LASERS Asset Allocation Follow Up

1
The Impact of Nontraditional Asset Classes on
Your Portfolio
June 21, 2006
Richard M. Charlton Chairman CEO
One Main Street, Cambridge, Massachusetts
02142-1524 [phone] F (617)
374-1313 www.nepc.com
2
What Is Risk?

• The perceptions (nonetheless important)
• Being different
• Newspaper risk
• Reelection risk
• The reality
• Legal/regulatory problems
• Failure to achieve satisfactory investment
  returns
• Event risk
• Excessive volatility
• The most common measure of investment risk is
  standard deviation of expected investment returns
• Standard deviation is a measure of the range of
  outcomes
• The industrys most common proxy for the
  estimation of risk

3
Using Standard Deviation to Measure Risk

• Consider an investment with an expected return of
  8 and a standard deviation of 5
• Nine periods out of ten, 67 of the actual
  returns will be between 3 and 13
• Nine periods out of ten, 95 of the actual
  returns will be between -2 and 18
• Can calculate the likelihood of failing to
  achieve any objective. For example, nine periods
  out of 10
• 50 chance return will be below 8
• 16 chance return will be below 3
• 5 chance return will be negative

4
The Importance of Reducing Risk

• Consider a 100 investment in two portfolios over
  2 years
• Each investment has a 0 average return, but
  different risk
• Risky Investment A
• Less Risky Investment B
• Investment A earns 50 in year 1 and loses 50 in
  year 2
• 50 and -50 0 average 2 year return
• Investment B earns 10 in year 1 and loses 10 in
  year 2
• 10 and -10 0 average 2 year return
• After 2 years, your initial 100 is now worth
• Investment A 75 (-13.4 economic, or
  compound, return)
• Investment B 99 (-0.50 economic, or
  compound, return)

5
Two Ways to Reduce Risk

• Invest in less-risky assets
• But this will generate lower returns,
• Inflation will further erode purchasing power of
  assets
• No chance of benefit increases at next
  negotiations
• In fact, likely that benefits will be cut
• Diversify
• Combining risky assets that have dissimilar
  return patterns can stabilize overall returns
  without reducing expected return
• (Dissimilar return patterns are uncorrelated, or
  poorly correlated)
• Can raise returns at current risk levels
• Or, lower risk levels from current levels while
  maintaining return

6
History As An ExampleWheres The Risk?
Asset Allocation as of 03/30/00
Real Estate
Cash
Intl Equity
Large Cap
Core Fixed
Equities 68
Fixed Income 32
Asset Allocation as of 09/30/02
Small/MidCap
Real Estate
Intl Equity
Large Cap
Core Fixed
Cash
Equities 49
Fixed Income 51
7
The Evolution of Diversification
2000s
Market Neutral
Portable Alpha
Global Asset Allocation
1990s
TIPS
Domestic Asset Allocation
Global Bonds
Real Estate
1980s
Private Equity
Small Cap
High Yield
Maximize Mgr Skill (Relax Constraints)
International Equity
Emerging Market Equity
Emerging Market Debt
Hedge Funds
Commodities / Real Assets
Currency Mgmt
8
Return/ Risk Frontier
Efficient frontier with domestic stocks and bonds
only the 1980s
100 Equities
100 Bonds
9
Return/ Risk Frontier
Efficient Frontier with diversifying financial
assets, w/o Alterative Assets the 1990s
Efficient frontier with domestic stocks and bonds
only
10
Return/ Risk Frontier 10 Risk Level
9.0 Return
8.5 Return
7.5 Return
Efficient frontier with domestic stocks and bonds
only
Frontier with diversifying asset classes, w/o
Alternative Assets
Frontier using Alternative Assets the 2000s
11
Asset Allocation - 10.0 Risk Level
Traditional Stocks and Bonds the 1980s
Large Cap Equities
Core Fixed Income
Equity 56.0
Fixed Income 44.0
Diversified Asset Classes the 1990s
Core Fixed Income
Intl Equity
Intl Small
Long Bonds
Small Cap Equities
Emerging Equities
Emerging Debt
Global Bonds
Large Cap Equities
High Yield
Fixed Income 49.0
Equity 51.0
Alternative Asset Classes the 2000s
Emerging Debt
Core Fixed Income
Intl Equity
Intl Small
Long Bonds
Emerging Equities
Global Bonds
Private Equity
Hedge Funds
Large Cap Equities
High Yield
Portable Alpha 10
Alt. 10.0
Equity 42.0
Fixed Income 48.0
12
Asset Class Allocations 10 Std Dev
13
Return/ Risk Frontier 8 Return Level
11.4 Risk
9.0 Risk
8.0 Risk
Efficient frontier with domestic stocks and bonds
only
Frontier with diversifying asset classes, w/o
Alternative Assets
Frontier using Alternative Assets
14
Asset Allocation - 8.0 Return Target
Traditional Stocks and Bonds the 1980s
Large Cap Equities
Core Fixed Income
Equity 67.0
Fixed Income 33.0
Diversified Asset Classes the 1990s
Intl Equity
Intl Small
Core Fixed Income
Long Bonds
Emerging Equities
Small Cap Equities
Emerging Debt
Global Bonds
High Yield
Large Cap Equities
Cash
Fixed Income 50.0
Equity 45.0
Cash 5.0
Alternative Asset Classes the 2000s
Emerging Debt
Intl Equity
Intl Small
Emerging Equities
Global Bonds
Private Equity
Hedge Funds
Large Cap Equities
Core Fixed Income
High Yield
Portable Alpha 10
Alt. 10.0
Equity 28.0
Fixed Income 62.0
15
Asset Class Allocations 8.0 Return Target
16
Actual NEPC Client Asset Allocation Changes
Asset Allocation as of 06/30/02
Small/MidCap
Real Estate
Cash
Intl Equity
Large Cap
Core Fixed
Fixed Income 34.7
Equities 53.8
Market Neutral
High Yield
Asset Allocation as of 06/30/05
Global Fixed
Small/Mid Cap
Large Cap
Core Fixed
Real Estate
Intl Equity
Equities 65.3
Fixed Income 27.3
High Yield
Market Neutral
Target Allocation
Mid Cap
Global Fixed
Small Cap
Alternatives
Intl Equity
Large Cap
Core Fixed
Equities 58
Fixed Income 25
Real Estate
17
Enhanced SP 500 Performance
Total Return vs. Risk 3 Year ending 03/31/06

