Taking the alternatives route to portfolio construction

InvestmentNews: Let’s ask each of our panelists to take a minute to tell our audience a little bit about themselves, their firms and how they use alternative investments in their portfolios. Why don’t we start with you, Richard?

Mr. Bregman: I am the founder and CEO of MJB Asset Management. We are a [Securities and Exchange Commission]-registered investment advisory firm; we create portfolios for our clients primarily using “40 Act SEC-registered mutual funds.

Strategically, we are committed to incorporating alternative strategies into all of our client portfolios unless they instruct us otherwise. And to that end, we always maintain at least one-third of each client’s portfolio in a variety of alternative strategies. And we’ve been gradually moving to that position since really the end of the tech bubble crash, starting somewhere in late 2002 and early 2003, moving to where we are now.

InvestmentNews: Steven?

Mr. Young: I’m chief investment officer of Curian Capital. We’re a registered investment adviser, as well. We’re the asset management arm of Jackson National Life [Insurance Co.].

Jackson, if you’re not familiar with the name, is an annuity provider with nearly $130 billion in assets. And the Jackson solutions are distributed through both wirehouse and independent advisers.

Curian Capital has $9 billion in [assets under management] and we’re a provider of unified managed accounts to independent broker-dealers. From an alternatives perspective, Curian oversees the allocation of both traditional and nontraditional investments, both on the Jackson annuity platform and within the Curian UMA platform. Some of those alternatives we manage internally, but many of the strategies are from firms such as The Boston Co. [Asset Management LLC] or BlackRock [Inc.], AQR [Capital Management LLC], Invesco [Ltd.] and others.

It’s a driving focus for Curian to bring an intense level of diligence and portfolio construction that’s used by some of the big institutions, the multibillion-dollar pools of assets. And we want to bring that diligence and portfolio construction to a much broader investor base.

WHAT IS AN ALTERNATIVE?

InvestmentNews: One thing that we struggle with is the idea of defining alternatives. Steve, how does Curian define alternatives?

Mr. Young: I think that is sometimes a little bit of a confusion or a debate, what qualifies as an alternative, and I think in the simplest terms, we would define alternatives as either an asset class or a strategy that performs differently than traditional stock and bond investments. So that’s it at its simplest level, both asset classes and strategies, different than stock and bonds. But then you get into the asset classes — what do you mean by that?

So things like private equity, commodities, infrastructure, currency — even volatility — today are some of the unique asset classes. Then there are strategies that have the flexibility to hold both long and short. The ability to short securities helps define what alternatives are. The ability to use derivatives and leverage also defines an alternatives strategy. And some of those strategies might use traditional asset classes going both long and short. And some of those strategies are referred to as literally long and short stock or bond portfolios, market-neutral, arbitrage strategies, global, macro or managed futures.

InvestmentNews: Is there an objective that a strategy has to have or an asset it has to have in order to be considered an alternative?

Mr. Young: The objective would be that they just behave differently than traditional stock and bond portfolios. So that objective can be an absolute-return strategy, where they’re looking for consistently positive returns, which certainly in the equity market, that’s different — an equity is going to have negative returns. Or it could be an objective for just appreciation, but they go about it much differently in the use of some of the strategies that I talked about, going long and short, using derivatives, using futures that would cause the return pattern to be very different than a traditional stock or bond portfolio.

InvestmentNews: Noncorrelation, essentially?

Mr. Young: Exactly.

InvestmentNews: Richard, what’s your general perspective on how you define an alternative investment?

Mr. Bregman: I go about halfway as far as Steve does. I’m on the side that it’s strategy-driven. And if you have a strategy that is designed to perform differently than a long-only strategy through the use of shorting a derivative’s leverage, then I will view that as an alternative strategy. I agree that there are asset classes that move differently than traditional stocks and bonds. For me, though, unless they’re incorporating some type of shorting capability or unless the managers have the ability to integrate a short strategy within their approach, I don’t consider it to be an alternative for our purposes.

InvestmentNews: Why are alternatives even important? Why can’t you just go 60% stocks, stock/mutual funds, 40% bond funds and live happily ever after? Richard?

