Investing 101: The Basics

TEXT VERSION

 Outline

1.Investment Beliefs: The foundation for success (or failure)

2. Asset Mix Policy: Determines your long run investment returns
3. Asset Class Selection
4. Asset Class Weighting
5. Rebalancing: Why, when and how?
6. Investment Styles
7. Performance and Benchmarks
8. Security Selection
9. Environmental, Social and Governance Factors: ESG
10. Conclusions

 1. Investment Beliefs: The foundation for success (or failure)

1. Do we believe markets are “efficient”? (I.E. No one can beat the market)
– if yes: then invest in passive indexes
– if no: invest in active managers (as we largely do here)

2. What is our time horizon?
– short, medium, long?
– 1,5,10, or 25 years?

3. Do we believe in “mean reversion”? (I.E.: returns revert back to their normal trend line
or: “Trees don’t grow to the sky”)

4. Do we believe that risk and return are highly correlated? (I.E.: high returns only come with high risk)

5. Do we believe in balanced or specialist managers? (We use specialist managers – one for each type of
investment)

6. Do we believe in internal or external investment management? (We choose external managers to
manage our funds)

 2. Asset Mix Policy: Determines your long run investment returns

1. Conventional wisdom: 90% of returns are determined by asset mix

2. Asset mix: % of investments in “stock type” vs. “fixed income” type investments

3. Following chart shows the more you invest in stocks, the greater your returns, BUT the greater the
volatility

4. Risk is measured by volatility: how much returns vary over a given time period.

5. Determining your risk profile is key: “How much are you prepared to lose and how long do you
have to recoup your loss?”

6. Choice: “You can either eat well or you can sleep well”

 7. Example A.: Average return = 10%, return per year= 10%, 10%, 10%, 11%, 9% = low volatility

8. Example B.: Average return = 10%, return per year = 20%, 0%, -10%, 25%, 15% = high volatility

9. Volatility measured by “standard deviation”

10. “Success” measured by “information ratio” = Average return divided by standard deviation
– the higher, the better

11. Example A: standard deviation = 0.707. Information ratio = 10/ .707 = 14.14

12. Example B: standard deviation = 14.577. Information ratio= 10/14.577 = 0.686

 3. Asset Class Selection

1. Two broad categories: “Ownership type” vs. “Fixed Income type”

2. Ownership type: you own the asset and take all the gains and losses; I.E.: you take all the risk

3. Fixed income type: you loan money to someone else who retains ownership and pays you interest.

Your only risk is if they default

4. Ownership type:

-Common stock/shares – U.S or Foreign (developed or emerging markets)/ Large, mid or small
capitalization (“cap”)
-Real estate
-Alternatives E.G.: Infrastructure, private equity, hedge funds, commodities

5. Fixed income type:

-Cash (bank accounts)
-Short-term securities (< 365 days, commercial paper, certificates of deposit, U.S. Treasury Bills)
– Mortgages
-Preferred shares (non-voting, pay interest that fluctuates)
– Bonds (U.S. or foreign/ government or corporate/ investment grade or high yield)
-Private debt (not traded on public markets)

6. Note that real estate and infrastructure can also have fixed income type characteristics

 4. Asset Class Weighting

1. How much do you put in each asset class?

2. That is known as your “policy, neutral, normal or target” asset mix.

3. Defined for each broad asset class (E.G.: 60% equities/40% fixed income) and each sub-component

4. Also define +/- ranges for each asset class to allow for deviations and minimize buying and selling


Sample Asset Class Weighting:

Asset Class Target Weighting Range/Tolerance

Equities 60% +/-10%
– U.S. 40% +/- 7%
– Foreign 20% +/- 5%

Real Estate 10% +/- 5%

Alternatives 5% +/- 2%

Fixed Income/Bonds 25% +/- 10%
– U. S. 20% +15%/ – 5%
– Foreign 5% +/- 5%

TOTAL 100%

 5. Rebalancing: Why, When and How

Why: To return your actual asset mix back to your asset mix policy/target

Mean reversion : “Trees don’t grow to the sky”

At some point, your winners will fall and your losers will rise

Maintains your desired risk profile as expressed through your asset policy mix

Note: it is contrarian and seems counterintuitive – why sell your winners?

