Dynamic Asset Allocation

Thomas Chevrier, Ph.D.Head of State Street Associates, Asia Pacific

State Street Global Markets

Outline• Introduction to Dynamic Asset Allocation

– Why DAA

– What is DAA

– Allocation Strategies and Constraints

• Results– Model Performance

– Betting Returns

• Methodology– Dynamic Equities and Bonds Asset Allocation

– Dynamic Currency Asset Allocation

– Quality of Alpha

• Conclusion

• Appendix– Futures Basket

– Cost

2

-7%

-2%

3%

8%

13%

18%

23%

Jun-99 May-01 Apr-03 Mar-05 Feb-07 Jan-09 Dec-10

Annualized 2 Year Rolling Returns

High Turbulence SAA

Typical Australian Investor Performance Through Time

• Preserving Portfolio Value Is a Constant Challenge

3

Strategic Asset Allocation (December 2010)*

Asset Class Weight

Australian Equities 30%International Equities 15%Emerging Market Equities 5%Property 10%Alternatives 15%Australian Composite Bonds 5%Australian Sovereign Bonds 5%International Bonds 5%Cash 10%

Total Weight of Dynamic Assets 80%* Quarter 2010 Rainmaker Roundup Industry Funds Turbulence is determined using Global Asset Turbulence Index

Source: State Street Bank Europe Limited

Why Dynamic Asset Allocation ?

4

-7%

-2%

3%

8%

13%

18%

23%

Jun-99 May-01 Apr-03 Mar-05 Feb-07 Jan-09 Dec-10

Annualized 2 Year Rolling Returns

High Turbulence SAA DAA

Statistics Over Crisis Periods

November 2000 - February 2003 Total Return

Standard Deviation

Average Monthly Return

October 2008 - February 2009 Total Return

Standard Deviation

Average Monthly Return

SAA -3.50% 5.45% -0.12% SAA -9.78% 6.39% -2.04%DAA 2.79% 4.18% 0.11% DAA -6.13% 4.94% -1.26%

What is Dynamic Asset Allocation ?• Take advantage of specific market environments

Dynamic Asset

Allocation

Asset Allocation

Model

Carry Trade

on/off?

Stock / Bonds

Cheap?

Currency Turbulence

Index

Strategic Asset Allocation5

Individual Bet Size <5%

Total Bets in any direction <15%

Short Selling Allowed X

Short Currencies X

Leverage X

Long / Short Strategy X

3 Allocation Strategies

Currencies

Sample Constraints

6

Equities

Bonds

Equities

Bonds

Currencies

Results

• Betting on Equities, Bonds, and Currencies:– Out-of-sample information ratio of 0.89

– Worst drawdown reduced from over 17% to less than 15%

– Reduced probability of a loss and Value-at-Risk

– Takes bets 97% of the months

– Average monthly turnover of 8%

7

July 1997 - December 2010 Backtest (%)

SAAPublication Lag Out of Sample In Sample

Bets on Equities and Bonds Information Ratio - 0.64 1.23 1.56 Sharpe Ratio* 0.47 0.68 0.79 0.89 Return-to-Risk Ratio 1.15 1.37 1.47 1.56 Largest Drawdown -17.53 -13.20 -10.44 -11.88

Bets on Currencies Information Ratio - 0.64 0.75 1.60 Sharpe Ratio* 0.47 0.56 0.54 0.63 Return-to-Risk Ratio 1.15 1.24 1.22 1.29 Largest Drawdown -17.53 -18.40 -18.09 -17.74

Bets on Equities, Bonds, and Currencies Information Ratio - 0.89 1.46 2.04 Sharpe Ratio* 0.47 0.76 0.88 1.04 Return-to-Risk Ratio 1.15 1.43 1.56 1.69 Largest Drawdown -17.53 -14.11 -11.04 -12.09

