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Harold Camping, perhaps the world’s worst prophet, inaccurately predicted the “End of Days” twice in the past 12 months. After his first failed conjecture, a billboard popped up in North Carolina: “That was awkward,” it said.
We at aiCIO agree with that billboard, and think that credibility is lost after such horrifically inaccurate occurrences. Thus, our Year in Preview—in which we look at the viability of multiple investment strategies and options in 2012—showcases soothsayers on both sides of each debate. Like a savvy financier, we are hedging our bets to avoid becoming the Harold Camping of the institutional investment world. Clever, eh?
The genesis of this feature emerged from discussions I’ve had throughout the year with chief investment officers, asset managers, and consultants. One complaint about the financial publishing industry is that it has its eyes locked firmly on the rearview mirror. Multitudes of websites in this niche industry of institutional investing report on who was fired, who was hired, what hedge fund is being investigated, and what investors did yesterday. Few look ahead and help investors discern what will come tomorrow. The purpose of this section, then—indeed, the purpose of all the magazines, conferences, and website that encompass aiCIO—is to help large capital owners predict what 2012 will bring. My only regret is that we couldn’t cover more than five topics within these pages.
The strategies and investments included must meet a few criteria: They have to interest the Editor; they have to allow for honest disagreement and contention; and they have to scare at least some investors. We believe that we have fulfilled these criteria with our five topics: low-volatility investing, risk parity, real estate, commodities, and liability-driven investing.
So enjoy our prognostications—or at least our attempts to discern what certain markets will do under certain conditions. If one of our contributors gets it right, kudos. If they get it wrong—well, perhaps we will soon be purchasing billboard space ourselves. —Kip McDaniel
RISK PARITY STRATEGIES
Ephemeral or essential? Risk parity divides its critiques along these lines. Our prognosticators have their say.
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PRO: “There are no new ideas. There are only new ways of making them felt.” This quote, by Caribbean-American writer, poet, and activist Audre Lorde, is a truth that is especially relevant in the world of finance. Ideas build upon their predecessors. Risk parity—a term that has gained momentum following the chaos of the financial crisis—is built upon the investing tenet of diversification, championed by Harry Markowitz’ Modern Portfolio Theory of 1952. The financial crisis made it apparent that a fresh approach to investment thinking was desperately needed, as the financial world had become too comfortable and complacent about the status quo.
Risk parity—a risk-based approach to allocating capital—has become a catchphrase in the institutional investing sphere. It’s an idea that criticizes the traditional 60/40 portfolio mix, which inherently yields an uneven distribution of risk. Risk parity, then, aims to maximize diversification by taking equal risk in each investment, thereby decreasing assets with large shares of the investment risk budget and increasing lower-risk assets.
Investors can’t have it all, however. Despite its attractively high Sharpe ratio, a risk parity-generated portfolio suffers from comparatively low returns. Thus, consultancy NEPC and other risk parity supporters reiterate the value of a tainted word: leverage. “While leverage isn’t formerly part of the theory, it is part of the application,” says NEPC Partner Chris Levell. “Another way of thinking about it is to look at the capital market line—leverage allows you to exceed expected returns along the efficient frontier.”
Outlining the flexibility of risk parity in terms of its application, Levell says the embrace can be full or partial. In other words, a fund manager could allocate 5% to 10% of the portfolio in the strategy or, on the other end of the spectrum, implement the strategy at the total portfolio level—which is typically done within the more experimental and ahead-of-the-curve endowment and foundation universe.
Yet leverage is a word investors continue to fear. “Investors are always going to have a leverage blowup story in their heads,” Levell says, explaining the mindset of investors eager to find a method of mitigating risk, yet hesitant to embrace a strategy that might rely on leverage to achieve considerably enticing returns.
Doubters of the approach are numerous. Marlena Lee, vice president at Dimensional Fund Advisors, has claimed in a recent research paper that over the last 81 years, risk parity portfolios have not produced higher Sharpe ratios than the traditional 60/40 balanced approach. According to Lee, while proponents of risk parity claim the investment strategy is an alternative approach to asset allocation that promises better risk-adjusted returns, the “promise is deceptive.” The reason, according to Lee’s research: “out-of-sample results show that the touted benefits of risk parity only appear in the last 30 years during a period of falling inflation and interest rates.”
