably depending on the asset in question. This suggests that although certain ‘alternative’ assets can play an important role in both the generation of returns and in the control of volatility, this sub-set is not homogenous in its behaviour.

• It is evident that most of the asset correlations vary significantly depending on whether the returns are calculated on a hedged or unhedged basis. This suggests that the treatment of foreign currency exposures for different assets has a significant impact on the role they can play in a portfolio and the subsequent level of diversification that can be achieved.

• This result highlights the risky nature of the Australian dollar as a base currency and the potential diversification benefits of other currencies, most notably the US dollar. Managing the appropriate level of base currency exposure and carefully selecting other exposures is therefore a critical decision.

To further emphasise the last couple of points, in Figures 9 and 10 we have restated and consolidated the same charts to show the clusters of correlations for equities, bonds and alternatives on both a hedged and an unhedged basis.

A broader set of equity market exposures can be beneficial to the overall risk-adjusted returns of a portfolio

Treatment of foreign currency exposures for different assets has a significant impact on the role they can play in a portfolio


Figure 9: Correlation clusters for equities, bonds, ‘alternatives’ on a hedged basis

10

20

30

40

50

60

-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

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)


Bonds

Alternatives

Equity

Figure 10: Correlation clusters for equities, bonds, ‘alternatives’ on an unhedged basis

10

20

30

40

50

60

-1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0

Var

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)


Bonds

Alternatives

Equity

Source: Bloomberg, see Appendix for details

It can clearly be seen that the general effect of leaving foreign currency exposures unhedged has been to significantly reduce the correlations of assets to Australian equities. Does this mean we should be advocating a fully unhedged approach for a multi-asset fund that is targeting a return in excess of CPI? We explore the importance of active currency management in the next section.


To hedge or not to hedge?

The decision of whether to hedge foreign currency exposures as an Australian-based investor can make a significant difference to the overall outcome experienced – it not only affects the return achieved of individual assets but also impacts their interaction with other assets.

Given the return objectives of diversified growth strategies are typically structured with the specific domestic liabilities of the investor in mind (e.g. Australian CPI +5% for Australian investors), it therefore follows that the starting point for the strategy’s currency exposure should also be domestically skewed. In other words, the base position for a diversified growth strategy should involve the full hedging of overseas assets back into the base currency. Every currency exposure deviation away from that starting point is then a deliberate and conscious decision based on the views about different currencies, the roles they can play in a portfolio and how they interact with one another.

As we explain later on the paper in the section about the Investec Diversified Growth Strategy, different currencies exhibit different characteristics and can play varying roles in a portfolio, e.g. as a return generator, as a risk reducer, or as an uncorrelated stream of returns. However, in order to understand the roles that different currencies can play in a diversified growth portfolio, it is first of all important to understand the characteristics of the base currency in question, as this will influence the manner in which other currencies interact relative to it.

We would categorise the Australian dollar as a ‘Growth’ currency given that its performance and behaviour is linked to global drivers of economic growth. Figure 11 shows the rolling 36 month correlations between the S&P 500 (in USD terms) and the return from Australian dollar vs US dollar. Figure 11 supports our view that the currency exhibits growth properties and is particularly sensitive to market crises (as its correlation to equities has spiked over these periods, i.e. the Australian dollar has tended to depreciate when equity markets have been falling).

Figure 11: Rolling 36 month correlation of S&P 500 (USD) to AUD/USD

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1992 1995 1998 2001 2004 2007 2010 2013

Source: Bloomberg, 31 March 2015

Different currencies exhibit different characteristics and can play varying roles in a portfolio.


As well as looking at historical relationships to help determine the expected behaviour of the Australian dollar, we also try to understand why the relationships exist and therefore whether they are likely to persist. For the Australian dollar, we believe the role of China as a key export partner for Australia’s commodity products, notably iron ore, has significantly increased the relationship between the currency and global risk assets.

