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Can alternative betas increase the riskadjusted return of balanced portfolios? We analyze 7 premiums over 85+ years and find strong diversification effects
25 NOVEMBER 2012
X-asset themes
CONTENTS
Summary: the role of alternative betas in a long-term portfolio ........................................................................................................ 3 The curvature premium ............................................................................................................................................................................ 4 The credit premium................................................................................................................................................................................... 5 The FX carry premium............................................................................................................................................................................... 6 The defensive sectors premium .............................................................................................................................................................. 7 The value premium ................................................................................................................................................................................... 8 The dividend premium.............................................................................................................................................................................. 9 The size premium .................................................................................................................................................................................... 10 Alternative betas in a portfolio context.................................................................................................................................................11
+46 8 50623246
X-asset themes
Equities
4% 3% 2% 1% 0% 0% 5% Alternative betas
Credit
Value/Growth*
Defensive sectors/market
Value/Growth
OECD LEI
Equities
Credit premium
T-bills
Gvt.bonds
Credit
15%
*Trading costs of 75 bps has been included for equity related premiums, 40 bps for the credit premium and 50 bps for FX carry Note: the combined "Alternative betas" has been constructed as an equal weighted basket
In order to avoid patterns that are essentially statistical noise, it is imperative that there is a qualitative explanation for the premiums, but also that we can document them historically and understand how they work in various macro economic climates. Historical returns vary for all asset classes, and any 10-20 year period can thus give seriously misleading information about the true nature of long-term returns and their interaction with other investments. We think 80 year is the minimum data sample required to cover all types of investment climate and give a relatively confident estimate of the long-term return and risk. In this study, we start by identifying risk premiums that meet the basic criterions before we turn to the role of a basket of such assets in a broader portfolio. We impose three criterions on the alternative betas in order to include them in the analysis: a) they must have demonstrated empirical performance over many decades, i.e. showing a positive risk premium during various macroeconomic climates b) they have to have an intuitive explanation for why the risk premium exists and c) there needs to be broad backing from academic studies covering different time periods and markets to support consistency of the risk premium. By applying these criterions, we end up with relatively few risk premiums, but are able to cover all macro economic scenarios. We analyze seven risk premiums that fit the bill, from fixed income, FX and equity markets on a stand-alone basis using 85+ years of data. All alternative beta vehicles are based on a long and short position (the risk premium), fully funded with US T- bills and includes estimated costs. These should be seen as generic constructions, interpreted as guidelines that in practice might be implemented differently. The historical excess returns have been highest for the FX and equity related vehicles, while the fixed income premiums are more marginal (at least without leverage). Individually, they all have experienced long periods of real losses; hence it is important to include a basket of alternative betas for internal diversification. As an equal weighted basket, they have historically had a lower risk than government bonds and at the same time slightly higher return, including estimated costs. The basket also delivered positive return in all parts of our strategic and tactical cycles, varying from 2.5% to 5% in real terms, uncorrelated to government bonds and equities as well as macro factors like the OECD leading indicators and US inflation. Due to the truly uncorrelated nature of the returns, the alternative beta basket ends up with a high allocation in a portfolio with traditional assets for all risk levels. They should however not be seen as a substitute to the traditional assets but a complement. Equities will start being very profitable investments again, maybe in 5-10 years time; the main roles of alternatives is to allow to maintain the exposure order not to miss out on the next secular bull market.
