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Investment Strategy Webinar January 16, 2013

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Page 1: Investment Strategy Webinar - Aon · Investment Strategy Webinar January 16, 2013. 2 ... kevin.hrad@aonhewitt.com ... fees and with top performers drawing capital from weaker managers,

Investment Strategy Webinar

January 16, 2013

Page 2: Investment Strategy Webinar - Aon · Investment Strategy Webinar January 16, 2013. 2 ... kevin.hrad@aonhewitt.com ... fees and with top performers drawing capital from weaker managers,

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Presenters

Steve Cummings, President & CEOPhone: 847.442.0064Email: [email protected]

Mike Sebastian, PartnerPhone: 312.715.3352Email: [email protected]

Peter Hill, PartnerPhone: 312.715.2925Email: [email protected]

Kristen Doyle, Associate PartnerPhone: 312.715.3310Email: [email protected]

Tapan Datta, PrincipalGlobal Asset AllocationPhone: 011 + 44 020 7086 9076Email: [email protected]

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Presenters (cont’d)

Kevin Hrad, Senior ConsultantPhone: 312.715.3337Email:[email protected]

Lucinda Downing, Senior Research AnalystPhone: 001 +44 207 086 9440Email: [email protected]

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Discussion Topics

Opening Remarks Market Views: Fiscal Cliff and Diversification Opportunities Hedge Funds in 2013 Securities Lending Regulatory and Market Update Closing RemarksQ&A Session

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Market Update and a focus on Emerging Market Local Currency Debt

Tapan Datta & Lucinda Downing

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Fiscal Cliff Aftermath – Tax Hikes to Pressure the Consumer

Fiscal cliff’s worst scenario avoided, but there is an aftermath…

$200 bn in tax rises coming through, which is not far from 2% of disposable income, a point of weakness in the economy over several years…

If sequester is avoided, the economy can bear it, if it is not, far worse outcomes possible.

If sequester is avoided, consumer and business spending can just offset each other.

THE INCOME STRUGGLE(Real personal disposable income, $m, constant prices)

4000

5000

6000

7000

8000

9000

10000

11000

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Page 7: Investment Strategy Webinar - Aon · Investment Strategy Webinar January 16, 2013. 2 ... kevin.hrad@aonhewitt.com ... fees and with top performers drawing capital from weaker managers,

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Treasury Bond Yields – Less One Sided!

Some firmness in US treasury yields is appearing, and the yield curve has been steepening.

Driven by doubts about how much more balance sheet expansion by the Fed.

Inflation expectations remain contained.

Fiscal issues still showing limited impact so far…sequester impact?

TREASURY YIELDS: LONGER YIELDS FIRMER(% rise in yields since end June 2012)

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y

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Equities Versus Bonds: How Will the Equity Risk Premium Normalize?

Though equities still face lots of risks, ultra-low bond yields make equities look very attractive on a relative basis. Equity risk premiums are over 2% higher than normal.

The unusually high equity risk premium will correct either through rising bond yields, or because profit outcomes disappoint expectations.

We expect both, but the adjustment process is more likely to come from rising bond yields.

Equities should be outperforming bonds.

US EQUITY RISK PREMIUM

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Jan 98 Jan 01 Jan 04 Jan 07 Jan 10 Jan 13ERP

Equities cheap relative to Government bonds

Equities expensive relative to government bonds

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Historical Breakdown of Total Return

Limited interest rate risk

Portfoliodiversification

Potential for capital and currency

appreciation

Yield enhancement

Local EM debtbenefits

With low yield levels in developed markets and a continuing search for yield, local emerging debt offers an attractive yield.

Our positive view on local emerging debt relative to other fixed income asset classes is based on this yield pick-up and expected currency appreciation.

Currency’s high return contribution in any one year means that it is important to get the currency direction right.

Benefits of Emerging Market Local Currency Debt

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Local Currency Emerging Debt: Character Attributes?

Local and hard currency bond yields have different return drivers:

– Domestic rates, not USLocal debt is driven more by domestic emerging market factors, whilst hard currency debt is anchored on US yields.

– Higher credit ratingThe average credit rating of local debt is higher than that of hard currency debt (BBB+ vs BB+). Over 80% of local EM debt is investment grade, compared to around 60% in hard currency.

