Managed Volatility: A Highly Risk-Efficient Approach to Investing in Emerging Markets

Transcription

1 Managed Volatility: A Highly Risk-Efficient Approach to Investing in Emerging Markets Executive Summary Adrian Banner, Ph.D. INTECH Chief Executive Officer Chief Investment Officer abanner@intechjanus.com (609) Soonyong Park, CFA, CPA Janus Capital Institutional Chief Institutional Client Strategist soonyong.park@janus.com (303) Emerging equity markets are normally associated with higher levels of risk. When returns were high, investors could look the other way; however, as growth slows and liquidity is no longer abundant, investors cannot ignore the risks associated with emerging markets. Further, as risk allocation takes center stage for institutional investors, we ask: Is it possible to capture the return premium offered by emerging markets equity (EME) as a strategic asset class, harvest alpha from the inefficiency of the market and at the same time meaningfully lower the risk associated with it? We believe the answer is emphatically yes. Using managed volatility strategies, one can exploit the inefficiencies of emerging markets indexes while dynamically controlling risk at the EME portfolio level and, by extension, at the global equity structure level. Investors do not need to sacrifice the growth potential associated with emerging markets equity in exchange for risk reduction. From the perspective of risk efficiency, maintaining or increasing the expected return target while lowering the expected risk by approximately a quarter is unequivocally a good investment outcome in any market environment, for all investors. Until recently, the application of managed volatility strategies has been limited to developed market equities. In the current environment, where risks abound and returns are hard to come by, all investors should seriously consider the merits of investing in EME via managed volatility strategies. C FOR INSTITUTIONAL INVESTOR USE November

2 Most investors use cap-weighted global benchmarks as a starting point for establishing EME allocations. For example, as of May 31, 2013, emerging markets equity accounted for 12% of the global equity markets as represented by the MSCI ACWI Index. For late adopters of EME, allocations may be less than 12% within their global equity portfolios; conversely, for early adopters, such as university endowments, allocations might be meaningfully higher. The Harvard Management Company s policy portfolio allocates roughly 33% of its global equity portfolio to EME, dividing global equities equally among U.S., non-u.s. developed and emerging market components. Whether one is an early or late adopter of emerging markets equity as a strategic asset class, its influence on portfolio risk warrants greater attention than in the past, especially given the high volatility and increasing correlation of emerging markets equity to developed markets equities. When returns were high, investors could look the other way; however, as growth slows and liquidity is no longer abundant, investors cannot ignore the risks associated with emerging markets. Furthermore, as risk allocation takes center stage for institutional investors, we ask: Is it possible to capture the return premium offered by EME as a strategic asset class, harvest alpha from the inefficiency of the market and at the same time meaningfully lower the risk associated with investing in it? We believe that the answer is unequivocally yes. Using managed volatility strategies, one can exploit the inefficiencies of emerging markets indexes while dynamically controlling risk at the EME portfolio level and, by extension, at the global equity structure level. As more and more investors increase their allocation to emerging markets equity to meet their long-term return objectives, they cannot turn a blind eye to the risk embedded in emerging markets equity. Returns: The Virtue of Emerging Markets Equity Judging by asset flows, most institutional investors have embraced the merits of emerging markets investing and now consider emerging markets equity a strategic asset class within the traditional asset allocation framework. In stark contrast to U.S. equities, which have experienced roughly $430 billion in outflows, institutional investors have added $240 billion to their EME allocations (Exhibit 1) from January 2008 to June This move, in large part, reflects institutional investors desire to access the return premium that emerging markets equity have historically delivered over their developed markets equivalents. Case in point, emerging markets equity has outpaced U.S. equities by 2.9% and non-u.s. equities by 7% per year for the past 25 years, as measured by MSCI indices (Exhibit 2). Exhibit 1: ea equity net flows since 2008 Net Flows ($B) Active Exhibit 2: Realized and forecast equity market data for U.S., non-u.s. developed and EME -668 More