X-asset themes
100
July 1927 = 1
10
0
3M 1Y 2Y 3Y 5Y Time to maturity 10Y
Source: GFD, Ecowin and SEB X-asset
1927
1937
T-bills
1947
1957
1967
1977
1987
1997
2007
Gvt.bonds
Equities
Gvt.bonds curvature
Source: GFD, Ecowin and SEB X-asset
Note: The yield levels are the average monthly yield at annual rates
The premium: The curvature premium is constructed as going long one part of the 2Y government bond while shorting one half of the 5Y bond and the Treasury bills, hence taking advantage of the concave shape of the yield curve. Our analysis indicates that this construction, with the steep first 1-2 years of the curve offered a premium of 0.15% at very low risk over the past 85 years. This barbell strategy showed an uncorrelated relationship to government bonds and equities as well as key macro risks such as OECD leading indicator and US CPI. The vehicle: The risk premium translates into a real return of 0.75% for the curvature vehicle. The return is low but the same can be said about the standard deviation. This could work well as a substitute to Treasury bills with a 25% higher long term return, at a slightly higher level of risk. However, it might not work well in the current economic climate due to the extremely low interest rates wiping out most of the premium, and the low rate regime will probably be for some years. Also, since this vehicle is relatively small when fully funded, it is very sensitive to costs. We have decided not to use leverage in this study but there is a possibility of using leverage, leading to better results.
Chart 5. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%
Equities
Gvt.bonds curvature
Source: GFD, Ecowin and SEB X-asset
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
As can be seen in the distribution chart, the returns of the vehicle are relatively low and show a relatively stable pattern. This can also be seen in our cyclical analysis where we note that the curvature vehicle has a return pattern close to Treasury bills while outperforming in early recession and late downturn. Chart 6 shows that the correlations of the vehicle are relatively variable through time while the average is located close to the centre of the chart.
X-asset themes
100
July 1927 = 1
10
0 1927 1937
T-bills
1947
1957
Gvt.bonds
1967
1977
Equities
1987
1997
2007
Credit premium
Source: GFD, Ecowin and SEB X-asset
For example, as can be seen in chart 7, the US corporate bond TR index performed worse than the replication during the early 30s, the early 80s and most recently in 2008 when the economy suffered during deep recessions. The chart also shows that the corporate bond index has its lowest 12 month return at around -25% while the lowest return for the credit premium during the same period has been around -15%, i.e. roughly 40% lower losses. The premium: Usually the credit premium is calculated as the credit bond minus the government bond return but in this analysis we have stripped out not only government bond beta but also equity beta. This is done by taking a long position in a corporate bond index and a short position of 75% in government bonds (20% 5Y and 55% 10Y) and 12.5% each in equities and treasury bills. Historically over the last 85 years this strategy yielded a risk premium of 1.1%, uncorrelated to stocks and bonds while correlated to credit. The construction, just as all alternative betas covered in the analysis, is just a generic example; weights may vary depending on market, durations and other factors.
Chart 9. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30% 20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%
Chart 10. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 OECD LEI US CPI
Equities
Credit premium
Source: GFD, Ecowin and SEB X-asset
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
The vehicle: The real return during the 85 year period has been 1.3% with a cost of 40 bps. The distribution of returns for the credit premium vehicle is concentrated with moderate returns or losses. The premium shows a semicyclicality which is apparent when looking at the rolling correlations, where it is both positively and negatively correlated towards leading indicators through time. The credit premium also tends to have its lowest returns during market declines, when most of the defaults occur. Returns have however on average always been kept above zero during these times.
X-asset themes
5%
10
4%
Japan
5%
6%
Source: GFD, Ecowin and SEB X-asset
1927
The premium: The FX carry premium, based on US cross currency rates, has been constructed as going long the money market rate with the highest return the previous month and shorting the money market rate with the lowest return, while gaining the corresponding spot rate returns. A dynamic number of currencies from industrialised countries have been used, starting in 1927 with CHF, SEK and USD and with time adding up to a total of ten currencies, Academic studies based on data from the post-Bretton Woods era show a historical premium of around 7%. Our longer study going back to 1927 finds a risk premium of 4.1%, rising after 1970 when the fixed exchange rate regimes were abandoned. The vehicle: The real return for the FX carry vehicle has been 4.2% for the same period, when deducting a cost of 50 bps. Interesting to note regarding this risk premium is that over the period 1927-2011 correlations to the traditional assets as well as all other alternative betas has on average been around zero. Even when looking at the period 19702011, i.e. excluding the period with fixed exchange rates, the risk premium has been uncorrelated to all assets.