Risk parity supporters, however, assert that the approach is more of a philosophy for all market environments—including a potentially rocky 2012. “There’s a misperception out there that because risk parity leverages bonds, its success solely depends upon the performance of fixed-income. Our general philosophy of the strategy involves paying more attention to risk evenly—basing our focus on risk rather than allocation of capital,” says Bryan Belton, PanAgora’s Director of Multi-Asset Strategies.
Risk parity, then, should be looked at not as an investment fad, but as a protective, cautious way of managing risk that is here to stay—a philosophy applicable to all markets. Consultants and others in the industry supportive of the strategy assert that the leverage used in a risk parity approach should not be feared, but should be used with prudence. “Completely avoiding leverage will limit returns. Leverage is a risk but when used prudently within a risk parity framework—like all risks—it should be rewarded over time,” Levell asserts. —Paula Vasan
CON: You are leading a rafting tour and are poised at the top of a river run. One route is a class five whitewater rapid; the other is a lazy river. Which one do you choose?
In the face of a challenging investment environment, institutional investors are flocking toward the lazy river. One seemingly safe route is risk parity. Hailed as an effective strategy due to its risk-adjusted returns and apparent success in the recent credit crisis, it is getting attention as a way to create balanced portfolios that are buoyant in unsteady markets. However, is this seemingly smooth ride masking rocky times ahead?
Next year, in fact, provides a flood of reasons to reassess the current assumption of safety. Opponents of risk parity are quick to suggest that the success of the strategy is not a testament to the strategy itself, but instead to market conditions—conditions that may not be present in the coming year. Some argue that standard deviation is not an accurate way to measure risk and that assets may be more closely linked to each other than anticipated. In that same vein, investments run the risk of being more correlated than we would like to believe (read 1.0).
The conditions going forward for risk parity seem less than ideal. Leveraging bonds can prove dangerous—with yields sitting near all time lows. The strategy of heavily leveraging up something deemed less risky can be just as dangerous as putting less weight in holdings with greater risk.
When Ben Inker, head of the asset allocation group at Boston-based GMO, last spoke with aiCIO, he made a case for the potential pitfalls of risk parity. That case has only gotten stronger over time. He warned of the dangers of buying overpriced assets by putting faith in a static portfolio for all environments. Inker went on to say that “if you diversify into assets without risk premiums, you might as well keep it in cash.” Inker further cautioned that the risk parity approach often assumes risk premiums into existence that may not exist, as well as assuming that historical returns and volatility are guides to the future.
Asset owners, by and large, understand these risks. The 109 senior investment officials who responded to our July 2011 Risk Parity Survey said that the most common issues keeping them up at night were the use of leverage/counterparty risk (65.9%), board and staff education (46.3%), and timing (39%). One respondent offered that “Any concept that quantifies risk has no place in investing.” This was echoed in Inker’s words that “Risk is not a number. It is the permanent impairment of capital.” Our survey spotted the benchmarking of risk parity as another big question mark. Despite little consensus, a “GTAA” or “MSCI World” benchmark seems to be leading the pack. There was a hint of a Gold Standard, however, with funds that have already implemented a risk parity strategy being more likely to choose a Global/GTAA benchmark.
The 2011 Risk Parity Survey also showed that more than 50% of respondents were, or are looking into, allocating to such strategies. With echoes of 130/30 and other faddish investments in mind, is risk parity at risk of becoming a bubble? Perhaps so. aiCIO recently held a conference in Sydney, Australia on the subject. One consultant, when asked whether it was a bubble, said it was—and cited the evidence that conferences were now being held exclusively on the topic.
For those in the raft: don’t say you weren’t warned. —Jordan Milne
REAL ESTATE INVESTING
Real estate, two words that make most cringe. Will this persist— or end—in 2012?
