Investment Strategy Webinar

November 14, 2012

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Presenters

Mike Sebastian, PartnerPhone: 312.715.3352Email: mike.sebastian@aonhewitt.com

John Geissinger, PartnerPhone: 203.852.1100Email: john.geissinger@aonhewitt.com

Duncan Lamont, PrincipalGlobal Asset AllocationPhone: 011 + 44 020 70869168Email: duncan.lamont.2@aonhewitt.com

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Discussion Topics

Opening RemarksMarket Update and Outlook: Spotlight on DiversificationNew Hewitt EnnisKnupp Thought Leadership: Harvesting the Equity Insurance Risk PremiumNew Hewitt EnnisKnupp Thought Leadership: Conviction in Equity Investing

Q&A Sessions throughout the presentation

Market Update

Duncan Lamont

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Mixed Messages From Consumers and Businesses

US consumers are in confident

mood

But businesses are getting

nervous about the fiscal cliff

…and the Eurozone remains in

the doldrums

Capital Goods Orders (Exc. aircraft&defence) (3 month change)

-30%-25%-20%-15%-10%-5%0%5%

10%15%

2005 2006 2007 2008 2009 2010 2011 2012

Consumer Confidence (University of Michigan index)

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55

60

65

70

75

80

85

90

2009 2010 2011 2012

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Risk-on Risk-off Environment Has Driven Asset Performance

Cross-asset class performance

has been very similar for risky

asset classes

Treasuries and equities have moved in

opposite directions but both have

performed well overall!

Risky assets have moved in tandem

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140

Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12

Ret

urns

(Reb

ased

)

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Hig

h Y

ield

Spr

ead

(bps

)

Commodity Total Return Global Equities US High Yield Spread (RHS)

Risky assets versus safe haven assets

-50%-40%-30%-20%-10%

0%10%20%30%40%50%

Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12-6%-4%-2%0%2%4%6%8%10%12%14%

S&P 500

Treasuries

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Correlations Increase During Crises but This Time Has Been Worse

Correlations w ith Equities

-1.00

-0.75

-0.50

-0.25

0.00

0.25

0.50

0.75

1.00

HistoricLong Term

BlackMonday1987/88

LTCM1998/99

Dotcom2000/02

FinancialCrisis 2008-

Treasuries Corporate Bonds Commodities

REITs Fund of Hedge Funds Global Macro Hedge Funds

Higher than normal

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Credit: Return Potential Now Limited

A big squeeze on expected returns is on.

Credit has rallied big time, driving yields down to very low levels.

Interest rate (duration) risk here now a problem should global government bond yields rise.

Even on a pure ‘spread’ basis, our risk-premiums (against expected credit quality risks) suggest limited room for further sustained falls.

CREDIT RISK PREMIUM NOW APPROACHING PRE-CRISIS LEVELS

0

100

200

300

400

500

600

700

2002 2004 2006 2008 2010 2012

MORE ATTRACTIVE

LESS ATTRACTIVE

2% yields don’t offer much scope for

return!

US CORPORATE BOND YIELDS AT VERY LOW LEVELS (Intermediate credit index)

0123456789

2002 2004 2006 2008 2010 2012

%

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Summary of Medium-term Market Views

Equities Cautious on medium-term view, but prefer to bondsFavor large cap Rebalance to neutral within growth-valueFavor non-US markets on any rebalancing now neutral on emerging markets

Bonds Ultra low yields make bonds vulnerableTake profits on credit – move back towards targetFavor intermediate to long duration interest rate exposureFavor Investment grade and secured loans to high yield

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

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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.

Harvesting the Equity Insurance Risk Premium

John Geissinger

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An Investor Challenge

Investors have been challenged to reduce portfolio sensitivity to equity markets without sacrificing long-term expected returns.Risk Parity solutions have gained traction as levered fixed income portfolios have outperformed as interest rates declined to historical lows. It is unclear how this solution will perform in rising interest rate environments.Another solution is to find unique sources of non-correlated returns. A wide net must be cast to capture these unique investments. There is no “silver bullet.”We believe the “Equity Insurance Risk Premium” is one such source of non-correlated returns.

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Motivation for Strategy

Implied volatility in equity index options systematically overestimates actual realized volatility

0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%

01/0

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Implied vs. Realized Volatility

VIX Realized

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Review of Option Pricing: Black-Scholes Model

Variables in option prices:– Stock price-known– Strike price-known– Time to expiration-known– Risk free rate-known– Volatility of stock price-UnknownVolatility estimates that are biased upwards, all else equal, create overpriced option prices.