Chart 13. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30%
0.2
Chart 14. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 OECD LEI US CPI
20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5%
Equities
However, since the beginning of the financial crisis, correlations to equities and leading indicators have picked up a great deal. An explanation to this would be the severity of the last recession leading to a flight of capital from volatile currencies, primarily to the USD, CHF and JPY, to a much larger extent compared to previous recessions. This has lead to losses for the FX carry strategy during the financial crisis, while our cyclical analysis shows that the vehicle has had positive return in all other recessions since 1970. Even though it is a lot more cyclical now, we see this strategy as interesting in the current climate because of the global imbalances of large debtor nations with zero interest rate policies and currencies expected to depreciate during the coming decade. I.e. we think it will hold going forward.
5%-10%
10%-15%
15%-20%
FX carry
Source: GFD, Ecowin and SEB X-asset
20%-25%
25%-30%
30%-35%
35%-40%
> 40%
-1.0 -0.8 -0.6 -0.4 -0.2
X-asset themes
8% Real return
7% Market 6% Telecom
July 1927 = 1
30%
100
10
0
25%
1927
1937 T-bills
A complementary explanation is that investors may engage in herd-like behavior, overweighting sectors that lead the market during normal times, while analysts also extrapolate cyclical earnings growth. Only in recessions and shortterm corrections do earnings expectations and valuation adjust to more realistic levels; this is consistent with the strong tendency of the long-term premium to be concentrated in periods of poor overall return. The reason why this pattern does not extend to the two other low-risk sectors, telecom and utilities, could be more intense political regulation surrounding these sectors. Both are natural monopolies, thus the earnings they extract tend to be capped through policy makers capping prices. These two sectors, compared to the three other defensive sectors, have had higher dividend yields but far lower earnings growth, leading to lower returns. The premium: This strategy, the most defensive of the four equity related risk premiums, has been constructed as investing in an equal-weighted basket of the three defensive sectors while taking a short position in the total market. During the period 1927-2011, this strategy delivered a premium of 1.3%. Other papers covering the low volatility anomaly have found a risk premium around 1-2% on a yearly basis. The analysis has been based on the Fama and French data of sectors, reconstructed to match the ten Global Industry Classification Standard (GICS) sectors.
Chart 17. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30%
0.2
Chart 18. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 US CPI
20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0%
Equities
OECD LEI
The vehicle: The defensive sectors vehicle has delivered a real return of 1.2% over the same period, with a cost of 75 bps. The returns have been evenly distributed and the vehicle has had a lot lower tail risks compared to equities. This with on average negative correlation to the stock market (-0.41) and to OECD leading indicator (-0.42, measured over the period 1961-2011) while being uncorrelated to US CPI. The 10Y rolling correlations to leading indicators has varied quite a bit but been mostly on the defensive side of the chart, while experienced both slightly negative as well as positive correlation to inflation.
0%-5%
5%-10%
Defensive sectors/market
Source: GFD, Ecowin, Fama & French and SEB X-asset
10%-15%
15%-20%
20%-25%
25%-30%
30%-35%
35%-40%
> 40%
-1.0 -0.8 -0.6 -0.4 -0.2
X-asset themes
Value
10
0 1927 1937 1947 T-bills 1957 1967 Gvt.bonds 1977 1987 Equities 1997 2007 Value/Growth
Chan and Lakonishok (2002) base their argument on market psychology; the value premium would arise due to investors exaggerating the problems of the distressed value companies and the future earnings growth of apparently successful companies. We note that growth stocks suffer more during recessions, which is when optimistic earnings expectations tend to adjust to more realistic levels. The premium: This risk factor is based on the Fama and French factors value and growth and is constructed by going long stocks with the 30% highest book-to-market ratio while shorting stocks with the 30% lowest ratio. The total market is split in two parts based on size and the book-to-market portfolios are constructed by equal weighting the book-to-market portfolios from the small and large size sample. This is done in order to be sure that the value premium is not capturing a hidden size premium. The value versus growth strategy has yielded a risk premium of 3.8% during the last 85 years, while other studies have shown a premium of between 2% and 7%.
