© 2008 northern trust corporation northerntrust.com the northern trust experience a c c e s s. e x...

© 2008 Northern Trust Corporation northerntrust.com

The Northern Trust ExperienceThe Northern Trust ExperienceA C C E S S . E X P E R T I S E . S E R V I C E .

Lori R. RunquistDirector, Alternative Investment Strategies

John D. SkjervemChief Investment Officer, Personal Financial Services

Avoiding Common Investment Mistakes


Bonds

Common Investment Mistakes:

The Northern Trust Experience

Actively Managed Bond Funds vs. Laddered Bond Portfolios

Actively Managed Bond Funds Total return investment approach

Superior risk management: Broad diversification by state, region,

sector and security

Precise duration management and yield curve positioning

Competitive bidding and scale reduces transaction costs

Overnight liquidity

Laddered Bond Portfolios Provide regular, certain income and

principal payments

Transparent portfolio holdings

Often positioned as “free of charge”

Investors allocate assets to municipal bonds to provide both capital preservation and current, tax exempt income generation. These objectives can be met through either a laddered bond portfolio or through actively managed bond funds.


Income Generation

Funds’ monthly distributions result in more consistent income stream

Total return approach provides capital appreciation opportunities

Adaptable to changing yield curve conditions

0%

1%

2%

3%

4%

5%

'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07

Tax-Expemt Yield for Laddered Portfolio*

Yield For Northern Intermediate Tax-Exempt Fund**

* Reflects the average yield for a typical 1-10 year laddered portfolio. Calculation assumes 50bps account management fees.

** Calculation net of mutual fund fees.


Active Management

Active management mitigates risks and can capitalize on yield, maturity and credit opportunities

Funds provide cost effective liquidity facility

Better, dynamic interest rate (i.e., duration) and reinvestment risk management

Superior diversification profile

Yield Spread (1-30 Year Muni Bonds)

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400

'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07

Year

Ba

sis

Po

ints

Bond Funds Can Capitalize On Yield Spread Opportunities


Lower Costs

Commissions are a hidden but material fee in laddered bond portfolios

Larger trading denominations in bond funds allow for lower transaction costs

Strong inverse relationship between transaction costs and par value traded


Summary: Funds v. Ladders

Bond Fund Bond Ladder

Income Generation

Total Return

Risk (i.e., duration) management

Fees & Transaction Costs ? ?

Liquidity

Diversification

Transparency


Hedge Funds



Why Invest in Hedge Funds?

As a Hedge to Equities: Diversified hedge fund strategies can generate positive

returns in down markets

As a Fixed Income Alternative: Bond-like risk with greater upside potential in diversified

Fund of Funds

As an Equity Alternative: Some clients pursue an aggressive hedge fund approach

seeking alpha from individual managers


7.19%

4.19%

9.80%

9.54%

0% 5% 10% 15%

Annualized Returns (Net of Fees) January 1990 – March 2008

Hedge Fund of Funds¹

S&P 500 Index

Lehman Aggregate Bond Index

US 90 Day Treasury Bills

Hedge FOF*S&P 500

LB Aggregate

90 Day T-Bill

1990

17.5

-3.1

8.9

8.0

1991

14.5

30.5

16.0

5.8

1992

12.3

7.6

7.4

3.6

1993

26.3

10.1

9.8

3.1

1994

-3.5

1.3

-2.9

4.3

1995

11.1

37.6

18.5

5.7

1996

14.4

23.0

3.6

5.2

1997

16.2

33.4

9.7

5.3

1998

-5.1

28.6

8.7

5.3

1999

26.5

21.0

-0.8

4.9

2000

4.1

-9.1

11.6

6.2

2001

2.8

-11.9

8.4

4.4

2002

1.0

-22.1

10.3

1.8

2003

11.6

28.7

4.1

1.2

2004

6.9

10.9

4.3

1.3

2005

7.5

4.9

2.4

3.1

2006

10.3

15.7

4.3

5.0

¹Source: Hedge Fund Research, Inc., HFRI Fund-of-Funds Index consists of approximately 800 fund of funds.