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PRO: “Lost in the woods? Build a house,” or so the adage goes. The updated version is to forego the house and invest in an apartment building with public transit access to a 24-hour city. Partially as a result, in 2012 an oversold real estate market will offer institutional investors unique properties with solid cash flows and potential upside. The outlook for the buyers and active managers is also enhanced by the continuing ability to secure long-term borrowing funds at historically low rates. The key is to manage risk while investing in products that accord with the themes driving global capital flows.
The subprime crisis was a painful reminder that real estate is not an asset that performs well with uncurbed leverage and liabilities that can only be met through a constant appreciation in value. Historically, property gives back more from cash flows than price increases. Joshua Kahr, Professor of Real Estate Finance at Columbia University says, “traditionally, real estate has a moderate risk and return profile. And it is meant to be an illiquid investment.” This is relevant for fully funded long-only managers because the combination of regular cash flows and illiquidity premiums make real estate a vital portfolio diversification tool.
At the macro level, Dr. Karl Case, co-creator of the Case-Shiller Home Price Index says, “the good news for now is that we seem to be treading water and at some point the demographics will kick in.” He adds that for 35 months the US has been at a 60-year low for housing starts, “[so] it won’t take a lot of buyers to move the market.”
At a more granular level, multifamily dwellings are seeing strong demand and particularly robust geographies include Tier-1 cities like San Francisco, LA, Washington DC and New York. The shift to apartment living is supported by downsizing Boomers and the significant reduction in national home ownership, which dropped from nearly 70% in 2004 to 65% today. Prices in urban areas are also buoyed by Gen Y’ers migrating for career prospects and the rise of a non-Western elite with a flight-to-quality mandate for their often newly acquired fortunes. Internationally recognized buildings in high barrier markets are arguably a better investment than ever.
Kahr says the best way for pensions and endowments to operate in the current climate is through programmatic equity partnerships with active managers. He says the best ones will “allow LPs [investors] to deploy capital on a sequential one-off basis, making considerations for location and product particulars.” Clifford Mendelson, CEO of Metropolis Capital Finance adds that “it is important to understand the full track record of active managers and know the extent to which managers are matching their liabilities against their assets.”
Greg Mackinnon, Director of Research at the Pension Real Estate Association calls real estate investment trusts (REITs) “an imperfect proxy on private equity real estate markets as well as a way to gain exposure to attractive developments in foreign markets.” He adds that institutional investors need to bear in mind that liquidity also brings volatility. For Mendelson, the key to investing in REITs “is to understand the quality and nature of the assets within the REIT and not just the dividend rate, which can be fleeting.”
Real estate markets are still under heavy pricing pressure, but shying away from favorable deals that accord with the shifting economic environment is no way to make up for previous damage done to institutional balance sheets. Risk management is as essential as ever, but as Baron Rothschild sagely pointed out, the best time to buy is often when there is blood in the streets—even if that blood is your own. —Aran Darling
CON: Historically and wrongly, real estate has been viewed by the masses as a ladder or escalator—always going up—taking investors higher the longer they stay on. Institutional investors haven’t been much more cognizant, allocating a significant portion of long capital to this ‘’ever steady’’ asset class. For pension funds today, significant means roughly 10% of total assets, up from 6-8% 10 years ago.
The reality: Despite taking many to new heights, its failsafe reputation is more of a myth, leading to precarious strategies and dangerous behaviors. Real estate is more akin to an elevator, moving up or down, dropping off eager investors along for the ride at different floors depending on which buttons they press and which moves they make. These days the elevators are busy, with many hopeful riders waiting in the lobby.
Today as always, however, the potential dangers of this asset class are being revealed. With 2012 around the corner, key players are taking note and adjusting their steps. Billionaire real estate investor, Tom Barrack—founder of California-based Colony Capital, which manages $34 billion—is bearish about the commercial real estate market. In a post earlier this year, Barrack cited the Case-Shiller Home Price Index—a bell-weather if there ever was one for the American housing market—as falling 4.2% in the first quarter alone, being down 5.1% compared to its level one year previous. He then warned us to “get ready for further declines.”
