The Evolvement of Pension Management:
Searching for opportunities in alternative investment
December 13, 2006
Even Chen
Institutional & Segregated Fund Business
JPMorgan Asset Management ,Taiwan
2
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
3
How did U.S DB pension plans lose so much ground?
Historical analysis of asset/liability performance for hypothetical plan
4
81% of U.S. Top 200 corporate pension plans with an underfunded status ending 2005
Median funded ratio:86% - remains at 2004 levels
There is a significant difference in return on assets between top and bottom performers
5
Easy money is a thing of the past
The good old days in global investment sphere
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
197519761977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004
Source: JPMorgan Asset Management; MSCI World Index 1975~2004
Increasing volatility in S&P 500 return distributions
0%
1%
1%
2%
2%
3%
3%
4%
-80% -60% -40% -20% 0% 20% 40% 60% 80%
Jun-03Oct-99Oct-97
return
frequency
Source: JPMorgan Asset Management Estimates: S&P 500 distribution of 10 year trailing returns using monthly data
year
return
6
Pensions all over the world reveal a strong home bias
Investors all over the world reveal a strong home bias
Domestic equities as a share of total equity allocation and as total world market capitalization in select markets
1% 1%
53%55%
33%
74%
HK Nordics US
Share in market cap
Share in portfolio
Source: MSCI, JPMorgan Asset Management. The chart shows the percentage of each market as represented in the MSCI World index (December 2004), and as a percentage of the equity portion in average pension portfolios. Shown for illustrative purposes only.
7
But domestic equity has underperformed and volatility is much higher
Cumulative return of Taiwan equity vs. Global equity 1991 = 100
Source: MSCI, Ibbotson, JPMorgan Asset Management. The chart the cumulative return for S&P/IFC Taiwan TR index, S&P 500, MSCI Europe and S&P/IFC Emerging Market Index . Shown for illustrative purposes only.
0
100
200
300
400
500
600
91 92 93 94 95 96 97 98 99 00 01 02 03 04
Domestic TW equity
EME
US
Europe
MarketsHistorical volatility
Taiwan 34%
US 14%
Europe 15%
Asia ex. JP 20%
8
Relaxing constraints on international equities leads to better portfolios
Efficient frontiers with different limits on international assets
Risk
Ret
urn
Unconstrained
Max 50%
Max 10%
Zero
Source: JPMorgan Asset Management based on proprietary optimization model using long-term expected return assumptions, historical volatility and correlations. Shown for illustrative purposes only.
Domestic expected to outperform
Domestic expected to
underperform
Typical allocation
0%
10%
20%
30%
40%
50%
60%
-2.50% -1.50% -0.50% 0.50% 1.50% 2.50% 3.50%
Expected return of domestic vs. international
All
oca
tio
n t
o d
om
esti
c
What return premium would justify a high concentration in domestic?
9
The correlations are the key to the success of diversification
Correlation with Taiwan equity index 1990-2004
Source: MSCI, Ibbotson, JPMorgan Asset Management. The chart shows the 3-year rolling correlation for S&P/IFC Taiwan TR index, with S&P 500, MSCI Europe and S&P/IFC Emerging markets Index. Shown for illustrative purposes only.
US
Europe
EME
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
94 95 96 97 98 99 00 01 02 03 04
Performance of different equity portfolios during select global equity bear markets
-27%
-45%
-22%
-41%
-14%
-35%
-12%
-33%
-50%
-45%
-40%
-35%
-30%
-25%
-20%
-15%
-10%
-5%
0%
1997 - 99 2000 - 01
100% domestic85% domestic65% domestic55% domestic
10
The world has become “one market”
11
A more diversified portfolio with non- traditional assets would have held up better
Performance of different asset classes during 00 - 02
Source: MSCI, Ibbotson, JPMorgan Asset Management. The chart shows the annualized compound return for S&P/IFC Taiwan TR index, S&P 500, MSCI Europe and S&P/IFC Emerging markets index during the period March 2000 – December 2002. Shown for illustrative purposes only.
