Back to the Future: Conventional Investing in a Complex World Based on a Brandes Institute publication by Bob Maynard, Advisory Board member and CIO of the Public Employee Retirement System of Idaho (PERSI)

-00

-10

-10

-09

-09

-09

-08

-08

-08

-07

-07

-07

-06

-06

-06

-05

-05

-05

-04

-04

-04

-03

10%

-03

-03

-02

-02

-02

-01

-01

-01

-00

-00

Daily Price Movement

What are these illustrations?

Daily S&P Price Movements 1950-2010

8%

6%

4%

2%

0%

-2%

-4%

-6%

-8%

-10%

Seismogram of Sumatra Earthquake

Source: Pennsylvania Department of Conservation and Natural Resources, http://www.dcnr.state.pa.us/topogeo/hazards/sumatra.aspx. Accessed Oct. 20, 2010.

S&P 500 Index Daily Price Changes (2002-2010)

Source: Factset, as of 12/31/10. Past performance is not a guarantee of future results.

Who is Bob Maynard?  Chief Investment Officer for the Public Employee Retirement Plan for Idaho State Workers (“PERSI”)  Oversees about $10 billion  Improved performance for PERSI from 99th percentile among public funds before his arrival to top-quartile*  Member of Brandes Institute Advisory Board *Maynard, Robert M. “Back to the Future: Conventional Investing in a Complex World.” January 2010. Available at www.brandes.com/institute

Back To The Past  “Investment life in the 1990s was easy.” –Bob Maynard  Pension funds generally met their liability funding targets of 7-8% (although some sophisticated endowments did better).  Investors typically used a “conventional” approach:  Set a target allocation range across equity (active and/or passive), fixed income, and cash  Accept market volatility and periodically rebalance  Allocations were typically based on the mean variance model  Assuming normal “bell curve” distributions of returns  Returns would be proportionate to volatility (“risk”)

Then Came the Endowment Model Premise

Conclusion and Response

Market volatility increased

Avoid volatility by using variety of less liquid alternatives

Markets are inefficient

Intense active and opportunistic approach

Markets are more complex

Complex organization and strategy

Diversification helps

The more diversification the better

“The premises were largely correct, but the conclusions were wrong – often disastrously so.” -Bob Maynard

Conventional vs. Endowment Models Public Equity (total) Russell 3000 MSCI EAFE MSCI Emerging Markets Public Bond (total) U.S. Non-U.S. TIPS Alternatives (total) Real Estate Commodities Private Equity Hedge Funds

PERSI 55% 29% 17% 9% 30% 20% 0% 10% 15% 8% 0% 7% 0%

Harvard 33% 11% 11% 11% 15% 8% 2% 5% 52% 9% 14% 13% 16%

Source: Swensen, David F. Unconventional Success: A Fundamental Approach to Personal Investing. New York: Free Press. 2005; PERSI; Harvard Management Company; Yale University.

Yale 26% 11% 6% 9% 9% 4% 0% 5% 65% 18% 5% 19% 23%

Conventional vs. Endowment Models Contrast between a Simple and a Complex Approach Conventional investing (simple) Endowment model (complex) Transparent

Opaque

Liquid securities

Illiquid securities

Daily pricing

Leverage

Risk management by diversification

Risk managed by quant models

Focused on few asset classes

Scattered, opportunistic

Goal: survive volatility

Goal: avoid volatility

Diversification does not assure a profit or protect against loss in a declining market.

Issues with the Endowment Model  “Conventional investing is more than sufficient…when the real return requirements are in the range of 3% to 5% over long periods.”  “The conventional approach probably would not be sufficient if the real return requirements are above 6% for prolonged periods.”  “Those who adopt the endowment approach should be aware they are entering a game where the odds are heavily stacked against them.”  “(The endowment model) tries to pick up hundreds of nickels… while underestimating the speed and acceleration of the steamrollers coming in their direction.”  “A complex investment world does not require a complex response.”  “The goal should be to survive comfortably with the highest odds over the very long term.” -Bob Maynard All bullet points are quotes from Bob Maynard’s text

Short-Term Markets “Wilder” and “Milder” Expected vs. Actual Frequency of Monthly Returns for U.S. Stocks (1926-2010) 13%

11%

Expected 9%

Frequency

Actual 7%

5%

3%

1%

-1% -14%

-10%

-6%

-2%

2%

6%

10%

14%

Monthly Return Source: Actual returns from Ibbotson’s Stocks, Bonds Bills and Inflation, as of 12/31/10. Expected returns were generated under the assumptions of a normal distribution using Ibbotson data. Past performance is not a guarantee of future results.

