finding the right fit: how to leverage alternative portfolio structures

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FINDING THE RIGHT FIT: HOW TO LEVERAGE ALTERNATIVE PORTFOLIO STRUCTURES

Wednesday, October 25 | 2:00pm - 3:00pm ET


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Subject Matter Experts

Chris Shaw, Moderator

Managing Director,

DST Asset Manager

Solutions

John Alshefski, Panelist

Senior Vice President,

SEI Investment Manager

Services

Zachary Klehr, Panelist

Executive Vice President

Fund Management,

FS Investments


Fund rationalization driving asset managers to differentiated strategies1

Mutual funds/ETFs not a panacea for all retail investment strategies

Distributor receptivity to BDCs and interval funds improving

Advisors' active allocations more thoughtful around a passive core

portfolio2

A More Constructive Time For Alternatives

1 Financial Times, U.S. asset managers embrace interval funds – March 20172 Financial Times, Investors gravitate to core/satellite portfolios – March 2015


Average allocations to alternatives should rise from

10% to 14% of client portfolios within three years

That shift would represent a projected increase of

nearly $150 billion in net flows to alternatives in the independent advisory channel1

Increased Allocations, Increased Sales

Source: Blackstone Group/Investment News, Alternatives in the Mainstream – March 2017

The rise of alternatives in client allocations


• Evolving investor demand• Alternative funds offer some of the return potential of hedge funds and commodity

funds in a regulated vehicle

• Diversification among traditional asset classes • Alternative 40 Act funds offer investments in asset classes less correlated to traditional

markets and often with higher returns than fixed-income funds

• Many sponsors have moved away from “absolute returns”

• Mainstream asset class• Increased popularity and sales has led to tremendous growth within this asset class

• Managers extending reach down market• Creating an alternative mutual fund provides access to the retail consumer

• Mutual funds offer transparency, daily liquidity and custodial safeguards derived from 1940 Act restrictions, responding to concerns about some hedge funds’ illiquidity and suspensions of redemptions and/or gating

Current Trends

Source: SEI, FUSE

Growth drivers


Expectations for future returns are falling

The odds of a 60/40 portfolio earning 5% real returns per year for the next 10 years is 0%1

Finding low-correlated assets is challenging

The correlation of a 60/40 portfolio to the S&P 500 is 0.992

Today’s Market Requires Finding Alternative Sources Of Return

“Take the 5% Challenge! (or The ‘Lloyd Christmas’ Lesson)” as of October 2016, published by Research Affiliates, LLC, using data provided by MSCI Inc., Bloomberg and Barclays.

Probabilities are rounded to the nearest whole number. The probability of the 60% U.S. stocks/40% U.S. bonds portfolio earning a 5% annualized real return over the next 10 years is

0.2%.

For the period of 12/31/2000–6/30/2017. 60/40 portfolio is composed of 60% S&P 500 Total Return Index and 40% Barclays Capital U.S. Aggregate Bond Index, rebalanced monthly.


0%

Probability

0.99

Correlation


Low Interest Rates Have Profound Impact On Wealth Management

1. Morningstar and Bloomberg as of December 31, 2016

2. 72% decline as of December 31, 2016


U.S. 10-year treasury rate: declined 72% since 19871,2

-1%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1987 2016

12.43%

7.70%6.33%

3.62%

1980s 1990s 2000s '10-'16

Japan Mexico

Asia TMT

HousingEMU & China

Commodities

Barclays AGG Average Annualized Return (%)1


Risk Is Rising…

1. Bloomberg. Estimated duration of the U.S. bond market based on the Barclays U.S. Aggregate Bond Index. Data through June 30, 2017. Duration is a measure of a bond’s sensitivity

to interest rate changes. The higher the bond’s duration (which is measured in years), the greater its sensitivity to the change. Generally, for every 1% increase or decrease in interest

rates, a bond’s price will change approximately 1% in the opposite direction for every year of duration. Note that the 6% decline shown above is an approximation. Shown for illustrative

purposes only.


U.S. bond market duration at highest on record

Duration (years)1

3

4

5

6

7

1989 2003 2017

A 1% increase in rates = a 6% decline


…While Expected Returns Are Falling

Note: Target Date Fund (“TDF”).

1. Research Affiliates, LLC using data provided by MSCI Inc., Bloomberg, and Barclays. As of October 2016.

Note: Probabilities are rounded to the nearest whole number. The probability of the 60% U.S. stocks/40% U.S. bonds portfolio earning a 5% annualized real return over the next 10 years

is 0.2%.