This Growth characteristic of the Australian dollar goes some way to explaining why the correlation of unhedged returns has been lower than for hedged returns. Foreign assets gain value from an Australian investors’ perspective when the Australian dollar depreciates (and vice versa), which has recently typically occurred in global market sell-offs, meaning that the currency effect acts somewhat as a counterbalance to the negative returns that would otherwise be achieved.

However, it is not as simple as just concluding that all foreign asset exposures should be left unhedged. When calculating the impact from the hedging of foreign asset exposures, the interest rate differentials between the foreign country and the domestic country needs to be factored in. Australian investors have benefited, particularly in the last few years, from the interest rate differential being in their favour (i.e. the interest rate in Australia has been higher than in other developed countries), which has meant, for example, that a fully hedged exposure has generated a positive carry. Figure 12 shows just this – it decomposes the return that an Australian investor would have received from fully hedging an allocation to the S&P 500 index into the component relating to the underlying index return in USD and the component relating to the hedging benefit.

Figure 12: US equities (AUD hedged) return decomposed: US equities local return and interest rate differential benefit

-50

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30

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

% %

US Equities (USD) - LHS Interest rate differential benefit - LHS US Equities (AUD Hedged) - RHS

Source: Bloomberg, 31 December 2014

Understanding the ‘Growth’ characteristic of the Australian dollar is very important.


So should an investor be focused on the potential return uplift resulting from hedging overseas exposure or should they be focused on the correlation and portfolio construction benefits from leaving overseas exposure unhedged?

The answer, of course, is not straightforward, and lies somewhere in between. There will be times when it is right to hedge overseas exposure for some assets but not for others. Conversely, there will be other times when it is right to leave more overseas exposure unhedged (e.g. in the event of market turmoil). This trade-off between increased carry versus volatility reduction is often a central theme in our investment debates around hedging strategies. From a diversified growth strategy perspective there is the further consideration of taking all positions relative to the base currency objective, as described earlier.

Figure 13 demonstrates both of these points. It shows the difference between the monthly returns from a fully hedged allocation to the S&P 500 index and the monthly returns from an unhedged allocation to the S&P 500 index, from an Australian investors’ perspective. A positive figure indicates that the fully-hedged allocation has outperformed the unhedged allocation over a particular month, and vice versa. We have overlaid the chart with the cross rate between the Australian dollar and the US dollar. It can be seen that in periods of Australian dollar strength, it has been advantageous to fully hedge the overseas exposure. Conversely, in periods of Australian dollar weakness, it has been advantageous to leave overseas US dollar exposure unhedged.

Figure 13: Monthly differential between S&P 500 AUD hedged and unhedged, and AUD/USD rate

-0.2%

-0.15%

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0%

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Difference (RHS) AUDUSD (LHS)

Source: Bloomberg, 31 March 2015

The primary conclusion is that understanding and managing currency exposure is a vital component to integrate into the investment process, playing both a risk management and return enhancement role.

The answer on whether to hedge or not hedge is not straightforward.

Understanding and managing currency exposure is a vital component to integrate into the investment process


Potential uses for of diversified growth strategies for Australian Superannuation Funds

Having outlined the typical features of diversified growth strategies and the benefits they can provide above, it is clear that they can play an important role for Australian institutional investors. This is particularly the case given that equities are the key drivers of returns for most Australian Superannuation funds, large and small, DC or DB. This reliance on equities comes with a cost of short term volatility that can create uncertainty about returns that investors will achieve at any given point or over a particular time horizon. For DB schemes that are looking to meet their liabilities, this lack of certainty creates issues, particularly if they are in the path of de-risking assets. For DC schemes, volatility can unsettle members such that they lose faith in the concept of pension savings prompting a switch to lower returning ‘safer’ assets.

Below, we outline four potential uses that diversified growth strategies can play and assess the applicability of these uses for different types of institutional investors. We finish with an exploration of what the impact of including a diversified growth strategy in a ‘typical’ Australian Superannuation Fund could have been.