importantly, most institutional consultants believe that the return premium of emerging markets equity over developed markets equity will persist well into the future. As an example, consider Callan Associates capital market assumptions in Exhibit 2 for equities of U.S., non-u.s. and emerging markets for the next 10 years. Of the three regional equity markets, emerging markets equity is the only one that meets the 8% long-term actuarial rate of return required by institutional investors. Finally, from a philosophical and active management standpoint, EME offers the best alpha potential. Conventional wisdom states that markets become less efficient as one moves away from U.S. equities and toward emerging markets equity; further, an active manager s ability to generate excess return increases with the level of market inefficiency. Thus, in the current perceived low-return environment, investors can find two appealing sources of return in emerging markets equity: high expected return at the underlying asset class level and high expected alpha from active management due to the inefficiency of emerging markets Passive ACWI ex-us EAFE EME Global US Source: evestment Alliance. Net flows from January 1, 2008 to June 30, Realized: Return Risk Return Risk U.S. Equities 9.8% 14.9% 7.8% 18.7% Non-U.S. Developed Market Equities 5.7% 17.5% 7.6% 20.0% Emerging Market Equities 12.7% 24.0% 8.0% 27.8% Assumed Long-Term Plan Level Required Rate of Return 8.0% Source: MSCI, Callan Associates 2012 Capital Market Assumptions. Callan Associates 10-Year Forecast 2

3 Risk: The Inconvenient Truth of Investing in Emerging Markets Equity contribution to risk of a global equities portfolio at two different allocation levels. As shown in Exhibit 3, variation in annual returns for EME has been extraordinarily high, and one might expect such high observed risk levels to temper investors enthusiasm for EME. Exhibit 3: MSCI index returns, Calendar Year USA EME Difference % -53.2% 16% % 79.0% -52% % 19.2% -4% % -18.2% 20% % 18.6% -2% Source: MSCI. Returns in USD; gross returns. However, as shown in Exhibit 1, fund flows into EME for the past several years indicate otherwise. It appears that due to the realized return premium from yesteryear, investors have, in essence, given emerging markets equity a free pass when it comes to risk and until recently, discussions of EME implementation have focused mainly on its virtues, rather than on concerns about its accompanying risks. First among these concerns should be the long-term volatility forecast for emerging markets equity compared to other regional equities. Callan Associates forecast of EME volatility in Exhibit 2 is almost 28%, about 50% higher than that of U.S. equities. This forecast is not too far off the realized volatility of 24% 1 over the past 25 years ( ). To make standard deviation less abstract, if 2008 represented an extremely unusual year (let s say close to a negative 2.5 standard deviation event, or about one in two hundred years), one should have expected a loss of about 47% for Indeed, in 2008 the MSCI Emerging Markets Index lost 53%. Second, while risk is important at the individual asset level, ultimately what pension officers care about is risk at the overall plan level. Emerging markets equity, by virtue of its high risk and high correlation 2 to developed equity markets, is a meaningful contributor to portfolio risk at the overall global equity structure level. Exhibit 4 demonstrates EME s Exhibit 4: EME s contribution to portfolio risk in the global equity structure EME Allocation within Global Equities Description 12% 33% Increase Global Equity Portfolio Risk 15.4% 16.8% 1.5% Contribution to Global Equity Portfolio Risk 14.9% 43.6% 28.6% Source: Callan Associates and Janus Capital. Risk is defined by standard deviation. Risk allocation represents estimates based on variance and correlation forecasts from Callan Associates 2012 Capital Market Assumptions. When an investor s EME allocation matches the benchmark weight i.e., allocating 12% of the global equity portfolio to EME as of May 31, 2013 the risk of the overall global equity allocation is estimated to be 15%, of which the EME allocation itself accounts for 15%. Portfolio risk, however, increases markedly as the allocation to EME increases. When one allocates a third of the global equity portfolio (as the Harvard Management Company does) to EME, the risk at the global equity level increases to 17% and EME s contribution to overall risk increases to 44%. Therefore, increasing allocation to emerging markets equity not only increases its contribution to the overall portfolio risk, but also the risk of the overall global equity structure. In other words, when one increases the allocation to emerging markets equity, the success or failure of the global equity allocation becomes more and more dependent on the performance of the emerging markets portion of the portfolio. Managed Volatility Strategies: Higher Expected Return at Meaningfully Lower Risk Managed volatility strategies are similar to other active longonly equity strategies in that they target some level of excess return over the capitalization-weighted benchmark; they markedly differ from the latter in that they have a dual objective of lowering volatility and capital loss, especially at times of market stress. Over an entire market cycle, one can expect a risk reduction of between 20% and 30% from managed volatility strategies when compared to the standard equity benchmark. 