Real estate
Inflation bonds
Long duration
Commodities
EMD
Global equity
TW equity
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
0% 5% 10% 15% 20% 25% 30% 35% 40%
Historical risk
His
toric
al r
etu
rn
Performance of different portfolios during 00 - 02
-16%
-4%
-1%
-18%
-16%
-14%
-12%
-10%
-8%
-6%
-4%
-2%
0%
His
tori
cal r
etur
nGlobal equity Equity / bond
portfolio
Diversified portfolio
Source: MSCI, Ibbotson, JPMorgan Asset Management. The chart shows the annualized compound return for MSCI World equity, a balanced 50% equity / 50% global bond portfolio, and a diversified portfolio consisting of 10% DJAIG TR commodity index, 10% JPMEBI Emerging markets debt index, 10% US Inflation –linked bonds, 20% Lehman Brothers Long government / credit index, 15% US Large cap S&P 500 index, 15% MSCI EAFE index, 10% S&P/IFC Taiwan TR equity index, 10% Direct real estate NPPITR index during the period March 2000 – December 2002. Shown for illustrative purposes only.
12
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
13
There are pronounced differences in the average portfolio allocations
for U.S. and Europe pensions
Europe favours a more conservative mix while U.S has greater concentration in domestic assets
14
U.S. is more inclined to routinely rebalance asset allocation while Europe appears more willing to actively shift away from their strategic allocations
15
There is also pronounced differences in return expectations and benchmarks for measuring
U.S. has higher return expectation than Europe
Differences in how success is measured
16
Utilizing broader range of assets and more active management styleShow great willingness to use alternative asset classes / strategies to enhance returns
Trends in embracing active equity investment management
17
Hiring innovative strategies and tools - Europe is more likely to use absolute return while U.S. prefers portable alpha relatively
Showing a divergence in using innovative strategies between Europe and U.S.
Derivative is popular tool hired to enhance portfolio performance
Leverage is less popular tool taken to boost returns
18
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
19
Higher funding target to be required
20
Yield curve for discounting liabilities
*Assuming an upward-sloping yield curve
21
Overview of possible accounting changes
22
Responding to the challenges
Different rules and concerns lead to different strategies used to enhance performance
Source:JPMorgan Pension Survey December 2006
Innovative solutions
23
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
– Hedge Fund
– Real Estate
– Private Equity
– Currency Overlay
24
Alternatives have become popular assets for pension plans
Investment in alternative asset classes for U.S. pension plans
Source:JPMorgan Pension Survey December 2006
25
Why alternatives?
Strong outperformance over past decade The alternative world – $3 trillion in assets
26
Alternative asset return assumptions in 2008
Source: JPMAM Estimates ;US dollar-based assumptions; compound (IRR) 10-15 years returns
27
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
– Hedge Fund
– Real Estate
– Private Equity
– Currency Overlay
28
Source: HFRI
More money from institutions contributes to an unprecedented growth of hedge fund assets
0100200300400500600700800900
1,0001,1001,2001,300
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006YTD
8,987Funds
Estimated growth of hedge fund assets (1990 to June 2006)Assets in billions
2000 2001 2002 2003 2004 2005 2006 2007 20080%
10%
20%
30%
40%
50%
60%
Year
Inst
itu
tio
nal
Per
cen
tag
e o
fT
ota
l H
edg
e F
un
d N
et F
low
s
Institutional share of total Hedge Fund capital flows
Assets within the hedge fund industry have grown at an unprecedented rate throughout the last decade
Source: Casey, Quirk & Acito and The Bank of New York analysis
29
Benefits of allocating to hedge funds in a diversified portfolio
1 Measure of risk adjusted return. The risk-free rate is the U.S. 3-Month T-Bill rate annualized over the period.
2 Maximum drawdown is the largest percentage drawdown during the period
3 Hedge Fund Research (HFR) is a widely used industry benchmark, although the exact composition of these indices remains proprietary.
Hedge funds have higher risk-adjusted returns with low correlation compared to traditional asset classes
July 1996 through June 2006
S&P 500MSCI World -
Local
J.P. Morgan Global Bond -
Local
Lehman Aggregate Bond
Hedge Fund Research (HFR) Fund Weighted
Index3
Return 8.32% 6.92% 6.55% 6.22% 10.64%
Standard Deviation 15.66% 14.55% 3.01% 3.63% 7.43%
Sharpe Ratio1 0.30 0.23 0.97 0.71 0.94
Correlation with HFR Fund Weighted Index 0.72 0.77 -0.13 -0.05 1.00
Maximum Drawdown2 -44.71% -46.80% -8.14% -3.55% -11.42%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Annualized Standard Deviation (Volatility)
An
nu
alize
d R
etu
rn
Risk and Return of Stocks, Bonds and Hedge Funds: 1990 - 2005
100% Lehman Govt./Corp. Bond
100% Hedge Fund Composite1
100% S&P 500
50% S&P 500 and 50% Lehman Govt./Corp. Bond
Source: PerTrac. Hedge Fund Composite represented by HFRI Weighted Composite (net of manager fees)
Past performance may not be indicative of future results. Indices are shown for illustrative purposes. Indices are not available for investment by the public nor are fees and expenses charged by indices. This is not intended and should not be interpreted as the performance of an actual investment.
