2007 INSTITUTIONAL CLIENT CONFERENCE Innovative Leadership, Creative Solutions © 2007 Northern Trust Corporation N O R T H E R N T R U S T Portable Alpha Investing The Separation of Alpha and Beta John Krieg, CFA Director, Investment Product Management Northern Trust Global Investments Wayne Bowers Director, Global Fixed Income Northern Trust Global Investments

2  Why all of the Interest in Portable Alpha?  What is Portable Alpha?  Anatomy of a Portable Alpha Strategy  Alpha Generating Strategy Review  Fixed Income as an Alpha Source  Portable Alpha in an LDI Framework  Concluding Thoughts Portable Alpha Table of Contents

3  Lower return expectations, compressed spreads, and relatively low interest rates have resulted in investors “searching for alpha.”  Desire for efficient and flexible investment strategies that help manage (not eliminate) risk.  Hedge fund (and other risky asset classes) flows hit record levels in  Increased acceptance of derivatives, synthetics or structured products to implement an asset allocation.  Pension Protection Act (PPA) and FAS 158 have changed the landscape for defined benefit plans. Portable Alpha Why all of the Interest in Portable Alpha? The market environment and changing objectives have led investors to consider alternatives to traditional portfolio management.

4 Total Return Alpha Beta Derived through manager’s skill Generated through market exposure Sources Fundamental Active and Quantitative Strategies Hedge FOF /Market Neutral Libor +, Credit/Currency GTAA, Multi-Strategy HF Index Replication Strategies Index Derivatives (exchange traded and OTC) Separating Alpha & Beta create the building blocks of constructing portable alpha strategies. β α Separating Alpha and Beta

5 What is Portable Alpha? S&P 500 Futures Short Duration Fixed Income Portfolio (LIBOR + 100) S&P 500 Futures Proceeds A financial engineering process of applying the alpha generated by any asset class strategy to another distinct market index or portfolio. β α += 100 Basis Points of Additional Return

6 Derivatives Market – Depth and Breadth The derivative market’s rapid growth and increasingly higher trading volumes are making derivative securities highly liquid investments. The depth of OTC derivatives is evident by the active market across most market indices. OTC Derivatives Market $450 trillion Bond Market $65 trillion Equity Market $40 trillion * Source: BIS, NTGI Research

7 Derivatives Market – Growth The OTC Derivatives Market has grown approximately 30% per year since 2000

8 Portable Alpha – Investor Activity Growth in Derivative Based Enhanced Strategies (e.g., Stock Plus type products) has boomed over the past 3 years.  Assets in Derivative Based Enhanced exceeded $50 billion (1) as of The Top 200 U.S. Pension Plans had nearly $33 billion in portable alpha strategies. Investors are increasingly considering alternatives to traditional portfolio management. FundFire.com (Feb ’07) cited a recent survey of over 200 US corporate and public plans:  28% of the survey indicated they are in portable alpha strategies and looking to expand their investments Note: (1) Callan Associates and Northern Trust

9 The market environment and changing objectives have led investors to consider alternatives to traditional portfolio management. The concepts of alpha and beta separation are becoming widely accepted. We are still in the early stages of using portable alpha. The growth of the derivatives market makes portable alpha a reality. Portable Alpha - Market Summary We believe that portable alpha is a viable option in today’s market

10 What is Portable Alpha? Passive Enhanced Index Quantitative Active Fundamental Active Fees Tracking Error Excess Return Choosing the market exposure (beta) first limits your opportunity set. Once a strategic asset allocation is determined, investment strategies are chosen within each asset class. For example, a 70% allocation to domestic large-cap equities is implemented through a S&P 500 Index, Enhanced Quantitative or Active strategy. The Traditional Approach….. Index Plus

11 What is Portable Alpha? The Portable Alpha Way…. The Alpha generating source is considered first under Portable Alpha. Select consistent alpha sources, regardless of asset class or beta exposure.  Incorporates a broad set of investment strategies ranging from long-only to hedge funds.  Provides the flexibility of combining alpha strategies that are less than perfectly correlated.  Allows for more customized solutions to better fit your investment objectives and generate more risk-efficient returns. The appropriate beta (market) exposure can be replicated through derivatives or synthetic instruments.