1. One-stop shop

As outlined earlier, the majority of diversified growth approaches offer investors exposure to a combination of traditional and alternative return sources, with the aim of achieving a stable and positive total return over time. Therefore in many respects, the multi-asset teams managing these strategies and the trustee boards managing their pension funds are not too different in what they are trying to do. Diversified growth strategies, in effect, offer investors a ‘one-stop shop’ of exposures. Most pension funds would be unlikely to rely solely on one diversified growth strategy to achieve their goals, although experience in the UK has shown that DC schemes have often used one or two diversified growth strategies as the main component in their default range.

2. An option within the Superfunds structure

With Australian Superannuation Funds increasingly looking at providing different risk/return options to their members, we think that diversified growth strategies can play an important role in this provision of options. For example, diversified growth strategies can provide an option of a return of inflation +5% with half the level of volatility of equities, in isolation, or can be combined with other assets such as equities and bonds to provide additional options, with the risk/return objectives depending on the exact mix of assets.

Diversified growth strategies can play a variety of different roles for different types of institutional investor.


3. Liquid alternatives solution

We demonstrated above that a global opportunity set and an active approach to currency management can result in a set of return streams that are very different to domestic Australian returns, particularly to domestic equities. The risk management disciplines of diversified growth strategies, including explicit downside protection mechanisms, can also help to differentiate the return pattern of these strategies. Given the majority of diversified growth strategies are available to investors on a daily dealing basis, they can be regarded by investors as providing many of the characteristics of a liquid alternatives solution by offering an effective diversifier away from equities, while still providing the required return potential.

4. Outsourced CIO model

As we explained above, most diversified growth approaches are flexible in their overall asset allocation, being able to react to changing market dynamics more quickly and nimbly than most pension funds, which are typically restricted by their governance arrangements. This asset allocation flexibility is important as it allows the strategy not only to benefit from significant return opportunities, but also to protect against significant market threats. As well as benefiting directly from this asset allocation expertise through an allocation to a diversified growth strategy, pension funds can also utilise these asset allocation insights to help them in the management of the overall pension fund portfolio too. This concept of idea sharing between the investment manager and the pension fund to influence the management of the pension fund portfolio is known as an ‘outsourced CIO model’.

Different roles for different investors

The roles that diversified growth strategies can play will depend on the nature of the investor. For example, a sophisticated pension fund with strong levels of governance will probably have less need for a diversified growth strategy as a diversifier in their portfolio, but may benefit from the outsourced CIO role it can play. The diagram below attempts to summarise the different roles diversified growth strategies can play for different investors.

Greater relevance for schemes with strong governance

Greater relevance for schemes with limited governance

One-stop shop

Option within Superfund structure

Liquid alternatives

solution

Outsourced CIO model

The roles that diversified growth strategies can play will depend on the nature of the investor.


Modelling the benefit of diversified growth inclusion

To illustrate the potential benefits from including an allocation to a diversified growth strategy, and to highlight its role as a diversifier away from equities in particular, we have conducted some analysis that models the impact on introducing a diversified growth strategy into a ‘typical’ portfolio. We have chosen an initial strategic asset allocation based on what we consider to be broadly representative for an Australian Superannuation scheme, as follows:

Figure 14: A representative Australian Superannuation scheme portfolio

Australian cash 10.0%

Australian equities 25.0%

International developed market equities (ex Australia) 22.5%

Emerging market equities 5.0%

Australian bonds 10.0%

Global bonds 7.5%

Australian property 10.0%

Infrastructure 10.0%

Source: Investec Asset Management

We have assumed a hypothetical portfolio, (which we refer to below as the ‘typical’ portfolio) that rebalances on an annual basis, with a hedge ratio of 50% (i.e. foreign assets are 50% hedged back to Australian dollar). To represent the diversified growth strategy, we have used the track record of the Investec Diversified Growth Strategy. Given this track record is sterling based, we have calculated returns hedged back to Australian dollar. Further details around our methodology, including the assumptions and the proxy indices used, can be found in the Appendix.

Figure 15 shows the impact on the return and volatility of returns for the portfolio, on an annualised basis from May 2008 (the inception of the track record) to end March 2015 given different sized allocations to the Investec Diversified Growth Strategy.