3 Therefore, if the long-term expected return and risk forecast for EME are 8% and 28%, respectively (as in Exhibit 2), then investors in managed volatility strategies should expect long-term total return in excess of 8%, net of fees, with average risk between 20% and 22%. To illustrate the potential benefit of a managed volatility EME strategy on global equity portfolio risk, Exhibit 5 (see page 4) replicates the analysis from Exhibit 4 by replacing the entire EME allocation with such a strategy. In this illustration, the 24% realized risk from 1988 to 2012 is lowered by about a quarter to a median level of 18%. The benefits of an emerging markets managed volatility strategy within the global equity structure are easy to see: 1 The realized volatility of 24% is an annualized estimate based on monthly gross returns in U.S. dollars of the MSCI EM Index. When estimated based on annual returns from 1988 to 2012, the realized volatility is approximately 36%. 2 Although not shown herein, the correlation between the S&P 500 Index and MSCI EM Index has been steadily increasing. Based on two-year rolling monthly returns, the correlation between the two exceeded 0.8 for the period ending December 31, The volatility reduction estimate is based on INTECH s proprietary simulated returns from 1995 to

4 Exhibit 5: EME managed volatility s contribution to risk in the global equity structure Allocation within Global Equities Description 12% EME 12% EME MV Decrease 33% EME 33% EME MV Decrease Global Equity Portfolio Risk 15.4% 14.8% 0.6% 16.8% 15.0% 1.8% Contribution to Global Equity Portfolio Risk 14.9% 11.4% 3.5% 43.6% 35.7% 7.9% Source: Callan Associates and Janus Capital. Risk is defined by standard deviation. Risk allocation represents estimates based on variance and correlation forecasts from Callan Associates 2012 Capital Market Assumptions. At a 12% allocation within the global equity structure, replacing a regular EME strategy with an EME managed volatility strategy lowers total portfolio risk from 15.4% to 14.8%, and the EME contribution to global equity risk drops from 15% to 11%. At a 33% allocation within the global equity structure, replacing a regular EME strategy with an EME managed volatility strategy lowers total portfolio risk from 16.8% to 15.0%, and decreases the EME contribution to risk from 44% to 36%. Finally, the estimated total global equity risk at 15.0% (with a 33% allocation to an EME managed volatility strategy) is about the same as the estimated total global equity risk of 15.4% achieved with only a 12% allocation to a typical EME strategy or index fund. In other words, a managed volatility strategy enables investors to increase the emerging markets allocation from 12% to 33% to generate higher returns without taking on additional risk at the global equity structure level. Implementation Do Not Ignore Currency Volatility when Implementing Managed Volatility Strategies in Non-U.S. Markets In U.S. equities, the implementation of a managed volatility strategy requires the estimation of risk and correlation among the underlying securities; in emerging markets and non-u.s. developed market equities, the estimation of risk and correlation must include the currency volatility as well. As shown in the chart below, from , the currency volatility was about 9.0%, a meaningful contributor to the risk of the emerging markets equity. An otherwise low volatility security in Brazil can be highly volatile in dollar terms if the Brazilian real is highly volatile against the U.S. dollar; likewise, a moderately volatile security in Indonesia will remain moderately volatile if the Indonesian rupiah is stable in relation to the U.S. dollar. The foregoing observation implies that the implementation of managed volatility strategies in non-u.s. markets requires risk and correlation estimates that combine the volatilities of the underlying securities and currency. Non-U.S. markets: realized risk from % 20.0% 15.0% 10.0% 5.0% USD 18.0% Local Currency 15.4% FX Effect 7.5% USD 24.0% Local Currency 23.0% FX Effect 8.9% Given the potential benefits of managed volatility strategies (i.e., the ability to generate excess return above the benchmark and meaningfully lower risk at the portfolio level), it is surprising that only a select few have explored the implementation of