Risk Allocation Strategies for Long-Term Market Outlook

1. LAPERS Conference Investment Education for Trustees September 16, 2018 Phillip R. Nelson, CFA Partner, Director of Asset Allocation

2. Investment Education for Trustees What is Risk Long-Term Market Outlook Allocate Risk More Efficiently

3. What is RIsk

4. The Long-Term challenge All investors face the same fundamental challenge Capital + Investment Earnings equals Obligations + Expenses Adjustments are required to balance the equation if earnings do not meet return objective Contributions must be higher or obligations + expenses lower Adjusting risk exposure is the most fluid lever Take more risk or allocate risk more efficiently to meet target Requires an understanding and awareness of risk And an understanding of both assets and liabilities to determine the “right” amount of risk in a portfolio • C + I = O + E

5. What Is Risk? Risk is the perception of an adverse outcome Risk of not meeting the long-term return goal Risk of low probability event (tail risk) Risk of permanent loss of capital Risk of underperforming policy and peers Many risks can be limited with a strategic plan Based on investors’ circumstance, preference, and overall objective Risk mitigation approaches take on many forms Diversified and risk balanced asset allocation policy Tactical asset allocation shifts Diversifying investment approaches

6. Meeting Expectations Is The Key Risk The primary risk is falling short of the return goal What is the dollar impact of not reaching your return target? What is the entity’s economic cost to fund the obligation? Example: Actuarial expected return = 7.5% 70/30 allocation falls short of the target with a 6% expected return Shortfall analysis displays dollar impact of not meeting return goal

7. Can US Assets Meet your Target Return? Source: Yale – Shiller Data, Bloomberg

8. Long-Term Market Outlook

9. Portfolios are becoming more complex Source: (Bottom) *Based on NEPC’s 30 Year Capital Market Assumptions

10. Consensus investment outlook LOW RETURNS

11. The Longest US Bull Market Source: S&P, Bloomberg, NEPC

12. a trillion dollar Rally Source: Bloomberg, NEPC

13. How Far are we from the top? Source: Bloomberg, NEPC

14. Building Blocks of Equity Returns

15. Is the Recent History Sustainable?

16. can we be more Efficient with Risk TOday? Index Inception: S&P 500 - 1926, MSCI EAFE – 1970, MSCI EM – 1988, US High Yield – 1983, US Core Bonds – 1976, US TIPS – 1997 Source: Ibbotson-Morningstar, eVestment, Sharpe Ratio range spans 5th to 95th percentile

17. prospects for the future We encourage reducing exposure to assets that have outperformed over a prolonged period such Tilt exposure to assets underperforming expectations in recent years, particularly emerging market equities Public market asset returns offer less support for investors to achieve target objectives A mature private markets portfolio is a key contributor to meeting long-term portfolio objectives Improving the return outlook involves trade-offs May include higher portfolio level risk, use of leverage, illiquidity, and greater tracking error relative to benchmarks and peers Each trade-off needs to be evaluated appropriately in context of the program’s investment goals

18. Allocate Risk More Efficiently

19. An Introduction to Beta Groups Employ a classification system to facilitate portfolio management decisions Provide a framework to align portfolio exposures with overall investment objectives Goal of beta groups is to ensure portfolio structuring supports investment objective Beta Group Structure

20. What are Beta Groups Assign each investment to a beta category to view the portfolio with a beta group lens

21. Why Beta Groups Optimization of public market asset classes will not be sufficient to meet elevated return expectations Incorporating illiquidity, fees, and complexity must be evaluated in the context of the overall objective Beta groups are a portfolio construction tool to address constraints for the modern investor Source: *Based on NEPC’s 30 Year Capital Market Assumptions