Figure 15: Modelling the impact of introducing a diversified growth fund into a Superannuation fund

PorTFolIo rETurn VolATIlITy ShArPE rATIo

‘Typical’ portfolio 5.2% 9.3% 0.13

5% in DGF (funded from Australian equities) 5.7% 8.9% 0.19


10% in DGF (funded equally from Australian and International DM equities)

5.9% 8.6% 0.22


15% in DGF (funded equally from Australian and International DM equities)

6.4% 8.2% 0.29

20% in DGF (funded with 15% from Australian equities and 5% from International DM equities)

6.9% 7.9% 0.37

Source: Bloomberg, 31 March 2015, see Appendix for details

This modelling is not intended as advice or a recommendation but is intended as an illustrative example of the potential benefits an allocation to a diversified growth strategy could provide if included in a typical Superannuation portfolio.


It can be seen that in this exercise, there has been a clear portfolio benefit to including a diversified growth strategy (in this example ours) in a broader portfolio over the period modelled. The modelled realised return is higher, the overall portfolio volatility is lower and thus results in better risk-adjusted returns. It is noteworthy that the benefit is enhanced when substituting from Australian equities rather than International equities.


The Investec Diversified Growth Strategy

We launched an Australian vehicle within our Diversified Growth Strategy in May 2015, but we have been successfully managing multi-asset strategies for over 20 years and have managed the Investec Diversified Growth Strategy (with a sterling base currency and track record) since 2008.

Objectives and performance

The Investec Diversified Growth Fund (Australian) targets a return of Australian CPI +5% per annum, gross of fees, with half the level of equity volatility, over rolling 5 year periods. We judge the success of the Fund by achieving both the return and risk objectives. The performance of the sterling track record is shown in Figure 16 for reference.

Figure 16: Illustrative performance of the Investec Diversified Growth Strategy composite*

Annualised (gross) performance in GBP 5 year historical volatility***

Per

cent

age

(%)

5.6%

11.9%

13.1%

9.0%

7.0%7.4%

4.9%

6.4%7.4% 7.5%

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1 year 3 years p.a. 5 years p.a. Since inception p.a.**

Diversified Growth GBP Inflation Plus UK CPI + 5%

DGF Equities

*Source: Investec Asset Management GIPS composite report. This is a representative track record for our sterling based Diversified Growth Strategy **Composite inception date is 30 April 2008, returns of less than a year are not annualised. ***MSCI World GBP Hedged, over 5 years

Investment team

Michael Spinks and Philip Saunders are the co-portfolio managers, and so therefore, the ultimate decision makers for the Investec Diversified Growth Strategy. Michael, who joined Investec Asset Management in 2012, has managed diversified growth strategies since 2006 and has 19 years of investment experience. Philip has managed the Investec Diversified Growth Strategy since its inception in 2008 and has spent the majority of his 34 years of experience managing multi-asset strategies at Investec Asset Management.

Managing multi-asset mandates, with the breadth of opportunity set available to us, requires significant resource, experience and specialist expertise. The Investec Diversified Growth Strategy therefore benefits from being managed

Our investment team is research-driven and this is reflected in its structure.


within the Investec Multi-Asset team. This is an experienced, well-resourced and well-organised team of over 20 portfolio managers and analysts.

The Multi-Asset team is structured into seven Specialist Research Groups: Macro; Equity; FX & Rates; Credit; Commodities; Property, Infrastructure & Private Equity; and Alternative Risk Premia – to ensure the generation of specialist ideas for potential use amongst our different investment strategies.

Furthermore, the culture of Investec Asset Management means the Multi-Asset team is able to draw on the specialist equity, fixed income and alternatives expertise within the firm, both in terms of shared information and resource, as well as through specific allocations to specialist programmes managed by these teams.