* Riskless return = 4.5%

DAA

Model Performance

8

Betting Returns

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

Jul-97 Jul-99 May-01 May-03 Mar-05 Mar-07 Jan-09 Dec-10

Publication Lag Average

9

• Batting average is 61.25%

Dynamic Equities & Bonds Allocation Model

• Monthly publication

• 5 investor behavior signals

• 5 fundamental signals

• Customizable

Favors Stocks

Favors Bonds

Source: State Street Bank Europe Limited

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Asset Allocation Model(as of 28 February 2011)

Signal Favors

Investor Behavior Regime Map Bonds Global Sector Risk Appetite Stocks Emerging Markets Flows Stocks Global Sovereign Bond Flows Neutral Global Dividend Yield Correlation Stocks

Fundamentals Relative Valuation Stocks US Earnings Growth Bonds Global Yield Curve Stocks Turbulence Indices Stocks Global Breadth Bonds

Model Favors Stocks

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100% Private Equity

International Property

Cash Plus 2%

Infrastructure

International Inflation-Linked Bonds

Specialist Credit

Australian Property

Diversity

Cash

Australian Sovereign Bonds

Australian Composite Bonds

Emerging Market Equities

International Equities

Australian Equities

Dynamic Equities & Bonds Allocation Model

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Dynamic Currency Allocation Model

no active adjustment to exposure

0

1

2

3

4

5

6

7

8

9

0

5

10

15

20

25

Jul-97 Nov-98 Mar-00 Jul-01 Nov-02 Mar-04 Jul-05 Nov-06 Apr-08 Aug-09 Dec-10

Mov

ing

Ave

rage

Turb

ulen

ce I

ndex

Currency Turbulence Index and 30-Day Moving Average

Turbulence Index

Moving Average SubprimeMortgage

Crisis

Ruble Crisis

Accounting Scandals

9-11

Dot-comBubble Burst

Source: State Street Bank Europe Limited (February 2011). Published Daily

Increases exposure to countries with interest rates higher than Australia & vice versa

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-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

NZD

NOK

CHF

SEK

CAD

GBP

JPY

EUR

USD

Dynamic Currency Allocation Model

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Currency Exposure (%)

CurrenciesExposure as % of Total Portfolio

CAD 1.99CHF 0.68EUR 3.10GBP 1.79JPY 2.50NOK 0.18NZD 0.08SEK 1.84USD 14.17

Total 26.34

• For Australian investors, currencies tend to diversify the portfolio, therefore taking currency bets may lead to greater portfolio risk in addition to generating potential alpha

• 26.34% is a small exposure which does not allow us to take large active bets

Quality of Alpha

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Quality of Alpha

Percentage of Months with Bets

Mean Return of Bets

Batting Average

Average Win

Average Loss

Win/Loss Ratio

Information Ratio

# years confident

Bets on Equities and Bonds Publication Lag 91.88% 0.10% 56.05% 0.45% -0.36% 1.28 0.64 8.99Out of Sample 91.93% 0.18% 60.13% 0.49% -0.29% 1.51 1.23 2.41In Sample 91.98% 0.23% 65.41% 0.49% -0.28% 1.89 1.56 1.48

Bets on CurrenciesPublication Lag 50.63% 0.07% 50.96% 0.25% -0.13% 1.04 0.64 3.96Out of Sample 50.93% 0.07% 53.33% 0.24% -0.12% 1.14 0.75 2.91In Sample 51.23% 0.13% 60.38% 0.25% -0.06% 1.52 1.60 0.64

Bets on Equities, Bonds, and CurrenciesPublication Lag 96.88% 0.14% 61.25% 0.47% -0.38% 1.58 0.89 4.83Out of Sample 96.89% 0.22% 66.46% 0.51% -0.33% 1.98 1.46 1.75In Sample 96.91% 0.31% 71.60% 0.54% -0.28% 2.52 2.04 0.90

Conclusion

• Valuable information in SSGM indicators

• Can help to– Generate significant Information Ratio

– Reduce risks

• Even with a constrained, simple, yet realistic DAA model, the out-of-sample gains are impressive

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Legal DisclaimerState Street Global Markets is a registered trademark of State Street Corporation (incorporated in Massachusetts).State Street Associates is a registered trademark of State Street Corporation.

