Hedged Equity by Harvest Funds

Hedged Equity

Harvest Funds AS www.harvestfond.no

Disclaimer This information is intended for general information purposes only and does not constitute solicitation of or an offer to participate in any investment. This information does not, nor does it purport to, constitute any form of investment advice, recommendation or independent analysis. Consequently, it has not been prepared in accordance with the rules and regulations governing such publications. This information is not, and does not purport to be, complete. The information is strictly confidential and should not be copied or circulated to anyone but the addressed recipients. The complete offering documents for the relevant investment fund should be read carefully and potential investors should seek independent investment advice before making an investment. No assurance can be given that the stated investment objectives will be achieved and the value of investments may fall as well as rise.

Past performance is no guarantee for future returns. The investment manager, its directors, employees and consultants do not accept any form of liability (whether arising in contract, tort or negligence or otherwise) for any error, omission or similar misrepresentation in this general information or for any loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this information or any other person.

Investment in alternative investment fund(s) managed by the investment manager (the “AIFs�) are solely for sophisticated investors who are professional clients or eligible counterparties under the rules of the Norwegian Securities Trading Act. The AIFs are unsuitable for any person not meeting such qualifications. Investment in the AIFs are intended for investors who can accept the risks associated with such an investment and who have no need for immediate liquidity in their investment. Investments will be subject to strict limitations on transferability and withdrawal. There will be no secondary

or public market. The foregoing list of risk factors is not complete. If you are unsure as to whether or not you qualify, please contact the investment manager.

Investment in the UCITS fund(s) managed by the investment manager are suitable for both non-professional and professional investors. On the website, you will find the latest updated information to investors, such as KIID documents and supplements.

We make no warranties that the material in this presentation is appropriate or available for use in countries other than Norway. Persons receiving this information is obliged to investigate whether there are any restrictions in their jurisdiction, and if so, to comply with any such restriction. The investment manager does not accept any responsibility for any failure to comply with any such restriction. For further information, please contact the investment manager.

2 Harvest Funds. All rights reserved.

The Problem 3 Harvest Funds. All rights reserved.

The ‘60/40’ investment model is broken Nominal 'yield' on the U.S. '60/40' Portfolio 16.0 %

•

Nominal expected return next 10 years for the U.S. ‘60/40’ portfolio is probably the lowest since 1881

14.0 % 12.0 %

•

•

Low bond yields simultaneously with low equity yields mean that the ‘60/40’ portfolio appears very risky

10.0 % 8.0 % 6.0 %

Although expectations for low nominal returns are mitigated by prevailing low inflation, a mountain of global debt represents future inflation risk

•

Whereas U.S. equities are among the most expensive in the world, interest rates are lower elsewhere making the outlook for ‘60/40’ unattractive in most developed markets.

•

Consequently, prudent investors should manage risk in a disciplined fashion and invest actively in countries, sectors or stocks that offers a return commensurate with risk taken.

4 Harvest Funds. All rights reserved.

4.0 % 2.0 % 0.0 % 1881

1901

1921

1941

1961

1981

2001

Our Solution 5 Harvest Funds. All rights reserved.

Hedged equity in the ‘core’ offers a genuine hedge against stock market declines Equity Long/Short had similar drawdowns as a 50/50 balanced portfolio 0%

Equity long/short offers similar 3-year rolling returns as the 50/50 balanced portfolio 35.0% 30.0%

-5%

25.0% -10% 20.0% -15%

15.0%

-20%

10.0% 5.0%

-25% 0.0% -30%

-5.0%

-35%

-10.0%

50/50 MSCI World / Global Agg

HFRI Equity Hedge

50/50 MSCI World / Global Agg

A bond portfolio only represents a hedge when rates go down with stocks, the short side works regardless of the reason stocks fall

6 Harvest Funds. All rights reserved.

HFRI Equity Hedge

Using judgement, co-incident and leading indicators to determine market cycle position

Not about ‘market timing’ but conditional probabilities!

7 Harvest Funds. All rights reserved.

Taking risk in line with market cycle •

Overall portfolio risk level is guided by market regime

•

We divide the market cycle into four regimes: spring, summer, fall and winter

•

We are concerned about taking enough risk as well as not taking excessive risk

•

Net short or net long in excess of 100% will always be expressed using options with max loss capped to option premium

8 Harvest Funds. All rights reserved.

Creating positive convexity by shorting negative convexity Illustrative

Short Book

Long Book

Long + Short Book

80%

+

50%

40%

-30%

=

-20%

-60%

Downside Capture

Upside Capture

Portfolio construction in the long book is seeking positive convexity (upside capture > downside capture) 9 Harvest Funds. All rights reserved.

Downside Capture

Upside Capture

Portfolio construction in the short book is seeking negative convexity (which becomes positive when stocks are sold short)

Downside Capture

Upside Capture

Diametrically opposite goals of long and short books maximizes convexity of the fund

Example: Stock market’s mispricing of leverage is another source of ‘crisis alpha’ In practice, the market does not adhere to CAPM

S&P 500 versus High Default Probability Firms

12-Month Rolling Drawdowns

350.0

0%

300.0

-10% -20%

250.0

-30%

200.0

-40% 150.0 -50% 100.0

-60%

50.0

-70%

SPX

High Default Probability

SPX

01/02/18

01/10/16

01/06/15

01/02/14

High Default Probability

Selling short highly levered firms is another source of crisis alpha which is in limited supply for the long-only investor as such firms tend to have only small weights in the benchmark indices 10 Harvest Funds. All rights reserved.