22. Beta group: Equity example Beta group investment objective is total return relative to an opportunity cost of MSCI ACWI IMI Core Exposure: Main corpus of beta group. Market-cap weighted exposure to passive US equity and active approaches for EAFE and EM Dynamic Exposure: Use of non-US small-cap approach to add exposure to small companies, increased capital commitment to Europe/Asia private markets Opportunistic Exposure: Smaller satellite investments in European venture capital, long/short Japan equity approach, biotech sector fund • Opportunistic Equity Exposure • References an idiosyncratic or thematic opportunity. (e.g. Biotech sector fund) • Dynamic EquityExposure • Expresses cyclical over/under weights relative to strategic target. (e.g. Overweight EAFE or underweight US buyout funds) • Core EquityExposure • Represents the opportunity cost of the beta group (e.g. MSCI ACWI IMI) and strategic private market exposure

23. Define an opportunity cost Opportunity cost should be a liquid and an easily- referenced market index (e.g. MSCI ACWI IMI) Opportunity cost serves as a long-term benchmark Evaluate investment decisions within the beta group relative to the appropriate opportunity cost Opportunity costs will differ across investors Credit/Rates: Opportunity Cost Example Public DB Plan: US Aggregate Bond Index Endowments & Foundations: US TIPS Taxable Investor: US Municipal Bond Index Corporate DB Plan: Long Corporate Bonds

24. Equity Beta group – opportunity Cost

25. Other considerations Improving portfolio efficiency involves trade-offs Trade-offs include portfolio risk budget, Illiquidity, fees, tracking error to benchmarks and peers Each need to be evaluated appropriately in context of the program’s investment goals Goal helps to ensure portfolio structuring supports the overall investment objective Beta group construct can introduce material peer risk and complicate performance assessment Beta groups are a complement not a replacement for traditional asset allocation tools

26. Asset Allocation Risks Are More Clear Beta group approach provides more accurate risk profile view and clarifies investment objective

27. Beta Group Case 1: Hedge Funds Hedge funds exhibit persistent beta exposures Beware of naïve diversification when setting asset allocation targets for “hedge funds” Moving hedge funds into applicable beta groups is a better reflection of both fund and portfolio risk Source: eVestment

28. Case 2: Private Markets Private markets have an underlying beta exposure Classify illiquid approaches according to their sources of price risk and/or beta exposure Liquid market proxies are a funding source for private markets and align investment objectives Source: ThomsonReuters

29. Practical Considerations Governance Investment Policy Statement changes Board/Committee education Defining benchmarks for beta groups and components Risk Management Develop process for adjusting portfolio exposures Frequency of review, ability to act (also governance) Performance Reporting Reworking reports can be challenging; consider using framework for risk management and allocation decisions Beta groups should have sub-composites to account for less-frequent private market reporting

30. ExampleBeta GroupAllocation

31. Sample Equity Beta Group Proposed Allocation Liquidity Geography

32. Sample Credit/rates Beta Group Total Allocation Liquidity* Breakout Geographic Breakout *Illiquid is defined as any allocation with a reasonable expectation of quarterly on 90 days’ notice or greater to process a redemption

33. Sample Real Assets Beta Group Total Allocation Liquidity Sub-Beta Exposure* * “Other” includes natural resource equities, which include underlying energy exposure.

34. Key Final Questions What level of complexity do you desire or can you manage effectively? How sensitive are you to peer results? What are the liquidity needs and tolerance for illiquidity risk? Do you have a time horizon to tolerate strategy underperformance relative to the benchmark? Is there a stated fee budget and do you look to balance the use of active and passive approaches? What is your overall investment objective? 34

35. Disclaimers & Disclosures • Prepared exclusively for attendees of the LAPERS Conference. Not for redistribution. • The opinions presented herein represent the good faith views of NEPC as of the date of this presentation and are subject to change at any time. • The comments provided herein should be considered a general overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. • Information used to prepare this report was obtained directly from various external sources. While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within or the completeness of such information. • All investments carry some level of risk. Diversification and other asset allocation techniques do not ensure profit or protect against losses. • NEPC does not generally provide legal, regulatory or tax advice. Please consult your attorney or tax advisor for assistance as needed. • Past performance is no guarantee of future results.