TIAA-CREF asset management

Benefits of Diversification

2nd Annual OECD WPC World Pensions Investment Forum

P. BRETT HAMMONDMANAGING DIRECTOR AND CHIEF INVESTMENT STRATEGIST

February 9, 2012

Diversification within alternative assets (eventually)

Most institutional portfolios share three basic characteristics:

�A total portfolio volatility that is more than 90% dominated by equity volatility

�Portfolio-level beta values that almost always lie between 0.55 and 0.65

�Total projected volatilities (sigmas) of 10-11 percent in “normal” equity markets

Expected returns and the sigma line

Emerg. Mkt Equity

Equity Hedge Funds

Venture Capital

Private Equity

REITs

Real Estate Commodities

Sigma (Expected Standard Deviation)

Exp

ecte

d R

etur

n

0302 4 6 8 10 12 14 16 18 20 22 24 26 28

14

2

4

6

8

10

12

U.S. Equity

Global exUS Equity

U.S. Bonds All

U.S. Bonds TIPS

Cash

0

Absolute Return

U.S. Bonds Govt

Emerg. Mkt Equity

Equity Hedge Funds

Venture Capital

Private Equity

REITs

Real Estate Commodities

Sigma (Expected Standard Deviation)

Exp

ecte

d R

etur

n

0302 4 6 8 10 12 14 16 18 20 22 24 26 28

14

2

4

6

8

10

12

U.S. Equity

Global exUS Equity

U.S. Bonds All

U.S. Bonds TIPS

Cash

0

Absolute Return

U.S. Bonds Govt

The beta line and beta-based structural alphas

Equity Hedge Funds

Private Equity

REITsReal Estate

Commodities

Beta

Exp

ecte

d R

etur

n

-2-0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

14

0

4

6

8

10

12

U.S. Equity

Global Equity

AllBonds

Cash

-0.4

AbsoluteReturn

GovtBonds

2

Venture Capital

EmergingMkt Equity

TIPS RETURN ASSOCIATEDWITH THE U.S. EQUITY MARKET

RETURN ASSOCIATEDWITH THE ASSET CLASS

Equity Hedge Funds

Private Equity

REITsReal Estate

Commodities

Beta

Exp

ecte

d R

etur

n

-2-0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

14

0

4

6

8

10

12

U.S. Equity

Global Equity

AllBonds

Cash

-0.4

AbsoluteReturn

GovtBonds

2

Venture Capital

EmergingMkt Equity

TIPS RETURN ASSOCIATEDWITH THE U.S. EQUITY MARKET

RETURN ASSOCIATEDWITH THE ASSET CLASS

Source: TIAA-CREF. Calculations based on Morgan Stanley Research data, 2006

60/40 versus diversified portfolios using alternatives*

60/40 60/40 Plus VC KS KS-VCU.S. Equity 60 45 13 0 0International Equity 18 6 0 0Emerging Market Equity 10 16Absolute Return 0 0Equity Hedge Funds 0 0Venture Capital 35 24Private Equity 8 33REITS 31 20Real Estate 20 20Commodities 7 12U.S. Bonds All 40 37 46 0 0Cash 0 0 0 0 0Expected Return 5.85 5.95 7.37 8.19 7.83Sigma 11.17 11.17 11.17 11.17 11.17Sharpe Ratio 0.52 0.53 0.66 0.73 0.70Beta-Based Portfolio Alpha 0.67 0.88 3.45 4.30 3.47Portfolio Beta 0.65 0.64 0.45 0.44 0.52

60/40 – US Equities, US Bonds, CashPlus – US Equities, International Equities, US Bonds, CashVC – Same as Plus, with addition of Venture CapitalKS – All Asset ClassesKS-VC – All Asset Classes except Venture Capital

*MODEL INPUTS:

Efficient frontier with the kitchen sink portfolio

Emerg. Mkt Equity

Equity Hedge Funds

Venture Capital

Private Equity

REITS

Real EstateCommodities

SIGMA

EX

PE

CT

ED

RE

TU

RN

0302 4 6 8 10 12 14 16 18 20 22 24 26 28

13

1

2

3

4

5

6

7

8

9

10

11

12

U.S. EquityInternational Equity

U.S. Bonds All

U.S. Bonds TIPS

Cash

60/40 PLUS

KS

0

Absolute Return

60/40 versus diversified portfolios using alternatives*

60/40 60/40 Plus VC KS KS-VCU.S. Equity 60 45 13 0 0International Equity 18 6 0 0Emerging Market Equity 10 16Absolute Return 0 0Equity Hedge Funds 0 0Venture Capital 35 24Private Equity 8 33REITS 31 20Real Estate 20 20Commodities 7 12U.S. Bonds All 40 37 46 0 0Cash 0 0 0 0 0Expected Return 5.85 5.95 7.37 8.19 7.83Sigma 11.17 11.17 11.17 11.17 11.17Sharpe Ratio 0.52 0.53 0.66 0.73 0.70Beta-Based Portfolio Alpha 0.67 0.88 3.45 4.30 3.47Portfolio Beta 0.65 0.64 0.45 0.44 0.52

60/40 – US Equities, US Bonds, CashPlus – US Equities, International Equities, US Bonds, CashVC – Same as Plus, with addition of Venture CapitalKS – All Asset ClassesKS-VC – All Asset Classes except Venture Capital

*MODEL INPUTS:

Portfolio alpha and beta

60/40 60/40 Plus VC KS KS-VCU.S. Equity 60 45 13 0 0International Equity � 18 6 0 0Emerging Market Equity � � � 10 16Absolute Return � � � 0 0Equity Hedge Funds � � � 0 0Venture Capital � � 35 24 �

Private Equity � � � 8 33REITS � � � 31 20Real Estate � � � 20 20Commodities � � � 7 12U.S. Bonds All 40 37 46 0 0Cash 0 0 0 0 0Expected Return 5.85 5.95 7.37 8.19 7.83Sigma 11.17 11.17 11.17 11.17 11.17Sharpe Ratio 0.52 0.53 0.66 0.73 0.70Beta-Based Portfolio Alpha 0.67 0.88 3.45 4.30 3.47Portfolio Beta 0.65 0.64 0.45 0.44 0.52

*MODEL INPUTS: 60/40 – US Equities, US Bonds, CashPlus – US Equities, International Equities, US Bonds, CashVC – Same as B, with addition of Venture CapitalKS – All Asset ClassesKS-VC – All Asset Classes except Venture Capital

Bundled alternatives portfolios

60/40 Plus KS Bundle 1 Bundle 2U.S. Equity 45 0 34 33International Equity 18 0 8 5Emerging Market Equity 10 6.25 10Absolute Return 0 6.25 0Equity Hedge Funds 0 6.25 0Venture Capital 24 6.25 10Private Equity 8 6.25 10REITS 31 6.25 0Real Estate 20 6.25 15Commodities 7 6.25 5U.S. Bonds All 37 0 9 12Cash 0 0 0 0Expected Return 5.95 8.19 7.07 7.47Sigma 11.17 11.17 11.17 11.17Sharpe Ratio 0.53 0.73 0.63 0.67Beta-Based Structural Alpha 0.88 4.30 2.05 2.55Beta 0.64 0.44 0.63 0.61

50 50

Plus – US Equities, International Equities, US Bonds, CashKS – All Asset ClassesBundle 1 -- Equal allocation amongst AlternativesBundle 2 – 50% to Alternatives

MODEL INPUTS:

Note: Totals may not add to 100% due to rounding

Bundle 2 portfolio breakdown

WEIGHT RETURN ALPHA BETAU.S. Equity .33 2.39 .00 .33International Equity .05 .36 .07 .04Emerging Market Equity .10 .93 .34 .08Absolute Return .00 .00 .00 .00Equity Hedge Funds .00 .00 .00 .00Venture Capital .10 1.23 .75 .06Private Equity .10 1.23 .32 .10REITS .00 .00 .00 .00Real Estate .15 .83 .57 .01Commodities .05 .26 .29 -.01U.S. Bonds All .12 .45 .20 .02Cash .00 .00 .00 .00

Total Portfolio 1.00 7.47 2.54 .61Alternatives Bundle .50 4.26 2.26 .23

Estimates are used for illustrative purposes only and may or may not reflect current expectations for any or all asset classes.