01/10/12

01/06/11

01/02/10

01/10/08

01/06/07

-80%

01/02/06

01/10/17

01/08/16

01/06/15

01/04/14

01/02/13

01/12/11

01/10/10

01/08/09

01/06/08

01/04/07

01/02/06

0.0

Our Process 11 Harvest Funds. All rights reserved.

The three pillars of our process

1. Reverse-engineering of market expectations embedded in prices and comparing them against both base rates and our measured judgement

2. Industry-dynamics approach 3. Forward-looking risk management

12 Harvest Funds. All rights reserved.

Our Process

Our Process

What is ‘baked into’ the price?

Reverse-engineering of expectations

We use the corporate life-cycle to measure profit and growth expectations embedded in the current market price Risk Indicators Reverse-engineer market expectations ‘reads’ the expectations embedded in a stock with a long-term discounted cash flow model, thus reversing the common practice which begins with earnings or cash flow forecasts to estimate the future intrinsic value of a stock

Reference Cases (Base Rates)

+

Probability Distributions

Very high market expectations

Anticipating anticipations

Measured Judgement

Idea Generation We don’t focus on the ‘right outcome’ but where the market is mispricing the skew of probabilities – anticipating anticipations 13 Harvest Funds. All rights reserved.

Netflix

(example)

•

Netflix is categorized as a Star with current CFROI of 8% and asset growth of 35%. It must retain its Star status to generate future excess returns.

•

The market expects the firm to maintain profitability and grow assets by 15% p.a. during next 5 years. Alternatively the firm must improve profitability to 15% and grow at 7% (or any combo in between)

•

Using historical base rates, the probability of growing by 15% or more for a company at the current stage in the life-cycle (with revenues in excess of $25b) is only 5%.

•

Our Process

Improving profitability to 15% whilst retaining 7% growth, considering declining asset turns from heavy investing in content when competition is hardening would be extremely hard.

14 Harvest Funds. All rights reserved.

Reverse-engineering of expectations

Reverse-engineering market expectations

Market expectations

The market’s expectations for Netflix are too elevated to make a prudent investment

From platform to movie maker?

Most important thing: industry dynamics

Our Process

Industry-dynamics approach

Industries are profitability escalators N = 1,435 starting in the middle 3 quintiles in 2000-04

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Bottom Quintile

Middle 3 Quintiles

Top Quintile

Ending position (2010-14) Downward trend industry

Upward trend industry

Megatrend industry

•

More than 70% of firms moving from middle to top quintile profitability belonged to industries in up- or mega- trends

•

Nearly 80% of firms slipping from middle to bottom quintile belonged to industries in downward trends Source: McKinsey

15 Harvest Funds. All rights reserved.

•

Industry dynamics are the most important driver of individual firm’s profitability

•

Historically more than 60% of winning stocks came from leading industry groups

The ‘5G roll-out’ is probably one of the most important industry growth stories today…….

Our Process

Industry-dynamics approach

………yet, the ACWI index offers only 3% exposure to the ‘5G roll-out’ theme

16 Harvest Funds. All rights reserved.

Forward-looking risk management

Our Process

Forward-looking risk management

• We manage risk by preparing and adapting:

Wheel Of Risk

17 Harvest Funds. All rights reserved.

• Preparing, using forwardlooking risk indicators to capture asymmetric probability distributions • Adapting, using stop-losses, respecting trend-reversals and identifying long-term growth narratives

The Outcome 18 Harvest Funds. All rights reserved.

The Outcome

CONVEXITY, and why it matters Convexity in a long-only core equity portfolio means relative convexity. That is, an asymmetric capture of the market’s up and down months. E.g. if the market declines by 1%, a 60% downside capture means that the portfolio declines by 0.6%

• During the 50 years from 1964 to 2013, a 60% downside capture would have required only 70% upside capture to match the return of the S&P 500 index • Breakevens are determined by: • Average return on upmonths • Average loss on downmonths • Percentage of up-months

19 Harvest Funds. All rights reserved.

Convexity improves the effect of compounding

20 Harvest Funds. All rights reserved.

The Outcome

The upside from less downside The blue line represents the performance of the MSCI World Index. It shows where a portfolio would end if it participated in 100% of the market’s gains, but also took full part in 100% of its losses. The torquise line represents a portfolio that participated in 60% of the MSCI World’s gains, but experienced only 30% of the MSCI World’s downside during market declines. Over time, investors would be closer to reaching their investment goals by reducing wild market swings.

44%

Increase in portfolio’s ending value

49%

Risk reduction (volatility)

$802 $557

$100

12/1/1989

12/1/1992

12/1/1995

12/1/1998

MSCI World (net TR)

21 Harvest Funds. All rights reserved.

12/1/2001

12/1/2004

12/1/2007

12/1/2010

12/1/2013

12/1/2016

Upside Capture: 60% / Downside Capture: 30%

Generating excess returns during ‘bad times’ improve investors’ total portfolio

The Outcome

-10%

Worst Drawdown

-15%

-20%

-25%

50% Convexity Strategy + 50% Global Agg

Reducing worst drawdown by 32%

-30%

50% Index + 50% Global Agg

Reducing volatility by 26%

-35%

-40% 5%

6%

6%

7%

7%

8%

8%

Standard Deviation of Returns

22 Harvest Funds. All rights reserved.

9%

9%

10%

10%