Institutional elevator riding persists, however. Industry leaders like the California Public Employees’ Retirement System (CalPERS) are looking to alter their real estate strategy—albeit this time into less risky real estate holdings. The powerhouse is reducing its allocation target to 8% from 10% until the end of the year, acknowledging that safer commercial-
real-estate opportunities are getting scarce. Players like the Maryland State Retirement System are also following suit.
But are we in a mini-bubble that should cause even starker movements? An index of commercial-property values by Green Street Advisors has risen more than 45% from its 2009 lows—and is only 10% below its all-time highs. Looking at such evidence—plus, perhaps, gut instinct—the California State Teachers’ Retirement System (CalSTRS) has expressed the view that we might possibly be in bubble territory. Somewhat similarly, the Texas Municipal Retirement System’s first real-estate investments avoided traditional holdings—top cities, namely—in favor of senior and student housing and medical offices, as well as office buildings in secondary cities such as Minneapolis and Portland, suggesting concerns about core holdings.
But we don’t want to be completely biased. While “not seeing a mini-bubble in real estate,” Mercer Investment Consulting’s Allison Yager sees similar risks in real estate as elsewhere in this fragile economy. “I’m not negative on real estate as an investment by itself—it would suffer like other sectors in a recession,” she says. There are some areas that are stronger in the sector than others, she says, adding that “before 2008, there was tremendous excess supply compared to the demand. That’s why everyone is concerned about the economy. If we go into a full recession, real estate will suffer once again with everything else.” And, opposed to the Texas pension’s move, Yager sees “prices recovering better in stronger markets such as New York, Washington, Los Angeles, and San Francisco.”
So should asset owners get on, or off, the real estate elevator for 2012? The truth of the matter is that opinions of intelligent people vary wildly. If you thing the economy has bottomed out, get on. If you think we’re in for a double-dip, perhaps get off. Just don’t get caught mindlessly riding from floor to floor. —Jordan Milne
COMMODITIES INVESTING
They’ve enjoyed an impressive bull run, but will 2012 be the year commodities turn to bear?
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PRO: Welcome to an unprecedented event in world economic history: Since 2007, while debt-saddled Western economies have sputtered in a rut, commodities have rallied as a robust middle class has grown and flourished in populous non-Western countries. Endowments and pension fund managers should capitalize on this global shift by making well-considered investments in commodities.
Certain commodities offer portfolios insurance against the effects of monetary indiscretion at home, and, more broadly, the commodities spectrum provides exposure to growth in other parts of the world. Some commodities investments, such as private and public equity investments in mining and energy projects, provide an intrinsic value that is attained through discounting future cash flows. The prices of those that do not have regular income, like commodities-linked index funds, are pure functions of supply and demand. As David Rosenberg, chief economist at the prominent Canadian investment firm Gluskin Sheff, points out, “the case for investing in commodities has strengthened in recent years because supply curves have become more inelastic.” In other words, stock levels and resource deposits are increasingly seen as finite, which is reflected in consistently rising prices.
The task of guarding assets from value erosion has been made more challenging by the continued slippage of the US dollar index, as well as by uncertainty created by multi-trillion dollar bond purchases and near-zero percent interest rate targeting by central banks. Indeed, real returns on five- and ten-year US treasuries are in the red. Because commodity prices rise when currency values fall, they offer natural insurance against insecurity over the effects of unpredictable monetary policy.
The concern with insurance for most fund managers is that it comes with a premium, thereby increasing costs. However, the premium of holding commodities is very low right now and is forecasted to stay that way for the medium term. The Fed’s current “Operation Twist,” in which it buys 30-year bonds and sells ones with shorter maturities, flattens the long end of the yield curve. According to Bart Melek, head of commodity strategy with TD Securities, “this results in a negative opportunity cost for owning commodities which are stores of value, such as metals.”