Mr. Bregman: Well, first of all, because bonds are no sure thing — not that they ever were, but you can have undesirable results in the bond market these days. That’s one thing. Alternatives are not right for everyone and they don’t need to be incorporated in everybody’s accounts, but they provide another engine for return generation. And ideally, if you’re in a rising market on the equity side, you don’t necessarily want to be in a lot of alternatives, from the way I view them, because you’re in a rising market. And you don’t mind being highly correlated.

HEDGING THE UNFORESEEABLE

But if you’re in an uneven market, a down market, you’d like to have that low correlation or noncorrelation, or negative correlation to the markets, and that’s when the alternatives strategies really become important. Because the markets are unpredictable in any given moment — and that doesn’t seem to be changing — it’s important to have some component of alternatives in there as a hedge against the unforeseeable, the unknowable, and the risk that’s inherent in securities markets.

InvestmentNews: To follow up, you said alternatives aren’t right for everyone. When wouldn’t an investor be suited for such investments?

Mr. Bregman: In my experience, that’s an intellectual versus an emotional argument. Intellectually, I would argue pretty strongly that they are suitable for everyone, but I believe there are just some number of clients who don’t like them, don’t trust them, hear the word “derivatives” and don’t want to be anywhere near them. For other reasons, clients are just not comfortable with them. It’s not my style to force them down anybody’s throat if they don’t want them. But intellectually, I think most people benefit from them over the long run from the reduced volatility, the law of large losses and avoiding large losses through hedging strategies, and the reduction of volatility, which helps emotional investors stay invested as opposed to running for the exits when times get bad.

InvestmentNews: Steve, maybe you could expand on what Richard just touched on, that whether you’re managing the money or you’re an adviser, it is part of your job now to help investors understand the importance of alternatives.

Mr. Young: Probably one of an adviser’s biggest challenges is to help an investor understand why they might be suggesting something different.

We, as homeowners, understand that every few years, we have to refinance our homes and we put that money back into the economy. So it was very stimulative as we refinanced our mortgages.

Corporate America did the exact same thing. You know, if you’re a [chief financial officer] of a company, every few years, you got the luxury of refinancing your debt, and your lower interest expense meant bigger profits. And the money was used elsewhere in the economy, so it was very stimulative. So declining interest rates really helped smooth out economic activity and economic cycles. Recently, as the economy went into a recession, the Fed cut interest rates. They had the luxury of cutting interest rates, and that was very stimulative. Without the benefit of that, given that interest rates — at least on the short end — are at zero, we think economic cycles could be more pronounced going forward.

If you’re a stock investor, the economic cycles certainly are anticipated and/or reflected in stock prices. So stock prices could be more cyclical going forward, very similar to what we experienced the last dozen years. If you’re a bond investor — given that we’re at ultralow rates, short-term rates at zero — you’re not going to get that appreciation potential any longer in bonds. The 30-year bull market in bonds is over. So if you own bond mutual funds or you’re a bond investor, not necessarily that you abandon those, but you might want to acknowledge that we’re at the end of the 30-year bull market and maybe complement not only your bond portfolios but your stock portfolios with something that’s different. And that’s alternatives.

InvestmentNews: Where does an adviser go to get started in this area? Are there specific places that you can recommend to start your research in alternatives? It’s a pretty diverse area, obviously, and there are registered products and unregistered products, and some that are available only to high-net-worth people, and there is a growing list of products that are coming out as registered mutual funds.

What’s your first move?

HOW TO SCREEN FUNDS

Mr. Bregman: Well, if you’re talking about mutual funds, you’re going to be looking at Morningstar [Inc.]. One of the interesting trends has been — it’s not quite, but almost a reversal of the brain drain that was going on a decade ago, when the mutual fund industry was supposedly losing its best and brightest to the hedge fund industry, because the opportunity for hedge fund managers to invest differently and make more money was pretty evident relative to the comparatively constrained world of mutual funds. But over the last decade, a lot of the hedge fund providers have found that it’s in their interests to have the same strategies available in mutual funds.

There’s been an explosive growth in “40 Act mutual funds offering hedging strategies. If you’re investing in mutual funds, then you’re going to be probably at some point using Morningstar to screen for funds that are doing something in the alternatives space. They have categories now, they have long/short and things of that nature, but you can screen using R-squared for correlation to see who has low correlations. You can do that with standard-deviation screens to get low volatility, low correlation, and there are any number of ways of doing it.

