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May 26, 2010 Max Darnell Partne ner, , Chief Inv nvestment - - PowerPoint PPT Presentation
May 26, 2010 Max Darnell Partne ner, , Chief Inv nvestment - - PowerPoint PPT Presentation
May 26, 2010 Max Darnell Partne ner, , Chief Inv nvestment Officer Fi First Quadrant, L.P. Questions To Be Addressed Where do equities go from here, and how risky is the path we're on? How much should investors care about the dollar and
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What’s Wrong With This Picture?
Long-term expectations based on historical returns
Expected Risk % Excess Return (%) 2 4 6 8 2 4 6 8 10 12 14 16
100% Bonds 100% Stocks
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Assumes a 7.5%-8.0% return to equities
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The Problem With Historical Returns
Most singularly important fact about last thirty years of market returns:
> Structural and secular decline in risk premium (“required return”)
> Markowitz (1952) – manage risks in portfolios rather than in isolation > International diversification (1970’s) > Shareholder protection, improved transparency, etc.,
> For required return to fall, prices must rise
> High single digit equity returns due to decline in required risk premium
If real earnings and real GDP grow between 1.5%-3.0%, where does a 6% real return on equities come from?
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Expect Dramatic Market Swings to Occur More Frequently
“Fatter tailed” world
> GDP growth more evenly spread across markets
> Good news – diversification means smoother average day > Bad news – dependence upon less well developed, less tested, legal, financial,
political infrastructure means wider cracks will appear in periods of stress
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Even the cracks in the US have been shown to be wider than assumed
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Key Points
Equities face strong headwind from here
> Developed market growth: overcoming balance sheet burden > Emerging market growth: exploiting balance sheet advantage
Risks are asymmetrically biased to the downside Near-term inflation risk is commodity driven; monetary inflation risk is intermediate-term
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Equities Can Trend Sideways For A Long Time
January 1872 – March 2010
Source: Global Financial Data (GFD) Stocks for the Long Run, by Jeremy J. Siegel, McGraw-Hill Companies; 4nd edition
25 Years 15 Years 17 Years 12 Years 15 Years
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1872 1881 1891 1901 1911 1921 1931 1941 1951 1960 1970 1980 1990 2000 2010
Log of US Stock Market Growth
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Emerging market growth
Exploiting balance sheet advantage in growth markets:
> We have seen strong growth and strong growth forecast across emerging
economies
> Public and private sector balance sheets have improved with tightening spreads
and improving access to longer term funding
> Steady advances in infrastructure (“market plumbing”) support investments and
growth prospects
Challenges associated with change
> Refining financial, economic, and social infrastructure. > Risks of policy mistakes in unchartered waters is high. > Differentiation between markets and types of economies important
Direct versus indirect exposure to growth
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Inflation
The problem with our massive injection of liquidity
> Throwing gas on the fire – liquidity was a leading cause of our past crisis > With money multiplier low (read: lending facility crippled), not likely to be an
immediate problem
> Monetary-based inflation is a concern further down the road
Commodity-based inflation a nearer-term concern
> Commodity price inflation can be distinct from monetary inflation > Not under the control of our central banks – we’ve forgotten that > This may be main impediment to growth
Asset allocation implications
> If monetary inflation remains tame near-term, leveraged sovereign debt remains
an attractive hedge against equity market decline
> Commodities take on more immediate importance as inflation hedge
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Does It Matter Whether the Dollar is Cheap or Expensive?
January 1970 – March 2010
US Dollar1 1 Yr Subsequent Return 3 Yrs Subsequent Return 5 Yrs Subsequent Return
Expensive
- 3.0%
- 19.6%
- 29.5%
Q2
- 1.4%
1.5%
- 7.2%
Q3
- 2.3%
- 6.1%
- 7.5%
Q4
- 0.1%
2.2% 5.5% Cheap 2.3% 7.3% 13.1% Cheap-Expensive (Annualized) 5.3% 8.3% 7.4%
1USD returns are the MSCI World Ex-US cap weighted returns of USD.
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Potential Impact of Ignoring Hedging in Strategic Portfolio
1 Year 3 Years 5 Years
US Dollar1
January 1970 – March 2010
5.3% 8.3% 7.4% Sterling2
January 1970 – March 2010
6.5% 5.5% 4.3% Yen2
March 1970 – March 2010
8.5% 8.4% 4.7% Euro3
January 1970 – March 2010
2.5% 4.4% 4.0% Currencies Have Large Impact on International Investments Over One, Three and Five Year Periods (Cheap – Expensive)
1USD returns are the MSCI World Ex-US cap weighted returns of USD. 2JPY, GBP currency returns are relative to an equal weighted basket of the currencies in MSCI Developed World markets
(AUD, CAD, DKK, EUR, HKD, JPY, NOK, NZD, SGD, SEK, CHF, GBP, USD) . 3 DEM used in place of Euro prior to Euro formation.