Commodity prices contracted in 2009, but not nearly as much as equities—and their recovery was far swifter. Rosenberg sees that as a call to action. “In the worst global recession since the 1930s,” he says, “no commodity made a new low. As a long-term investor, you want to buy things that do not make new lows during the bottom of a cycle.” According to Rosenberg, commodities have a positive outlook because the marginal buyers and the new engines of the world economy are outside the US and other fiscally constrained G10 states. Melek agrees, noting, “China has had a 24% infrastructure increase over the past few years. India has moved 200 million people from the hinterland into cities. [They’re] building an America every ten years—and that takes a lot of iron ore and other materials.” Whether investors choose the direct investment, dedicated commodities manager, or ETF route is secondary to this secular trend.
Pension funds—and, to a lesser extent, other asset owners—tend to move through markets in a manner resembling continental drift. In this case, such behavior might actually be a good thing. The crash of 2008 exposed the problems with long-bias price vulnerability in traditional allocations. Commodities, arguably better than any other asset class, offer natural risk management properties as well as secular growth driven by macro fundamentals. Expect that to continue next year. —Aran Darling
CON: The developing world is, by definition, developing. To do so, it needs raw materials to turn into roads, bridges, and other types of infrastructure. With that in mind, it would make sense to allocate a hefty portion of a pension scheme asset pool to commodities, the asset class that contains these raw materials, right? Wrong.
Well, at least if you think that would be anything other than a diversifying tactic.
Many believe that commodities offer the best inflation hedge—fuel, minerals, and metal ores all fall under this banner, and as the price of these raw materials rise, so does the end product. This is where the confusion also arises, according to Crispin Lace, a director in the consulting practice at Russell Investments in London. “Commodities are the ultimate supply/demand-led investment—they are not as simple as they first appear. The asset class is not a wealth creator, like debt or equities, although they have some intrinsic value. They are called ‘commodities’ for a reason,” Lace said.
This year, investors turned away from commodities, according to a survey by Bank of America Merrill Lynch. In October, the highest number of fund managers since February 2009 said they were underweight in the asset class. In February of this year, almost 30% of these same managers were overweight in their allocation to the asset class. In November they returned to take a neutral stance on the sector, but this was mainly due to them running from traditional asset classes, such as equities and bonds, that were impacted by the Eurozone crisis.
Lace noted that it was important to make the distinction between soft and hard commodities, as they would be affected by different factors. For example, poor weather leading to a bad harvest in North America last year drove up wheat prices, while increasing wealth in the developing world has meant a higher demand for meat, driving up lean hog prices. These are soft commodities. Hard commodity prices are driven by different metrics. Political uprisings during the Arab Spring earlier this year saw crude oil prices rise significantly. As well, the price of gold rocketed as the financial crisis took hold and spooked investors into moving into safe havens. Lace added: “Commodities may give a return above inflation, but an investor has to consider the cost of the processing, technical development, and refining of the raw material before they can see a link between the starting and finished article.” Companies spend billions of dollars, pounds, and euros marketing their products and this all has to be included in the end price. This price often goes into the calculation of inflation, which will be considerably higher than the cost of the raw material.
“Commodities are a valuable tool and there are many more positives than negatives, but they should be used tactically to create alpha by taking a macro view rather than being used as a blunt instrument to hedge inflation,” Lace concluded. By mid-November the global index that tracks a basket of general commodities, the S&P GSCI, had risen 2.16%. In the US, inflation was running at 3.9% in October. In the UK, it was even higher at 5.2%.
For the moment, pension schemes seem content to use the asset class as an alpha generator. According to this year’s annual asset allocation survey by Mercer Investment Consulting, only 7.5% of European pension schemes had an investment in commodities and the average allocation was 1.8%. In the 2011 Towers Watson Global Alternatives Survey, the consultants reported only 3% of US pension schemes’ allocation to alternative asset classes was destined for commodities—a tiny proportion of their portfolios. Since global markets will start 2012 in as shaky of a state as they spent the last six months, any risk-taking or alpha-seeking by pension schemes is likely to be subdued at best; this meagre commodities allocation appears set to continue. —Elizabeth Pfeuti
LIABILITY-DRIVEN INVESTING
Most people agree it’s not if, but when for this strategy. So is 2012 the year?