For private partnerships, you need to use other sources and have other capabilities. Steve, you can probably discuss that more effectively than I can, because my practice is focused on the “40 Act side of it. But that’s where I would start off and that’s where I typically do a lot of my initial research. Then, of course, the regular due diligence kicks in. Speak with the managers. See what their strategy is. See what their track record is. See if they’re doing what they say they’re going to do. See what their longevity is and their compliance, and all of those things that you would normally do when vetting managers.

InvestmentNews: Steve, you said you’ve been 30% in alternatives since 2007?

Mr. Young: I started my commitment to them in “02 and it’s gradually morphed into one-third of the portfolio.

InvestmentNews: That’s a big allocation to alternatives. Most advisers would be well below that. What has been the evolution of the registered products you invest in? Does this make it more challenging or does it make it easier to do research when Morningstar has an alternatives category, and then underneath the alternatives category of mutual funds, you’ve got long/short, market-neutral, bear market, currency, commodities, etc?

There is a lot more information out there, but still it might be foreign to a lot of advisers.

Mr. Young: It is. You have to commend Morningstar for trying to bring some sort of order to this category, but at the same time, it’s a category that defies definition. You know, the whole point of it is to do things that are outside of the box. So it’s hard to box something that’s supposed to be outside of the box. And I agree that it’s a little bit challenging, so I don’t typically go by the categories. But you can, as a starting point, to see what an industry resource such as Morningstar is doing to categorize these strategies.

HELP FOR ADVISERS

InvestmentNews: Richard, do you use any outside services to help you do your due diligence or do you do it yourself?

Mr. Bregman: I’m doing it primarily by myself. I rely on Morningstar as an initial screen, and after that, it’s just an intelligence-gathering operation. It’s speaking to other people in the industry. It’s talking with the managers and then just tracking.

My policy is not to give anything to my clients that I’m not prepared to invest in myself. So I end up buying a small piece of a fund. I have 50 or 60 little pieces of funds all over the place just to watch them, just to get their materials, just to read what they’re saying and be able to get access to them.

Steve, I wanted to ask you a question on something you said, because I thought it was really interesting. When you come across a firm, let’s say AQR, which is doing hedge funds and doing registered products and “40 Act funds and the whole bit, you’ve done due diligence on them as a partnership and a hedge fund.

So suppose they they’re offering a product that’s in the “40 Act space, but it’s just the same strategy that they’ve got in a private partnership. If you were an adviser, would you be comfortable saying, “AQR, it’s a big name, and now they’re in an SEC-registered structure, so I can take comfort in the fact that they’re complying with whatever the SEC wants them to do to be registered and take that in and of itself as a level of comfort”?

Mr. Young: I think when a manager like an AQR or any other hedge fund brings forward a “40 Act vehicle, it does give you a certain level of comfort knowing that they have to follow certain rules and restrictions, as well as the transparency of the investments that’s required when investing in a “40 Act fund. Historically, hedge fund managers in general were very secretive of their holdings and wouldn’t share that information, and thought that was their value-added. And nowadays, through “40 Act vehicles, they’ve got to be much more transparent. It does give you some confidence as to: Are they investing in what they say they’re investing in?

But we still do the diligence because many of those firms are managing limited partnerships. If they’re not following the operational protocol that we’re comfortable with, and something were to happen because of the leverage they’re taking or their counterparty risk, that’s not necessarily part of the “40 Act, but it’s certainly part of the manager themselves. The firm runs into some trouble, and all of a sudden, you have headline risk and reputational risk, and it might even affect the “40 Act fund. But we’d prefer to do anything we can to avoid that, so we go kind of the extra mile and meet face to face with not only people like Cliff Asness at AQR but the firm itself, the operational side, the trading desk and so forth.

Mr. Bregman: You mentioned the HFRI index with the 33 different categories, which is a lot. There are all sorts of hedge fund replication strategies and now there are sort of hedge fund indexing strategies. Is it worth investing in a strategy that’s just replicating the HFRI?

Mr. Young: That’s one way to gain access to those nontraditional streams of returns, through a replication product, and there are an increasing number of those. It might be philosophically the same question as, “Gee, do I go passive in equities or do I go active?” in that you can of get passive exposure to a broad cross-section of alternative investments. We’re of the view that investing in alternatives is very skill-focused, still an opportunity to add significant alpha and that perhaps indexing might not be the most effective way. It still may be the most cost-efficient way, but there’s value-added in going to the funds themselves and building a portfolio of diversified alternative investments.

