CHANGE THE MEASURE: MEASURE THE CHANGE:

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.”

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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

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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 constraintsA single currencyOne labour pool

Inflation, interest rates, have moved in the same direction in most developed markets

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Over the past 15 years correlations have moved from 36% to over 85% between North American markets and the rest of the Globe1

Importantly market corrections are largely occurring together

Recent Corrections in the S&P/TSX vs. the S&P 500 and MSCI EAFE

From ToS&P/TSX

(CAD)S&P 500

(USD)MSCI EAFE

(USD)

June 18, 2008 March 6, 2009 -48.33% -47.87% -53.58%

July 19, 2007 Aug 16, 2007 -11.98% -8.97% -12.18%

April 19, 2006 June 13, 2006 -12.31% -6.27% -9.74%

Sept 11, 2002 Oct 9, 2002 -13.81% -14.45% -13.47%

Global Markets Have Arrived

Source: Bloomberg

The Pattern of Market Returns is Not Helpful

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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?

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Canadian Bonds40%

Financials5.64%

Canadian Equities35%

Financials10.68%

MSCI World25%

Financials6.26%

“Sometimes the Way we Look at the Problem is the Problem”Stephen R. Covey

23% Financial Exposure

As at June 30, 2007 60% S&P/TSX & 40% MSCI World

Consumer Discretionary 7.69Consumer Staples 4.77Energy 20.15Financials 28.65Health Care 3.93Industrials 7.93Information Technology 6.50Materials 12.54Telecommunication Services 5.28Utilities 2.55

Total 100.00

Typical Balanced Portfolio – June 30, 2007 Typical 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

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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

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Sectors offer better diversification than marketsCorrelation average of 0.69 versus 0.85 for regional markets

Securities are less correlated than sectors

MSCI

World Energy Materials Industrials

Cons

Disc

Cons

Staples

Health

Care Financials

Info

Tech

Telecom

Services Utilities

MSCI World 1.00

Cons Disc 0.87 1.00

Cons Staples 0.81 0.74 1.00

Energy 0.73 0.51 0.51 1.00

Financials 0.88 0.86 0.77 0.51 1.00

Health Care 0.78 0.69 0.74 0.44 0.69 1.00

Industrials 0.92 0.90 0.75 0.63 0.87 0.72 1.00

Info Tech 0.82 0.80 0.57 0.50 0.67 0.65 0.77 1.00

Materials 0.87 0.74 0.67 0.79 0.70 0.60 0.80 0.67 1.00

Telecom Services 0.81 0.72 0.66 0.56 0.68 0.68 0.74 0.75 0.68 1.00

Utilities 0.70 0.52 0.64 0.64 0.53 0.58 0.57 0.50 0.59 0.64 1.00

10 Years as at September 30, 2011

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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 andsecurity exposure can reduce risk levels

Source: Zephyr StyleADVISOR

Heisenberg Uncertainty Principle“The Presence of the Observer Changes the Nature of the Observed”

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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. 1992 - 2003

If the incentive goal is not changed, the portfolio construction will likely not change

Decide on a Goal that Serves Your Plan’s Need

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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. 102-113, Fall 2007

Blitz, van Vliet 1986 – 2006 (global)

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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