Diversifying Portfolios

Disclaimer This presentation contains my personal views The structure is still a work in progress I work for a public entity in the United States ○ According to a broad swathe of the US population I am ■ Lazy ■ Incompetent ■ Corrupt ■ Overpaid I am thrilled to be correct 51% of the time There is no guarantee the ideas in this presentation are in the 51% 2

Illinois Teachers’ At a Glance Was founded in 1939 Has 400,000 active or retired members Manages a $45 billion asset pool Pays out $5 billion in benefits annually Receives $4 billion in contributions annually Is 42% funded ○ Not the worst in America! Has a 7.5% actuarial assumed rate of return Invests $3.7 billion in risk parity and GTAAs Invests $3.4 billion in absolute return strategies 3

TRS’ Target Asset Allocation 4

Agenda 5 Factors as building blocks Diversifying strategies Implementing a hedge fund program

Factors as Building Blocks 6 All asset prices can be reduced to a series of expected cash flows that have various environmental and behavioral sensitivities Prices are the market’s “best guess” of future cash flows coupled with environmental predictions Take this framework and decompose assets into factor sensitivities ○ Build portfolios focused on factor diversification ○ Robust way to include non-traditional investments

Factors as Building Blocks 7 Source: BlackRock

Fundamental Factors / Premia Risk transfer from one party to another ○ Purchase of an economic interest ■ Exposure to negative environments ○ Buyer must be compensated for bearing this risk ■ Positive expected return of all risky assets over time Prices of these economic interests are driven by changes in expected growth and inflation ○ Equities ■ Growth surprise risk ○ Fixed income ■ Inflation surprise risk 8

Behavioral Factors / Premia Sensitivities to anomalies or behaviors of the marketplace that are better explained by market segmentation and participant bias Individual assets / securities have sensitivities ○ Generally overpowered at the market level Market participants are heterogeneous Results in hundreds of observed factors ○ Trend ○ Value ○ Momentum Isolate factor premia for a more robust return ○ Requires active implementation 9

Diversifying Strategies Asset correlations are driven by common factors Portfolio effects of diversification Most portfolios are under-diversified Accessing diversifying strategies ○ Risk parity ■ Balanced approach to long-only investing ■ Capture fundamental risk premia ○ Style focused investments ■ Trend, value, momentum ■ Capture behavioral premia ○ Uncorrelated active management ■ Alpha focused investments 10

Correlations Driven by Factors 11 Source: FT Alphaville, HSBC, Bloomberg

Correlations Magnified by Uncertainty 12 Source: FT Alphaville, HSBC, Bloomberg

Diversification Benefits 13 Source: Bridgewater

Institutional Portfolio Diversification 14 Source: AQR

Accessing Diversification 15 Source: AQR

Risk parity ○ Diversifies against surprises in growth and inflation ○ Traditional 60/40 portfolio is levered to rising growth and falling inflation 16 Fundamental Factor Investing Source: Bridgewater

Behavioral Factor Investing Behavioral factor investing pursues anomalies not captured by traditional market factors ○ Referred to as smart beta, dynamic beta, style premia, etc… Generally constant factor exposure Focus on loss periods and skew when evaluating 17

Behavioral Factor Investing 18 Source: CFM

Alpha Investing Attempt to identify uncorrelated return profiles predicated on manager skill and implementation Varying factor exposures Not all alphas have the same value for a portfolio 19

Building a Hedge Fund Program Most strategies are short volatility Better construct for evaluating characteristics Fund of funds vs. direct programs Picking managers 20

Short Volatility Profile 21

Convergent & Convex Convergent Non-traditional trading strategies that are differentiated but may be correlated (negative performance) in times of stress Convex Non-traditional trading strategies that are differentiated and are generally negatively correlated (positive performance) in times of stress 22

22 Strategy Buckets Distilled to Activist investing Convertible bond arbitrage Credit long/short Credit long bias Commodity long/short Equity long/short Equity long bias Event driven Multi-strategy Event driven Relative value Volatility selling Commodity arbitrage Fixed income arbitrage Statistical arbitrage Structured credit Volatility arbitrage Trend Global Macro Market making Portfolio Insurance Volatility buying Opportunistic Convergent Convex

Convex / Convergent Profiles 24

Blended Profile 25

Fund of Funds vs. Direct By mandate FoFs have to invest in hedge funds ○ They are trying to build a portfolio with both factors and alphas to deliver a satisfactory return stream to their clients FoFs tend to generate alpha, but it can be diluted by over-diversification FoFs tend to be heavily convergent Direct portfolios can be tailored for a better fit ○ Requires expertise in-house 26

Selecting Hedge Funds Requires answers to just 3 questions! Can a manager consistently ○ Discount what the market is expecting? ○ Develop variant views? ○ Harvest those variant view? 27

Contact Information Ken Musick Senior Investment Officer Teachers’ Retirement System of the State of Illinois