**Year-toDate performance through 3/31/08.* The HFRI Fund-of-Funds Index is shown net of fees. All other indexes are shown gross of fees and expenses. It is not possible to invest directly in an index.Past performance is no guarantee of future results.

2007

10.1

5.5

7.0

4.7

2008**

-4.1

-9.5

2.2

0.7

Hedge Fund Performance


6.9%

3.9%

-2.0%

-5.8%

0.3%0.1%

1.9% 1.2%

0.7%1.3%

-0.6%

1.6%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

S&P 500 Hedge Fund of Funds Composite Index

Return Volatility – Hedge Fund of Funds vs. S&P 500

During the most difficult periods of equity performance**, hedge fund of funds outperformed the S&P by an average of 511 basis points (see last set of bars)

If a line is drawn through all of the green bars (hedge fund of funds) the slope is much flatter, less volatile, than the blue bars (S&P)

37 Months 33 Months

Over 5% + 3 to 5% 1 to 3% 1 to -1% -1 to -3%less

than -3%

30 Months 32 Months 55 Months

Average Monthly Returns for the 219 MonthsBetween January 1990 – March 2008

32 Months

*Past performance is not indicative of future returns+ Indicates months when the S&P 500 return was greater than 5%**Defined as when the S&P return was less than -3% Source: HFRI Fund of Funds Index consists of approximately 800 fund-of-funds.HFRI Fund of Funds Index is net of fees and S&P 500 index is gross of fees.

Between January 1990 and March 2008, hedge fund of funds outperformed the S&P 500 in 95% of the down months and have historically exhibited lower volatility than that of the public equity markets.*


Common Mistake – Insufficient Diversification

Chasing Hedge Fund returns during strong markets can lead to disaster when markets correct

July / August 2007 double digit losses

Subprime, CDOS

Statistical arbitrage sell off

Suspended redemptions

Diversified Fund of Funds vs Direct Selection Managers sourced differently

Due diligence completed thoroughly

Risk monitored actively


Fund of Funds Solution

Role of Hedge Funds should be: Capital preservation

Measured growth

Diversified exposure

Not wealth creation via speculation 1998 Mortgage-Backed Securities squeeze

1999 Quant Equity L/S momentum-to-value reversal

LTCM: highly leveraged illiquid positions caused normally uncorrelated strategies to converge


Chasing After or Running from Short-Term Investment Performance



Would You Hire This Manager?

C re a t e d w i th M P I S ty lu s ™

C u mulativ e P e rfo rman ce

100

120

140

160

180

200

220

240

260

280

Gro

wth

of $

10

0

ManagerBenchmark

Manager Benchmark Excess Return

Annualized Return 21.90 16.91 4.99


Or This Manager?

C re a t e d w i th M P I S ty lu s ™

C u mulativ e P e rfo rman ce

70

75

80

85

90

95

100

105

110

115

Gro

wth

of $

10

0

ManagerBenchmark

Manager Benchmark Excess Return

Annualized Return 1.26 2.64 -1.38


Taking a Long Term View

12/31/95 to 12/31/00 12/31/00 to 12/31/03 12/31/95 to 06/30/07

Manager 21.90 1.26 14.98Benchmark 16.91 2.64 11.97Excess Return 4.99 -1.38 3.07

C re a t e d w i t h M P I S t y l u s ™

C umulativ e P e rfo rmance

Dec-95 - Jun-07

100

150

200

250

300

350

400

450

500

550

Gro

wth

of $

10

0

Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Jun-07

ManagerBenchmark

Conclusion: The manager performed as expected. Adhering to a relative value approach within the large cap value style, this manager delivered consistent out-performance in rising market environments but trailed its benchmark in a downturn.


C re a t e d w i t h M P I S t y l u s ™

Qua rte rly P e rform a nce

Sep-01 - Sep-06

-25

-20

-15

-10

-5

0

5

10

15

20

25

Tot

al R

etur

n, %

Sep-01 Dec-01 M ar-02 Jun-02 Sep-02 Dec-02 M ar-03 Jun-03 Sep-03 Dec-03 M ar-04 Jun-04 Sep-04 Dec-04 M ar-05 Jun-05 Sep-05 Dec-05 M ar-06 Jun-06 Sep-06

Manager Benchmark

Cause For Concern?