InvestmentNews: One of our audience members has asked a question that a lot of people may be thinking about. Five years ago, we were not talking about alternatives like we are today. Are alternatives trendy? Is this just the latest buzz and will there be something else in a few years? Or do you think something so fundamental has changed that alternatives are going to become an increasing part of client portfolios?

Mr. Bregman: I don’t know what’s going to change down the road. I think that there is some trendiness associated with the alternatives movement. I think that it’s great that the conversation is out there and that people are talking about it, and that investment advisers are being forced, in effect, to learn about them and be able to use them effectively, because I believe that traditional stocks and bonds or traditional long portfolios, long-only portfolios, are limited. You’re just not using the full investment spectrum.

And that limitation worked great in bull markets — the 30-year bond bull market that Steve mentioned and the run in the stock market in the “90s and parts of this decade, as well. But it was limited; it was limiting. It is great when markets go up, but they don’t always go up, and people are recognizing that. Why not use all of the tools in the toolbox?

NO FLASH IN THE PAN

So I think it’s here to stay. However, I think advisers/intermediaries who view it as a fad do so at their own risk. It’s here, and I’ve come across investors who say they only really want to be in alternatives. They just don’t want to take the risk of long-only positions. And that might be an extreme view, but it’s out there. So I don’t think it’s a flash in the pan.

Mr. Young: I might add to that, too, with regard to the question on trendiness, because I think there is that risk of investors’ jumping on board and taking a 10%, 20% or in Richard’s case, even a 30% position in alternatives. And then we go on a nice bull market run for stocks, very much like we’ve experienced so far this year with stocks, up double digits, and then they look at their alternative portfolio and it is up maybe 5% so far through August. And they’re thinking, “Boy, I thought this was going to be a good investment. Why doesn’t it keep pace with the S&P 500?”

So advisers need to keep in context what alternatives are intended to do — they’re intended to behave differently than the S&P 500. I mean, that’s the precise reason for owning alternatives. And when you have runs in the market like now, people will say, “Gee, why isn’t it doing as well?” And you only need to look back at the down period. That law of large losses that Richard referenced is why you really want to own alternatives. So I think as advisers go into alternatives, they need to keep it in perspective, especially relative to what their investors’ perspective might be — which all too often is the S&P 500 when it’s running and absolute returns when it’s not.

Mr. Bregman: Steve, tell me what you think about this. There is sort of a subtext to it, because some alternatives strategies are much more directional than others. So to a certain extent, if you’re an adviser and you do have a view of the market, but you’re not really committed — you think right now stocks are OK but you’re a little bit nervous — you can have a buy-write type of strategy, which is going to be directional as opposed to a market-neutral strategy, which might not be a particularly effective tool in this environment or might not be consistent with your views.

So you can tweak it to try and get a little bit more in that market.

InvestmentNews: Richard, can you break down that buy-write strategy?

Mr. Bregman: It’s taking a long-only position in, typically, large-cap U.S. stocks, and you are either buying options or selling options around those positions to enhance your returns and/or limit your losses on the downside.

InvestmentNews: But a full collar, which would be a put and a call, would limit your upside and limit your downside?

Mr. Bregman: Right. You’re putting a limit on your upside and downside, but you’re not changing your directionality too much.

InvestmentNews: You’ve got two main purposes of alternatives exposure in a portfolio — hedging risk and enhancing performance. And even that is oversimplifying it. But if you buy an index of alternative strategies, how much are you just offsetting everything? Richard, in noncorrelation, you have to almost be like a surgeon saying, “OK, right now, we need to enhance some performance.”

Look at the stock market right now. The S&P 500 is up 13% or something year-to-date. Among alternatives tracked by Morningstar, the best-performing category is up 3.1%. The worst category in the bear market is down 18.7%.

If you’re a financial adviser, your clients are going to say, “Why do I want to be in alternatives?” It seems like right now would be a time you’re probably pushing alternatives to hedge some of that risk, to protect yourself from maybe some stormy seas ahead, correct?