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Explanation for Anomaly Lies within Behavioral Finance

Individuals place different values on interim gains and losses relative to a reference point, rather than on final wealth.Loss aversion: Individuals value losses greater than an equivalent gain, relative to the reference point.Variable risk seeking behavior: Individuals prefer an uncertain gamble with an expected loss over a guaranteed loss of the same amount.Individuals subjective perception of probability differs from objective probabilities, specifically overestimating low probability outcomes and underweighting all others.

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Implications of Behavioral Finance on Option Pricing

Prospect Theory: Loss avoidance (green area) valued more than gain foregone (red area), leading to higher value to option than under risk free arbitrage approach of Black-Scholes. Implied volatility is therefore biased upwards.

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Description of Strategy

Invest 50% in the S&P 500 and sell out of the money calls with a probability of exercise of approximately 20%Invest 50% in cash and sell out of the money puts with a probability of exercise of approximately 20%

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100% Equity

50% Equity/50% Bills

Covered Option Writing

Reduce Equity Risk

Add Insurance Risk

100% Bills

Hypothesis

The presence of an insurance risk premium will reduce risk and add diversified return

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Historical Performance

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%12

/01/

9209

/01/

9306

/01/

9403

/01/

9512

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9509

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9606

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9703

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0003

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Ret

urn

Rolling 3 Year Returns

Option Strategy

S&P 500

Equity/Bill Blend

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Historical Performance(1/90-3/12)

Diversification of equity insurance risk premium provides enhanced returns

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Annualized Return

Option Strategy S&P 500

50% S&P 500/ 50% Tbills

1yr 11.63% 8.54% 4.54%3yr 18.14% 23.42% 11.55%5yr 7.53% 2.01% 2.00%10yr 8.32% 4.12% 3.31%20yr 10.54% 8.59% 6.19%Inception 10.47% 8.71% 6.42%

Annualized Standard Deviation

Option Strategy S&P 500

50% S&P 500/ 50% Tbills

1yr 8.29% 16.08% 8.04%3yr 8.18% 16.00% 8.00%5yr 10.65% 18.92% 9.45%10yr 8.86% 15.92% 7.96%20yr 8.30% 15.03% 7.54%Inception 8.26% 15.15% 7.60%

Sharpe RatioOption

Strategy S&P 50050% S&P 500/ 50% Tbills

1yr 1.397 0.529 0.559

3yr 2.205 1.457 1.430

5yr 0.609 0.051 0.101

10yr 0.733 0.144 0.185

20yr 0.880 0.356 0.392

Inception 0.836 0.339 0.375

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Risks

Short term underperformance in periods of sharp market movements when options will be exercised.Underperformance in a trending market with low volatility.These risks are mitigated to some extent through the use of one month options and dynamic strike prices.

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A Final Thought: Selling Insurance vs Buying Insurance

Insurance buyer payoff is replicated by “buying high and selling low”.Profitable long term strategy is to do the opposite: “buy low, sell high”

Insurance Buyer Payoff Profile

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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.

Conviction in Equity Investing

Mike Sebastian

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Classifications of Manager Skill

Unskilled Underperform on averageafter fees and trading costs Net alpha < 0

No Evidence of Net Alpha

Earn enough excess return on average to cover fees and costs,

but no moreNet alpha ≈ 0

Skilled Outperform on average net of fees and costs Net alpha > 0

Our research separates investment manager products into three categories based on statistical analysis of returns

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Manager Skill, 1975-2011

0%

10%

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70%

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90%

100%

1989

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2011

Unskilled (BSW) No Evidence of Net Alpha (BSW) Skilled (BSW)

Unskilled (HEK) No Evidence of Net Alpha (HEK) Skilled (HEK)

Start of HEK Study

82.4%

15.9%

1.6%

Manager skill has steadily declined since the 1990s, and we estimate that only about 2% of products demonstrate evidence of true skill today. Success with active management requires a high bar.