Chart 21. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30%
0.2
Chart 22. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 US CPI
20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%
OECD LEI
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
The vehicle: The corresponding real return for the value vehicle has been 3.7% for the same period of time, with a cost of 75 bps. Historically, the value versus growth vehicle has had its highest return in market declines where equities suffer losses, which shows that this strategy is of a defensive nature as well. The real return of the value versus growth strategy has on average been positive all through the strategic and tactical cycles, supporting the fact that it has been close to uncorrelated to leading indicators, varying only slightly. Even though the correlation to equities has been slightly positive over the 85 year period, the risk premium has shown to have defensive characteristics. Also, the distribution of 12 month real returns shows a more concentrated return pattern compared to equities, with lower tail risks.
X-asset themes
10
0 1927 1937 T-bills 1947 1957 Gvt.bonds 1967 1977 Equities 1987 1997 2007 High/Low dividend
Source: GFD, Ecowin, Fama & French and SEB X-asset
One should note that in the very highest segment of the market, there are lots of firms that have had, under a short period of time very lucrative earnings or a collapse in the stock price, and by that being able to increase the dividend yield substantially. This has however not been sustainable through time and therefore the high dividend payouts have not been able to continue, leading to migration to lower dividend groups. Therefore, it is an advantage if sustainable dividend payment is a selection criterion when investing in high dividend yield stocks. The premium: This particular risk factor has been constructed as investing in the 30 percent of the market with the highest dividend yield while going short the 30 percent with the lowest yield. Studies estimate a risk premium in the range of 1.5% to 5% while our analysis shows a premium of 2.2% since 1927, with no correlation to the stock market.
Chart 25. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30% 20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%
Chart 26. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
Source: GFD, Ecowin, Fama & French and SEB X-asset
US CPI
OECD LEI
Equities
High/Low dividend
Source: GFD, Ecowin, Fama & French and SEB X-asset
The vehicle: When constructing an investable vehicle of the dividend premium and deducting a cost of 75 bps, the historical real return has been 2.1%. Supporting the explanations, stocks with a high dividend yield have systematically had smaller losses than the total market during periods of cyclical weakness, which means that this equity related vehicle also has defensive characteristics. The correlation to growth indicators is mostly negative, and the correlation to inflation is variable, allowing this like the three other equity related risk premiums to deliver abovetrend returns during both high-inflation and low-inflation secular bear markets.
X-asset themes
Qnt 1 Qnt 2 Qnt 3 Qnt 4 Qnt 5 8.4% 8.7% 8.4% 7.8% 6.1% 31.8% 26.9% 24.4% 21.9% 18.1% 0.24 0.30 0.32 0.33 0.30
Qnt 3 Qnt 4
Qnt 2
Qnt 1
July 1927 = 1
100
10
Qnt 5
30%
35%
1927
1937 T-bills
1947
1977 Equities
1987
The premium: The risk factor has been constructed as going long the second quintile of the market while going short the fifth quintile, where the quintiles are based on market cap with quintile one including the smallest firms. The reason for not using quintile one is because it captures micro cap firms. Academic studies covering the size premium show a premium of around 0%-6% while our analysis over the 85 year period has shown a risk premium of 2.4%, The vehicle: The real return for the size vehicle during the same period of time has been 2.3%, when charging a cost of 75 bps. This alternative beta, contrary to the three other equity market based strategies, does not possess defensive characteristics but have positive correlation to both equities and leading indicators, making it more favorable when equity markets perform well. It has shown to be tactically cyclical, while not being cyclical during the longer time horizons of the strategic cycle. Chart 30 shows the 10 year rolling correlation to US CPI and OECD leading indicators and confirms the cyclicality of this vehicle, showing basically only positive correlation to leading indicators.