More

But More “Normal” Over the Longer Term Expected vs. Actual Frequency of Annual Returns 5-Year Rolling Returns (1926-2010) 30%

25%

Expected Frequency

20%

Actual

15%

10%

5%

0% -20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

More

Annual Return Rolling periods represent a series of overlapping, smaller time periods within a single, longer-term time period. For example, over a 20-year period, there is one 20-year rolling period, eleven 10-year rolling periods, sixteen 5-year rolling periods, and so forth. Source: Actual returns from Ibbotson’s Stocks, Bonds Bills and Inflation, as of 12/31/10. Expected returns were generated under the assumptions of a normal distribution using Ibbotson data. Past performance is not a guarantee of future results.

Frequency vs. Contribution in Monthly U.S. Equity Market Returns (1926-2010) 13%

11%

Contribution Actual

Frequency

9%

7%

5%

3%

1%

-1% -14%

-10%

-6%

-2%

2%

6%

Monthly Return Source: Actual returns from Ibbotson’s Stocks, Bonds Bills and Inflation, as of 12/31/10. Past performance is not a guarantee of future results.

10%

14%

More

Avoiding “Wilder but Milder”: the Long-Term Approach  Long-term

 Normal randomness  Volatility is more consistent  Efficient markets

 Short-term

 Fat tails and high peaks  Wild and mild randomness  Volatility clusters with unpredictable direction  Inefficient markets

“Unfortunately the …wilder (but milder) world is described by mathematics that are intractable for reasonable use in portfolio construction….The impact of turbulent market behavior fades as….time horizons lengthen and planning portfolios for returns over 5-10 year periods can generally use….standard theory” - Bob Maynard

The Continuity Problem with a Complex Approach  Consistency and continuity in an investment approach are critical over time  The client (whether institutional or individual) must…  Understand and agree with the strategy  Have staff or advisors to provide continuity in management (especially for complex strategies)  Have the patience to withstand periods of underperformance  Pension funds and other institutions sometimes struggle with item 2; individual investors may have problems with item 1; but all investors show strain under item 3

Liquidity is Often Overvalued, But…. …Liquidity can be invaluable!  Under stress (2008-9), liquidity dried up for the Endowment Model  Institutions with short-term cash needs had no liquidity in large segments of the portfolio

 Their solution: borrow in the bond market or sell public securities at “rock bottom” prices… just when conventional investors should have been buying them

“Illusory Returns” Growth of $1 in HFRFOF Index and 55-15-30 Portfolio As of 12/31/10 $4.50

$4.00

HFRFOF

$3.50

55-15-30

$3.00

$2.50

$2.00

$1.50

$1.00

$0.50 Dec-92

Apr-95

Aug-97

Nov-99

Mar-02

Jul-04

Nov-06

Source: Standard & Poors; Hedge Fund Research, Inc.; Barclays Capital; MSCI, Russell Investments as of 12/31/10. Past performance is not a guarantee of future results. 55-15-30 Allocations: 55=Public U.S. Equities-Russell 3000 Index, 15= International Stocks-MSCI EAFE, 30= Public Bonds, Barclays Capital U.S. Aggregate Index.

Mar-09

“Illusory Returns” HFRFOF and S&P 500 Index Excess Returns vs. a 55-15-30 Portfolio As of 12/31/10 120% 100% 80%

HFRFOF S&P 500

60% 40% 20% 0% -20% -40% -60% -80% Dec-92

Apr-95

Aug-97

Nov-99

Mar-02

Jul-04

Nov-06

Source: Standard & Poors; Hedge Fund Research, Inc.; Barclays Capital; MSCI, as of 12/31/10. Past performance is not a guarantee of future results. 55-15-30 Allocations: 55=Public U.S. Equities-Russell 3000 Index, 15= International Stocks-MSCI EAFE, 30= Public Bonds, Barclays Capital U.S. Aggregate Index .

Mar-09

“Phony Diversification”  Diversification is meant to reduce specific risk. But the endowment model’s “search for alpha” adds specific risk back to the portfolio. “By adding the attempt to hit home runs (it) increases the chances for strike outs and…the potential for volatility.”  Diversification offers the (low correlation) free lunch. But the “endowment model’s…illiquid assets eliminates most…of that potential benefit.” Why ?  “Rebalancing and the free lunch of diversification go hand in hand. Rebalancing benefits increase as volatility rises. If you don’t rebalance…you get no diversification return benefits.” Endowments couldn’t rebalance assets that had become illiquid.  “The benefits of rebalancing only can be achieved by actually implementing a rebalancing strategy.” And that’s a lesson to all investors! The simple conventional model may be better, but “is useless if not put into action.” Diversification does not assure a profit or protect against a loss in a declining market. All quotes above are attributed to Bob Maynard.

PERSI Cumulative Returns (1965-1992) $16

$14

$12

PERSI

US Stocks

US Bonds

US Cash

$10

U.S. Stocks $14.14

U.S. Bonds $8.52

$8

U.S. Cash $6.25 $6

PERSI $6.14 $4

$2

$0

Source: PERSI, as of 6/30/09. Past performance is not a guarantee of future results. Note: U.S. Bonds represented by the Barclays Capital Aggregate Index. U.S. equities represented by Russell 3000 Index. Cash represented by Treasury Bills.