Fund
Median
SP 500
18
Rankings Dramatically Improve
Prior to NEPCs Engagement
Four Years Later
19
Case Study NEPC Client
Fixed Income
Domestic Equity
Intl Equity
Portable Alpha
Portable Alpha
Alternatives
Absolute Return
EMD
Large Cap
Long Bonds
HY
Devl
SC
EM
Mid Cap
SC
Fixed Income 31
Equity 37
An alternative approach to bundled management
20
Customized Portable Alpha Overlay
Total Return vs. Risk 5 Year ending 03/31/06

Overlaid SP 500
Portable Alpha Plan
Median HF
Large Core Median
SP 500
21
Case Study NEPC Client
Composite
S P 500
Lehman Aggregate
22
Case Study NEPC Client
Composite
Lehman Aggregate
S P 500
23
Alternatives are Attractive

• Private equity, venture capital, mezzanine, etc.
• Return enhancers
• Early entry into private investment opportunities
• Trade off liquidity for the prospect of higher
  returns
• Hedge funds, funds of funds
• Risk reducers
• Returns tend to be mostly alpha (value added)
  rather than beta (benchmark generated)
• Returns, therefore, tend to be moderate,
  consistent and independent from traditional
  benchmarks
• Relationship between hedge fund return patterns
  and traditional long-only asset class return
  patterns is low (favorable)
• Returns can be isolated and overlaid onto
  traditional long-only benchmarks where alpha is
  otherwise difficult to generate

24
Alternative Asset Fee Considerations

• Alternative asset value proposition
• Unfunded liabilities for pension funds have
  increased
• Benefits are under increasing pressure
• Traditional asset classes expected to
  underperform
• Alternatives offer prospect of improved
  performance
• Alternative asset cost drivers
• Analysts are highly specialized, in demand, more
  highly paid
• Large, well-known funds may be closed to new
  investors
• Must continuously find appropriate strategies
• Industry players constantly changing
• No reliable industry-accepted database of
  managers
• Due diligence is costly and time-consuming
• Background checks required
• Complex legal documentation and negotiation
  required

25
Costs Related to Alternative Assets

• Hedge Funds
• Estimated 8,000 hedge funds
• Hundreds of new managers enter the space annually
• Approximately 10 fail per year
• Finding truly institutional funds with capacity
  is time-consuming
• Monitoring performance requires customized
  software
• Source of alpha
• Volatility, liquidity, leverage, correlation and
  style-drift
• Software costs often escalate as assets increase
• Due diligence requires analyzing more than
  returns
• Strategy mix
• Operational controls
• Pricing policies
• On-site visit necessary for proper due diligence

26
Costs Related to Alternative Assets

• Private Equity
• Fund-raising window for new partnerships is often
  narrow
• New products have very limited shelf lives
• Client liquidity needs must be matched with
  manager characteristics
• Venture stage, sector, vintage year
• GP evaluations require reviews of all underlying
  cash flows
• Attribute performance to individual partners and
  industry sectors to determine true value creators
• Customized software monitors each cash flow from
  each portfolio company and partnership
• Costs increase as assets increase
• As fund ages, addressing amendments to the
  limited partnership agreements becomes more
  time-consuming