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Climbing Again, But Carrying Heavier Burden
Why We’ll Succeed
> Cheap money – massive injection of liquidity > Flexible, adaptive economies > Growth from less burdened economies (e.g., emerging markets) > Tendency to succeed in the face of adversity
Why We Might Stumble
> Consumer and sovereign balance sheets leave little room for error > Credit facility not what it used to be > Improvements in corporate profits mostly result of cost cutting > Potential for further decline in residential real estate > Commercial real estate and regional banks > Dependence on less well developed infrastructure in more global economy
Successful Growth Requires a Stronger Back and More Careful Steps
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Asset Allocation Implications
Guard against tail risk
> Leveraged sovereign bonds to hedge against equity related risk > Real assets to hedge against commodity-based inflation risk > Utilize options for hedging when price of “insurance” is fair or cheap
Stand ready to adjust strategic return assumptions if extremes return
> Utilize tactical approach or revisit strategic assumptions > Establish currency hedge ratios based on fair value
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What Should Investors Have Learned From Recent Events?
Diversification didn’t fail. Portfolio construction did. Too much risk is equity-related. Risks should be better balanced. Optimal portfolio changes with the risk climate. Clarity about the roles of individual asset classes needs to be developed.
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The Role of Diversification in Your Portfolio
“Diversification is used to dissolve the diversifiable sources of risk. Beta is produced by this mixing and dissolving.”
–Max Darnell, FQ Perspective, Jan 2009 Rethinking Beta
What Diversification Does Do For You
> “Beta” is exposure to non-diversifiable
(systematic) risk
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Often confused with market risk
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Non-diversifiable, or systematic, risk has expected compensation
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Diversifiable risk is not expected to be compensated
> Diversification dissolves diversifiable,
uncompensated risk… leaving “beta matter” that should be compensated
Fallacies
> Individual markets are “betas” > “Don’t keep all your eggs in one basket” > Diversification means spreading risk across
asset classes
> Diversification should prevent large losses
Risk avoidance is not the goal of diversification. The goal is to favor systematic risk over idiosyncratic risk, and by so doing, favor compensated risk
- ver uncompensated risk
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18 0.98 0.97 0.90 0.91 0.90 0.83 0.43 0.65 0.40 0.81 0.76 0.16 0.22
FIXED INCOME / ALTERNATIVES (30/10%) Barclays Capital US Aggregate 20% Citigroup World Ex-US Govt. 5% Merrill Lynch High Yield 5% Dow Wilshire Real Estate 2.5% HFRI Private Issue/Reg.D 2.5% HFRI Fund of Funds 2.5% S&P GSCI 2.5%
Conventional View of Diversification vs. Reality
Sample Investment Plan Asset Allocation1 Correlations to S&P 500 Index – Five Years Ending March 31, 2010 EQUITIES (60%) Russell Large Value 10% Russell Large Growth 10% Russell Small Value 10% Russell Small Growth 10% MSCI World Ex-US 15% MSCI Emerging Markets Equity 5%
Correlations to S&P
Total Sample Plan Asset Allocation1 Correlation to: S&P 500 Index: 0.97
Sources: First Quadrant, LP, StyleAdvisor, Bloomberg
1Sample Plan is a hypothetical portfolio used for illustrative purposes only.
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“Increasing breadth, by increasing the number of pie slices, may reduce diversification of the total portfolio by increasing correlations across asset classes.”
–Ed Peters, FQ Perspective, Does Your Portfolio Have “Bad Breadth?”
“Bad Breadth”
January 1988 – December 2009
Sources: StyleAdvisor, Datastream
1Merrill Lynch Emerging Market Sovereign Plus index inception date is January 1992. 2Equal weighted portfolio consisting of the following: Citi US Treasury Index, 7-10 Year, US AAA/AA Corporate Index,
7-10 Year, ML High Yield Master, ML Emerging Market Sovereign Plus Index.
Correlation to Citi US Treasury Index, 7-10 Year Overall Citi US AAA/AA Corporate Index 0.84 ML High Yield Master 0.00 ML Emerging Market Sovereign Plus¹ 0.18 Correlation to S&P 500 Overall High Volatility regime Low Volatility Regime Citi US Treasury Index, 7-10 Year 0.05
- 0.07
0.36 Citi US AAA/AA Corporate Index, 7-10 Year 0.25 0.20 0.38 ML High Yield Master 0.57 0.61 0.36 ML Emerging Market Sovereign Plus¹ 0.54 0.61 0.40 Diversified Bond Portfolio1,2 0.52 0.57 0.42
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Using Leverage to Balance Risk
A long-term perspective based on empirical evidence
Traditional Balanced Plan and Risk Balanced Plan are hypothetical plans used for illustrative purposes. Stock is based on broad market index. Bond is based on broad market Long-Term Treasuries.
Diversifies Risk and Maximizes Reward
Plan Type Stock/Bond Sharpe Ratio Traditional Balanced Plan 60% / 40% 0.67 Risk Balanced Plan 28% / 72% 0.77 Risk Balanced Plan 43% / 114% 0.77
Risk % Excess Return to Cash % 2 4 6 8 2 4 6 8 10 12 14 16
100% Bonds 100% Stocks
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Does Risk Balancing Work?
