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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.
The Northern Trust Experience
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.
The Northern Trust Experience
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)
0
100
200
300
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
The Northern Trust Experience
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
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
The Northern Trust Experience
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
The Northern Trust Experience
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.*
The Northern Trust Experience
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
The Northern Trust Experience
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
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.
The Northern Trust Experience
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!
The Northern Trust Experience
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
t o
f p
ort
foli
o
DSCR STPL ENER FINA HLTH INDU INFT MATS TCOM UTIL
The Northern Trust Experience
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.
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.
21 deals represent over 1/3 of total announced value
Bifurcation of the buyout market
Performance measurement implications
Source: 2008 Preqin Global Private Equity Review
The Northern Trust Experience
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 +
The Northern Trust Experience
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
The Northern Trust Experience
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.
The Northern Trust Experience
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.