12 The Anatomy of a Portable Alpha Strategy = Alpha ++ Beta R2000 Alpha Libor Interest Rate Swap Floating Rate Beta R2000 Beta Interest Rate Swap Fixed Rate Beta (1) Interest Rate Swaps are the beta exposure used to hedge the interest rate risk of the DB Plan’s Liabilities. A B CD Transporting Small Cap Equity Alpha

13 Beta R2000 Alpha A. Identify Alpha Generating Strategy Beta R2000 Index Alpha The Anatomy of a Portable Alpha Strategy Identify an active investment manager who has consistently generated total returns in excess of the small-cap equity index. Capture the active manager’s alpha by investing in this strategy while shorting the small-cap market exposure. Total Return

14 LIBOR (1) Beta R2000 Index Receive Pay + The Anatomy of a Portable Alpha Strategy The hedge is conducted through a short position in a total return swap on the Russell 2000 Index. The investor pays the total return on the Russell 2000 Index and receives LIBOR (1). (1) For ease of explanation, this example assumes the swap trades at Libor flat. B. Short unwanted Beta exposure

15 LIBOR Interest Rate Swap Floating Rate Beta Interest Rate Swap Fixed Rate ++ The Anatomy of a Portable Alpha Strategy C. Capture Desired Beta Exposure Receive Pay Under an LDI framework, investors can use interest rate swaps to capture the necessary interest rate exposure (beta) to match the plan’s liabilities. Going short the interest rate swap results in receiving a fixed-rate payment and paying LIBOR.

16 ++ The Anatomy of a Portable Alpha Strategy = D. Port Small Cap Alpha to Beta Alpha Beta Interest Rate Swap Fixed Rate Transporting the small-cap alpha to this interest rate swap positions the investment strategy to generate excess returns over the plan’s liabilities.

17 The Anatomy of a Portable Alpha Strategy = 2.30% % 2.30% 5.25% 13.00% 5.00% (1) Interest Rate Swaps are the beta exposure used to hedge the interest rate risk of the DB Plan’s Liabilities. Transporting Small Cap Equity Alpha An efficient total return strategy generating an absolute return of 7.3% or 2.3% over any designated index. A B CD

18 Identifying Alpha Generating Strategies The alpha engines used in portable alpha strategies have expanded from long only equity and fixed income to alternative asset classes. An alpha target or risk tolerance helps define the alpha sources used in portable alpha strategies. Alpha sources need to consistently demonstrate out-performance (over rolling periods) and have high information ratios. Liquid, diversified and uncorrelated strategies are ideal. Investors should look for alpha that can be easily separated from known beta or alpha strategies with little to no underlying beta exposure. Higher alpha generation eventually comes at the cost of increased beta exposure, lack of transparency, and/or increased leverage. We believe identifying and generating consistent sources of alpha are a major challenge in a portable alpha strategy.

19 Portable Alpha Strategies Across the Return Spectrum Enhanced Cash Libor Equity (1) (Long Only) Quant 130/30 (1) Currency/Credit Mkt. Neutral HF Hedge Fund FOF Multi-Strategy 50 – 100 bps100 – 200 bps200 – 400 bps400 – 600 bps Active portfolio of short duration fixed income securities with an average portfolio duration of less than 1 year. Goal is to outperform the short term financing rate of LIBOR. Active portfolio that seeks to exceed the market return. A skilled portfolio manager generates alpha through security selection, sector allocation or other active investment decision. 130/30 is typically a quantitatively managed strategy that goes long 130% and short 30%, with a neutral beta of 1 to a particular index. A currency/credit strategy manages long/short currency in developed and emerging markets through pair trades. A market neutral HF minimizes market risk or beta exposure through long and short positions that offset each other. Hedge FOF is a diversified pool of hedge funds that invests in a variety of strategies among multiple managers. Multi-Strategy hedge funds manage a basket of low correlation strategies determined by the manager. Strategy: Alpha: Description: (1) The beta exposure would need to be shorted to be used as an alpha strategy.