30
More institutions are investing but aggregate allocations remain small
Percentage of Institutional Investors Using Hedge Funds
2003 2004
U.S. 23% 28%
Europe 23% 32%
Japan 18% 40%
Source: Greenwich Associates (December, 2004)*Continental Europe
2.0%1.0%0.4%Japan
1.0%1.0%1.0%Continental Europe
0.6%
1.6%
1.6%
2004
0.2%
1.2%
1.3%
20032002
0.1%United Kingdom
0.9%Canada
1.0%U.S.
Hedge Fund Allocation as a Percentage of Total Institutional Assets
Percentage of Institutional Investors Using Hedge Funds
Source: Greenwich Associates, Demand & Hiring for Hedge Funds 2001-2005
15% 20% 23% 28% 28%
0
50
2001 2002 2003 2004 2005
31
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
– Hedge Fund
– Real Estate
– Private Equity
– Currency Overlay
32
European pension funds place significantly more faith in property than other regions of the world
Europe pension fund allocations to real estate by country ended 2002
33
There is a better diversification impact of investing in property than in international equities
Private property correlations 1995-2004 U.S. correlations with foreign markets 1996-2005
Source:GPR,MSCI,JPMorganSource:IPD,JPMorgan
34
Domestic
Other
Domestic
Other
Sources: Company filings, JPMorgan
Typical non-Real Estate International Company
Cross-border correlations within Real Estate Companies kept down by staying local
Domestic
Other
Domestic
Other
Typical Real Estate Company
Sources: Company filings, JPMorgan
Revenue shares for Real Estate and non-Real Estate companies
35
Sources of revenues for Top 10 broad market and real estate firms
Source:Company filings,JPMorgan Source:Company filings,JPMorgan
Top 10 broad market firms Top 10 real estate firms
36
70% stocks
30% bonds
Adding REITs to global portfolios produces better risk/return profile
Global Stocks and Bonds
Ten years through September 30, 2006
Return: 5.91%Risk: 10.39%
Sharpe ratio: 0.22
Return: 6.55%Risk: 9.83%
Sharpe ratio: 0.30
Annualized Return 11.81% 5.72% 5.43%
Standard Deviation 13.45% 14.51% 6.53%
RES Equity Fixed IncomeTen years through September 30, 2006
10% RES
60% stocks
30% bonds
With 10% Global Real Estate Securities
Source: Ibbotson, GPR, MSCI,J.P. Morgan Investment Management
The following indices were used as proxies for the respective asset classes: Global Real Estate Securities (GPR 250 Index), Equity (MSCI World), Fixed Income (JPM Government Bond Index Global).
37
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
– Hedge Fund
– Real Estate
– Private Equity
– Currency Overlay
38
Buyout is mainstream market in P.E
Distributions by US private equity funds (1990-09/30/2003)
Annual percent net change in portfolio valuations US venture and buyout formed 1992-2003
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
1990 1992 1994 1996 1998 2000 2002
Year
Buyouts
Venture
Distribution $mn
Database Source: VentureXpert database from Thomson Venture Economics
Investment Data Source: The MoneyTree Survey by PricewaterhouseCoopers/Thomson Venture Economics/NVCA
All other data Source: Thomson Venture Economics
-50
0
50
100
150
200
1992 1994 1996 1998 2000 2002
Year
Pe
rce
nt
Venture Buyouts
39
Emerging markets potentially have room to grow
Geographic breakdown in 2005 P.E as a percentage of GDP
Data Source: Private Equity Intelligence
40
P.E with a stable performance compared to global equity
P.E versus MSCI 1994-2005
Data Source: Private Equity Intelligence
300% return in 10 years
41
The trend of “Mega” will dominate the P.E market
Raised AUM in buyout from 2004 to 2006 The bigger AUM, the better performance
Data Source: Private Equity Intelligence
42
Beta and Alpha in P.E
P.E as a beta market versus public equity (S&P500) ; 5-years rolling annualized total return since 1986
Data Source: JPMorgan,Datastream,LPX,Cambridge Associates
43
Agenda
Basic observations of pension management
Pension surveys & trends
– New sources of return
– U.S.pension reforms and challenges for plan sponsors
The benefits of alternative investment in portfolio management
– Hedge Fund
– Real Estate
– Private Equity
– Currency Overlay
44
The diversification going into global assets generates currency risk
45
Unhedged currency exposure has significant volatility6.