The traditional 60/40 portfolio will fall short over the next decade

Odds of mainstream portfolios earning a 5% annualized real return in the next 10 years1

7%6%

9%

13%

0%

5%

10%

15%

20%

25%

60% US Stocks/40% US Bonds Public Pension TDF (T+10) TDF (T+20) TDF (T+30)

0%


Certain investment strategies can fit within a mutual fund structure:• Traditional equity long/short or market neutral

• Multi-strategy/multi-manager

• Merger arbitrage/event-driven/special situation

• Global tactical allocation and global macro strategies

• Credit strategies/convertible arbitrage/senior debt

• Managed futures/commodities

Hedge fund strategies which are not a fit for a mutual fund:• Illiquid strategies

• Highly concentrated portfolios

• Nonfinancial investments

Other requirements that could hinder an adviser’s ability to effectively deploy certain investment strategies

• Liquidity needs for fund redemptions

• Prohibited investments,

• ‘40 Act restrictions

• IRS tax restrictions

Which Alternative Strategies Fit Within AMutual Fund?


Structure


Avoid the mismatch

BDC REIT CEF Mutual Fund

Structure

liquidityLow High

Asset liquidity Low High

Investment

horizonLonger Shorter

The dog should wag the tail, not the other way around.


The Manager Matters

Source: Morningstar, Lipper TASS database. Bonds represented by Morningstar U.S. Core Bond Funds. Stocks represented by Morningstar U.S. Large Cap Core Funds. Alternative

strategies represented by the following TASS fund classifications: Fixed Income Arbitrage (Long/Short Credit); Convertible Arbitrage (Relative Value); Long/Short Equity; Event-Driven;

Global Macro; and Managed Futures. Performance measured from December 31, 2004 through December 31, 2014.


Performance spread between top and bottom-decile managers

2004-2014

2.5%5.0%

13.3% 12.9%

18.0% 17.3%19.3% 21.5%

-2.9%-6.1%

-10.5%

-13.2% -12.5%-16.1% -16.3% -16.4%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Str

ate

gy p

erf

orm

an

ce

Bonds Stocks Relative

value

Long/short

credit

Event-

driven

Global

macro

Managed

futures

Long/short

equity

Traditional strategies Alternative strategiesStrategy

Performance

spread

Long/short

equity37.9%

Managed

futures35.6%

Global macro 33.4%

Event-driven 30.5%

Long/short

credit26.1%

Relative value 23.8%

Stocks 11.1%

Bonds 5.4%


The Issue Of Scale


While the processes between the qualified purchaser (QP), accredited and retail markets are similar, volumes are dramatically different.

QP/ Accredited

1,000xRetail

40,000x

Average order: $1,000,000 Average order: $25,000

To raise $1,000,000,000…


Retail Investing And Illiquid Alternatives


Historically, qualified purchasers and accredited investors could invest in alternatives through private placement offerings, but retail investors could not.

Retail investors have gained access to illiquid, institutional grade alternative investments through products like non-traded BDCs, closed-end funds and REITs.

The illiquid alternative investment processes is geared towards qualified purchasers and accredited investors, and has not evolved to meet the needs of retail investors.

Qualified purchaser

Accredited investor

Retail investors

Non-traded funds

Subscription document


Increasingly important for asset managers

• 15 U.S. regulatory bodies oversee the financial services industry

• Rules are constantly evolving

• Failure to comply represents material risk and potential financial liability to stakeholders

• For illiquid alternatives, regulations vary by state and product and require manual controls

Regulation Is At The Core Of Financial Services

Challenge


Liquidity Constraints Need to be Considered When Deciding on Structure of Product

Investor liquidity

Asse

t liq

uid

ity

Hedge

Funds

(LPs)

40 Act

Interval

funds

40 Act

Mutual

Funds


Hedge Fund (LP) 40 Act Interval Fund40 Act Alternative

Mutual Fund

Who Can Invest? Accredited Investors Any Investor Any Investor

How Many

Investors Can

Invest?

3(c)(1): 100 investors

3(c)(7): Unlimited

Qualified Purchasers

No LimitNo Limit

Performance Fee?Yes, if limited to

Qualified Clients

Yes, if limited to

Qualified Clients

Yes, if limited to

Qualified Clients, but not in

practice

12b-1 Fee? N/AYes, but exemptive

relief requiredYes

Multiple Share

Classes?Yes

Yes, but exemptive

relief requiredYes

How Long to

Launch?Approximately 60 day

• Approximately 180 days in

total

• Initial SEC registration at

least 3 months; often

longer

• Afterwards, new Interval

Funds require same

process

• Approximately 180 days in

total

• Initial SEC registration at

least 3 months; often

longer

• Afterwards, new mutual

funds can be launched in

75 days

Product Structure Comparison for Alternative Strategies



Mutual Fund

Asset Liquidity

Restrictions?None

Must maintain liquid

assets sufficient to meet

Repurchase Offers during time

between notice of Repurchase

Offer to shareholders

and Repurchase Pricing Date

Illiquid securities limited

to 15% of net assets

Liquidity

Structure?

