The Capital Preservation Challenge
May 2006
Why is Capital Preservation relevant?
2
Happiness
0
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
Wealth Utility
-2
-4
Market returns
-6
-8
-10
-12
Disappointment
Utility
-14
1
Are traditional top-down approaches still optimal?
JPMorgan capital market return assumptions (10-15 yr))
.90
.60
.50
.50
2
.40
Intl Stocks Correls (incl Japan)
Intl Stocks Correls (excl Japan)
Dec-97
.30
Dec-96
Dec-02
Dec-03
Dec-01
Dec-97
Dec-96
Dec-95
Dec-94
Dec-93
Source: Datastream, JPMAM
Dec-00
Intl Bonds Correls (excl JGBs)
.30
Dec-92
– Diversification needs to be sought outside
of beta space
Intl Bonds Correls (incl JGBs)
Dec-95
.40
Dec-03
.60
Dec-02
.70
Dec-01
.70
Dec-00
.80
Dec-98
.80
5yr trailing
Correlations
Dec-94
5yr trailing
Correlations
Dec-99
– Increased intra-asset class correlation
makes efficient portfolio construction
difficult
.90
Dec-98
 Decreasing benefits of diversification
in core asset classes
Dec-93
– Strategies with a greater degree of market
neutrality need to be utilised
Dec-92
– Return objectives can no longer be met by
excessive beta exposure
2000
Current
Dec-99
 Reduced asset class return expectations
11.5%
10.5%
9.5%
8.5%
7.5%
6.5%
5.5%
4.5%
3.5%
Traditional approach to building portfolios
 Historically 90% of portfolio returns and risk dependent on strategic asset allocation
 Portfolios have historically been too dependent on a small number of decisions
No. of
decisions
Equities
Geographic
region
Large/
small
cap
Bonds
Industrial
sector
Value/ Cyclical/
growth defensive
Credit
2
Duration Currency
5
Beta
/low
beta
Geographic
region
Investments
Industrial
sector
Volatility
7
1000’s
 To increase returns, investors have had to increase exposure to high volatility asset classes
 Portfolios have been built from asset class choices. So alpha has been hostage to beta
3
If securities are held for index-relative reasons opportunities for
active management are reduced
Cumulative market-cap distribution of MSCI World ranked by size*
 50% of global equity index is in 8% of the
companies
(%)
100
 Focuses investments on relative size
90
80
 Focuses too much on the past
70
60
 May not reflect the best investment criteria
50
40
30
20
10
0
0
250
500
750
1,000
1,250
Number of companies
* Source: Datastream
Alpha is hostage to beta buckets
4
The case for a total return approach
 At its purest level the principal objective of our industry should be to achieve the highest
risk adjusted total return for our clients
 Investors have an asymmetric approach to risk – the real risk is losing money
 Investors care increasingly less about index benchmarks
 In a low nominal return environment, alpha is more important than beta (choice of assets)
 Active management
… the challenge is obvious, the question is how to achieve it…
5
Traditional total return was fixed income oriented
Past:  During declining inflation and yields, bonds exhibited an attractive total return
profile
US Core CPI
US 10 yr bond yield
16
14
12
10
8
6
4
2
0
80
84
88
92
Source: MacData, JPMAM
Now:
6
 Interest rates low, credit spreads have narrowed
 Equity dividends should increase
96
00
04
How do we define total return investing?
 Risk is defined in terms of capital loss rather than benchmark relative performance
 Return objective is set independently of asset class - i.e. Cash plus
 More upside capture / less downside capture. Optionality
 Portfolios managed as one unit rather than subdivided into component parts
 Management is active and flexible
 Transparent in process and holdings
... investors have an asymmetric attitude to risk and return
7
Total return: a flexible solution
Total Return:
 Concentrated portfolio of
best company specific
ideas
Characteristics of
Benchmarking
 Returns closely track
index
 Always fully invested
 Risk is relative
 Only a small percentage
of active positions
 Inability to use all
available investment tools
8
 Ability to use all available
investment tools
 Market risk
reduced/controlled
 Lower volatility
 Can hold cash
 Within the regulations of
UCITS
Characteristics of
Hedge Fund Investing
 Star Fund Manager
culture
 Strategy risk
 Short risk
 Leverage
 Liquidity constraints
 Limited transparency
Total return positioning
Performance & Diversification
Absolute return strategies
Alpha
The Total Return opportunity set We choose the correlation with the market
‘Conventional’ Active Funds
Index Funds
0
Correlation with markets (R2)
• Unconstrained investing using a broad range of investment tools
• Concentrated in our best company specific ideas
• Flexible market exposure
9
100
The building blocks for managing total return funds
 Agnostic to choice of investment assets
 Active risk control
– economic factors
 Top down/bottom up
 Identify sources of return
– sectors
– regions/countries
– themes
– security specific factors
– market and security exposures
– diversification
– “Value at Risk”
– stress testing
– hard controls
– equities
– bonds
– convertibles
– currencies
... effective management of downside risk
10
Allocation to different asset classes
Equity Exposure
Convertibles
Bonds
Cash
Others*
Total Delta **
%03
100%
90%
80%
70%
%02
60%
50%
40%
%01
30%
20%
10%
%0
0%
Jan-05
11
Feb-05
Mar-05
Apr-05
May-05
* Money Market Funds and FRN
** Equity specific risk from stock and convertibles
Jun-05
Jul-05
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Recommended objectives and portfolio characteristics
Performance target
Benchmark
Process
Alpha Source
Equities
Convertible Bonds
Cash
Bottom-up with Dynamic Asset Allocation
Best Investment Ideas
0 - 30%
0 - 50% (part of 30% total equity risk budget)
Straight Bonds
0 - 100%
Cash
0 - 100%
Derivatives
Optional, no leverage
Expected Volatility
Low
Currency Hedging
Yes
A core low risk holding
12
Cash +3%
Summary
 Target capital preservation with a multi-asset approach to get desired asymmetric
risk/return profile
 Top down themes combined with bottom up security selection
 Alpha combined with modest levels of beta (beta arises solely from active positions, not
from benchmarks)
 Flexible active management
 Transparency in process and holdings
… objective
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best risk adjusted return
 Olivia Mayell - Client Portfolio Manager, Global Multi Asset Group
Tel +44 (0)20 7742 5467 • e-mail: olivia.c.mayell@jpmorgan.com
Any forecasts or opinions expressed are JPMorgan’s own at the date of this document and may be subject to change. The value of
investments and the income from them may fluctuate and your investment is not guaranteed and investors may not get back the full
amount invested. Past performance is not a guide to future performance. Exchange rates may cause the value of underlying
overseas investments to go down or up. Investments in smaller companies may involve a higher degree of risk as they are usually
more sensitive to market movements. Investments in emerging markets may be more volatile than other markets and the risk to your
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. Telephone lines are recorded and may be monitored for security and
training purposes
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