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PRO: Corporate defined-benefit plan (DB plan) sponsors are expected to make large contributions in 2012, building on the capital added in 2011. “The losses of 2008 are finally being taken into account in the calculation of funded status,” observes Karin Franceries, an executive director in J.P. Morgan Asset Management’s Strategic Investment Advisory Group, in New York. Among the 342 companies in the S&P 500 that still sponsor DB plans, contributions are estimated at $91 billion for 2012, a 76% increase from 2011, according to David Zion, head of accounting research at Credit Suisse.
This is a great opportunity, then, for sponsors to bolster their plans’ fixed-income exposures by starting or adding to an LDI program, to better align asset portfolios with the duration and credit characteristics of plan liabilities.
Truth be told, the argument in favor of basic LDI—simply buying bonds with longer maturities—is not terribly strong when viewed from the perspective of likely asset returns. In mid-November 2011, the 30-year US Treasury bond yield wavered around 3%—the lowest levels for the year, and not far off the record low of 2.53% set in December 2008.
Nevertheless, today’s bond market presents a couple of attractive return features around the edges. One is a steep yield curve: “From the 10-year to the 30-year Treasury yield there’s a pickup of about 100 basis points,” notes Neil Burke, a fixed-income portfolio manager at Loomis, Sayles & Company in Boston. Sponsors can add return by moving portfolios managed against the Barclays Capital Aggregate US benchmark, now yielding about 2%, to Long Government/Credit territory, in which yields are about 4%. “That’s a lot of pickup in yield for simply moving further out on the curve; many of our clients are looking at that for the new money they are adding to their plans.”
Another return feature is credit spreads, which are on the high side—at about 170 basis points for AA corporate bonds. “They’re not at their widest ever, but certainly above average,” says Franceries. (That spread was under 1% for much of the past decade.) “Treasury yields will likely stay low for a long time, but credit spreads have room to contract,” Franceries explains. “If they do, your liability will increase. Therefore buying those bonds before credit spreads compress would make sense.” Franceries also suggests looking at leveraged LDI applications for 2012—bringing in futures or swaps to increase a plan’s hedging ratio as an alternative to physical bonds: “You can benefit from the additional hedge, and by leaving your risk asset portfolio intact, also benefit from any upside in stocks.”
Sponsors may not make a killing on the bonds they buy in 2012, but simply judging the effectiveness of LDI in asset terms misses the point. LDI is about reducing risks—the risk that a plan won’t have adequate funding to pay its benefits, or that a sponsor will be surprised with contributions when assets and liabilities head in opposite directions. Holding out until yields rise is like waiting for Lipitor to go generic in order to save money on treating a blood cholesterol level of 300.
“Is there a perfect time to start or broaden an LDI program?” asks Burke of Loomis Sayles. “Nobody knows, because very few people can accurately predict interest rates. We suggest averaging into it—even when the 30-year Treasury was back at 3.75%, everyone said rates could only go higher, but if they had implemented then, they would be very happy today.” —John Keefe
CON: The first rule for any pension scheme is to have its liability obligations in mind when the assets are invested: Be too risk averse and you might never make it over the line if the sponsor runs into problems later; be too risky and you might force an otherwise healthy sponsor under via demands to remedy a high deficit. This is why all pension schemes should follow a liability-driven investment framework. Few consultants or asset managers shun this theory today, but the technical mechanism created by professionals to hedge out the main types of unrewarded risk through a system of bond investing and swaps may not be the way to proceed in the current environment.
John Belgrove, Principal at consultants Aon Hewitt said,“The theory is to reduce what can be regarded as unrewarded risk, such as that attached to interest rates, inflation and, more recently, longevity. The counterpoint to this is timing.” Unlike investment risk, which is expected to be rewarded in the long run by a commensurate level of excess return or premium, interest-rate risk is not expected to carry an inherent long-term risk premium. However, sovereign debt yields can move very significantly over economic cycles, causing severe funding volatility to under-hedged pension schemes. Why suffer that accounting uncertainty if it’s unrewarded? The question is whether the risks are great enough to warrant paying to get rid of them.