– Shorter durationThe average duration of the local bond index currently stands at 4.9, compared to 7.5 for hard currency debt.

– More concentrationThere are just 15 countries in the JPMorgan GBI-EM Global Diversified Index compared to 55 countries in the EMBI Global Diversified Index, JPMorgan’s hard currency index.

Local debt yield = Local yield + currency exposureHard currency debt yield = US treasury yield + credit spread

Hard and Local EM Debt Yields

4

6

8

10

12

14

16

Dec-97

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

%Hard Currency EM Debt Local EM Debt

Despite higher credit quality, local emerging bond yields are higher than hard currency counterparts as low US yields have dragged down ‘safer’ hard EM debt.

Country Weights:GBI-EM Global Diversified Index

Indonesia 10%

Malaysia 10%

Mexico 10%

Russia 10%

South Africa 10%

Turkey 10%

Brazil9% Chile

0%Colombia

4%

Hungary 6%

Poland 10%Philippines

1%

Thailand 7%

Peru 2%

Nigeria1%

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Summary of Medium-Term Market Views

Equities Cautious on medium-term view, but prefer to bonds We still favor large cap, but view now moderated after small cap

underperformance We are neutral on growth vs value Even with US underperforming we favour non-US markets on any rebalancing

Bonds Continue with negative views on bonds Take profits on credit – move back towards target Favor intermediate to long duration interest rate exposure, but long duration

credit exposure Prefer local to hard currency emerging market debt

Alternative Asset Classes Favor real estate, hedge funds, infrastucture and selected private equity investments

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Hedge Funds in 2013

Kevin Hrad

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Hedge Funds: 2012 Performance Overview

2012 Hedge Fund Performance vs. Strategy Indices

4.7%3.4%

0.7%

4.9%

6.9%

4.1%

-2.8% -2.3% -1.6%-2.5%

-4.6%

3.0%1.7%

3.4% 3.6%

1.8%

-1.0%

3.1%1.8%

6.2%5.2%

-0.2%

8.5% 7.4%

10.0%

0.1%

2.9%2.4% 1.9%1.3%

-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%8.0%

10.0%12.0%

HFRI Fund WeightedComposite Index

HFRI Fund of FundsComposite Index

HFRI Macro Index(22.1%)

HFRI Event-DrivenIndex (24.5%)

HFRI Equity HedgeIndex (26.7%)

HFRI Relative ValueIndex (26.7%)

1Q 2012 2Q 2012 3Q 2012 4Q 2012 2012 Year

2012 Hedge Fund Performance vs. Major Market Indices

4.7%3.4%

11.9%

0.3%

-5.6%

3.0% 2.4%

6.8%

1.6%1.3% 1.8%0.2%

6.2% 5.2%

16.1%

4.2%

-2.3%-2.8%

2.1%2.9%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

HFRI Fund Weighted CompositeIndex

HFRI Fund of Funds CompositeIndex

MSCI ACWI Barclays Agg Bond Index

1Q 2012 2Q 2012 3Q 2012 4Q 2012 2012 Year

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Have Hedge Funds Underperformed?

The risk-return chart above plots the annualized return of hedge fund and various public market indices over the past 4 years against the annualized volatility over the same period

The plots illustrate that, on a risk-adjusted basis compared to a hypothetical policy benchmark of 65% global equity / 35% U.S. bonds, direct hedge fund strategies have performed relatively well while FoHFs have been in-line

Risk/Return: Trailing 4 Years Ending 12/31/2012

Dow Jones U.S. Total Stock Market Index

MSCI All Country World ex-U.S. Index

MSCI All Country World Index

Barclays AggregateBond Index

Credit Suisse High Yield Index

HFRI Fund Weighted Composite Index

HFRI Fund of Funds Composite Index

65/35 ACWI/BC Agg

T-Bills

0%

5%

10%

15%

20%

25%

0% 5% 10% 15% 20% 25%Annualized Risk

Annu

aliz

ed R

etur

n

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Return Dispersion Across Hedge Funds

Source: HFR

2012 Risk and Return of Individual Hedge Funds Hedge fund index returns do not account for the success of individual managers

