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Traditional assets work in the long run, but they dont diversify macro risks well. Expanding the universe can increase risk-adjusted return, but risks remain.
25 NOVEMBER 2012
X-asset themes
CONTENTS
Summary: Expanding the universe.......................................................................................................................................................... 3 Traditional assets long-term track record with flaws........................................................................................................................ 4 Expanding the universe with non-traditional assets ............................................................................................................................ 7 Constructing long-tem portfolios using the full tool-box .................................................................................................................... 9 Cyclical risk in a balanced, expanded portfolio ................................................................................................................................... 10
+46 8 50623246
X-asset themes
FX carry
Credit
Macro
Value/Growth
Commodities
CTA Small/Large cap High/Low dividend
Defensive sectors/market
OECD LEI
Gvt.bonds
Defensive sectors/market
Equities
T-bills
Gvt.bonds curvature
T-bills
Credit premium
Credit
-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00
Note: The combined "Alternative betas" has been constructed as an equal weighted basket Source: GFD, Ecowin, Fama & French and SEB X-asset
In this note, we expand the investment universe to include commodity futures, hedge funds and alternative betas. This work builds on earlier in-depth studies of historical returns, but here we tie all the strains together, analysing all the different asset classes on the same basis as we look at traditional assets. These assets lack the transparency and track record of traditional assets, but they turn out to be less susceptible to the risks that hurt traditional assets. Nontraditional assets are thus not attractive because of their high returns, but because they offer a range of uncorrelated sources of return the holy grail of asset allocation. Commodities stand out as the only asset class providing inflation protection. Hedge funds as a group do not offer true diversification, but our exposure is comprised of strategies with proven diversifying effects, and the seven alternative betas we have identified complement each other as well as the traditional assets on all horizons.
Chart 3. Optimal portfolio traditional assets, 15% VaR
10% 26%
31%
44%
32%
33%
5%
5%
Source: GFD, Ecowin, Fama & French and SEB X-asset
The stronger diversification achieved by including non-traditional assets increases the risk-adjusted return of a balanced portfolio, with significant exposure to alternative beta at all risk levels. Based on our forward-looking estimates, we find an optimal allocation to non-traditional assets of around 54% for a 15% Value- at-Risk long-term portfolio. Alternatives only displace fixed income assets, but allow an increase in the equity allocation that leads to an expected extra annual return of around 0.6%. However, while the long-term risk-adjusted return improves, including non-traditional assets in a balanced portfolio does not eliminate losses in episodes of market distress.
X-asset themes
Sweden Canada South Africa Norway UK USA/World/World ex USA Switzerland NetherlandsAustraliaIreland Spain New Zealand Belgium Finland
0%
5%
15%
20%
Real US t-bill returns have averaged 1.6% since 1835, but it has not been stable. In the 1800s it was above 3%, but after a trend break in early 20th century, in connection with the collapse of the Gold Standard, real returns have averaged 0.5% with several periods of major losses. For a global comparison we use numbers from Global Investment Returns Yearbook (CS 2012) covering data for 19 countries 1900-2011. Their real T-bill returns range from -3.5 to 2%, with volatility between 4% and 14%. T-bills can thus suffer irrecoverable losses from extreme inflation/currency shocks, but global exposure can mitigate concentration risk. Our long-term estimate for the real T-bill return is 0.75%.
Since 1820 10-year US government bonds have had a real annual return of 3%, with a trend change around 1910 after which the return dropped from 4% to 2%, in our view caused by the collapse in the gold standard that also triggered a sharp decline in real T-bill returns. Bond returns have had an unstable relationship with growth, but they have invariably been negatively correlated to inflation. Higher and more variable inflation in the 20th century has thus reduced the level of real bond returns, even though the risk premium tripled from 0.3% to 0.9% after 1910.
X-asset themes
Belgium
Japan Germany
20%
25%
Bonds have limited short-term risk the largest 12M real loss is around 20% but the past 100 years have seen two long periods of sustained, inflation driven losses for US bond-holders, with negative returns in one case extending over more than 40 years. Meanwhile, 6 of 19 countries in GIRY experienced outright losses over the full period since 1900, the same six countries that showed a negative real t-bill return. However, even in these countries the losses were smaller than those for T-bills, so all 19 countries in GIRY have had positive government bond risk premiums between 0 and 2.5%. Our forward-looking estimate is for a long-term risk premium of 1.25% and a real return of 2%.
