Emini Education - Managing Volatility in Equity Portfolios

Transcription

1 PH&N Trustee Education Seminar 2012 Managing Volatility in Equity Portfolios

2 Why Equities? Equities Offer: Participation in global economic growth Superior historical long-term returns compared to other asset classes: The Equity Risk Premium Inflation Protection: Real cash flows Income: Dividend yields are currently higher than bonds Liquidity: Trade daily Transparency: Public securities The Problem: Equity returns are volatile The Goal: Capturing the Equity Risk Premium, with less volatility 2

3 Long-Term Returns The Triumph of the Optimists 80 One dollar invested in 1964 is now worth S&P/TSX Composite Index DEX Universe Bond Index DEX 91-Day T-Bill Index Consumer Price Index (CPI) $65 $36 $ $7 at December 31,

4 Long-Term Volatility Stocks are much more volatile Rolling 1-year Returns 100% 80% 60% S&P/TSX Composite Index DEX Long Term Bond Index 40% 20% 0% -20% -40% -60%

5 Decomposing Equity Returns Where do returns come from? Dividend Yield + Earnings Growth + Change in Valuation = Equity Return 5

6 Why Have Equities Lagged Long Bonds? Over the past decade 9.5% 7.3% S&P/TSX Composite Index 2.4% Dividend Yield + Earnings Growth -4.6% + Change in Valuation = Equity Return 10.1% S&P 500 Index 1.9% 3.6% -8.4% Source: RBC GAM 6

7 Share of Global GDP (PPP, %) Where Will Earnings Growth Come From? Emerging economies soon supplant developed economies Advanced Economies Emerging Economies Emerging economies will have a bigger share of world economy after North American companies derive a significant portion of their sales from overseas Note: IMF forecasts to Post-2016, assume real GDP growth decreased annually by -0.1% for Emerging Economies and by -0.05% for Advanced Economies. Source: Haver Analytics, RBC GAM 7

8 P/E Ratio Can Valuations Fall by Half Again? Valuations have already fallen to 1980s levels 35 World Equity Market Trailing P/E Ratio Ten years ago Trailing Long-term average Today Source: Datastream 8

9 What Will the Next 10 Years Look Like? Better starting point for 2 out of 3 variables Ten Years Ago S&P/TSX Composite Index S&P 500 Index At December 31, 2011 S&P/TSX Composite Index S&P 500 Index Dividend yield 1.9% 1.6% 2.9% 1.9% Trailing earnings $327 $37 $813 $98 Price/Earnings ratio 24x 31x 15x 13x Forward earnings growth???? Source: RBC GAM 9

10 How To Reduce the Volatility of an Equity Portfolio? Many approaches Asset Allocation-Based Approaches Using Derivatives Geographic Diversification Value or Income Strategies Low Volatility Equity Strategies 10

11 Asset Allocation-Based Approaches What are they & how do they work? What are they? Reduce total portfolio volatility by reducing equities at the right time Alternatively, alter total asset mix to better compensate for the volatility of equities How do they work? A number of rules-based strategies have recently been proposed. For example, Volatility-Responsive Asset Allocation Risk parity Challenges & considerations? Timing markets is hard! Being out of the market at the wrong time can be costly May require a balanced manager structure, or use of derivatives 11

12 Using Derivatives What are they & how do they work? What are they? Reduce volatility by hedging with derivatives How do they work? Buy puts Buy VIX futures Other strategies Challenges & considerations? Complexity structuring, legal Risk leverage, operational Canadian equity derivatives markets are illiquid Cost - insurance is seldom free; costs more if house is already on fire Trustee knowledge and comfort 12

13 Geographic Diversification What is it & how does it work? What is it? Diversification is the original free lunch Equity markets are not perfectly correlated Overall portfolio risk (volatility) reduced by diversifying How does it work? Diversify across various developed and emerging equity markets Challenges & considerations? Equity market correlations have been rising with globalization Little protection from crashes - correlations go to 1 in crises But protects against sustained underperformance in one geography Offers global industry diversification 13

14 Geographic Diversification Canada has had long periods of underperformance before S&P/TSX Composite Index vs MSCI World Index 10 years: S&P/TSX Composite Index up 115% vs MSCI World Index up 38% 19 years: MSCI World Index up 726% vs S&P/TSX Composite Index up 188% 13 years: S&P/TSX Composite Index up 97% vs MSCI World Index up 9%? Source: RBC GAM 14

15 Income & Value Strategies What are they & how do they work? What is it? Certain investment styles and strategies naturally result in less volatility: e.g., value strategies or income strategies How does it work? Value The bad news is already priced in Income Dividends smooth returns, and dividend-paying companies often have more stable business Challenges & Considerations? Volatility reduction depends on manager: objectives, process, skill If volatility reduction is an objective when you hire a manager, it should also be part of the evaluation Income - past 2 decades have benefited from yield rally 15