managed volatility strategies in emerging markets. For large institutions, whose strategic EME implementation has been severely hamstrung by the dearth of skilled active EME managers with ample capacity, managed volatility strategies can serve as an anchor and a complement to fundamental stock-picking strategies in a multimanager structure. The lower overall risk provided by the volatilitymanaged strategy can be thought of as counterbalancing the extra risk taken on by traditional active managers in a global equity structure. Smaller institutions, which often lack the necessary resources to research and hire multiple emerging markets equity managers, generally hire just one active EME manager or gain 0.0% World ex USA EME exposure through passive portfolios. For smaller institutions with passive EME allocations, managed volatility strategies represent a clear and superior alternative one that provides a diversified exposure to emerging markets equity at meaningfully lower risk levels. Alternatively, as a lower-cost replacement for a traditional active EME strategy, a managed volatility strategy provides similar levels of alphaseeking opportunity while meaningfully reducing the EME portfolio risk. Conclusion Due to superior historical performance, many investors have been lulled into ignoring risks associated with investing in emerging markets this despite the fact that EME represents one of the most volatile strategic assets within institutional portfolios. Yet, as more investors set their minds to de-risking, EM 4

5 or increasing the risk efficiency of their portfolios, now may be the time to reassess emerging markets equity from a risk standpoint without losing sight of the return opportunities afforded by this asset class. Managed volatility strategies provide a simple, highly effective way to mitigate risk within emerging markets and, more broadly, within global equity structures. The volatility reduction of these strategies brings EME closer to the risk levels of non- U.S. developed markets equities, where realized volatility has been about 18%. Above all else, investors do not need to sacrifice the growth potential associated with emerging markets equity in exchange for risk reduction. From the perspective of risk efficiency, maintaining or increasing the expected return target while lowering the expected risk by approximately a quarter is unequivocally a good investment outcome in any market environment for all investors. Until recently, the application of managed volatility strategies has been limited to developed markets equities. In the current environment, where risks abound and returns are hard to come by, investors should seriously consider the merits of investing in EME via managed volatility strategies. About INTECH For more than 25 years, global investment manager INTECH has been offering institutional investors highly disciplined, mathematical equity strategies that seek long-term returns in excess of the target benchmark, while attempting to reduce the risk of significant underperformance relative to that benchmark. Since 1987, INTECH has been generating alpha by taking advantage of stock-price volatility while limiting relative risk and trading costs. The company s global headquarters is located in West Palm Beach, Florida, with its research office in Princeton, New Jersey, and an international division in London. INTECH is an independently managed subsidiary of Janus Capital Group Inc. (NYSE: JNS), based in Denver, Colorado. About Janus Janus Capital Institutional is the institutional business arm of Janus Capital Group, a global asset management firm founded in Headquartered in Denver, Colorado, Janus Capital has offices in fourteen countries. Our mission is to deliver better client outcomes by providing investors with a range of investment capabilities including research-driven equity, fixed income, alternatives, risk-managed equity and value equity solutions for clients managed by Janus, INTECH and Perkins Investment Management. In the U.S., we offer investment expertise to specific market segments, including corporate plans, endowments and foundations, Taft-Hartley and public funds. These views expressed herein are subject to change at any time based upon market or other conditions, and are current as of the date at the beginning of the publication. While all material is based upon sources of information believed to be reliable, their accuracy and completeness cannot be guaranteed. The information, analyses, and opinions expressed herein are for general information purposes only and are not intended to provide specific advice or recommendations for any investor. Past performance is no guarantee of future results. Investing involves risk including the loss of principal and fluctuation of value. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This material has not been approved, reviewed, or produced by MSCI. 5