C HANGE THE M EASURE : M EASURE THE C HANGE : Are We Incenting Managers Properly? ”Institutional investors will return to the basics over the next 10 years, says a report from McKinsey & Co. It predicts investors will move away from a focus on beating benchmarks and maximizing alpha regardless of market conditions to one that emphasizes meeting fundamental investment objectives. ‘The Best of Times and the Worst of Times for Institutional Investors’ found that among the major shifts investors need to make in order to adapt to the new market landscape is to adopt a more forward looking investment approach involving more communication with managers on their objectives and strategies.”

2 Typical regional asset allocation approach will have different risk implications than when it was implemented in the 90’s MSCI EAFE S&P 500 Bonds TSX Hire specialists in each silo Reward them for beating their benchmark Control risk through low asset correlation

3 Globalization is a Reality Globalization has led to a much more integrated economy World Bank & Central Bankers share and cooperate to a much higher degree Multilateral and bilateral trade agreements have increased market links Euro zone has imposed Fiscal & Monetary constraints A single currency One labour pool Inflation, interest rates, have moved in the same direction in most developed markets

4 Over the past 15 years correlations have moved from 36% to over 85% between North American markets and the rest of the Globe 1 Importantly market corrections are largely occurring together Recent Corrections in the S&P/TSX vs. the S&P 500 and MSCI EAFE FromTo S&P/TSX (CAD) S&P 500 (USD) MSCI EAFE (USD) June 18, 2008March 6, %-47.87%-53.58% July 19, 2007Aug 16, %-8.97%-12.18% April 19, 2006June 13, %-6.27%-9.74% Sept 11, 2002Oct 9, %-14.45%-13.47% Global Markets Have Arrived Source: Bloomberg

The Pattern of Market Returns is Not Helpful 5 If higher correlations are the new norm, then this pattern is likely to represent your whole equity portfolio Perhaps this structure and the measurement are not appropriate As Managers, if staff achieve a goal ten times in ten, but the company is put into distress four times in ten, would you change your metric?

6 “Sometimes the Way we Look at the Problem is the Problem” Stephen R. Covey 23% Financial Exposure As at June 30, % S&P/TSX & 40% MSCI World Consumer Discretionary7.69 Consumer Staples4.77 Energy20.15 Financials28.65 Health Care3.93 Industrials7.93 Information Technology6.50 Materials12.54 Telecommunication Services5.28 Utilities2.55 Total Typical Balanced Portfolio – June 30, 2007Typical Equity Portfolio 28% Financial Exposure An index does a reasonable job of defining the choice of companies available, but maybe not the characteristics of the right companies to invest in to fund a Pension Plan

7 An index portfolio 15 years ago versus the last 5 years Higher correlations imply higher volatility with no return enhancement Approaches that control “tracking error risk” will see total portfolio risk increase 100% Equity Correlation from 15 Years Ago Correlation in the last 5 Years 100% Bond Source: Zephyr StyleADVISOR

Can we restore diversification? Bottom up portfolio construction still seems to offer diversification opportunity Broader mandates with fewer restrictions 8

9 Sectors offer better diversification than markets Correlation average of 0.69 versus 0.85 for regional markets Securities are less correlated than sectors MSCI WorldEnergyMaterialsIndustrials Cons Disc Cons Staples Health CareFinancials Info Tech Telecom ServicesUtilities MSCI World1.00 Cons Disc Cons Staples Energy Financials Health Care Industrials Info Tech Materials Telecom Services Utilities Years as at September 30, 2011

10 Control Risk through security selection and sector exposure not market weightings A security and sector driven approach has the opportunity to restore some diversification and mute volatility. 100% Equity Correlation from 15 Years Ago Correlation in the last 5 Years 100% Bond Addressing diversification with sector and security exposure can reduce risk levels Source: Zephyr StyleADVISOR

Heisenberg Uncertainty Principle “ The Presence of the Observer Changes the Nature of the Observed ” 11 In investment management, the measurement changes the behaviour of the measured  Closet indexers exist as a result of measurement to a market benchmark  One third of active fund strategies studied were judged to be “closet indexers” All Equity Mutual Funds in the U.S If the incentive goal is not changed, the portfolio construction will likely not change

Decide on a Goal that Serves Your Plan’s Need 12 For most pension investors, an absolute goal of CPI + 5% for the equity portion is likely of better service to the plan than to outperform a market portfolio  The greater the consistency, the better The pattern of return matters  Loss of capital has greater repercussions than outsized gains  Pension plans have difficulty storing surplus Long-term results for the S&P indicate approximately a 9% return Would you trade potential upside for stability? Much evidence suggests there may be no return loss for the greater return stability

Risk & Reward in Equities May Not Be Positively Correlated Source: Blitz, David and Van Vliet, Pim, The Volatility Effect: Lower Risk Without Lower Return (April 2007). Journal of Portfolio Management, pp , Fall 2007 Blitz, van Vliet 1986 – 2006 (global) 13

14 Client, consultant manager interaction needs to be broad and in depth to achieve the results Plan’s need Mandates should be broad and flexible enough to allow managers to use the breadth of economic sectors and the depth of companies to access the diversification available Benchmarks should be more focused on what the plan needs to achieve Benchmarks should be focused on risk adjusted return, not simply value add