– Thousands of hedge funds report returns to various index providers (>2,200 direct hedge funds and >600 fund of hedge funds (FoHFs) included in HFR indices)

– Return dispersion across managers remains relatively high

– Larger managers generally outperformed smaller and less experienced peers and amassed the bulk of inflows during 2012

– Investors should focus on high conviction managers with characteristics indicative of future success: Broad ownership and significant co-

investment among key professionals Large and stable asset base of high

quality investors Well-resourced (front and back office) Sound philosophy and process Strong track risk-adjusted track record Fair terms, accessible, transparent Source: Deutsche Bank Markets Prime Finance,

Hedge Fund Intelligence

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2013 Industry Outlook

Hedge fund performance expectations for 2013 are difficult to forecast, however we expect returns to exceed those of traditional equity and fixed income markets on a risk-adjusted basis

Hewitt EnnisKnupp Medium Term Views:– Limited upside for stocks with earnings growth headwinds, fiscal tightening, and potential volatility– Very low bond yields with greater downside than upside risk– Hedge funds best equipped to add value amid fluid market conditions

Notable Trends

– Institutional interest in hedge funds has never been greater, and we expect this trend to continue; plan sponsors have been implementing new and expanding hedge fund portfolios across a variety of objectives

– The last couple years have been difficult for many hedge funds; with a waning outlook for incentive fees and with top performers drawing capital from weaker managers, we expect some consolidation but also an elevated number of spin-out launches

– We expect the trend of outflows from FoHFs to continue as the industry has been squeezed by competitive forces

In response, FoHF managers have been evolving to remain relevant among larger institutional investors

Likely to see further consolidation, custom solutions, and specialized strategies such as the seeders and specialty and illiquid credit funds that emerged in 2012

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2013 Strategy Outlook

Credit markets offer some of the most appealing risk/reward characteristics, and event-driven / credit opportunities are abundant– Managers have been sifting for value through settlement claims and European sovereigns, and

others see value in pockets of the RMBS market– A relatively scarce amount of M&A activity in 2012 should be surpassed in 2013; excess cash

reserves and tempered organic growth prospects suggest more strategic acquisitions– Even as credit-oriented opportunities surfaced during the course of 2012, managers have generally

remained patient to wait for an attractive entry point

Global macro managers have a brighter outlook within the political/central bank-driven environment after a year of steadily rising equity markets and dampened trading volumes; larger and more nimble managers have an advantage

Long/short equity managers were largely positioned neutrally in terms of their net and gross exposure ranges due to uncertainty regarding the fiscal cliff outcome and other macro/political factors; managers have since become fully invested along with more big picture clarity

Large, established, and globally-oriented multi-strategy managers continue to be well-positioned to take advantage of fluid opportunities; those with longer horizons and less need for liquidity are able to fill financing voids left by banks and others investors limited by capital needs and guidelines

The emergence of opportunistic fund launches that offer investors an opportunity to harness price dislocations in more illiquid market segments, mainly credit; characteristics include high single-digit / low double-digit return objectives, specialized mandates, drawdown structures

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2013 Strategy Outlook (cont’d)

Source: KKRSource: J.P. Morgan Prime Brokerage

A favorable stock-picking environment should support long/short equity managers– Stock correlations have fallen dramatically

since the elevated levels seen in 2010-2011– Secular trends in several sectors creating

opportunities– Potential to reduce volatility of long-only

equity portfolio

The search for yield should boost demand for specialized credit managers

– With spreads and yields at historical lows, opportunities exist both long and short

– Shorts focus on overvalued credit in late cycle bull market, and long positions invest in specialized markets (e.g. direct lending)

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Hedge Fund Asset Flows

Total hedge fund assets under management continue to grow steadily

AUM reached all-time highs in 2013 and is expected to increase primarily through allocations from institutional investors

While total asset flows have been positive over the past 3 years, FoHFs have experienced net outflows in each of the past 5 years

Source: HFR

Source: HFR

Hedge Fund Industry Annual Asset Flows

$-

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Q12012

Q22012

Q32012

-$200,000-$150,000-$100,000-$50,000$0$50,000$100,000$150,000$200,000$250,000

Assets Net Flows

$ Milli

ons)

$ Millions)

Hedge Fund Asset Flows: Direct vs. FoHFs

$(250,000)