 When: When your asset holdings for a particular asset class exceeds the maximum or

minimum range for that asset class


Example: U. S. Equities – Target= 60% Minimum: 50%, Maximum: 70 %

– Actual weighting as of quarter end = 73%

– Cause: higher increase in market value of U.S. stocks
compared to other asset classes

How: 1. Time based –rebalance every quarter or year. Go back to asset class target even if actual

weighting is within range. E.G.: Actual 73%, Target 70%. Sell 3%

2. Policy driven – rebalance if outside of actual range
– amount buy or sell: back to target, minimum or maximum of range
or some set formula, E.G.: ½ way between actual and target

3. Use cash flow to buy underweight asset class
– use income received from dividends, interest and proceeds from
sales to buy underweight asset class
– Note: may take a long time

 6. Investment Styles

Equities: The Style box

1. Define Geographic market: U.S; Global; Developed Markets; Emerging Markets

2. Size: Small Cap Mid Cap Large Cap

Style: Value Value Value

Growth Growth Growth

Core Core Core

3. Investment approach: Top-Down vs. Bottom-up

 Bonds:

Geographic Market: U. S. or Foreign

Type: Government or Corporate

Quality: Investment Grade (BBB) or below Investment Grade (<BBB)

Style: Sector/quality rotators or Interest-rate anticipators

 7. Performance and Benchmarks

Why do we invest; To earn income to support our investment objectives

How do we know if we are earning enough or the right amount?

It depends on what we are comparing to

Do we fire a manager A who loses 10% and retain one B who earns 10%?

We could, but what if A’s peers lost 20% and B’s peers gained 20%?

Performance standards:

1. Absolute – E.G.: 7% per year or Consumer Price Index + 4%
2. Relative to Passive Index – E.G.: S&P 500 Index + 1%
3. Relative to Other Similar Managers – E.G: top 50% of managers in group

 7. Performance and Benchmarks

Key Indices:

Type Index 5 year return 10 year return 25 year return
annualized annualized

U.S. Large Cap Stocks S&P 500 9.42% 12.56% 7.64%

U.S. Bonds BBG Barclays 0.02% 1.06% 3.97%

U.S. Real Estate FTSE NAREIT 3.98% 6.80% 7.63%

Non-U.S. Stocks MSCI EAFE 1.54% 4.67% 4.50%
Developed Markets

Note: 1. Median U.S. Large Cap Manager has trouble beating S&P 500 Index
2. Time in the market is key – cannot successfully time the market

 8. Security Selection

1. Diversification is key

2. “Don’t put all your eggs in one basket”

3. Most active stock managers have “concentrated” portfolios – they don’t invest in all the stocks in the
benchmark index (otherwise, they would be like a passive manager)

4. Statistically, the benefits of diversification decrease as the number of stocks held > 32

5. Most active stock managers will hold 20-50 different stocks depending on the portfolio type

6. As not all asset classes move up or down at the same time, aim to diversify amongst those that move
in different direction. I.E.: low correlation

 8. Security Selection

1. Investment Sectors:

2. Major global stock indices have 11 sectors with varying weights

3. U.S. S&P 500; High: Information Technology 28% Low: Energy 2%

4. Canada S&P/TSX; High: Financial Services 30% Low: Health Care 1%

5. Maximums set per sector: E.G.: 25%, or Benchmark Weight + 33%

6. Maximums set per security: E.G.: 10% of portfolio in any one stock; or lesser of 50% of sector weight
and 7% of portfolio in any one stock

 9. Environmental, Social and Governance Factors: ESG

1. Rapidly evolving issue for pension plans and foundations/endowments

2. Europe in lead, followed by Canada , and then U.S.

3. Pension plans have fiduciary obligation to members. Restricted in how they apply ESG
to investments. Foundations/endowments have few external restrictions

4. Maria Droste Foundation has its guidelines on restricted investments — ahead of most

5. Governance issue: How does Maria Droste Foundation vote its “proxies”.?
I.E.: Maria Droste votes its own proxies, or managers vote as they decide, or managers vote as
instructed by Maria Droste

6. Challenge for Maria Droste Foundation: Finding managers that will construct portfolios as we
desire with appropriate benchmarks

 10. Conclusions

1. Focus on big picture objectives. Leave implementation to managers

2. Key priorities: A. Investment beliefs, B. Asset mix policy, C. Asset class selection
D. Asset class weighting

3. Define your risk tolerance: “Live well vs. sleep well”

4. Diversify (but not too much) between asset classes, asset sectors and individual securities:
“Don’t put all your eggs in one basket”

5. Select managers that seem best for a specific mandate and set realistic investment goals
and benchmarks

6. Stay invested: don’t try to time the markets. Markets reward those who commit for the long haul