Real total S&P 500 return has thus been remarkably stable at around 6% over the past 200 years, but as Chart 11 shows the return has been extremely volatile. 12-month losses have exceeded 40% more than once, and there are regular periods of negative returns lasting as long as 20 years. Real equity returns have had a variable correlation to inflation, with the correlation turning positive when inflation is low, but they have always been negatively correlated to growth. Indeed, our cyclical analysis shows equity losses are clustered in economic downturns on all time horizons.
Chart 13. Real equity market risk and return, 1900-2011
9% 8% 7% 6% Real return 5% 4% 3% 2% 1% 0% 10% 15% 20% 25% Standard deviation
Source: Global Investment Returns Yearbook 2012
Australia
South Africa
Canada World
USA Sweden New Zealand Finland Norway Ireland Spain France Belgium Japan Germany Italy
Switzerland
30%
35%
40%
X-asset themes
As was the case for bonds, the higher variability of real returns in the 20th century has been accompanied by an increase in the risk premium. The excess S&P 500 return over T-bills rose from 3% between 1835 and 1910 to more than 5% after 1910, even though the real return for equities didnt budge. The rise of paper money and inflation has clearly reduced long-term returns for fixed income assets, but does not appear to have a similar effect on equities. Over the very long term, equity returns are actually less risky than bond returns: the real returns since 1900 have been positive for all the 19 countries in the GIRY sample even those that had negative long-term bond returns and risk premiums are in a range from 2.5-6.5%. Our forward-looking long-term estimate for real equity return is 5.75%, consistent with a 5% risk premium over T-bills.
Even after factoring in defaults, the long-term excess return is positive, but the total real return has nonetheless suffered during both short and long periods of government bond losses. The biggest 12-month real losses of around 25% have thus coincided with extreme losses for government bonds. The excess return is correlated with equity beta, as equity capital is a buffer for credit losses, and credit risk can rise in a non-linear way relative to the risk of similar government bonds in periods with very low equity prices and high volatility, limiting the ability to hedge against extreme equity losses. Credit has underperformed government bonds by more than 15% during equity crashes. Due to the conflicting forces combined in the two parts of corporate bond returns, credits link to macro factors is unstable: the correlation to growth indicators ranges from almost perfect positive correlation to almost perfect negative correlation, while the correlation to inflation is dominated by the negative effect from duration risk.
Chart 17. Credit vs Treasury return, 1915-2011 Chart 18. Excess return and S&P 500 return, 1915-2012
In practice, the total return from a credit investment will depend on a range of factors with the average credit rating and the duration of the bonds in front. Our analysis, based on long-term US investment grade bonds, shows a real return from US credit of 3.3% since 1915, 1.3% more than government bonds, and a risk premium over T-bills of around 3%. Our forward-looking long-term estimate is a risk premium of 2.5% and a real return of 3.25%.
X-asset themes
0.40
Agriculture
0.20
Commodities Equities
0.00
Precious metals Industrial metals
Industrial metals
OECD LEI
-0.20
T-bills
Equities
Gvt.bonds
-0.40
Gvt.bonds
-0.60 -0.80
Credit
25%
30%
35%
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
Standard deviation
Source: GFD, Ecowin, SEB X-asset
Our commodity index is calculated from three sources: 1915-1950 data is based on reconstructed futures contracts from GFD, 1951-1969 results from a study by Gorton & Rouwenhorst (2005), and starting 1970 it is an equal weighted total return index based on four GSCI commodity sub-groups precious metals, industrial metals, agriculture and energy. Academic studies show a risk premium from commodities of around 5-7% over the last 50 years, but this was a favorable period for commodity returns. Using long-term data, we estimate the historical risk premium to have been 3% since 1915, at a risk level a bit below equities, and this is also our long-term forward-looking estimate.
Chart 21. Distribution of 12 months real returns, 1915-2011
50% 40% 30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 5%-0% 10%-5% 15%-10% 20%-15% 25%-20% 30%-25% 35%-30% 40%-35% > 40%
Equities
Commodities
Source: GFD, Ecowin and SEB X-asset
The distribution of commodity returns clearly deviates from the normal distribution and follow that of equity returns rather well with a similar 12 month average. Both have rather fat tails with maximum 12-month losses well above 30%, but equities have more extreme observations on both the upside and downside. Correlations with macro risks are very different from the traditional assets: real commodity futures returns are almost invariably positively correlated with inflation, while the correlation to growth indicators is more variable. Although commodities have a rather low return per unit of risk compared with equities, a small, diversified exposure is thus a valuable addition to traditional assets in a balanced portfolio thanks to the diversification benefits.