Issued by State Street Bank and Trust Company ABN 70 062 819 630, AFSL 239679 (State Street). This presentationis directed and made available only to institutional investors who are classified as wholesale clients under theCorporations Act 2001, and is not meant for the general public. The information contained in this presentation isobtained from a number of sources and its accuracy is not guaranteed by State Street nor is it a forecast of futurereturns. Past performance is no guarantee of future performance. This presentation contains general informationonly and is not intended to represent investment or professional advice. It is provided with the understandingthat the recipient will be responsible for making their own assessment and evaluation, and should seek the adviceof legal, tax and financial advisers before making any investment or trading decisions. State Street and its relatedcompanies and their directors and employees disclaim any liability for loss or damage howsoever caused by anyrecipient relying in any way on the contents of this presentation. Redistribution is prohibited without writtenconsent by State Street.

State Street Associates,

State Street Bank and Trust Company

One Lincoln Street

Boston MA 02111-2900

Appendix:

Considerations for Implementation

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Futures Baskets

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Futures Baskets (%)

Australian EquitiesInternational

EquitiesEmerging Market

EquitiesAustralian

Composite BondsAustralian

Sovereign Bonds

Equity FuturesAustralia 100Canada 3.59Europe 11.56Hong Kong 3.89 13.69Japan 16.92Singapore 2.63 9.09Switzerland 1.25UK 8.14US 55.60China 2.08India 15.44Mexico 19.81South Africa 11.20South Korea 6.50Taiwan 18.60

Bond FuturesAustralia 3 Year 94.29 87.43Australia 10 Year 5.71 12.57

Out-of-SampleTracking Error 1.59 1.90 8.13 2.15 2.47

Transaction Costs (bps) 0.54 0.79 1.30 0.50 0.50

Cost• For the most active DAA model, the Equities, Bonds, and Currencies model, we

observe an average annual cost of 16 bps

Cost (%)

Average Monthly Turnover

Standard Deviation of

TurnoverDAA on Equities and Bonds

Publication Lag 4.19 7.76Out of Sample 4.19 7.76In Sample 4.11 7.73

DAA on Currencies

Publication Lag 3.81 6.00Out of Sample 3.81 6.00In Sample 3.81 6.00

DAA on Equities, Bonds, and Currencies

Publication Lag 8.00 9.69Out of Sample 8.00 9.69In Sample 7.91 9.70

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Futures Transaction Costs

Futures Transaction Costs (bps)

Country Future Cost Roll Frequency

Australia ASX SPI 200 Index Futures 0.54 QuarterlyCanada S&P/TSE 60 Index Futures 0.51 QuarterlyEurope DJ Eurostoxx 50 Index Futures 0.16 QuarterlyHong Kong Hang Seng Index Futures 0.58 MonthlyJapan Topix Index Futures 1.90 QuarterlySingapore STI Index Futures 0.99 MonthlySwitzerland SMI Index Futures 0.52 QuarterlyUK FTSE 100 Index Futures 0.33 QuarterlyUS S&P 500 Index E-Mini Futures 0.66 QuarterlyChina Hang Seng China Entreprises Index Futures 0.56 QuarterlyIndia SGX S&P CNX Nifty Index Futures 3.45 MonthlySouth Africa FTSE/JSE Top 40 Index Futures 1.41 QuarterlySouth Korea KOSPI 200 Futures 1.91 QuarterlyTaiwan MSCI Taiwan Stock Index Futures 1.53 Monthly

Australia 3 year Australian 3 Year Bonds Futures 0.50 QuarterlyAustralia 10 year Australian 10 Year Bonds Futures 0.50 Quarterly

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