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How Investment Committees Spend Time

Clients spend significant resources overseeing active managers; there is a fixed element to these soft costs that suggests an efficiency argument for using more active management if any is used at all

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Evidence on Outperformance of Higher Active Risk Managers

Study FindingAmihud and Goyenko [2012] Funds with lower R2 (greater deviation from the market) outperformBaks, Busse and Green [2006] Managers willing to take big bets outperformBrands, Brown and Gallagher [2005] More concentrated funds outperformCremers, Ferreira, Matos and Starks [2011] The most active funds outperform; closet indexers underperformDa, Gao and Jagannathan [2010] High active share and aggressive growth managers outperformDuan, Hu and McLean [2009] Managers exhibit stock picking ability only in high-volatility stocksHuij and Derwall [2011] Fund managers willing to take big bets, and with broader investment

strategies, outperform

Ivkovic, Sialm and Weisbenner [2008] Households with more concentrated stock holdings earn better returnsJiang, Verbeek and Wang [2011] Managers’ highest-conviction stock holdings outperformKacperczyk, Sialm and Zheng [2004] More concentrated funds outperformPetajisto [2010] The most active stock pickers outperform; closet indexers underperform

Wang and Zheng [2012] Hedge funds with strategies more distinctive from peers outperformWermers [2000] Funds that trade more actively outperform

There is significant evidence of a link between investment manager products with higher active risk (higher conviction on the part of the manager) and value added

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Active Manager Value Added and Active Risk

-0.3% -0.3%-0.5%

-0.1% -0.1%

0.2%

0.0%

0.7%0.8%

1.0%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1 (L

owes

t) 2 3 4 5 6 7 8 9

10 (H

ighe

st)

Aver

age

Annu

aliz

ed A

lpha

Deciles of Active Risk

Alpha by Level of Active Risk (Manager's Chosen Benchmark)

Closet Indexing Strategies

High ConvictionStrategies

Our research finds a strong link between active risk and performance relative to the benchmark

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Active Manager Value Added and Active Risk (cont.)

-0.7%-0.8%

-0.7%

-0.4%

-0.6%

-0.2%-0.3%

-0.5% -0.4%

1.0%

-1.0%

-0.5%

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1.5%

1 (L

owes

t) 2 3 4 5 6 7 8 9

10 (H

ighe

st)

Ave

rage

Ann

ualiz

ed A

lpha

Deciles of Active Risk

Alpha by Level of Active Risk (Fully Style Adjusted)

Closet IndexingStrategies

High ConvictionStrategies

When fully adjusting for manager style and risk, we find value added onlyamong the managers who take the most significant active bets

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Active Manager Skill and Active Risk

0.0% 0.0% 0.0%

2.0%

0.0%

2.4%3.6%

2.4%

5.2%

13.9%

0%

2%

4%

6%

8%

10%

12%

14%

16%

1 (L

owes

t) 2 3 4 5 6 7 8 9

10 (H

ighe

st)

Ski

ll Pe

rcen

tage

Deciles of Active Risk

Skill Percentage by Level of Active Risk

Closet Indexing Strategies

High Conviction Strategies

Evidence of true skill is much stronger among the most active managers

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A Risk Puzzle

Institutional investors spend significant time and resources on active managementBut active management accounts for only a small amount (5% or less) of typical total fund riskInvestors’ portfolios are positioned to earn less alpha than they expect

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A Solution

We recommend that investors consider one of two directions with their public equity investments:– An Efficiency equity portfolio that is 100% indexed to a broad global equity

benchmark– An Opportunity portfolio that maximizes the odds of success from active

management in a high-conviction approach that is 80% or more actively managed

We believe that the Efficiency model is optimal for most investors. Efficiency investors demonstrate conviction through a bold course of action of differing from peers who subscribe to the current model of active equity management.For investors unwilling to go to such extremes, at a minimum consider a strategy that combines indexing with high-conviction active strategies and avoids the expensive diversification of low active risk strategies and multitudes of actively managed portfolios.

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A Call to Action

We call on the major players in active equity management to step up their game:– Investment managers must focus on higher-conviction strategies that allow

their skill to flow through to client returns, and reject low active risk strategies whose alpha is eaten up by fees and trading costs.

– Consultants must also act with greater conviction, putting forward only their strongest recommendations, avoiding “safe” managers and being willing to recommend indexing instead in areas where credible products are lacking, or closed to new investors.

– Asset owners must look within themselves to discover whether they are true believers. Those who are (the Opportunity investors) must demand conviction from managers and consultants, but also defeat their own value-destroying tendencies to chase returns and fire underperformers.

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Thank you.

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, December 19th, at 10 a.m. CST.