3%
-3.0
%
-5.2
%
8.7%
4.6% 5.9%
-2.3
%
15.1
%
2.0%
-6.1
%
1.5% 2.2% 3.7% 5.1%
-4.3
%
-2.3
%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Ann
ual P
erfo
rman
ce
MSCI World Local Return Currency Return Return to TWD Investor
Source: JPMorgan Asset Management, MSCI, Bloomberg
Annual returns of MSCI World to Taiwanese Investor
… Currency can have meaningful returns in international investing
46
How to hedge? Active,or passive,or “do nothing”
47
Perfect overlay versus actual overlay
Quarterly currency performance with perfect overlay Quarterly currency performance with actual overlay
48
Optimal hedge ratio varies by international exposures
Source: JPMAM
0%
10%
20%
30%
40%
50%
60%
70%
International Allocation
Opt
imal
Hed
ge R
atio
49
Adding value through active currency overlay management
50
Annualized hedging return for unhedged composite of JPMAM clients
The benefits of currency overlay management
* Unhedged results: Equal weighted composite of JPMorgan Asset Management's managed currency returns for MSCI World ex US, unhedged USD based portfolios from 1st September 1992 to 30 June 2005, currency return as measured by JPMorgan Asset Management. The results are gross of fees.
Source: JPMorgan Asset Management
0.0
0.2
0.4
0.6
0.8
1.0
1.2
5 5.5 6 6.5 7 7.5
Portfolio risk (%)
Currency OverlayHedging Return
Unhedged Currency
Portfolio currency return (%) Industry JPMAM All account information ratio 0.55
0.79
All account excess return 1.06%
1.42%
All account tracking error 2.25%
1.79%
Cumulative success ratio 75%
92%* JPMAM = 48 accounts, Industry = 241 accountsSource: Frank Russell, JPMAM Survey sample: 1989-2000
Frank Russell Survey for currency overlay
51
Appendix
52
The summary of U.S. pension reforms and implications
53
A hedge fund bubble has yet to be seen
54
Property securities market correlation minus broad stock market correlation 1996-2005
Source:GPR,MSCI,JPMorgan
55
LPX – Private Equity Index
Top 10 companies in LPX Major Market
Data Source: Newsletter LPX Major Market (30 June, 2006)
56
Searching for the optimal hedging ratio and foreign exposures
Sharpe ratios using different combinations of hedging and foreign exposure
57
The commingled trust funds are collective investment funds maintained by JPMorgan Chase Bank. Only qualified employee benefit trust and governmental plans that have appointed JPMorgan Chase Bank as fiduciary are permitted to invest in the fund. JPMorgan Asset Management advises JPMorgan Chase Bank regarding the management of the funds. Past performance is not indicative of future returns. Net returns are based on the highest applicable fee rate for this strategy.
This document is intended solely to report on various investment views held by JPMorgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
The value of investments and the income from them may fluctuate and your investment is not guaranteed. Past performance is no guarantee of future results. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made.
Performance results are gross of investment management fees. The deduction of an advisory fee reduces an investor’s return. Actual account performance will vary depending on individual portfolio security selection and the applicable fee schedule. Fees are available upon request.
The following is an example of the effect of compounded advisory fees over a period of time on the value of a client’s portfolio: A portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum would grow to $259 million after 10 years, assuming no fees have been paid out. Conversely, a portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum, but paying a fee of 1% per annum, would only grow to $235 million after 10 years. The annualized returns over the 10 year time period are 10.00% (gross of fees) and 8.91% (net of fees). If the fee in the above example was 0.25% per annum, the portfolio would grow to $253 million after 10 years and return 9.73% net of fees. The fees were calculated on a monthly basis, which shows the maximum effect of compounding.
Illustration showing impact of investment management fees: An investment of USD $1,000,000 under the management of JPMAM achieves a 10% compounded gross annual return for 10 years. If a management fee of 0.75% of average assets under management were charged per year for the 10-year period, the annual return would be 9.25% and the value of assets would be USD $2,422,225 net of fees, compared with USD $2,593,742 gross of fees. Therefore, the investment management fee, and any other expenses incurred in the management of the portfolio, will reduce the client’s return.
All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. They are based on current market conditions that constitute our judgment and are subject to change. Results shown are not meant to be representative of actual investment results. Past performance is not necessarily indicative of the likely future performance of an investment.
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Copyright © 2005 JPMorgan Chase & Co. All rights reserved.
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