Beta risk dominates alpha risk

90% of all portfolio volatility is due to equity beta

Diversification does not ensure a profit or protect against loss.

“Diversified” (Bundle 2) fund return higher

“Diversified” (Bundle 2) fund beta 0.6 (same as 60/40 portfolio) �

Normal

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

Normal

Normal

“Normal” market

Equity beta explains 96% of diversified fund vs. U.S. equity returns

Source: Morgan Stanley Research

1993-2007B1 Beta =0.56

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

-20.0 -10.0 0.0 10.0 20.0 30.0

Equity Return

B1 Return

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

B2 Return

Source: Morgan Stanley Research

60/40 Diversified

Beta Volatility Real Returns

0.61

0.83

8.43

9.54

6.27

7.29

Traditional 60/40 vs. diversified portfolios: 1993-2007

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

Traditional 60/40 vs. diversified portfolio: 1993-2007

Fear predominates

Portfolio volatility surprises

Correlations/betas go to 1

Liquidity needs predominate

But liquidity varies

Stress

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

Stress market

Stress returns: bundle 2 portfolio and and U.S. Equities

Source: MSCI monthly returns 1998 - 2007

-10.00

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

-20 -15 -10 -5 0 5 10 15

Equity Return

Portfolio C Return

Bundle 2 Return

Real Returns

60/40 Diversified

Beta Volatility

0.650.93

13.41

19.63

- 31.81

- 41.25

Traditional 60/40 vs. diversified portfolios: 2008 - Feb. 2009

Source: Morgan Stanley Research

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

Traditional 60/40 vs. diversified portfolios: 2008 - Feb. 2009

Beta

Volatility

Return

2008 2009 2010 2008-2010

60/40 Diversified

13.27 14.71

10.89 11.02

20.01 20.45

14.57 15.73

0.64 0.650.56 0.61

0.94 0.880.73

0.88

15.24

24.55

11.24 12.36

- 31.20

- 22.23

1.973.20

Source: Morgan Stanley Research

Traditional 60/40 vs. diversified portfolios: 2008 - 2010

FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR USE WITH OR DISTRIBUTION TO THE PUBLIC.

Stress betas when correlations go toward 1.00

Source: MSCI monthly returns 1998 - 2007

Original StressBeta Beta

B: 60/40 Plus F: Bundle 1 G: Bundle 2US Equity 1.00 1.00International Equity 0.77 1.18 Initial Beta 0.64 0.63 0.61Emerging Market Equity 0.76 1.70Absolute Return 0.28 0.56 Stress Beta 0.65 0.82 0.89Equity Hedge Funds 0.66 1.28Venture Capital 0.59 1.68 % Beta Increase 0% 30% 46%Private Equity 0.98 1.39REITS 0.48 1.13 Stress Vol 12.41 13.50 15.66Real Estate 0.07 0.07Commodities -0.29 0.56 Stress Correlation ~100% 94% 96%US Bonds All 0.14 0.14 w/US EquityCash 0.00 0.00

Portfolio

Comparing betas across allocations

Source: Morgan Stanley Research

(Lag?) (Stress?)

