Tactical Asset Allocation in Bull/Bear Markets

1. Tactical Asset Allocation in Bull/Bear Markets Timothy J. Marchesi, CFA President, CEO & Co-CIO DeMarche Associates, Inc.

2. Agenda • Importance of Asset Allocation • Tactical vs. Conventional Approach • Economic & Market Environment • Supercycles • Dynamic Investment Strategies

3. Importance of Asset Allocation • Studies estimate that asset allocation decision accounts for 91.5% of the variation between returns of different funds 1 • Asset mix optimization models mathematically seek maximum expected rate of return for a given level of risk (or minimization of risk for a given expected return) 2 1 Financial Analysts Journal, May/June 1991 – Brinson, Singer & Beebower 2 Global Asset Allocation Techniques for Optimizing Portfolio Management, 1994 – Lummer & Riepe

4. Review of Conventional Approach • Inputs based upon history • Typical models assume “average” future outcomes • Often ignore starting /ending market levels

5. Review of Conventional Approach • Typical models assume “average” future outcomes (sample chart below) 12% 10% 8% 6% 4% 2% Emerging Equities Small Cap Equities Large Cap Equities Hedge Fds Bonds Today 2015 2020 2025 2030

6. One-Year Returns Are Volatile Models incorporate standard deviation to manage risk

7. Model Optimization:The Efficient Frontier

8. What is Tactical? Webster’s: • “Small-scale action to serving a larger purpose” In Investment Management: • Method of modifying asset allocation based upon valuation estimates and judgments of the future return of markets or sectors

9. Time Horizon for Investment Objectives Asset Allocation Study has both a strategic perspective and a long-term secular perspective Investment Horizon ShortTerm Long Term Tactical Asset Allocation Strategic Asset Allocation Secular Asset Allocation Market Timing Several Market Phase Cycles Multiple Market Supercycles One Year Or Less Current Market Phase Cycle

10. DeMarche Market Phases A typical market cycle has four distinct phases: Stock Stock Corporate Corporate Total Total Tactical Market Phase Tactical Market Phase Prices Prices Earnings Earnings Return* Return* Phase I Phase I – – Early Bull Early Bull é é ê ê 62.0% 20.8% 0.5% -27.0% Phase II Phase II – – Bull Market Bull Market é é é é Phase III Phase III – – Late Bull/Early Bear Late Bull/Early Bear ê ê é é Phase IV Phase IV – – Bear Market Bear Market ê ê ê ê *Annualized cumulative returns of S&P 500 Index. Study based upon monthly data from 1/31/63-9/30/11. The annualized cumulative return for the full study period was +9.5%. Source: DeMarche Research

11. Markets Change Markets change over long periods of time • As markets change, relative value between asset classes changes • DeMarche research has acknowledged and identified these long wave markets as “Supercycles” • Multiple bull and bear markets exist within each “Supercycle”

12. DeMarche Supercycle Study

13. DeMarche Supercycle Study *As of 3/31/2011. Cumulative returns are shown for each cycle (non-annualized).

14. The Consumer in Supercycles

15. New Normal Macroeconomic Environment • Demographics • “Boomers” retire or shift emphasis from consumption to saving • Consumers gradually improve their finances • Paying down debt / increase savings

16. New Normal Macroeconomic Environment (cont’d) • Unemployment • Wage growth remains slow • Less help from asset gains (wealth effect) • Higher taxes

17. Strategic Implications ofCurrent Supercycles • Stock returns likely to underperform mean • Bond returns likely to underperform mean • Policies need other strategies to improve expected risk/return outcomes

18. Asset Allocation – Expected Returns Next 5 Year “Strategic” Period versus Long-Term “Secular” Time Horizon Source: DeMarche Associates. See notes on next slide.

19. Asset Allocation – Expected Returns (cont.) • Notes for chart on prior page: • Represents geometric return estimates for the 5 years beginning January 2012, compared to long-term average geometric returns over multiple Supercycles (no specific beginning point). 5-year horizon utilizes an assumption of a moderate economic growth environment within the current Supercycle, as defined by DeMarche. • U.S. Fixed Income has poor E.R. over the strategic period. Such assets presently have very low current income yield and are at risk of principal value losses as interest rates rise. • Other asset classes are shown for comparison.

20. Dynamic Investment Strategies • Hedge Funds • Global Tactical Asset Allocation (GTAA) Funds • Lifecycle or Target Date Fund (TDFs) • Intro to some assets used by dynamic strategies • Commodities • High Yield Bonds • Emerging Market Bonds

21. Brief Intro to Hedge Funds and GTAA Strategies • Different HF Fund of Funds approaches for clients • Conservative – emphasis on diversification, lower volatility • Strategic – more use of directional market bets, leverage • GTAA is long-only, relative valuation-based • Fees higher with HF • Limited transparency with HF • GTAA correlation is high (vs. stocks/bonds) • Wide variance across manager/strategies

22. Sample Range of GTAA Fund Approaches

23. What is a Target-Date Fund? • Description of TDF (or Lifecycle Fund): • Diversified investment option • Target a specific retirement year (2020, 2030, etc.) • Professionally managed • Stock allocation reduced as retirement year nears • Disciplined rebalancing of underlying funds • May use less-traditional investments

24. Example of TDF Asset Allocation Fewer equities as participant retire date nears Source: PIMCO, compiled by MarketGlide.

25. TDF Glidepaths Programs reduce equities over time; some have tactical range

26. Brief Intro: Commodities Energy, Metals, Agriculture, Livestock Weights differ among several indexes S&P has 65-75% Energy: others cap at 33% Portfolio diversifier Hedge against unexpected inflation Slight negative correlation to stocks & bonds in past Liquidity varies; fund choices very distinct Key concerns: China, oil, gold Total return from commodities comes from combination of: rolling futures contracts (roll yield), yield from the cash collateral, and the spot price gain or loss. Derivatives use is widespread (active or passive).

27. Brief Intro: High Yield & Emerging Market Bonds Both have low correlations to U.S. Bonds U.S. High Yield Bonds Quality ratings of “BB” or lower (below investment grade) Average maturities 3-10 years High level of current income payments Default risk rises in recessionary periods Higher volatility and potential losses than other fixed income Emerging Market Bonds are investment grade Obligations of foreign government or corporation Average maturities 3-10 years Higher fees (management, transaction, custodial) Political, liquidity, and other risks differ from U.S. bonds Currency risk (some issued in U.S. dollars)

28. Recommendations • Adjust asset allocation more frequently • Incorporate Supercycles • Emphasize liquidity • Diversify • Increase allocation to dynamic strategies

29. Questions? Thank you!