Is this cause for concern? The manager (-9.7% return) underperformed its benchmark (+2.7% return) by -12.4% in Q3 ’06!


What Happened, Part I?

This manager pursues a corporate restructuring strategy that is concentrated in the industrial, energy and financial sectors.

During Q3 ’06, Telecom and Information Technology outperformed, returning 11.9% and 3.7% respectively.

The manager’s annualized tracking error had been ~ 7% since 1995 which implied a 95% chance that the manager would perform +/- 14% relative to its benchmark over the course of a 1 year period.

Manager Sector Exposure

0%

20%

40%

60%

80%

100%

09/3

0/20

02

12/3

1/20

02

03/3

1/20

03

06/3

0/20

03

09/3

0/20

03

12/3

1/20

03

03/3

1/20

04

06/3

0/20

04

09/3

0/20

04

12/3

1/20

04

03/3

1/20

05

06/3

0/20

05

09/3

0/20

05

12/3

0/20

05

03/3

1/20

06

06/3

0/20

06

09/2

9/20

06

Date

Per

cen

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f p

ort

foli

o

DSCR STPL ENER FINA HLTH INDU INFT MATS TCOM UTIL


What Happened, Part II?

After a thorough quantitative and qualitative review of the portfolio, we determined performance was within expectations given the manager’s stated strategy and positioning.

In Q4 ’06, performance rebounded sharply further contributing to manager’s excellent long term track record.

Although niche managers can add significant value over time, we recommend pairing niche managers with complementary managers in the same asset class to reduce overall portfolio risk while still retaining upside alpha opportunities.

Created with MPI Stylus™

Next 3 Quarters

Sep-06 - Jun-07

-25

-20

-15

-10

-5

0

5

10

15

20

25

Tot

al R

etur

n, %

Sep-06 Dec-06 Mar-07 Jun-07

Manager Benchmark

Manager Benchmark

1 Year 23.46 16.05

3 Year 30.18 15.02

5 Year 23.40 14.62

7 Year 22.46 15.89

10 Year 17.54 12.14

Performance as of 6/30/07


Manager Termination

A Story of Two Large Cap Value Managers…

Manager A hired 1/1/98

1998 1999Manager A: 1.68% -5.38%Russell 1000 Value: 15.63% 7.33%

Cumulative 2 year excess return =

Manager B hired 7/1/02

2003 2004Manager B: 30.13% 14.93%Russell 1000 Value: 30.03% 16.49%

Cumulative 2 year excess return =

Which manager was terminated shortly thereafter?

-24.86% -1.56%


Our sell discipline reinforces our proven methodology.

Key portfolio professionals

Other investment professionals

Ownership change

Product capacity

Firm growth

Unexpected performance

Risk exceeds portfolio guidelines

Fundamental strategy shift

Inconsistent discipline

PerformanceProcess ChangeFirm ChangeStaff Change

Reasons for Termination

Manager Termination

Manager A

Action: Manager B was terminated in 2005.

No No No Extended, but not unexpected

Manager B Yes Yes ?? OK


Manager Termination

What happened subsequently…

2000 2001 2002 2003 2004 2005 2006

Manager A: 35.22% 16.84% -6.27% 41.52% 19.73% 9.64% 17.61%

Russell 1000 Value: 7.02 -5.60 -15.52 30.03 16.49 7.05 22.24

Excess return: 28.20% 22.44% 9.25% 11.49% 3.24% 2.69% -4.63%

Results: Manager A returned 18.26% (annualized) versus 7.80% for the Russell 1000 Value over this period

2005

Manager B: 5.67% (manager composite performance)

Russell 1000 Value: 7.05

Excess return: -1.38%

Results: We terminated Manager B across programs at the end of October 2005. Assets at the firm went from $9.7billion at the end of 3Q ’05 to $38 million by September 2006.