16 Income & Value Strategies Volatility compared to the S&P/TSX past 10 years Strategy Volatility* Range S&P/TSX Composite Index 14.5% Median Value Strategy % 20.5% - 9.6% Median Income Strategy % 13.5% - 9.6% Some Value & Income strategies reduce volatility more than others * Volatility is the annualized standard deviation of monthly returns Source: evestment 1. Median Volatility from Value Equity Style Emphasis screen in evestment database Sample size = 62 funds. 2. Median Volatility from Dividend or Income screen in evestment database. Sample size = 23 funds. 16

17 Low Volatility Equity Strategies What are they & how do they work? What are they? Long-only equity portfolios that prioritize minimizing volatility Objective is superior risk-adjusted returns than the market How do they work? Security Selection: Emphasis on stable stocks and businesses Portfolio Construction: More diversified, no reference to an index Typically managed by a quantitative investment process Challenges & considerations? A different path of returns than the market Benchmarking is less straightforward 17

18 Low Volatility Equity Strategies Origins in academic & practitioner research In Theory Index offers highest return for a given level of risk Riskier stocks should offer higher returns In Reality Lower risk stocks can earn returns as good or better than higher risk stocks Minimum variance portfolios earn returns similar to the index Holds across geographies & timeframes Though relative performance can diverge markedly over shorter time periods Research Markowitz (1952) Sharpe (1964) Black, Jensen, Scholes (1972) Haugen, Baker (1991) Fama, French (1992) Clarke, De Silva, Thorley (2006) Ang, Hodrick, Zing, Zhang (2006) Blitz, van Vliet (2007) Baker, Bradley, Wurgler (2010) 18

19 Low Volatility Equity Strategies Empirical evidence suggests no risk premium within equities 15% S&P/TSX Composite Index Stocks sorted by volatility (Dec Jul 2011) 10% 5% 0% Excess Return (return minus return on cash) -5% 5th Quintile (Most Volatile) 4th Quintile 3rd Quintile 2nd Quintile 1st Quintile (Least Volatile) Source: Phillips Hager & North Investment Management 19

20 Low Volatility Equity Strategies Why have they generated similar returns? Benchmarking 1,2 Investors may prefer less risk, but they hire managers to beat a benchmark The S&P/TSX Composite Index is not well diversified Human Behaviour 1,2 A lack of interest in boring stocks A preference for lottery-like payoffs Representativeness: e.g., buying a stock that looks like Microsoft did in 1985 These factors seem likely to persist Notes: 1. Baker, Bradley and Wurgler Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly 2. Blitz and van Vliet The Volatility Effect: Lower Risk without Lower Return 20

21 Low Volatility Equity Strategies What do these portfolios look like? Higher weighting in more stable, mature businesses: grocers, utilities, telecom Smaller weighting in more volatile businesses: natural resources, some industrial and tech companies Higher small/mid-cap representation: utilities and consumer staples are small segments of the market High quality: high & stable ROE Strong yield: typically higher than S&P/TSX Composite Index dividend yield As compared to a capitalization-weighted index or to an active portfolio managed to a capitalization-weighted index 21

22 Low Volatility Equity Strategies Balanced portfolio context: impact on total portfolio volatility Equity Allocation Total Domestic Balanced Portfolio Volatility at Varying Allocations to Equities S&P/TSX Composite Index Low Volatility Equity Strategy 20% 5.4% 5.0% 30% 6.2% 5.3% 40% 7.3% 5.8% 50% 8.4% 6.4% 60% 9.7% 7.1% 70% 11.0% 7.8% 80% 12.3% 8.6% Notes: 1. Residual, non-equity allocation of portfolio is assumed to be DEX Universe Bond Index 2. Volatility is defined as standard deviation of monthly returns (annualized) 3. This diagram is for illustrative purposes only and is not intended to represent the performance of any actual or future investments. The estimates shown are based on our forecasted volatilities and correlations for these asset classes. 4. The Low Volatility Equity Strategy used in this analysis is a hypothetical portfolio developed by RBC GAM for analytical purposes. For this analysis, we have assumed 15% standard deviation of monthly returns (annualized) for the S&P/TSX Composite Index and 10% as the comparable assumption for the Low Volatility Equity strategy. Both equity strategies were assumed to have similar correlations to the DEX Universe Bond Index. 22