The structure of the team is set out in the following diagram:

Strategy Leaders

Specialist Research Groups

Global Investment Infrastructure Support

Investec Investment team

Equities Fixed Income Alternatives

Macro

Team of 7*

John Stopford

Edmund Ng

Russell Sillbertson

Jeff Boswell

Michael Spinks

Max King

Marc Abrahams

FX & Rates

Team of 7

Commodities

Team of 4

Equities

Team of 9

Credit

Team of 5

Property, Infrastructure and

Private Equity

Team of 5

Alternative Risk Premia

Team of 4

DealingAs at April 2015. * Includes Mike Hugman, Investec Emerging Market Fixed Income team. Team members may sit in more than one research group

ESG Risk & Performance Implementation

Michael Spinks Philip Saunders


Investment approach

There are three key tenets of our investment approach:

1. We build the portfolio by focusing on underlying asset behaviours and relationships rather than relying on asset class labels

Market convention suggests that ‘bonds’ should behave differently to ‘equities’ and ‘alternatives’ should behave differently to both ‘bond’ and ‘equities’. However, we believe this convention is overly simplistic, inaccurate and dangerous. There are certain assets tagged as a ‘bond’ that actually behave more like ‘equity’. We demonstrated this above with our historic analysis of high yield bonds, which in our view should be thought of as equities ‘in disguise’. In respect of ‘alternatives’, we believe the phrase provides no clues about the behaviour of these assets, and the choice of which assets are covered by this term is subjective and changeable.

We, therefore, believe it is important to look beyond the labels of asset classes and instead focus on the underlying behaviours of asset classes when determining their role in a portfolio. As a result, it is our view that all investments exhibit either Growth, Defensive or Uncorrelated characteristics.

Growth assets react positively to increasing real economic growth, corporate earnings, cashflow and risk appetite. Defensive assets react positively to declining expectations of growth, and provide a safe haven in market crises. Uncorrelated assets have a variable relationship with growth and risk appetite, with performance generally unrelated to real economic and corporate earnings growth.

We believe a blend of these characteristics results in superior diversification and therefore more consistent outcomes.

• Equities• High yield debt• Emerging market debt

and currency• FX carry• Commodities• Property• Private equity

• Government bonds• Index linked bonds• Investment Grade

bonds• Volatility strategies• Shorting growth

• Infrastucture• Insurance• Commodity trading• Event strategies• Relative value

GrowTh DEFEnSIVE unCorrElATED


2. We use a bottom-up approach based on considering a broad opportunity set

Our active management approach invests in a broad opportunity set of Growth, Defensive and Uncorrelated investments. We believe the ability to access this broad opportunity set allows us to find the most attractive investment opportunities over the course of the business cycle. Given the different and changing behaviours of assets, a broad opportunity set provides us with various choices over time as to which assets to select, and importantly which asset not to select.

The investment opportunity set is not constrained solely to what assets you can own – the use of other investment techniques, such as expressing a negative view about an investment or expressing a relative value view, expands further the opportunity set available to investors. These techniques can change the underlying behaviours of assets and so provide other potential investment opportunities.

By adopting a global approach across a broad opportunity set, the characteristics can be adjusted through active currency management, adapting exposure with the base currency in mind. As shown above, particularly when managing from a risky currency base (as is the case for a sterling or Australian dollar-based investor), the decision on overseas currency selection is critical to adding returns and managing risk.

3. We appraise these opportunities using a consistent framework that focuses on what we call their Compelling Forces (Fundamentals, Valuation and Market Price Behaviour)

We believe that markets are driven by Fundamentals, Valuations and Market Price Behaviour:

○ Fundamentals – are the fundamental drivers improving?

○ Valuation – is the asset attractively valued?

○ Market Price Behaviour – are investors buying it or likely to start?

In our view, the best opportunities score well on all three metrics. We believe that good portfolio construction should exploit a broad range of these opportunities, balancing their quality against their contributions to risk.

‘Compelling Forces’ framework


Portfolio and positioning

Figures 17 and 18 show the model portfolio positioning of the Investec Diversified Growth Fund (Australian), as well as the illustrative currency positioning of the portfolio. We also show the historical positioning of the sterling Investec Diversified Growth Strategy since inception in Figure 19.