X-asset themes
Equities
Macro
T-bills Credit
15%
20%
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
Due to limited history of around 20 years of realized returns, our analysis uses risk factor replication of the beta return of hedge funds by several risk factors. The three strategies complement each other in balanced portfolios of most risk levels and would be included even with a conservative forward-looking estimate without alpha assumptions due to their attractive diversification characteristics. We find that a basket of the strategies would have had a real return of 2.5% and a risk premium of 2.1% since 1915 close to uncorrelated with macro risks. Our estimate for the forwardlooking risk premium of a balanced portfolio of diversifying hedge funds is 2% at a risk between Treasuries and credit.
Chart 25. Distribution of 12 months real returns, 1915-2011
50% 40% 30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 5%-0% 10%-5% 15%-10% 20%-15% 25%-20% 30%-25% 35%-30% 40%-35% > 40%
Equities
The distribution of returns from our hedge fund basket is more concentrated than that of equities, with much smaller tails. Real 12-month losses peak around 20%, similar to government bonds. But unlike government bonds, the hedge fund basket is not negatively correlated to inflation. Correlations with macro risk factors are less volatile than those for traditional assets and average correlation is very close to the center of Chart 26, highlighting the attractive diversification characteristics.
X-asset themes
Equities
4% 3%
Credit
Value/Growth*
Defensive sectors/market
Value/Growth
OECD LEI
Alternative betas
High/Low dividend
2% 1% 0% 0%
Alternative betas
Gvt.bonds
Gvt.bonds curvature
Equities
Credit premium
T-bills
Gvt.bonds
Credit
15%
20%
-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80
Note: The combined "Alternative betas" has been constructed as an equal weighted basket Source: GFD, Ecowin, Fama & French and SEB X-asset
*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
As with commodity futures, a majority of the individual alternative betas have rather low historical risk-adjusted return but attractive correlation benefits. All but one of the seven strategies have historically been below the riskreturn trend line of traditional assets. Like equities the performance from individual alternative betas vary over time. Some strategies have delivered flat or even negative returns over periods as long as 10-20 years. On the upside the alternative betas are close to uncorrelated with inflation with a tilt towards negative correlation to leading indicators. They are also internally independent, so an en equal weighted basket has historically had a real return of 2.2% with a risk around 5% like government bonds. Our forward-looking risk premium estimate is 1.6%.
Chart 29. Distribution of 12 months real returns, 1927-2011
50% 40%
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
OECD LEI
Equities
Note: The combined "Alternative betas" has been constructed as an equal weighted basket
Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset
12 month alternative beta returns are clustered around zero with relatively small tails and mainly on the upside. Over 40% of the observations are within the 0-5% return bucket and more than 90% of the observations are covered within -5% to +10% return. 12-month real losses peak below 15%, somewhat lower than for government bonds. Correlations with macro factors for the equal weighted alternative beta basket has been variable, but 10-year observations are generally scattered evenly around the centre, with the average being very close to uncorrelated to both inflation and leading indicators as well as to the traditional asset class returns.
Equities
0.20 0.00 Alternative betas -0.20 -0.40 Gvt.bonds T-bills Credit OECD LEI Hedge funds combo Equities
T-bills
-0.60
15%
20%
-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80
Note: The combined "Alternatives" has been constructed by equal weighting the alternative betas Source: GFD, Ecowin, Fama & French and SEB X-asset
*Trading costs of 75 bps has been included for equity related premiums, 25 bps for the credit premium and 50 bps for FX carry
Note: The combined "Alternatives" has been constructed by equal weighting the alternative betas
X-asset themes
We use resampled mean variance optimisation which, as the name suggests, uses resampling in order to avoid some of the well know problems with traditional Markowitz optimisation. Portfolios are optimised with a 12 month time horizon and a 98% confidence level. The three hedge fund strategies and the seven alternative betas enter the optimisation as individual strategies. No cost assumptions are included for traditional assets and commodities. For hedge funds and alternative betas costs are taken into consideration depending on the underlying asset class.
