Q Capital Markets Assumption Update

Transcription

1 Q Capital Markets Assumption Update

2 Q Capital Markets Assumption Update ii Distribution Technology Ltd

3 Contents 1. Introduction Assumptions Volatilities and correlations Expected Returns for bond asset classes Summary of Investment Assumptions Strategic Asset Allocation Efficient Frontier Risk Profile Boundaries Appendix A : Index Data Appendix B : Correlation Matrix Appendix C : Asset Classes on Risk / Reward Space Appendix D : Total Expense Ratios iii Distribution Technology Ltd

4 1. Introduction This update presents the results of the review of financial planning assumptions used on the Distribution Technology (DT) Planning and Sales and Services Platform ( the Platform ) to: Build model portfolios Define the portfolio efficient frontier Forecast portfolio outcomes The review is based on data up to the end of the second financial quarter of The nominated indices have been retained We have retained the nominated indices used for calculating volatilities and correlations for each asset class. Appendix A sets out the list of indices we have relied on and their inception dates. We have made an overarching assumption in deriving all the expected returns values, which is that the current Eurozone crisis is handled in an orderly manner and there will be no major shocks such as a Greek exit, a Spanish and/or Italian Sovereign bailout or a Eurozone split. DT provides this analysis on the understanding that investors will gain access to the outputs through a regulated advice process. The decision as to whether or not to include any asset class in an investor s portfolio and the amount to include should be made by advisers with the necessary Financial Services Authority (FSA) permission to give advice on investments in consultation with their client. DT accepts no liability in respect of any advice given to investors relating to investment strategies or the purchase of specific products. The following sections set out the methods we have adopted and the data we have used for our analysis. 1 Distribution Technology Ltd

5 2. Assumptions No significant change in volatility or correlation assumptions 2.1. Volatilities and Correlations As in previous reviews, correlations and volatilities have been derived from monthly historical index data. Our volatility estimates for this quarter are set out in Section 3 and correlations are set out in Appendix B Expected Returns for Bond Asset Classes The expected returns on fixed income asset classes have been based on prevailing yields at the review date. Conventional Gilts For our estimate of the expected nominal return on conventional Gilts, we have taken the yield to redemption of the iboxx Gilts Index. The yield on this index as at the review date was 2.4% pa. This results in a real yield of -0.1%, which is our expected return assumption for this quarter. We chose the All Maturities Index as most fund allocations within standard data feeds used on the Platform will be across a broad range of maturities. The implicit assumption is that bonds are modelled as rolling maturity bonds and not bonds held until maturity. Real yield for conventional Gilts this quarter is -0.1% The following table sets out the nominal yields on Gilts based on the Heriot-Watt Gilt Database for a range of maturities as at the review date. Table 1: Conventional Gilt Yields (Source: Heriot-Watt Gilt Database) Up to 5 5 to to 15 Over 15 Irredeema All stocks years years years years ble Number Nominal Yield (%) Duration (years) Weight (%) Distribution Technology Ltd

6 Index-Linked Gilts We have set the expected real return on UK Index-Linked Gilts to a rate of -0.1% p.a. This figure corresponds to the yield on the All Maturities Index-Linked Gilt Index, based on 2.5% inflation, as at the review date. Yields on the index are quoted on inflation assumptions of 0% and 5%. To arrive at the yield for 2.5% inflation, we used linear interpolation. This quarter, the yields on both 0% and 5% inflation are negative, meaning that these investments provide a return which does not keep up with inflation. The following table sets out the yields on Index-Linked Gilts for a range of maturities as at the review date. Table 2: Index-Linked Gilt Yields (Source: Heriot-Watt Gilt Database) The interpolated yield this quarter is -0.1% Up to 5 years 5 to 15 years Over 15 years All stocks Number Yield on 0% inflation (%) Yield on 5% inflation (%) Interpolated Yield on 2.5% inflation (%) Duration on 0% inflation Duration on 5% inflation Weight (%) Distribution Technology Ltd