In the aftermath of the last financial crisis—and possibly peeping over the edge of the next one—interest rates in most developing countries have been reduced almost as much as possible. As politicians and financial supremos desperately struggle to reignite growth, it is unlikely they will raise interest rates (at least in the short term). This has meant that hedging out this particular risk carries a potentially very high price today—although that may only be proven in hindsight. Belgrove said, “Long-dated swaps are not based just on what interest rates are today —the market expects yields to rise. Therefore, buying into such a deal in the current environment would mean pension schemes benefit if rates stay low for longer than the markets expect. Conversely if rates rise faster or more significantly than the markets expect over the short to medium term, pension schemes would have been better to keep their powder dry.”
There is no one-size-fits-all answer. Some schemes start much better hedged and funded than others. There needs to be a constant assessment of how long interest rates are likely to remain low and what catalysts might move them. In November, the European Central Bank lowered its interest rates to help the region rise out of its current crisis. Some economists have called for the 1.5% rate to be cut further. In the UK, interest rates have been stuck at 0.5% since March 2009. Another mooted round of quantitative easing could ensure yields across the maturity curve remain low for a good while yet. In the US, interest rates have been held at a record low of 0.25% since December 2008, and in August this year the Federal Reserve announced it was unlikely these would rise before 2013.
“A lot of schemes want to implement or extend an LDI strategy, but they are waiting to see better yields before setting it into motion,” according to Belgrove. “It is down to policy decisions and the economic environment—we all know such low interest rates cannot last forever, the key is finding the right trigger points to execute hedges and not regretting missed opportunities.” —Elizabeth Pfeuti
LOW-VOLATILITY INVESTING
The evidence seems robust, but does low-volatility investing really ensure stronger?
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PRO: In 1991, Nardin Baker and Robert Haugen published a paper in The Journal of Portfolio Management arguing that capitalization-weighted stock portfolios were inefficient. “Market-timing to domestic cap-weighted stock indexes is likely to be a suboptimal investment strategy,” they argued before suggesting that a focus on low-volatility investing should be considered.
I write this solely to show that low-volatility equity strategies are not a new topic of discussion. Baker himself agrees. “Absolutely—it’s been around a long time,” he told me in early November, 2011—20 years after the paper was published. “The evidence goes back to the early 1970s. People thought return would go to higher risk stocks—but research shows that this has never ever been true,” Baker said.
Baker lays out four facts, as he sees them, surrounding equity markets. “The first is behavior,” he says. “Exciting stocks are what analysts talk about. Low-volatility stocks are very boring, often associated with old-fashioned business models. It’s an excitement effect.” Second, there is an agency problem, he claims. “As an agent working for a pension plan or endowment, money managers are measured against a cap-weighted benchmark, and tracking error is gauged. Because of that they are forced to take a certain amount of risk—something like a beta between .95 and 1.1. So they get paid to outperform, and don’t get punished if they underperform. It’s an asymmetric payoff.” The third reason is that there is consistent friction in shorting stocks: shorting stocks is not free, and not easily accessible to every market participant. The fourth fact has to do with the underlying structure of most exciting companies: “When there is a high return on capital, it attracts other capital,” he says. “Basically, people come in and steal aggressive business models. These aggressive growth plans are always impacted by competition. Think technology companies versus steel mills.” The result, he believes, is that low-volatility strategies—that perhaps should have been arbitraged out of existence—are able to consistently outperform.
Baker compares this argument to the recent book and movie sensation Moneyball. “In Moneyball, traditional teams were paying up for stars to hit home runs—exciting players,” he says. “They were paying multimillion dollars for multi-year contracts—that’s just like paying for any exciting growth stock today. But many of those players might also strike out a lot or otherwise not perform consistently. Many are not worth the rich investment. These are the high volatility stocks. However, the guy who is less flashy but gets on base more often by hitting singles or walking a lot might contribute more runs and do more to help the team win games. These players are actually more valuable to have on the team—just like low-volatility stocks.”