Figure 17: Model portfolio positioning of Diversified Growth Fund (Australian)

Source: Investec Asset Management as at 30 April 2015

Figure 18: Model currency positioning of Diversified Growth Fund (Australian)

- 3.0%

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19.0%

76.0%

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SGD

KRW

NZD

ILS

ZAR

TRY

EUR

(Other developed)

JPY

INR

IDR

USD

AUD

2.3%

2.8%

5.1%

1.7%

-2.3%

2.5%

7.0%

16.1%

17.6%

0.2%

2.0%

5.7%

0.1%

0.7%

4.6%

4.5%

6.3%

8.2%

14.8%

-5% 0% 5% 10% 15% 20%

Precious metals

Global macro

Infrastructure

Volatility trading

Put options

Investment trade

Short dated government bonds

Cash

Government bonds

Private equity

Emerging markets debt

Property

EM equity

China/Hong Kong equity

Other Asia equity

European equity

UK equity

US equity

Japanese equity

Unc

orre

late

dD

efen

sive

Gro

wth


Figure 19: Historical positioning of the sterling Diversified Growth Strategy, since its inception

0%

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80%

Growth Defensive Uncorrelated

Ran

ge o

f allo

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-% o

f Fun

d A

UM

*Historical positions of a GBP sterling denominated portfolio, historic range since May 2008. Current position (diamond): 31 March 2015


Conclusion

There are a few key conclusions to highlight:

• A ‘diversified growth’ multi-asset portfolio can bring global breadth to a Superannuation scheme while paying attention to local liabilities. These approaches can balance risk and return in equal measure to build a robust portfolio that should smooth the path of returns over time.

• We emphasise the importance of a broad opportunity set as well as, in these times of rising correlations across asset classes, the need to take a bottom-up approach to uncover opportunities.

• Asset class labels can also offer the allure of diversification without actually offering significantly different underlying economic drivers, so a focus on behaviours rather than labels is paramount.

• Our historical modelling suggests that there would have been a clear portfolio benefit to including a diversified growth strategy in a typical Australian Superannuation portfolio. The modelled realised return was higher, the overall portfolio volatility lower and the result therefore was improved risk-adjusted returns. It should also be noted that the benefit was enhanced when substituting from Australian equities rather than International equities.

• Finally, there are many different approaches to diversified growth, providing Superannuation fund executives with a great deal of choice when selecting the most appropriate management style for their fund. Also, the role that diversified growth strategies can play for Australian investors will vary depending on the nature of the investor, but their potential as a liquid alternative solution, given their diversifying properties, stands out.


Appendix:

Figure 1 – Australian asset classes through the decades

In order to assess the long-term returns of Australian equities, Australian government bonds and Australian cash, we have referenced the Credit Suisse Global Investment Returns Sourcebook 2015, written by Dimson, Marsh and Staunton. This source provides long-term performance information pertaining to equities, government bonds and cash, for several markets over the period from 1900 to 2014 inclusive.

Figure 2 – Australian assets versus global assets over the past decade

○ Australia equity = MSCI Australia index (AUD)

○ Emerging market equity = MSCI Emerging Markets Total Return Index (USD)

○ US equity = S&P 500 Index (USD)

○ UK equity = FTSE 100 Total Teturn Index (GBP)

○ Europe equity = MSCI Europe ex UK Index (EUR)

○ Japan equity = TOPIX Total Return Index (JPY)

○ Australia government bonds = Bank of America Merrill Lynch Australia Government Bond index (AUD)

○ Australia corporate bonds = Bank of America Merrill Lynch Australia Corporate Bond Index (AUD)

○ Global government bonds = Bank of America Merrill Lynch Global Government Bond Index (USD)

○ Global corporate bonds = Bank of America Merrill Lynch Global Corporate Bond Index (USD)

○ Global high yield = Bank of America Merrill Lynch High Yield Bond Index (USD)

○ Hedge funds = HFRI Fund of Funds Composite Index (USD)

○ Commodities = Bloomberg Commodities Index (USD)