January 1960 – December 2009
Sources: Bloomberg, Global Financial Data (GFD) Global Balanced (60/40), Risk Balanced (40/140), and Global Stocks are broad-based indices based on data from Global Financial Data. Global Balanced (60/40) is a hypothetical plan used for illustrative purposes and is comprised of 60% global stocks weighted by capitalization and 40% global bonds and also weighted by market capitalization. Risk Balanced (40/140) is a hypothetical plan used for illustrative purposes and is comprised 40% global stocks equally weighted across 11 equity markets and 140% global bonds equally weighted across 6 bond markets.
- 4.5
- 1.6
- 0.6
0.2 0.7 1.2 1.6 2.3 2.8 4.6 0.7
- 3.0
- 0.9
0.0 0.7 0.8 1.5 1.3 2.5 2.5 4.0 0.9
- 7.6
- 2.9
- 1.2
- 0.1
0.8 1.6 2.4 3.3 4.3 6.9 0.7
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- 6
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2 4 6 8 10 1 2 3 4 5 6 7 8 9 10 Stock Return Decile Average Monthly Return Global Balanced (60/40) Risk Balanced (40/140) Global Stocks
Risk Balancing provides greater downside protection Risk Balancing delivers consistent returns during normal periods Risk Balancing gives up very little
- n the upside
Highest Long- Term Average Return
Lowest Highest
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Does Risk Balancing Work?
January 1960 – December 2009
Growth of a Dollar 1 10 100 1000 Jan-60 Jan-70 Jan-80 Jan-90 Jan-00 Jan-10 Global Stocks Global Balanced (60/40) Risk Balanced (40/140) $198 $52 $47 Dec-09
Sources: Bloomberg, Global Financial Data (GFD) Global Balanced (60/40), Risk Balanced (40/140), and Global Stocks are broad-based indices based on data from Global Financial Data. Global Balanced (60/40) is a hypothetical plan used for illustrative purposes and is comprised of 60% global stocks weighted by capitalization and 40% global bonds and also weighted by market capitalization. Risk Balanced (40/140) is a hypothetical plan used for illustrative purposes and is comprised 40% global stocks equally weighted across 11 equity markets and 140% global bonds equally weighted across 6 bond markets.
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- 10
10 20 30 40
Jan-63 Dec-65 Nov-68 Oct-71 Sep-74 Aug-77 Jul-80 Jun-83 May-86 Apr-89 Mar-92 Feb-95 Jan-98 Dec-00 Nov-03 Oct-06 Sep-09
3 Year Annualized Rolling Return
Global Balanced (60/40) Risk Balanced (40/140)
Hyper-inflation Period Speculative Bubble Period
Risk Balancing Will Underperform a 60/40 at Times
3 Year Annualized Returns, January 1963 – December 2009
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During Hyper Inflation (1979-1981)
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During Speculative Bubbles (1999)
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When Monthly Stock Returns are Magnified (i.e. 4/1970, 9/1974, 10/1987, 10/2008)
Dec-09
Sources: Bloomberg, Global Financial Data (GFD) Global Balanced (60/40), Risk Balanced (40/140), and Global Stocks are broad-based indices based on data from Global Financial Data. Global Balanced (60/40) is a hypothetical plan used for illustrative purposes and is comprised of 60% global stocks weighted by capitalization and 40% global bonds and also weighted by market capitalization. Risk Balanced (40/140) is a hypothetical plan used for illustrative purposes and is comprised 40% global stocks equally weighted across 11 equity markets and 140% global bonds equally weighted across 6 bond markets.
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Summary: Benefits of Risk Balancing
Risk Balancing Reduces the Downside Loss More than It Reduces Upside Return Risk Balancing Produces More Return for a Given Level of Risk No Active Decisions Simply a More Efficient Strategy
Return vs. Risk January 1960 – December 2009 Global Bonds Global Balanced (60/40) Risk Balanced (40/140) Global Stocks 2 4 6 8 10 12 2 4 6 8 10 12 14 16 Annualized Risk Annualized Return
Sources: Bloomberg, Global Financial Data (GFD) Global Balanced (60/40), Risk Balanced (40/140), and Global Stocks are broad-based indices based on data from Global Financial Data. Global Balanced (60/40) is a hypothetical plan used for illustrative purposes and is comprised of 60% global stocks weighted by capitalization and 40% global bonds and also weighted by market capitalization. Risk Balanced (40/140) is a hypothetical plan used for illustrative purposes and is comprised 40% global stocks equally weighted across 11 equity markets and 140% global bonds equally weighted across 6 bond markets.
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Low Volatility Low Volatility High Volatility
US Recession VIX = 30 Bond Market Sell-off VIX = 20 Asian Market Risk VIX = 35 LTCM VIX = 44 Tech Bubble VIX = 30 9/11 VIX = 34 Iraq War VIX = 40 Subprime Credit Crisis VIX = 60
Volatility Regimes Impact Asset Allocation
January 1990 – March 2010
Sources: Chicago Board Options Exchange, First Quadrant, LP
10 20 30 40 50 60 70 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 VIX Level
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In Summary
Expect lower returns Expect more volatility Look for growth where balance sheets are in better shape Increase allocations to non-equity related sources of return
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