Speakers:Steve Vogt, Co-Chief Investment Officer

Mesirow Advanced Strategies, Inc.

Calvin Jordan, Chief Executive OfficerNova Scotia Health Employees’ Pension Plan

Strategic Hedge Fund Investing

Today

• A Brief History• Refining Our Understanding of Hedge Funds• A “Balanced” Portfolio• Hedge Fund Roles• Nova Scotia Health Case Study

Evolution of Efficient Portfolio Construction• Over time investors have moved away

from commingled, diversified multi-strategy offerings

• Greater divergence in buying behaviors due to differing views about how markets will play out

• Heightened focus on:– Investments oriented around outcomes– Regulatory requirements– Investor specific objectives

Percentages provided represent Mesirow Advanced Strategies, Inc’s customized assets under management as of 12/31/2000, 12/31/2005 and 7/31/2015 as defined by Mesirow.

Hedge Funds: Refining Our Understanding

Hedge funds are not an asset class; rather a set of management/portfolio tools to under or overweight to achieve a specific goal or outcomeHow do hedge funds make money really?1. Active management

• Security selection• Trade construction (creating cheap convexity)• Allocation timing (net and gross exposure management)

2. Constructed “carry”• Hedge fund carry (e.g., short interest rebate, carry on collateral)• Liquidity intermediation

3. Leveraging alternative return styles• Momentum, mean-reversion, value, etc.

A “Typical” Investor ProblemOn the Surface, Allocation Looks Diversified

Dollar-WeightedIn Reality, “Risk Allocation” Dominated by Equities

Risk-Weighted

For illustrative purposes only. “Risk Allocation” is the percent of volatility that each asset class contributes to total portfolio volatility.

Adding Hedge Funds To SolveHedge Fund Roles

Spectrum of Hedge Fund Utility: 3 Examples• Risk Control

– Exceed cost of funding– Standard deviation < 5%– Beta to the MSCI World Index < 0.20

• Bond Substitute– LIBOR + 400 bps– Standard deviation < 4%– Beta to the S&P 500 Index < 0.30

• Return-Seeking/Opportunistic – Low double digit return expectations– High single digit volatility– 3-5 year liquidity

Objectives shown are for illustrative purposes only and are not meant to forecast the returns or risk parameters of any particular portfolio.

Case Study: Nova Scotia Health Employees’ Pension Plan

The views expressed are solely the speaker’s and do not represent investment advice. Investors should consult with their own advisors before taking any action.

In The Beginning...(Actually Pre-2008)

• Traditional Approach– Physical US equities– Return = US market return +/- active management– Risk = mostly market risk

• Portable Alpha Approach– Unfunded US equities using derivatives + “low beta” hedge funds– Return = US market return +/- (hedge fund return – finance cost)– Risk = mostly market risk

And Over “6 Days”…(About a Year of Consulting Hours)

• We more fully embraced Liability Driven Investing, viewing “risk” as the volatility of our funded ratio with our liabilities “marked to market”. This is what is meant by “risk” in this presentation;

• Decided to drastically increase our leverage recognizing that:– this could increase our expected returns;– it need not increase “risk” depending on how we invested;– our biggest source of “risk” is public equities, with the risk impact of

alternatives being comparatively modest and fixed income reducing risk.

Which Brings Us To October 2008Asset Class Allocation

Fixed Income 84.2%

Equities 42.5%

Alternatives38.5%

(includes “essential” hedge fund portion)

Leverage -65.2%

Total 100%

Details of NSHEPP’s investment policy are available at www.nshepp.ca by clicking on “publications” and “documents” tabs.

Temptation: More Return and Less Risk• Our consultant’s asset-liability model indicates that

compared to “Plan B”, NSHEPP has expected:– 24% lower funded ratio volatility; and– 0.9% / year higher returns.

51% better risk adjusted expected returns!

Actual results to date have been excellent, but this doesn’t prove anything.Note: “Plan B” is assumed to have 50% public equities, 40% universe bonds, 10% real estate (with 33.3% leverage).

The Liquidity Catch

• Using leverage will generally increase your asset volatility(not what I defined as “risk”), which increases the liquidity you need to: – rebalance to your target mix and risk budget; and– meet cash calls;

• Increasing your allocation to alternative assets generally decreases the liquidity you have;

• This is why hedge funds are an essential part of our strategy:– essential source of intermediate liquidity;– periodically “stress tested” to assure sufficiency

Implementing Hedge Funds With Our small Internal Team• NSHEPP uses “Fund-of-Funds”;• Allows us to focus on where we can add most value;• Makes allocation feasible for any fund;• Best providers have significant manager research and

portfolio construction capabilities;• Reduces implementation inefficiencies;• Fund-of-Funds providers able to negotiate enhanced terms

– (Rights, transparency, liquidity, fees that offset top level fee, etc.);

• Pension staff may resist if Fund-of-Funds structure conflicts with their career aspirations.

Key Takeaways

• Leverage generally increases expected returns;• Increased diversification into alternative assets can offset the impact

of leverage on funded ratio volatility;• But if you increase your alternative assets this will tend to reduce

your liquidity; • Hedge funds’ intermediate level of liquidity can be used to maintain

liquidity and risk at targeted levels by helping you rebalance;• Fund-of-Funds permit pension plans of all sizes to invest in hedge

funds effectively and efficiently.