GENERATING ALPHA: Michael A. Gayed, PREDICTING VOLATILITY & CORRECTIONS

PENSION PARTNERS, LLC About Us BUT ENOUGH ABOUT US… Investment manager of mutual funds and separate accounts Absolute return and equity sector rotation strategies Quantitative, objective investment process utilizing the principles of intermarket analysis Open, transparent communication through various writings, media appearances, and social media For more information, contact us at Generating Alpha: Predicting Volatility & Corrections 2 |

INTRODUCTION A VERY BRIEF Look at Asset Allocation THE PROBLEM IS… Single most important determinant of returns Asset allocation policy drives 90% of portfolio variability (Brinson, Hood, Beebower) On average, accounts for all of total return (Ibbotson & Kaplan) Average performance across all investments must equate to the market (Sharpe) Efficient Market Hypothesis (EMH) – no strategy can consistently outperform buy and hold Generating Alpha: Predicting Volatility & Corrections 3 |

INTRODUCTION A VERY BRIEF Look at Asset Allocation Generating Alpha: Predicting Volatility & Corrections 4 | Numerous studies put into question EMH If markets are not fully efficient, tactical managers can take advantage of anomalies How? Momentum Gradual Diffusion of Information Volatility Clustering Seasonality Inefficient Markets

INTRODUCTION DEFINING Intermarket Analysis Generating Alpha: Predicting Volatility & Corrections 5 | Branch of technical analysis Study of asset class and sector relationships Relative movement across and within markets can be predictive of on- coming booms, busts, volatility, and economic changes Ways of using intermarket analysis?

WHY WE’RE HERE A Look at Signals and Strategies Generating Alpha: Predicting Volatility & Corrections 6 |

OUR AGENDA What We Will Be Covering Today Generating Alpha: Predicting Volatility & Corrections 7 | Part I:Part II:Part III: Power of Utilities sector Volatility timing & seasonality Implementation & implications Using Treasuries as signal Dynamic asset class rebalancing Practical ways to allocate Beta RotationTactical Risk RotationExamples in Recent History CONCLUSION

BETA ROTATION PART I Generating Alpha: Predicting Volatility & Corrections 8 |

A look at theoretical performance… BETA ROTATION Power of Utilities sector Generating Alpha: Predicting Volatility & Corrections 9 | One of the best early predictors of the stock market (Edson Gould) Why? Highly sensitive to interest rate expectations and economic fluctuations Backtesting to 1926, a simple strategy of rotating either fully into Utilities of fully into the stock market based on rolling 4 week return significantly outperforms a buy and hold of both

BETA ROTATION A simple buy and rotate approach Generating Alpha: Predicting Volatility & Corrections 10 |

BETA ROTATION A simple buy and rotate approach Generating Alpha: Predicting Volatility & Corrections 11 | Annualized Returns by Decade Time PeriodBRSMarketUtilitiesOutperformance vs. Market# Weeks July %15.3%28.3%11.3% %0.1%-6.4%3.6% %9.6%8.8%3.0% %18.0%14.8%1.9% %8.4%6.5%2.0% %6.0%6.9% %16.7%18.1%5.7% %17.9%8.6%1.9% %-0.3%8.6%6.3% July %14.9%13.2%2.4%187 All Years13.9%9.8%9.0%4.2%4538

BETA ROTATION A simple buy and rotate approach Generating Alpha: Predicting Volatility & Corrections 12 |

BETA ROTATION A simple buy and rotate approach Generating Alpha: Predicting Volatility & Corrections 13 | But that’s not all… Annualized Return Divided by Annualized Volatility Time PeriodBRSMarketBRS-Market All Years

BETA ROTATION Violating Timing Generating Alpha: Predicting Volatility & Corrections 14 | Real strength of Utilities is as a signal on volatility Table 5: Annualized Volatility Time Period Vol of Market when BRS is in Utilities Vol of Market when BRS is in Market Differential July %31.0%-4.9% %14.8%-0.1% %11.2%5.2% %13.7%2.3% July %15.1%5.2% July %13.6%4.4% July %14.0%2.8% All Years18.1%16.6%1.5%