○ Emerging market debt local currency = JP Morgan GBI-EM Global Diversified Index (USD)

○ Emerging market debt hard currency = JP Morgan EMBI Global Diversified Index (USD)

Figures 3 – 8

For the series of scatter charts that plot the historical correlations of a range of different assets with Australian equities, where available, we have used month-end Bloomberg index data from 31 December 1989 to 31 March 2015 inclusive. The indices used for these charts are the same indices we described above in relation to Figure 2. There are some instances though, for example with emerging market debt, where the data series started after 31 December 1989. We have


plotted these historic correlations versus the variability of these correlations. The variability of correlation is calculated by using the standard deviation of the respective calendar year returns of each asset (i.e. 1990 to 2014 inclusive, where available). The calculations in those charts that used the hedged returns of different assets were based off the local market returns of these different assets. Given that hedged returns are calculated through adjusting the local market returns of the foreign assets for interest rate differentials, it makes little difference to the correlations (which are focused on the direction of returns rather than their magnitude) whether the interest rate differentials are incorporated or not. Therefore, for simplicity, we used local returns for this purpose.

The calculations in those charts that used the unhedged returns of different assets were based off the foreign asset returns translated into Australian dollars. As such, they were subject to the currency fluctuations between their local currency and the Australian dollar.

Modelling Figure 15

Our choice of the stated strategic asset allocation and the proxy indices used to represent the different assets was based on our knowledge of the Australian pensions market as well as from information from various asset allocation surveys. The indices used in our modelling were as follows:

○ Australian equities = ASX 200 Index Total Teturn (AUD)

○ Australian cash = Australian 1 Month Cash Total Return Index (AUD)

○ International developed market equities (ex Australia) = MSCI World ex Australia (USD)

○ Emerging market equities = MSCI Emerging Market Index (USD)

○ Australian bonds = Bloomberg Australian Bond Treasury 0+ Years Index (AUD)

○ Global bonds = Bank of America Merrill Lynch Global Government Bond Index (USD)

○ Australian property = UBS Global Investors Index (AUD)

○ Infrastructure = S&P Global Infrastructure Index (USD)

Over the period from May 2008 to March 2015 inclusive, we calculated the hedged returns and unhedged returns for the indices listed above. When modelling the returns achieved from different allocations, we assumed a hedging ratio of 50% (i.e. 50% of foreign asset exposure hedged) for the overall portfolio excluding any allocation to the Diversified Growth Strategy, and an annual rebalancing policy (i.e. allocations were brought back to the strategic weighting on an annual basis). The Sharpe Ratio has been calculated using the return of Australian cash.


2205

6 -

06/1

5

Important information

Investec Asset Management claims compliance with the Global Investment Performance Standards (GIPS®). For the purposes of GIPS®, the firm is defined as including all institutional and retail assets managed by the London entity of Investec Asset Management (IAM). The Investec Diversified Growth composite comprises global multi-asset portfolios targeting outperformance of UK inflation over rolling 3 year periods with bond like volatility. The composite was created on 10 June 2009. To receive a complete list of composite descriptions and/or a GIPS® compliant presentation, please contact us on [email protected] or write to: Client Infrastructure Team, Investec Asset Management, 25 Basinghall Street, London, EC2V 5HA, United Kingdom. The information contained in this document discusses general market activity or industry trends and should not be construed as investment advice. The investment objective will not necessarily be achieved and investors are not certain to make profits; losses may be made. The information contained in this document is believed to be reliable but may be inaccurate or incomplete. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. The information contained in this document is provided in good faith and has been obtained from sources believed to be reliable. It is not an invitation to make an investment nor does it constitute an offer for sale and is not a buy, sell or hold recommendation for any particular security. Portfolio holdings may change significantly over time. This communication should not be read by US persons. In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001). It is not an invitation to make an investment nor does it constitute an offer for sale. All data sourced from Investec Asset Management. Telephone calls may be recorded for training and quality assurance purposes.

Issued by Investec Asset Management, June 2015.

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