20 Global Fixed Income Market by Currency & Broad Sector Type Multi-dimensional Exposure  Global Interest Rate Exposure  Currency Exposure  Global Credit Exposure Multi-exposure instruments  Buying three 20 year bond issues in Euros, Sterling, & Dollars from the same corporate issuer will impact duration, credit and currency exposure. Source: Lehman Brothers, NTGI Fixed Income as an Alpha Source Global Fixed Income – Past and Present

21 Single exposure instruments (Derivatives)  Targeting the risk you want; Eliminating the risks you don’t want. The development of the derivatives market enabled efficient implementation of ideas. Moving away from benchmarks towards absolute return strategies. The risk budget sources remain the same (e.g., interest rate, currency and credit), however the implementation results in more efficient alpha. Fixed Income as an Alpha Source Markets & Solutions have been evolving - and so have the approaches to managing risk

22 Fixed Income as an Alpha Source Forecasting expected ranges and price movements across interest rates, credit and currencies is required to generate alpha. Combining these forecasts provides the framework for managing risk. Dollar Index – Investment Strategy Investment Grade Credit Spread US Int. Rates – Mkt. Yields vs. 6 Month Forecasts

23 Fixed Income provides a framework for efficient implementation of investment solutions Investment forecasting idea process stays dynamic Implementation strategy is key; removing unwanted risk Client driven move away from benchmarking to absolute return Portable Alpha sheds a new light on fixed income investing Enhanced Cash Credit Overlay Currency Overlay …is this the future? Fixed Income as an Alpha Source

24 Assessing the performance of the overlay approach... Significant out performance over traditional benchmarks. Lower volatility. More appropriate risk taking. Fixed Income as an Alpha Source Overlay strategies can result in:

25 Considerations when Selecting an Alpha Strategy Consistency of return Overall alpha strategy volatility Leverage Counterparty risk Liquidity risk Lack of alpha diversification Alpha Strategies are not without risk…

26 Considerations for Long or Short Beta Positions A successful portable alpha strategy needs to take into consideration an effective beta implementation. Timing is critical as markets move. Beta management is not a transaction.

27 Portable Alpha in Action How are investors using Portable Alpha today? Portable alpha works particularly well in an LDI framework.  Provides the flexibility to structure customized strategies.  Allows for the separation of the hedging and alpha decisions in the portfolio.  Results in meaningful improvements to the overall portfolio information ratio.

28 Portable Alpha and Extended Duration Strategies for LDI Portfolio A is a 70% S&P 500 and 30% LB Aggregate Portfolio Black segment represents an increasing long duration assets and decreasing equity exposure. Red segment represents a 100% allocation to various alpha strategies transported to interest rate swaps. Portable alpha strategies provide a risk-efficient means of generating excess return over a plan’s liabilities.

29 Measuring Efficiency of LDI Strategies Comparing returns to tracking errors for similar return generating strategies helps determine overall performance efficiency. Portable alpha strategies present higher LDI information ratios.

30 Adding Portable Alpha to a Current Allocation Blue segment represents increasing allocations to a hedge fund-of-funds strategy and decreasing allocations to equities. Portable alpha for a portion of the overall portfolio still creates the opportunity for risk-efficient excess return.

31 Concluding Thoughts Alpha Asset Allocation/ ALM Portable Alpha While derivatives and leverage are often cited as primary risks in a portable alpha strategy, these perceived risks are quite low. Derivatives allow the flexibility of more efficient means to implement your risk budget. Identifying and generating consistent alpha is a major challenge. Consider fixed income as an alpha source. Portable Alpha allows investors to separate the asset allocation decision from the alpha decision while still maintaining a strategic asset allocation. Beta Portable alpha is here to stay.