$(200,000)

$(150,000)

$(100,000)

$(50,000)

$-

$50,000

$100,000

$150,000

$200,000

$250,000

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

(YTD

)

($ M

illio

ns)

Single Strategy Hedge Funds FoHFs

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Fund of Hedge Funds Developments

FoHFs are adapting to a more difficult business environment

Institutional investors in particular have become more educated on hedge funds, and demands for higher returns and lower fees has led many to build portfolios of direct investments

A sharp rise in M&A activity

– Legacy owners using industry consolidation as an exit opportunity

Likely influenced by tax incentives and business valuations

– FoHFs struggling with organic growth are partnering with firms for greater outreach

Retail segment of U.S. and Europe is one targeted area

Institutional investors have leverage to negotiate with FoHF managers

FoHF Actions Client Activity

Strategic partnerships Customized accounts Opportunistic investments Acquisitions

Many institutional investors have elected to phase out their FoHF allocations in favor of direct mandates

FoHFs remain a popular option for others:– First time allocations– Inability to meet multiple direct fund

minimums– Limited staff resources

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Securities Lending Regulatory and Market Update

Kristen Doyle

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Securities Lending Regulatory Environment Update

Several rules and regulations that have been debated, scrutinized, and lobbied for and against since the aftermath of the 2008 financial crisis are set to begin taking effect in 2013

Certain components of the overarching financial industry reforms may directly impact the securities lending market

The regulations that HEK is following include:– Basel III– Dodd Frank: Section 165(e)– Dodd Frank: The Volcker Rule– Money market reform

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Basel III & Dodd Frank - Section165(e)

Basel III Recommendations on banking laws and regulations that create international standards

for capital requirements Basel III, which will begin to take effect this year and be phased in through 2018, calls for

higher capital requirements than Basel II– Under Basel III, banks are required to hold 4.5% of common equity (up from 2%) and

6% of Tier I capital (up from 4%)– Additional capital buffers that regulators can trigger in periods of high credit growth

Dodd Frank – Section 165(e) Dodd Frank section 165(e) is a regulation aimed at controlling credit exposures of banks

and other financial institutions Specifically, the regulation states that organizations must limit their credit exposure* to

any one company at 25% of the company’s capital Most securities lending agents have other lines of business that require taking on credit

exposure, and a limit of 25%** is believed to be unreasonable

*Defined as “the aggregate net credit exposure will include the net credit exposure between all of [an organization’s] subsidiaries and all subsidiaries of the counterparty”

**The threshold is even stricter at 10% for the six largest banks

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Basel III & Dodd Frank 165(e) Possible Impact on Securities Lending

The future of indemnification is in question Such regulations on capital and credit exposure implies an increased value on the capital

allocation process and the manner in which credit can be extended It is reasonable to question whether organizations that support securities lending

programs will deem indemnification as a worthwhile capital expenditure and/or allocation of credit exposure

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The Volcker Rule

The Volcker Rule, which is a specific section of the Dodd Frank reform act, is aimed at prohibiting banks from engaging in speculative trading

Technically, the rule went into effect in July 2012 on a “good faith effort” basis In reality, strict enforcement of the rule is yet to occur and debates among industry

participants and regulators continue

Potential Impact on Securities Lending Commingling of securities lending collateral into an unregistered pool may be prohibited Under the current form of the Rule, an unregistered pool may be deemed to engage in

speculative trading Custody lending agents that HEK regularly works with have already taken steps to

mitigate the impact from this unintended consequence Third party lending agents face less of an impact since most use separate accounts for

the investment of cash collateral or third party money market funds

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Money Market Reform

In late 2012, the Financial Stability Oversight Council (FSOC) officially proposed three options for enhancing the stability of money market funds

The following proposals may still evolve prior to adoption, but currently the options include:– Shifting from a fixed $1 net asset value to a variable net asset value– Capital buffers + redemption restrictions– Capital buffers + investment restrictions

Money market funds are used by securities lending agents as a vehicle to invest cash collateral

Any reforms to such funds may introduce administrative or operational burdens to securities lending programs

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Question & Answer

Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer sessions.

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Our next investment strategy update call is scheduled for Wednesday, February 20th, at 10 a.m. CST.