Mr. Bregman: That’s why I’ve got them in there. But as for the Morningstar data, that’s the challenge. The best-performing category is 3.1%. But there are hedging strategies and funds and products that are up more than that this year. So they are averages, and that’s the risk of categorizing that which is designed not to be categorized. And I agree with Steve — it’s a skill game when you’re looking for managers in the hedging space. And that’s part of what a good adviser is doing in those so-called categories, as well as the traditional areas: finding the managers who are able to perform.

THE NUTS AND BOLTS

InvestmentNews: We’re getting a lot of nuts-and-bolts questions about investing in alternatives. How do you decide what is the right portfolio allocation to alternatives?

Mr. Young: Institutions such as foundations, endowments, large pension plans and so forth have been using alternatives for decades. Smaller institutions, those with less than $25 million in their portfolios, had an allocation of about 10% as of the end of their fiscal year in 2011. Endowments and foundations have as much as 60% of their portfolio invested in alternatives. So those are going to be the headline grabbers like Yale and Harvard.

Even the smallest institutions that have 10% or maybe 20% of their portfolios in alternatives over the last 10 years and over the last 20 years have done very well, especially given the volatility in the equity markets relative to, say, retail investors or even the stock market itself, just kind of a buy and hold, whether it’s in stocks or 60/40.

With even at a 10% allocation, depending on what traditional investments are doing, you can have a meaningful impact. It does take a number of market cycles or even just one market cycle to realize that positive impact. You may not realize it in the very short term. This year is a great example: The S&P is up 12% or 13% and alternatives aren’t keeping pace. But again, that’s not why these big institutions invest in alternatives. It’s not for the short term. It’s not for beating the market when then market is running; it is for smoothing out the returns of their entire portfolio over the long term, and the math will suggest that if you can smooth out the returns, you have the chance for a larger pool of assets at the end of a timeframe than if you’ve got a very volatile stream of returns.

InvestmentNews: Richard, if you had to pick three or four must-have alternatives categories, what would they be?

Mr. Bregman: I don’t have a must-have list, because it changes depending on what the market conditions are. There are many types of strategies that are really arbitrage strategies where the manager is selling short and going long. In some particular strategy, it could be statistical arbitrage to take advantage of small differences in stock or variations in stock prices. It could be merger arbitrage or risk arbitrage where they are playing both sides of the merger. But a lot of times, those strategies are really tied to the risk-free rate and they are designed to get whatever it might be — 200 basis points, 300 basis points — above risk-free. And when risk-free is essentially zero, you’re talking about a market-neutral strategy that’s just not going to be able to kick out a large return.

BETA BLOCKERS

However, if you’re in a higher-interest-rate environment and/or a period of greater market volatility, that type of market-neutral strategy — pairs trading, whatever they are doing — might be much more appealing. So I don’t have a specific answer, but the basic ones that people know about and can understand pretty readily are merger arbitrage, where you’re playing an announced merger — you’re buying the target and selling the acquirer because there is a small gap in the offering price and the current market price, which narrows as the closing period comes. So it’s a small gain but relatively certain if they’ve done their homework well.

InvestmentNews: Steve, what’s working now in this environment that we’re in today? What are some of the strategies that have captured your interest?

Mr. Young: You asked the question earlier: Is there a must-have? The three categories that we identify alternatives would be, first of all, beta blockers, beta of the market. So if you want something completely different than the market, you’re going to have something with a beta of zero. So there are a number of strategies available if you’re looking to complement the stock market and reduce overall volatility. That includes market-neutral or long-short or absolute-return strategies.

The second would be alpha generators, those that are looking to seek higher returns but still control risk, or might have complementary correlations. Those things could be also long-short but maybe directional in nature — find some long-short emerging-market strategies that might offer some alpha, the managed futures, a possibility there; global macro, definitely an alpha generator.

DIRECTIONALS

And then the last category — and probably the one performing best right now —would be investments that are directional in nature. Those might be long-only, but they’re in asset classes that are different than stocks and bonds. So that could be your commodities, natural resources, maybe infrastructure, or even as focused as gold or some other precious metal.

They’re going to move in dramatic directions. Their correlations are very complementary. And it is when there are factors such as oil prices that have bounced off of the low $90s — or actually, in the $80s up to the mid-$90s — that they’re going to go through spurts of performance. And in our view, it’s what combination of those three make sense for your investor. Are they looking for enhanced return potential relative to their traditional assets? If so, you may want to focus more on the alpha generators and the directional. Or if they’re really looking to control risk, and maybe they’re looking for a complement to their bond portfolio, you’re going to bias it more towards the beta blockers with low volatility.