Chart 29. Distribution of 12M real returns, USD, 1927-2011
60% 50% 40% 30% 20% 10% 0% < -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%
Chart 30. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
Source: GFD, Ecowin, Fama & French and SEB X-asset
US CPI
OECD LEI
Equities
Small/Large cap
Source: GFD, Ecowin, Fama & French and SEB X-asset
This is also the most risky of the seven alternative betas, with an average standard deviation of 14% over the 85 year period. There are also a couple of very long drawdowns, for example during the 80s and 90s as noted earlier. One possible explanation for the missing premium during that period could be that investors were overpaying for IPOs during the dot-com mania, leading to overvalued firms in the small cap segment.
10
X-asset themes
Equities
Gvt.bonds
Gvt.bonds curvature Defensive sectors/market* Credit premium*
T-bills
15%
20%
*Trading costs of 75 bps has been included for equity related premiums, 40 bps for the credit premium and 50 bps for FX carry Note: the combined "Alternative betas" has been constructed as an equal weighted basket
Note: the "Alternative betas" is constructed by the weights from a normalised portfolio at 15% Value-at-Risk
Even though most of the alternative betas individually are below the risk-return trend line for the traditional assets, they make it into a portfolio with close to 50% weight at a risk level of 15% Value-at-Risk. This is due to favourable correlation characteristics, making them able to perform in a broader range of macro climates than stocks and fixed income. They are thus included in balanced portfolios even at relatively modest risk-adjusted returns. Fixed income assets are displaced when including alternative betas in a portfolio, while equity allocation is actually increased due to diversification added by the alternative betas, which in turn increases the long term return of the portfolio. Altogether, alternatives displace around 30-70% of the traditional asset portfolio depending on the level of risk. The credit, value, defensive sector-based and FX carry premiums have the highest weight in a portfolio at 15% Value-atRisk. The strategies also complement each other since they work well in different parts of the risk spectrum. In the truly long term case, the curvature and to some extent the credit premium has its highest allocation at low risk, while defensive sectors works well at low to medium risk and the value premium and FX carry at medium to high risk.
Chart 32. Optimal portfolio at a 15% Value-at-Risk level Chart 33. Alternative beta allocation along the frontier
100%
Traditional portfolio 10% 26% 1% 4% Expanded universe 0% 3% 14% T-bills Gvt.bonds Credit Equities Gvt.bonds curvature Credit premium Value/Growth Defensive sectors/market High/Low dividend Small/Large cap FX carry
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% Value-at-Risk Credit premium High/Low dividend 20.0% 22.5% 25.0%
15%
33%
Note: The alternative betas and the hedge fund strategies have been included individually. Value-at-Risk based on 98% confidence level and a 12 month time horizon
Note: Value-at-Risk based on 98% confidence level and a 12 month time horizon
With our forward-looking estimates and the historical correlations, a expanding the portfolio with alternative betas would increase return with roughly 50 bps per year, at a 15% Value-at-Risk level. This might not be a lot, but accumulates over time. Another value with the approach of alternative betas is the part of active allocation, since we have found strategies that have their peaks in return during declining markets while at the same time show a long term premium. It seems likely that this approach has a positive role in the hedging of cyclical risks and that it leads to a more clear-cut diversification effect. Hence by increasing allocation to alternative beta during distressed periods, losses will dampen or even result in positive returns, in times when equities perform negatively. This is particularly interesting in the current climate when a portfolio of equities and fixed income is expected to perform with low and volatile returns. This is something that will be covered in an upcoming analysis of our cyclical allocation framework.
11
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