As determined by the

manager of the fund

Repurchase offers required at

interval chosen by fund

(e.g., quarterly, semi-annually or

annually), unless changed by

Shareholders

Daily redemptions

Can Payment of

Redemption

Proceeds be

Delayed?

Yes

No. Repurchase

Payment Deadline must

occur seven days after

the Repurchase Pricing Date

No. Must pay

redemption proceeds

within seven days

following receipt of a

redemption request

NSCC Traded No No Yes




Mutual Fund

Use of Leverage Unlimited 33% 33%

How is the

Registration

Statement Updated?

N/A

• Annual update filing via Rule 486

under the Securities Act of 1933

• Automatic effectives

• Annual update filing via

Rule 485 under the

Securities Act of 1933

• Automatic effectiveness

Can 1099s be

issued?No, K-1’s only

Yes, if Fund meets Subchapter M

diversification

Yes, if Fund meets

Subchapter M

diversification

Exempt from ERISA

Plan Assets Rule?No Yes Yes



• No side pockets

• No side letters

• No carried interest payments or performance fees

• No gates or restrictions on transfers or redemptions

• No discounts on/negotiated advisory fees

Hedge Fund Features Not Allowed in 40 Act Mutual Funds


Don’t know how to distribute

• Looking for distribution partners with resources to help distribute. Don’t want to build sales force. Typically this approach is not successful

• Their strategies can be complex – The rules didn’t contemplate these financial instruments or strategies.

• Leads to grey areas that need to be interpreted. Fact specific so hard to leverage and leads to risk.

• We don’t have portfolio management experience

• Don’t understand portfolio managers concerns/options

• Don’t/Can’t test for all restrictions on a secondary basis. Need to rely on manager which provides additional risk to SEI in series trust model

• Additional/more complex agreements are involved such as ISDA and prime brokers. Impacts series trust model

Don’t have the necessary policies and procedures in place

Need more hand holding/guidance

• Requires more resources with ‘40 Act expertise especially legal/compliance and fund accounting

• What level of risk are we comfortable with? Traditionally we’ve stayed away from providing guidance

Challenges

Alternative managers may not know the market or restrictions


Expertise

Quantitative

• Quicker time to market and less expensive

• Sharing of trust level expenses and scale = Lower cost of ownership

• Trustee fees

• Legal fees

• Insurance fees

Qualitative

• Proven and accepted model

• Investment managers can focus resources on core competencies and value add activities

• Managing infrastructure is not a value add

• Funds should operate much like a private account with the exception of annual renewal of advisory agreement

• Less risk

• Maintain brand control

Why Firms Choose a Series TrustMutual Fund Structure

• Audit fees

• Compliance program expenses

23


Turnkey Series Trust Provides Complete Mutual Fund Infrastructure

XYZ

Investment

Adviser

Manages the

fund's portfolio

according to the

objectives and

policies described

in the Fund's

prospectus.

Provides

oversight of sub

advisers.

Independent Trustee

Counsel

Best practice for

independent trustees.

Chief Compliance Office

(CCO)

Adviser and sub-adviser

oversight. Reports directly to

Board of Trustees.

Board of Trustees

(Majority of boards must be independent trustees)

Oversees the fund's activities, including approval of the contract

with the management company and certain other service providers.

A C

DB

E G

HF

Distributor

Principal

Underwriter

Sells fund shares,

either directly to

the public or

through other

firms.

Administrator

Oversees the

performance of the

other companies

that provide

services to the

funds and ensures

that the fund's

operations comply

with the applicable

federal

requirements.

Transfer Agent

Executes

shareholders

transactions,

maintains records of

the transactions.

and other

shareholder account

activity, and sends

account statements

and other

documents to

shareholders.

Custodian

Holds the fund's

assets,

maintaining them

separately to

protect the

shareholders

interests.

Independent

Public

Accountant

Certifies the

fund's financial

statements.

Fund Counsel

Prepares and files

fund registrations

statements,

provides general

advice and board

support.

Sub Advisors

Mutual Funds

24

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