J.P. Morgan

6 G E O G R A P H I C A L A N D S T R A T E G Y D I V E R S I F I C A T I O N S T I L L M A T T E R The real art of the allocation exercise is in determining the probability of the forward outlook versus the status quo of the current equilibrium. Our capital market assumptions at J.P. Morgan are arrived at after an all-encompassing consideration of existing trends and, critically, how those trends might change over a strategic timeframe—which we believe to be 10 to 15 years, or two economic cycles. (See "Exhibit 8: J.P. Morgan's long-term expectations for equity risk and return," page 14.) Managing risk Estimating likely risk levels for equity investments is another necessary step. Over the past few years, the decline in global as well as in U.S. equity markets demonstrated the need to manage equity risk over the course of a full market cycle. In the equity absolute return space, both hedge funds and private equity strategies provide a measure of volatility abatement (depending on strategy selection) that public markets do not. Regardless of which risk measure is used—volatility, drawdown, beta or other risk metrics—there are methods to manage equity risk in a portfolio, including a factor-risk approach, analysis of execution strategies, and manager due diligence. A factor-risk approach, for example, provides a comprehensive prism for decomposing the equity exposure of non-transparent investment vehicles, such as non-public equities, into those easily observable. This allows investors to optimize across risk, return and alpha opportunities in non-public equities. By "factor" risk, we mean "looking through the secondary characteristics of fund structure, liquidity issues, fees and reporting periods, etc., to the core driver of investment risk." In other words, the equity risk premia can be derived not just from the traditionally managed active-passive public equity, but also from long-biased equity hedge funds and private equity. While there are meaningful differences between these strategies, at core, their returns and risk emanate from taking an ownership interest. 3 In addition, execution strategies layer another dimension onto equity risk taking. Some even argue that "execution" is more important than "allocation." That might be overstating the point, especially as the surge of assets into alternative strategies is likely to detract from the ability of at least average managers to generate meaningful alpha in excess of public market active manager returns. It is a matter of record. However, the choice of execution strategies can substantially alter the risk and alpha potential of equity exposure. But, as shown in Exhibit 4 on page 12, the historical reality is that economic growth does not always translate into positive public market returns and that public markets often misprice risk for elongated periods of time. It is therefore essential to consider a broader array of investment strategies to capture economic growth, manage risk and add strategies beneficial to generating potential alpha. One last perspective might help place the spectrum of equity execution in context. Public equity, hedge fund equity and private equity risk are simply points along the equity-efficient frontier, from the vantage point of factor risk. The alpha potential inherent across equity execution options merely shifts the frontier, but does not abrogate the idea that there are trade-offs that can be accomplished by altering the execution strategy. That said, successful manager due diligence within hedge fund and private equity strategies is the basis for rationalizing alternative equity allocations, as the dispersion of return is so wide as to make investing with a manager whose returns are average to below-average not worth the risk. Indeed, within both the hedge fund and private equity strategies, average or median manager performance may not adequately compensate for their inherent risks, which include key man, leverage, lack of transparency and illiquidity on top of the underlying equity risk. (See "Exhibit 9: Volatility we expect to see in equity markets," page 14, and "Exhibit 10: Dispersion of returns across equity strategies," page 14.) Home-countr y bias It is also important to take a clear-eyed look at a portfolio's potential home-country bias. And, it should be said that we do believe there can be some modest benefits to home-country bias. Investment committees choose home-country bias for a variety of reasons. Sovereign wealth funds often wish to support local financial markets, take a hand in a company's corporate governance as a large stakeholder, and/or believe 3 " Factor Risk Management: A generalized methodology for multi-asset-class portfolios," Anthony D. Werley, Chief Strategist for J.P. Morgan Endowments & Foundations Group, J.P. Morgan (2011).

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