7 Nominal Yield Q Capital Markets Assumption Update UK Corporate Bonds For UK Corporate Bonds, we have used the iboxx Corporate Index as the reference index. The inception date for this index is December Expected return is 1.5% Risk aversion has continued to drive gilts yields lower especially at the longer maturities and widened credit spreads for those issuances at the lower end of the credit spectrum. Given the extent of the low Gilt yields available and the concerns surrounding the impact of sluggish economic growth on equity markets, UK Corporate Bonds have again become a relatively attractive income proposition for new investments. Taking all the above into account, the expected return assumption for this quarter for UK Corporate Bonds has been set to 1.5% pa. International Bonds We have set the expected real return on International Bonds to -0.3%. This is based on the effective real yield of the index. The index has a high exposure to US Treasuries and German Bunds, whose current nominal yields are at historical lows as can be seen below in Figure 1. Figure 1: Nominal Sovereign Yields UK Gilt All Maturities Germany All Maturities US Treasury All Maturities 6.0% 5.0% Risk aversion continues to drive down Sovereign yields 4.0% 3.0% 2.0% 1.0% 0.0% Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 The assumption underlies various factors that are affecting the markets currently. Since 2008 the risk aversion in the market has increased, with a marked flight to safety. This has resulted in historically low yields for sovereign and high quality investment grade corporate bonds that are considered as safe assets. 4 Distribution Technology Ltd

8 The risk premium has been maintained Large scale bond purchase programs by Federal Reserve and Bank of England in the form of Quantitative Easing have changed the shape of the yield curve. In addition, the Eurozone crisis has resulted in an increased demand for German Bunds as companies try to hedge their exposure to peripheral European countries. Property For property we have maintained the risk premium over Gilts. This equates to a real return of 2.3% pa this quarter. This assumption results in a nominal return of 4.8% pa. Equities The DT platform splits equities into geographical regions. The following indices were used to calculate volatilities and correlations for equities: MSCI UK Total Return Index MSCI Europe ex UK Total Return Index MSCI North American Total Return Index MSCI Japanese Total Return Index MSCI Pacific ex Japan Total Return Index MSCI Emerging Market Total Return Index Economic growth forecasts reduced The table sets out our assumed returns for equities. We must emphasise that the market indicators 1 have been used as a guide in arriving at the following estimates. Table 3: Returns for Q Regions Expected Real Returns Expected Nominal Returns UK equity 4.6% 7.1% Europe ex UK equity 4.5% 7.0% North American equity 4.5% 7.0% Japanese equity 3.4% 5.9% Pacific ex Japan equity 5.2% 7.7% Emerging Markets equity 5.8% 8.3% We have reduced our assumptions from last quarter across all regions by 50 bps. This is due to combined reduction in Gilt yields of 30 bps from last quarter and a reduction in long term growth forecast 2 for the world economy of 20 bps. 1 Dividend Yield and Earnings Yield data for different regions and geographies from MSCI 2 Growth forecast estimates from International Monetary Fund (IMF) 5 Distribution Technology Ltd

9 We have applied a constant reduction across all regions since, as it provides the best indicator of global trade flows, regional inflation rates and currencies regimes. Will struggle to beat inflation Aligned to global growth Cash Our assumption for this quarter is -0.7% which translates into a nominal assumption of 1.8%. The Cash asset class in the application has two uses; it represents the cash holding for funds as well as the shorter term money market funds. Commodities Our real assumption for Commodities this quarter is 3.9%. This assumption is based on the global growth forecast from IMF that indicated that commodity prices are highly correlated with global growth. Hedge Fund Heterogeneous Investment Strategies We have retained our risk premium from last quarter and as such the expected real return for Hedge Funds this quarter is 1.0%. Hedge funds are not an asset class, but a heterogeneous mix of investment strategies. As such, it is feasible for certain strategies to produce returns which are higher than our assumption and vice versa. 6 Distribution Technology Ltd

10 3. Summary of Investment Assumptions The following table gives the assumptions that we have adopted for Q Appendix C provides a visual representation of the assumptions on the risk reward space. Asset Classes Table 4: Investment Assumptions for Q Expected Real Expected Nominal Returns Returns Volatility Cash -0.7% 1.8% 1.5% UK Corporate Bonds 1.5% 4.0% 7.6% UK Index Linked Gilts -0.1% 2.4% 7.2% International Bonds -0.3% 2.2% 8.2% UK Gilts -0.1% 2.4% 7.0% Q assumptions UK 4.6% 7.1% 19.5% Europe ex UK 4.5% 7.0% 20.0% North American 4.5% 7.0% 21.0% Japanese 3.4% 5.9% 23.0% Pacific ex Japan Emerging Markets UK Commercial Property 5.2% 7.7% 24.0% 5.8% 8.3% 27.8% 2.3% 4.8% 14.0% Commodities 3.9% 6.4% 23.0% Hedge Funds 1.0% 3.5% 11.0% 7 Distribution Technology Ltd