Baker—who admittedly has a vested interest, working now for Guggenheim Partners—thinks that these arguments, once again coming into fashion, will convince asset owners to invest more with such strategies. “Long periods of low returns and higher risk have hurt the funded status of many pension funds,” he explains. “Regulators are now telling big investment pools around the world that they have to budget risk more effectively—that they can’t just hand liabilities off to governments when they become unable to meet their liabilities. These factors, combined with new benchmarks that are not cap-weighted, show that cap-weighted portfolios are not the only game in town.” In 2012, Baker predicts low-volatility strategies outperforming—“unless we enter a strong bull market.” This, he explains, is traditionally the only market environment in which low-volatility underperforms more traditional portfolios. However, “on a risk-adjusted method, low-volatility still wins.” As a result, he believes, “consultants are basically now saying that their clients should go into ‘defensive equity strategies’—and low-volatility leads in this area.”
One question still remains: Why does low-volatility equity investing seem to move in and out of vogue with such, well, volatility? We’ll leave that to our naysayer on the other side of the page to tell you about that. —Kip McDaniel
CON: Financial academics and investment practitioners have extensively studied the low-volatility equity phenomenon and have come to general agreement that the strategy is successful in delivering superior risk-adjusted returns—across time and geography, and even beyond equities, bonds, and commodities.
It’s less clear why low-volatility strategies work. One hypothesis is that many investors avoid or cannot use leverage (to amplify the returns of less risky investments), and instead they meet their return goals by buying riskier stuff—and in the process bid prices up and drive returns down. Behavioral explanations are offered as well: that investors’ overconfidence in their forecasts of revenues and earnings exaggerates the demand for risky stocks. Whatever the true cause, the outperformance of low-volatility strategies over long periods violates the basic principle that higher-risk assets should be rewarded with higher returns. (Keep in mind that the scientific world needed about 100 years to pin down the mechanism behind the first wonder drug, aspirin.)
A second, more obvious element in the strategies’ success is the virtuous circle from compounding over time. “If the market is down 50% and then up 50%, you are still down 25%,” says Harin daSilva, president of Analytic Investors, in Los Angeles, and an innovator of low-volatility strategies. “But if you are down 10% and up 10%, you’ve only lost a dollar.”
MSCI publishes an index of a hypothetical low-volatility strategy for the US equity market (as well as companion indexes for other markets), and reckons it outperformed the broad US market in half of the 12 calendar years from 1999 through 2010 (in all cases, regimes of rising markets).
By following a less-volatile path, however, low-volatility delivered 2.42% in annualized excess total return from December 1998 to September 2011. (And that’s before an adjustment for differential risk—standard deviation of annual returns from 1999 through 2010 was 20.8% for the US market as a whole, and 14.2% for MSCI’s low-volatility index.)
Still, low-volatility strategies don’t work in every regime. The MSCI USA Minimum Volatility Index has lagged the market considerably in strong markets—by 15% in 1999, 10% in 2003, and nearly 9% in 2009. “Typically when higher-risk stocks are performing at their very best—not just that the markets are going up, but when high-risk stocks exceed their risk-adjusted expectations, such as during the TMT bubble, and the rally from the financial crisis in 2009—low-risk stocks are likely to underperform,” notes Brendan Bradley, head of managed volatility strategies at Acadian Asset Management, another pioneer in this field.
Low-volatility strategies have been running live for about five years, so their real-world performance advantage is drawn from a sample heavily influenced by two extreme data points—2008, when low-volatility excelled by 9% points, and 2009, when it fell short by a comparable amount.
“For low-volatility, a strong market environment is the other side of the moon—uncharted territory,” concedes Ted Aronson, founder of Aronson Johnson Ortiz, quantitative equity managers and another master of the style. “What if the European hysteria subsides, corporate America’s cash actually gets deployed, the economy rebounds, and real interest rates get to positive territory, so that equity returns can average 7% or 8% for years on end? Then you may not hear as much chatter about low-volatility.” —John Keefe
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