InvestmentNews: Richard, how often are you trading in and out of various strategies?

Mr. Bregman: I don’t trade strategies too often. Ideally, I don’t trade them at all, but obviously if changes are necessary. I’m more likely to change a manager than I am a strategy. But I will say within that context, while I don’t really have a view on the market so much, I do have a view on valuations, and earlier this year, I thought that U.S. stocks were comparatively undervalued. So I was happy to go a little bit more directional with the strategies and have a little bit more long-short type strategies in the portfolio and take out the more market-neutral, the beta blockers.

InvestmentNews: Someone is asking about managed futures as an asset class. Do you use them?

Mr. Young: We do. Using managed futures is just an efficient way to get exposures to different markets. So you can buy futures on stocks, you can buy futures on currencies and interest rates and all kinds of things.

So these managers have the flexibility to go just about anywhere. And oftentimes, they’re complementing their long and short positions together so they’re able to arbitrage some opportunities.

But it’s a good example of giving the manager flexibility to go just about anywhere. AQR and others are very kind of risk-focused.

They monitor that risk very closely so they’re not taking too much in any one area. And their track record suggests they’re very effective at monitoring that risk. The return patterns are extremely complementary to the traditional asset classes.

InvestmentNews: We’re also getting some questions about the fees of alternatives. This is an expensive category. How do you know when it’s worth it?

Mr. Bregman: Well, first, with alternatives, you are paying for something specific, typically in my view, low correlation and/or low volatility. So I start from the point of view that while I’m not looking for the cheapest alternative out there, beta is very inexpensive. Alpha is more expensive. And alternatives are more expensive yet and they have short positions, so they are, in effect, managing a larger number of assets.

So I’m not as concerned with low expenses for alternatives as I might be for a traditional long-only strategy. But at the end of the day, it’s the same for any active manager, even a passive manager. I mean, does our performance justify the fees that you are charging? And there is a fairly wide range of fees in the “40 Act space, and I would expect that the fees in that part of the universe gradually will come down. But you’ll never, in my view, get them down to Vanguard-type of levels. They have a long-short fund at [The] Vanguard [Group Inc.], which I don’t use, but the fees there are lower than they are for other long-short funds, but they’re not anywhere near their 8-basis-point type of fees for their index funds.

InvestmentNews: Steve, what do you have to say about fees?

Mr. Young: I think Richard hit on it. Bringing alternative investments to the mutual fund world is doing a lot to drive down fees. It used to be, you would pay a hedge fund manager through a limited partnership 2% on the assets you gave them every year. And then you gave the manager 20% of the gains that they realized every year.

So it was quite expensive, and there are certainly still structures like that. But I think in the “40 Act world, that isn’t permitted, and the fees are much more transparent. You can see it in the prospectus. So fees have become much more reasonable and I would think as the alternative space expands, you will see even more competition. It does get back to what Richard said — you get what you pay for. And if you’re looking for unique return patterns and alpha generators, some of those fees are going to be on the higher end relative to traditional investments.

REAL ESTATE

InvestmentNews: Richard, how does real estate fit into an alternatives mix, specifically real estate investment trusts? Do you use any REIT products right now?

Mr. Bregman: I typically don’t dedicate a portion of the portfolios to REITs. If it is a long-short REIT strategy, I’m more interested in it. If it is a traditional REIT long strategy, I don’t view it as an alternative, because they’re not going short. They do generate good income at times, depending on the prices and correlations; they’re publicly traded vehicles.

I prefer to find long-only managers who have wide charters. And when they find value in the REIT market, they go into the REITs, and I don’t question them on that at all. I don’t make that allocation decision on my own.

InvestmentNews: Steve, do you use REITs?

Mr. Young: We do, but we don’t necessarily classify them as alternatives. We think they are a great investment, but given that generally, REITs are traded on the exchange and they’re long-only — at least the ones we use — they’re going to act certainly in tune to the stock market, if not the same. So I don’t see them as the greatest diversifier or as great as alternatives, but we still like them. And the income that they’re generating is certainly attractive relative to what interest rates are offering now.

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