BETA ROTATION Volatility timing Generating Alpha: Predicting Volatility & Corrections 15 | But what about seasonality? Utilities Strength vs. High VIX/VIX Spikes (Jan July 2013) Criteria# Weeks % of Time BRS in Utilities % of Time in Utilities Overall Differential Top 1% of VIX Values (Above 49.3)1283.3%48.5%34.8% Top 5% of VIX Values (Above 34.7)6158.1%48.5%9.6% Top 10% of VIX Values (Above 29.3) %48.5%12.5% Top 1% of VIX Weekly % Changes (>40.0%)1258.3%48.5%9.8% Top 5% of VIX Weekly % Changes (>21.7%)6161.3%48.5%12.8% Top 10% of VIX Weekly % Changes (>15.5%) %48.5%5.2% Tail event conditions ARE predictable

BETA ROTATION Sell in May, Rotate Away? Generating Alpha: Predicting Volatility & Corrections 16 | But that’s not all… Table 8: Sell in May and Rotate Away? Time PeriodUtilitiesMarketBRS% of Time in Utilities Jan1.4%1.2%1.9%58.1% Feb0.0%0.6%0.8%49.3% Mar0.4%0.8%1.0%40.3% Apr1.0%1.3%1.5%45.8% May0.4%0.3%0.4%44.4% Jun1.6%1.0%1.4%53.4% Jul0.9%0.8%1.2%55.3% Aug1.0%1.1%1.4%52.5% Sep-0.5%-0.7%0.0%46.6% Oct0.6% 0.9%56.6% Nov0.6%1.0%1.2%50.7% Dec1.9% 1.7%43.0% Nov-Apr5.5%6.9%8.4%47.8% May-Oct4.0%3.3%5.3%51.5% Overall9.7%10.4%14.2%49.7%

BETA ROTATION Sell in May, Rotate Away? Generating Alpha: Predicting Volatility & Corrections 17 |

BETA ROTATION Implementation Generating Alpha: Predicting Volatility & Corrections 18 | More importantly… Possible to execute with Exchange Traded Funds

BETA ROTATION Implications on equities Generating Alpha: Predicting Volatility & Corrections 19 | As fiduciaries, nearly all asset allocators hold equities for clients Identifying high risk periods of increased volatility minimizes emotional response Reducing beta exposure, leverage, and positioning more conservatively might enhance equity returns But what about outside of equities?

TACTICAL RISK ROTATION PART II Generating Alpha: Predicting Volatility & Corrections 20 |

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 21 | Using Treasuries as signal A look at theoretical performance… Utilities useful for within equity allocation Treasuries helpful for bond/stock asset allocation Backtesting to 1977, a simple strategy that overweights bonds relative to stocks and vice-versa when long duration Treasuries on month-over-month basis outperforms intermediate produces stronger risk-adjusted returns Total return long duration Treasuries relative to intermediate provides clues on economy and risk

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 22 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 23 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 24 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 25 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 26 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 27 | All-In Strategy – 100% Treasuries or 100% Stocks

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 28 | All-In Strategy – 100% Treasuries or 100% Stocks Instead of 100% to Treasuries…

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 29 | Dynamic Risk Rebalancing What’s the easiest way of doing this? Rule: Overweight bonds when total return long duration outperforms intermediate duration in prior month

TACTICAL RISK ROTATION Generating Alpha: Predicting Volatility & Corrections 30 | Practical ways to implement Numerous bond and stock mutual funds/ETFs can be used to over/underweight The question of when to deviate from target weights can be answered by tracking total return behavior of Treasury ETFs Identifying periods where bonds are likely to outperform stocks can minimize portfolio drawdowns Helps answer when to buy, when to sell.

EXAMPLES IN RECENT HISTORY PART III Generating Alpha: Predicting Volatility & Corrections 31 |

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 32 | 2010: Flash Crash

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 33 | 2011: Summer Crash

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 34 | 2012: Two Mini-Corrections

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 35 | 2013: False Positives

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 36 | 2014: A defensive sector posture defines January-April Utilities top performing sector YTD Broad averages did NOT correct, nor did volatility meaningfully increase BUT high beta/high momentum names did crack following leadership Positioning into defensive/low beta sectors ended up outperforming aggressive/high beta ones 1234

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 37 | 2014: No Large-Cap Correction, But…

EXAMPLES IN RECENT HISTORY Generating Alpha: Predicting Volatility & Corrections 38 | 2014: Small-Cap Correction

CONCLUSION Generating Alpha: Predicting Volatility & Corrections 39 | Intermarket analysis can enhance asset allocation Within equities, tracking behavior of Utilities can be an early predictor of on- coming volatility Treasury total return behavior on a month-over-month basis can guide portfolio tilts when addressing fixed income/stock weightings To generate alpha, follow Utilities and Treasuries. Intermarket analysis which tracks relationships that lead can result in better risk management, and long-term alpha

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