Private Equity



Market Outlook

General widespread perception that returns have peaked

Too much money chasing too few deals

Unreasonable valuation environment

Credit markets have contracted

Source: Callan Associates, “Private Markets Trends”, Winter 2006-2007


Private Equity Fund Raising

Committments to US Buyout and Venture Funds(in Billions)

49.1

74.0

39.7

11.3 9.517.6

26.5 27.0 32.243.1

61.1

43.857.5

42.629.6

61.3

112.6

177.1

228.0

21.014.3

79.7

$0

$50

$100

$150

$200

$250

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Venture Buyout

Source: Private Equity Analyst, January 2008


2007 Global Buyout Activity

32%

47%

9%

9%

3%

1%

12%

8%

25%

56%

0% 20% 40% 60%

>$10B

$1B - $10B

$500M - $1B

$100M - $500M

$0M - $100M

Value No. of Deals

Source: 2008 Preqin Global Private Equity Review


2007 Buyout Deal Info – Regional Breakdown

957

787

471

$194

$474

$46

Europe

North America

Asia & RoW

Deals Value ($B)



2007 Buyout Activity

2,215 total transactions (1,007 in 2006)

21 deals represent over 1/3 of total announced value

Bifurcation of the buyout market

Performance measurement implications



Other Sectors

Distressed & “Stressed”

Small/Mid Cap LBOs

Deep Value Plays

International Buyouts

Country Specific Funds

Mega & Large Cap Deals

Return Expectation

1.0-2.0x

Return Expectation

2.5x +

Return expectations are gross of all fees.

Venture Capital

Return Expectation

3x +


Market Timing

Oversimplification of future performance expectations

Not understanding bifurcation of Private Equity markets can leadinvestors to mistakenly choose to miss investment periods

Regular “re-uppings” of commitments every two (2) years maintains consistent investment exposure


0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0 1 2 3 4 5 6 7 8 9 10

Year

% o

f P

ort

folio

in

Pri

vate

Eq

uit

y

Targeting an Allocation to Private Equity – Model Approach

Requires committing to consecutive fund-of-funds every other year

1st commitment equal to 100% of target allocation, and 80% to every subsequent fund

After 3rd commitment allocations become self funding

7% target reached and sustained

Model Approach

Note: All projections are based on assumptions. These assumptions are based on a model that, on average, a private equity investment will earn an overall 15% net internal rate of return and a 1.75x multiple on invested capital. Total investor portfolio is also assumed to grow 7% annually in nominal terms. Actual results may vary significantly from projections. Past results are not necessarily indicative of future performance. Information provided for illustrative purposes and not intended as an indication of any strategy employed by Northern Trust. Information should not be considered investment advice or a recommendation of any investment strategy or security described herein as it does not take into account an investor’s own circumstances.


0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0 1 2 3 4 5 6 7 8 9 10

Year

% o

f P

ort

foli

o i

n P

riv

ate

Eq

uit

y

Targeting an Allocation to Private Equity – Excluding Funds

Committing to every other fund-of-funds results in an underallocation versus 7% target (new commitment every fourth year instead of every second year)

It is possible to use a higher commitment rate every other fund to reach target, but this commonly creates inconsistent exposure to vintage years and portfolio companies

7% target NOT sustained

Excluding Funds

Underweight due to excluding funds

Note: All projections are based on assumptions. These assumptions are based on a model that, on average, a private equity investment will earn an overall 15% net internal rate of return and a 1.75x multiple on invested capital. Total investor portfolio is also assumed to grow 7% annually in nominal terms. Actual results may vary significantly from projections. Past results are not necessarily indicative of future performance. Information provided for illustrative purposes and not intended as an indication of any strategy employed by Northern Trust. Information should not be considered investment advice or a recommendation of any investment strategy or security described herein as it does not take into account an investor’s own circumstances.


Thank You

Avoiding Common Investment Mistakes

© 2008 northern trust corporation northerntrust.com the northern trust experience a c c e s s. e x...

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