Theoretical 93-07 93-97 98-02 03-07

U.S. Equity 7.25 7.59 17.23 -2.89 9.42Real Return

60/40 Plus Beta 0.65 0.53 0.61 0.49 0.61

Bundle 2 Beta 0.61 0.56 0.46 0.59 0.59

Plus v. B2 Close Close Lower High Same

Comparing total returns across allocations

Source: Morgan Stanley Research

Theoretical 93-07 93-97 98-02 03-07

U.S. Equity 7.25 7.59 17.23 -2.89 9.42Real Return

60/40 Plus 5.85 6.35 12.17 0.93 6.24

Bundle 2 7.47 9.70 13.21 4.62 11.46

Plus v. B2 Higher Much Higher Much MuchHigher Higher Higher

Diversification within equities

“Traditional” cap-weighted portfolios already diversified by

�Region, country

�Size

�Style

�Sector

But is this “true” diversification?

Other angles on equity diversification

�Size

�Value

�Volatility, risk

�etc?

True risk factors?

Long term historical performance of risk premia strategies

Source: MSCI Barra

Historical performance of risk based risk premia strategies

75

100

125

150

175

200

5/8

8

5/8

9

5/9

0

5/9

1

5/9

2

5/9

3

5/9

4

5/9

5

5/9

6

5/9

7

5/9

8

5/9

9

5/0

0

5/0

1

5/0

2

5/0

3

5/0

4

5/0

5

5/0

6

5/0

7

5/0

8

5/0

9

5/1

0

5/1

1

Cumulative Outperformance Relative to MSCI World

Equal Wgt

Risk Wgt

Min Volatility

Source: MSCI Barra

Historical performance of value based risk premia strategies

75

100

125

150

175

200

5/8

8

5/8

9

5/9

0

5/9

1

5/9

2

5/9

3

5/9

4

5/9

5

5/9

6

5/9

7

5/9

8

5/9

9

5/0

0

5/0

1

5/0

2

5/0

3

5/0

4

5/0

5

5/0

6

5/0

7

5/0

8

5/0

9

5/1

0

5/1

1

Cumulative Outperformance Relative to MSCI World

Country Value

Classic Value

Value Wgt

Source: MSCI Barra

Long term historical performance of risk premia strategies

Risk Premia Strategies

Equity Strategies

Low Volatility Strategy

Value Strategy

Momentum Strategy

…

Currency Strategies

Carry Strategy

Value Strategy

Momentum Strategy

…

Fixed Income Strategies

Term Premium

Credit Premium

High Yield Premium

…

Arbitrage Strategies

Merger Arbitrage

Convertible Arbitrage

Volatility Arbitrage

…

Selected examples of multi asset class risk premia strategies

Source: MSCI Barra

Conclusions

�Newer approaches to diversification within asset classes can add value (risk and return benefits)

�These can be systematically applied and constructed

�But they should not be undertaken naively—stress periods—liquidity issues—tilt bets

IMPORTANT INFORMATION

This material is for informational purposes only.

�Hedge funds, venture capital/private equity and non-traded real estate are subject to illiquidity and higher expenses than traditional investment vehicles.

�Alternative investments may be subject to the risks of leverage and speculative trading.�Commodity investments may be subject to substantial volatility.�Emerging market investments are subject to political risks and currency volatility.

This material has been prepared by and represents the views of the author, and does not reflect the views of any TIAA-CREF affiliate. These views may change in response to changing economic and market conditions. Any projections included in this material are for asset classes only, and do not reflect the experience of any product or service offered by TIAA-CRE F. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service.

All exhibits in this paper are for illustrative purposes only and do not reflect the expected performance of any investment or TIAA-CREF product or service. Correlations between alternative and traditional asset classes may change dramatically in times of financial stress.

TIAA-CREF Asset Management is a division of Teachers Advisors, Inc., a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA-CREF® personnel in its investment management area provide investment advice and portfolio management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®).

CONTACT INFORMATION

P. Brett HammondManaging Director and Chief Investment Strategist

TIAA-CREF Asset Management730 Third AvenueNew York, New York 10017–3206

(212) 490–9000www.tcasset.com

TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and FINANCIAL SERVICES FOR THE GREATER GOOD are registered trademarks of Teachers Insurance and Annuity Association.

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Appendix

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