23 Expected Return (assets liabilities) Low Volatility Equities LDI context: impact on portfolio risk & return Traditional portfolio (60% TSX equities + 40% Universe bonds) Duration-matched portfolio (60% TSX equities + 40% Duration-matched bonds) Low Volatility portfolio (60% Low volatility equities + 40% Duration-matched bonds) 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0% 2% 4% 6% 8% 10% 12% Standard Deviation (relative to liabilities) Notes: 1. This diagram is for illustrative purposes only and is not intended to represent the performance of any actual or future investments. The estimates shown are based on our forecasted returns, volatilities and correlations for these asset classes. 2. Volatility is defined as standard deviation of monthly returns (annualized) 3. Proxy portfolios used: TSX equities = S&P/TSX Composite Index; Universe bonds = DEX Universe Bond Index; Duration-matched bonds = DEX Long Term Bond Index; Low volatility equities = RBC GAM hypothetical Low Volatility Equity strategy cited on previous slide. 23

24 Low Volatility Equity Strategies Challenges & considerations Different Path of Returns Tends to outperform in falling markets but underperform in sharply rising markets Implementation considerations Generally simple to implement But a review of the total portfolio asset allocation may be appropriate Diverging from the peer group Benchmarking Traditional return-focused benchmarking is not sufficient Low volatility indices have their shortcomings, aren t yet published in Canada 24

25 Reducing the Volatility of an Equity Portfolio What works best in practice? Strategy Effectiveness Ease of Implementation Complexity Transparency Cost Asset allocation Derivatives Geographic diversification Value or Income strategies Low Volatility equities 25

26 Conclusions Equity returns have been suppressed by a declining valuation since the tech bubble this can t continue forever Equities offer a way to participate in global growth Some management styles naturally lead to lower volatility, but it depends on the manager Geographic diversification can t protect against crashes, but can protect against protracted economic or market underperformance Low volatility equities are an alternative approach to equity investment and offer substantial volatility reduction potential 26

27 Disclaimer This presentation is intended for institutional investors only. This document has been provided by Phillips, Hager & North Investment Management (PH&N IM) for information purposes only and may not be reproduced, distributed or published without the written consent of PH&N IM. It is not intended to provide professional advice and should not be relied upon in that regard. Information provided by PH&N IM or obtained from third parties is believed to be reliable, but has not been independently verified. We do not guarantee its accuracy or completeness and we assume no responsibility or liability for any errors or omissions. The views and opinions expressed herein are those of PH&N IM as of the publication date and are subject to change without notice. This information is not intended to be an offer or solicitation to buy or sell securities or to participate in or subscribe for any service. All simulated performance results have been compiled solely by PH&N IM and have not been independently verified. The Low Volatility Equity Strategy shown in this document is a hypothetical portfolio developed by RBC Global Asset Management Inc. for analytical purposes in researching the effect of low volatility portfolios within various investment contexts. This data is shown for illustrative purposes only, and should not be relied on as an indicator of future returns. The simulated historical performance record was constructed using a custom quantitative investment model and assumes that the same security selection and portfolio construction algorithms used to manage the portfolio today were used in the past, based on the data and the universe of investable securities available at the time. These results incorporate estimated transaction costs, including both trading commissions as well as an estimate of market impact cost based on the trade size and liquidity of individual securities. Simulated results are shown before management fees and other expenses. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Simulated results are achieved by means of the retroactive application of a back-tested model designed with the benefit of hindsight. The back-testing of performance also differs from actual account performance because an actual investment strategy may be adjusted any time, for any reason, including a response to material, economic or market factors. As trades have not actually been executed, the results may have under-or-over compensated for the impact of certain market factors, such as lack of liquidity. Some relevant events or conditions may not have been considered in the assumptions and actual events or conditions may differ materially from assumptions. The amount of risk associated with any particular investment depends largely on the investor s circumstances including time horizon, liquidity needs, portfolio size, income, investment knowledge and attitude toward price fluctuations. Investors should consult their professional advisors and consultants regarding any tax, accounting, legal or financial considerations before making a decision as to whether the funds mentioned in this presentation are a suitable investment for them. This document may contain forward-looking statements which reflects our or third party current expectations or relates to anticipated future events, results, performance, decisions, circumstances, opportunities, risks or other matters. Our predictions and other forward-looking statements may not prove to be accurate, or a number of factors could cause actual events, results, performance, etc. to differ materially from the targets, expectations, estimates or intentions expressed or implied in the forward-looking statements. These risks, uncertainties and assumptions include, among others, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, legislative changes and catastrophic events and business areas in which a fund may invest, and the risks detailed from time to time in the offering documents. Please consider these and other factors carefully and do not place undue reliance on forwardlooking information. The forward-looking information contained herein is current only as of the date of publication of this presentation. Due to the potential impact of these factors, we do not undertake, and specifically disclaim, any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by applicable law. PH&N IM is an operating division within RBC Global Asset Management Inc. (RBC GAM), an indirect, wholly-owned subsidiary of Royal Bank of Canada. \ Trademark(s) of Royal Bank of Canada. Used under licence. RBC Global Asset Management Inc., #IC