PERSI Cumulative Returns (1992-2009) $6

$5

PERSI

R3000

U.S. Bonds

Int. Equities

PERSI $4.12

$4

R3000 $3.85

$3

U.S. Bonds $3.00

$2

Int’l Stocks $3.85

$1

$0 Jul-92

May-94

Mar-96

Jan-98

Nov-99

Sep-01

Jul-03

May-05

Mar-07

Jan-09

Source: PERSI, as of 6/30/09. Past performance is not a guarantee of future results. Note: U.S. Bonds represented by the Barclays Capital Aggregate Index. U.S. equities represented by Russell 3000 Index. International equities represented by the MSCI EAFE Index.

Cockroaches and Conclusions  Complex, interactive, and tightly coupled financial system does not require complex, interactive, or tightly coupled investment strategies or organization  Robust rather than finely tuned  Finely tuned becomes too dependent on existing environment not changing  The cockroach . . .  Simple, transparent, and focused gives high odds of survival

The S&P 500 Index with gross dividends is an unmanaged, market capitalization weighted index that measures the equity performance of 500 leading companies in leading industries of the U.S. economy. Although the index focuses on the large cap segment of the market, with approximately 75% coverage of U.S. equities, it can also be a suitable proxy for the total market. This index includes dividends and distributions, but does not reflect fees, brokerage commissions, withholding taxes, or other expenses of investing. The Barclays Capital U.S. Aggregate Index is an unmanaged index consisting of U.S. dollar-denominated, fixed-rate, taxable bonds. The Index includes bonds from the Treasury, Government-Related, Corporate, Mortgage-Backed Securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), Asset-Backed Securities and Commercial MortgageBacked Securities sectors. Securities must be rated investment grade (Baa3/BBB-/BBB- or above) by Moody’s, S&P, and Fitch, respectively. When all three agencies rate an issue, a median or “two out of three” rating is used to determine Index eligibility by dropping the highest and lowest rating. When a rating from only two agencies is available, the lower (“most conservative”) of the two is used. When a rating from only one agency is available, that rating is used to determine Index eligibility. The index is a total return index which reflects the price changes and interest of each bond in the index. The Hedge Fund Research Inc. Fund of Funds Index (“HFRFOF Index”) is an equally weighted performance index that includes approximately 700 hedge fund of funds (both U.S. based and offshore funds). Funds in the index must have at least $50 million in assets under management or have been actively trading for at least 12 months. All funds report assets in U.S. dollars and returns net of all fees on a monthly basis. The MSCI EAFE (Europe, Australasia, Far East) Index with net dividends is an unmanaged, free float-adjusted market capitalization weighted index designed to measure equity market performance of developed markets, excluding the United States and Canada. This index often is used as a benchmark for international equity portfolios and includes dividends and distributions net of withholding taxes, but does not reflect fees, brokerage commissions, or other expenses of investing. MSCI Emerging Markets (MSCI EM) Index - MSCIEMF: The MSCI Emerging Markets Index with gross dividends is an unmanaged, free float-adjusted market capitalization weighted index designed to measure equity market performance in emerging markets throughout the world. This index includes dividends and distributions, but does not reflect fees, brokerage commissions, withholding taxes, or other expenses of investing. Russell 3000 Index - RUSSELL3K: The Russell 3000 Index with gross dividends is an unmanaged market capitalization weighted index that measures the performance of the 3,000 largest U.S. companies representing approximately 98% of the investible U.S. market. This index includes the reinvestment of dividends and income, but does not reflect fees, brokerage commissions, withholding taxes, or other expenses of investing. VIX : Created in 1993 by the Chicago Board Options Exchange® (CBOE®), the CBOE Volatility Index®, or VIX®, was originally designed to measure the market’s expectation of 30-day volatility implied by at-the-money S&P 100® Index option prices. In 2003, CBOE, together with Goldman Sachs, updated the calculation of VIX. Now, it is based on the S&P 500 Index and estimates expected volatility by averaging the weighted prices of S&P 500 puts and calls over a wide range of strike prices. VIX has evolved into a widely followed measure of market volatility and often is referred to as the “investor fear gauge.”

The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings, or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Please note that all indices are unmanaged and are not available for direct investment. Unlike bonds issued or guaranteed by the U.S. government or its agencies, stocks and other bonds are not backed by the full faith and credit of the United States. Stock and bond prices will experience market fluctuations. Please note that the value of government securities and bonds in general have an inverse relationship to interest rates. Bonds carry the risk of default, or the risk that an issuer will be unable to make income or principal payment. There is no assurance that private guarantors or insurers will meet their obligations. The credit quality of the investments in the portfolio is no guarantee of the safety or stability of the portfolio. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.

11988 El Camino Real │ Suite 500 │ P.O. Box 919048 │ San Diego, CA 92191-9048 858.755.0239 │ 800.237.7119 │ Fax 858.755.0916 www.brandes.com │ [email protected]