11 4. Strategic Asset Allocation The assumptions in this update note are used in two distinct ways; for constructing an efficient frontier from which investors can select an asset allocation that suits their risk appetite and to forecast the distribution of investment outcomes for a given asset allocation strategy. Table 5 shows the strategic asset allocations that will come into effect from 11 October Table 5: Current Strategic Asset Allocations Risk Profile UK Cash (GBP) UK Corporate Bonds UK Index Linked Bonds International Bonds UK Gilts UK Europe Ex UK North American Japanese Pacific Ex Japan Equities Emerging Market Equities UK Property Commodit ies Hedge Funds 1 100% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 2 41% 8% 0% 10% 22% 10% 0% 0% 0% 0% 0% 9% 0% 0% Strategic asset allocation 3 7% 20% 0% 15% 20% 15% 5% 5% 0% 0% 0% 13% 0% 0% 4 5% 27% 0% 5% 5% 24% 7% 9% 5% 0% 0% 13% 0% 0% 5 5% 21% 0% 0% 0% 28% 8% 11% 5% 5% 5% 12% 0% 0% 6 0% 17% 0% 0% 0% 36% 7% 10% 5% 9% 10% 6% 0% 0% 7 0% 7% 0% 0% 0% 44% 7% 12% 5% 12% 13% 0% 0% 0% 8 0% 0% 0% 0% 0% 38% 5% 5% 5% 19% 28% 0% 0% 0% 9 0% 0% 0% 0% 0% 17% 5% 5% 0% 29% 44% 0% 0% 0% 10 0% 0% 0% 0% 0% 5% 0% 5% 0% 25% 65% 0% 0% 0% 8 Distribution Technology Ltd

12 Expected Return Q Capital Markets Assumption Update 5. Efficient Frontier We have plotted the current asset allocations on the risk-reward space and compared it to the unconstrained efficient frontier using the Q2 assumptions as seen in Figure 2. The unconstrained efficient frontier shows the output from the optimisation exercise for long only portfolios. Figure 2: Efficient Frontiers based on Q Assumptions Unconstrained Asset Allocation Current Asset Allocation 6.0% 5.0% 4.0% Efficient frontier 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% 0.0% 2.6% 5.2% 7.8% 10.4% 13.0% 15.6% 18.2% 20.8% 23.4% 26.0% Volatility It can be seen that the current asset allocation adheres closely to the unconstrained efficient frontier. 9 Distribution Technology Ltd

13 6. Risk Profile Boundaries The Platform risk profiles are used to map portfolio risk to risk defined by scores from psychometric profiling questionnaires ( ATRs ). The ATR risk profiles to which these portfolio risk profiles are mapped are defined in relative and not absolute terms. That is to say, the questionnaires merely rank people in order of risk aversion without prescribing the level of volatility appropriate for a typical individual in a given risk profile. Most ATRs, in particular the Platform ATRs, are driven by a scoring matrix. The range of scores is usually subdivided in such a way as to generate a uniform scale. Risk profile boundaries The Platform uses volatility to define investment risk profiles. Our standard implementation defines 10 risk profiles by dividing the efficient frontier into 10 volatility bands. The boundaries for each risk profile are defined in terms of minimum and maximum volatility for that band. The efficient frontier volatility spectrum generally tends to cover ranges up to 28% volatility, representing the highest volatility estimated for our asset class universe. For each risk profile, an asset allocation is selected from the efficient frontier, with suitable constraints, and that portfolio is then used as the standard asset allocation for that risk profile. To maintain consistency with the methodology used for the consumer attitude to risk instrument used on the Platform, we divided the efficient frontier into uniform bands. For purposes of risk banding we only used volatilities up to 26%, as that is the range over which diversified portfolios sit on the frontier. The maximum of 28% is used for display purposes to ensure that all portfolios that use the asset classes defined on the Platform can be plotted on the efficient frontier. The implicit assumption in this approach is that the range of volatilities covered by the Platform is suitable for the majority of retail investors. Discussions with a broad range of market participants indicate that this is a suitable assumption. For this review we have retained the risk boundaries from last review. The current bands are set out in Table 6 on the following page. 10 Distribution Technology Ltd

14 Table 6: Risk Profile Boundaries for Q Risk Profiles Volatility for SAA Lower Boundary Upper Boundary 1 1.5% 0.0% 2.6% 2 3.6% 2.6% 5.2% 3 6.2% 5.2% 7.8% Risk profile boundaries 4 9.0% 7.8% 10.4% % 10.4% 13.0% % 13.0% 15.6% % 15.6% 18.2% % 18.2% 20.8% % 20.8% 23.4% % 23.4% 26.0% 11 Distribution Technology Ltd