Chart 33. Allocation along the efficient frontier
100% 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 20.0% 22.5% 25.0%
44%
32%
5%
5%
Source: GFD, Ecowin, Fama & French and SEB X-asset
T-bills
Gvt.bonds
Credit
Equities
Commodties
Hedge funds
Alternative betas
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
Taken as a group, alternative betas have a 25-70% allocation along the risk spectrum thanks to their attractive diversification characteristics. Hedge funds have a rather stable allocation along the efficient frontier at all but the highest risk levels, while the commodity exposure increases with risk level. In a portfolio at 15% Value-at-Risk nontraditional assets make up 54% of an unconstrained portfolio. They push out fixed income assets - the exposure to tbills and government bonds is reduced to close to zero and credits to less than half of that in a traditional assets only portfolio. Due to the uncorrelated nature of the independent alternative returns sources, we think its fair to call the expanded portfolio less concentrated, with increased diversification allowing a 6%-point increase in equity allocation which creates an additional annual return of 60 bps compared to a traditional portfolio at the same level of risk.
Value-at-Risk
1938
2008
Chart 35 shows portfolio return and risk by decade, and even in this limited sample the portfolio has experienced one decade with no return and one decade with twice the expected risk. Short-term risk has only been marginally reduced, particularly in the high-inflation 1970s, but tail risk remains and real 12-month losses still break the 15% limit during periods of extreme market stress such as the early 1930s and 2008 more often than they are supposed to. Adding alternative assets thus improves long-term risk-adjusted returns, but not enough to eliminate recurring periods of sub-trend returns over several horizons. In order to get a better understanding of the nature of this risk, we use the SEB Waves cyclical allocation framework, our systematic macro-based cyclical risk analysis based on three macro cycles across three different time horizons. Each cycle is broken down into four phases using historical macro indicators and we then analyse phase-dependent investment returns to identify macro-based clusters of risk. The underlying idea is that investors should be willing to pay more for risk that is not clustered in the same periods as other assets, and in particular for losses that are not clustered together with losses for the most risky assets.
10
X-asset themes
Our structural wave reflects a technology cycle of secular bull and bear markets, where each phase on average lasts 10-15 years. Traditional assets have their main drawbacks during crises, while non-traditional assets have stable and positive return in all phases but Golden age boom where returns are positive but lower. The expanded portfolio posts a positive real return in all phases, but in the high inflation capacity shortage phase the real return has been less than 1% while the low-inflation overcapacity crisis phase risk has significantly exceeded the long-term average.
Chart 37. Total real return in structural phases, 1927-2011
20%
10%
15%
8%
10% 5% 0%
Real return
6% 4%
Golden age boom Full sample Overcapacity crisis Capacity shortage crisis
2%
-5% Capacity shortage New era boom Overcapacity crisis Golden age boom crisis Gvt.bonds Credit Equities Commodities Hedge funds Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset
0% 0% 5% Standard deviation
Source: GFD, Ecowin, Fama & French and SEB X-asset
10%
15%
T-bills
The strategic wave is based on the output gap cycle: growth above trend or below trend and easing or tightening credit conditions determine four phases of the cycle with duration of 1-3 years. Traditional portfolio losses are concentrated in the first part of a recession. Alternative betas are basically a-cyclical with positive and stable return in all strategic phases, while both commodities and hedge funds have losses in early recession. Improved diversification is not enough to prevent the expanded portfolio from systematically posting average real losses and elevated risk in the early recession, mainly due to the significant losses from equities.
Chart 39. Total real return in strategic phases, 1970-2011
Note: Weights for optimised versions are 69% defensive sectors, 31% value and 45% cyclical sectors, 55% large cap
Early recession Late recession Early expansion Late expansion Gvt.bonds Credit Equities Commodities Hedge funds Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset
0%
5% Standard deviation
10%
15%
The tactical wave is based on the manufacturing inventory cycle, with leading indicators defining 3-6 month phases. Tactical asset class behaviour and portfolio performance is similar to strategic cycle: the sequence of relative returns is similar, it just happens faster. The most critical phase is early downturn where equities have sharp losses and all non-traditional assets hold up well. Again, the expanded portfolio has systematic losses at elevated risk in this phase.
Chart 41. Total real return in tactical phases, 1970-2011
Note: Weights for optimised versions are 69% defensive sectors, 31% value and 45% cyclical sectors, 55% large cap
15%
Real return
10% 5% 0% -5% -10% -15% -20% T-bills Early downturn Late downturn Early upswing Gvt.bonds Credit Equities Commodities Hedge funds Late upswing Alternative betas
10%
5%
Late upswing
Full sample
0%
Early downturn
Active asset allocation, including the expanded universe, is the subject of a coming study. The study will include a deeper analysis of systematic variations of especially non-traditional assets, the implications on portfolio performance and how phase dependent overlays can dampen portfolio drawdowns and reduce short-term risks.
11
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