15 Appendix A: Index Data The table below sets out the indices used for each asset class and inflation data Table 7: Indices used for each Asset Class Asset Classes Index Inception date Cash Bank of England, Monthly Average of UK banks' base rates Jan 1978 UK Corporate Bonds iboxx Corporate Index Dec 1997 UK Index Linked Gilts International Bonds Barclays Capital UK Government Inflation-Linked Bond Index Merrill Lynch Global Broad Market Index May 1981 Dec 1996 UK Gilts iboxx Gilts Index Dec 1997 UK MSCI UK Total Return Index Dec 1969 Index data Europe ex UK MSCI Europe (ex UK) Total Return Index Dec 1969 North American MSCI North America Total Return Index Dec 1969 Japanese MSCI Japan MSCI Total Return Index Dec 1969 Pacific ex Japan Emerging Markets MSCI Pacific (ex Japan) Total Return Index MSCI Emerging Markets Total Return Index Dec 1969 Dec 1987 UK Commercial Property IPD UK Monthly Property Index Dec 1986 Commodities S&P GSCI Total Return Index Jan 1970 Hedge Funds HFRI Fund Weighted Composite Index Dec 1989 Inflation Retail Price Index (RPI) Jun Distribution Technology Ltd

16 Appendix B: Correlation Matrix Table 8: Correlation Matrix for Q Asset Classes UK Cash (GBP) UK Corporate Bonds UK Index Linked Bonds International Bonds UK Gilts UK Europe Ex UK North American Japanese Pacific Ex Japan Equities Emerging Market Equities UK Property Commodities Hedge Funds UK Cash (GBP) 1.00 UK Corporate Bonds UK Index Linked Bonds International Bonds UK Gilts UK Europe Ex UK North American Japanese Pacific Ex Japan Equities Emerging Market Equities UK Property Commodities Hedge Funds Distribution Technology Ltd

17 Expected Returns Q Capital Markets Assumption Update Appendix C: Asset Classes on Risk / Reward Space Error! Reference source not found. shows each asset class return on the risk / reward chart. 7.0% Figure 3: Asset Returns and Volatility on Risk / Reward Space 6.0% Emerging Market Equities 5.0% Pacific Ex Japan Equities UK North American 4.0% Europe Ex UK Commodites Risk reward space 3.0% 2.0% UK Property Japanese UK Corporate Bonds 1.0% Hedge Funds 0.0% UK Gilts UK Index Linked Bonds -1.0% UK Cash (GBP) International Bonds -2.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% Volatility 14 Distribution Technology Ltd

18 Appendix D: Total Expense Ratios The table below shows the Total Expense Ratios (TER) used in the production environment. Table 9: Total Expense Ratios for different Asset Classes in production Asset Classes Total Expense Ratio Cash 0.5% UK Corporate Bonds 1.1% UK Index Linked Gilts 0.5% International Bonds 1.3% UK Gilts 0.6% TER data UK 1.6% Europe ex UK 1.7% North American 1.6% Japanese 1.7% Pacific ex Japan 1.7% Emerging Markets 1.8% UK Commercial Property 1.6% Commodities 1.2% Hedge Funds 1.6% 15 Distribution Technology Ltd

19 Basis of Preparation and Use You should not rely on this information in making an investment decision and it does not constitute a recommendation or advice in the selection of a specific investment or class of investments. The information does not indicate a promise, forecast or illustration of future volatility or returns. The outputs represent a range of possible indications of volatility and returns for various collections of asset classes. Distribution Technology is not liable for the data in respect of direct or consequential loss attaching to the use of or reliance upon this information. Distribution Technology does not warrant or claim that the information in this document or any associated form is compliant with obligations governing the provision of advice or the promotion of products as defined by the Financial Services Act. Copyright Distribution Technology Ltd 2012 onwards. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or any means, electronic or mechanical, including photocopying and recording for any purpose other than the purchaser s personal use without the written permission of Distribution Technology. Source of information RIMES Technologies Corporation, Markit iboxx, Bank of England, Office of National Statistics, Investment Property Databank, Heriot Watt University Gilt database and International Monetary Fund (IMF) Trademarks Distribution Technology may have patents or pending patent applications, trademarks, copyrights or other intellectual property rights covering subject matter in this document. The furnishing of this document does not give you any license to these patents, trademarks, copyrights or other intellectual property rights except as expressly provided in any written license agreement from Distribution Technology. All other companies and product names are trademarks or registered trademarks of their respective holders. Distribution Technology Ltd