Investment Strategy Webinar. November 14, 2012

Transcription

1 Investment Strategy Webinar November 14, 2012

2 Presenters Mike Sebastian, Partner Phone: Duncan Lamont, Principal Global Asset Allocation Phone: duncan.lamont.2@aonhewitt.com John Geissinger, Partner Phone: john.geissinger@aonhewitt.com 2

3 Discussion Topics Opening Remarks Market Update and Outlook: Spotlight on Diversification New Hewitt EnnisKnupp Thought Leadership: Harvesting the Equity Insurance Risk Premium New Hewitt EnnisKnupp Thought Leadership: Conviction in Equity Investing Q&A Sessions throughout the presentation 3

4 Market Update Duncan Lamont

5 Mixed Messages From Consumers and Businesses 90 Consumer Confidence (University of Michigan index) US consumers are in confident mood But businesses are getting nervous about the fiscal cliff and the Eurozone remains in the doldrums 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% Capital Goods Orders (Exc. aircraft&defence) (3 month change)

6 Risk-on Risk-off Environment Has Driven Asset Performance Risky assets have moved in tandem Returns (Rebased) High Yield Spread (bps) Cross-asset class performance has been very similar for risky asset classes Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Risky assets versus safe haven assets Commodity Total Return Global Equities US High Yield Spread (RHS) Treasuries and equities have moved in opposite directions but both have performed well overall! 50% 14% 40% 12% 30% 10% 20% 8% 10% 6% 0% 4% -10% 2% -20% 0% -30% S&P 500-2% -40% Treasuries -4% -50% -6% Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 6

7 Correlations Increase During Crises but This Time Has Been Worse Correlations w ith Equities Higher than normal Historic Long Term Black Monday 1987/88 LTCM 1998/99 Dotcom 2000/02 Financial Crisis Treasuries Corporate Bonds Commodities REITs Fund of Hedge Funds Global Macro Hedge Funds 7

8 Credit: Return Potential Now Limited A big squeeze on expected returns is on. Credit has rallied big time, driving yields down to very low levels. Interest rate (duration) risk here now a problem should global government bond yields rise. % US CORPORATE BOND YIELDS AT VERY LOW LEVELS (Intermediate credit index) % yields don t offer much scope for return! Even on a pure spread basis, our riskpremiums (against expected credit quality risks) suggest limited room for further sustained falls CREDIT RISK PREMIUM NOW APPROACHING PRE-CRISIS LEVELS MOREATTRACTIVE 100 LESS ATTRACTIVE

9 Summary of Medium-term Market Views Equities Cautious on medium-term view, but prefer to bonds Favor large cap Rebalance to neutral within growth-value Favor non-us markets on any rebalancing now neutral on emerging markets Bonds Ultra low yields make bonds vulnerable Take profits on credit move back towards target Favor intermediate to long duration interest rate exposure Favor Investment grade and secured loans to high yield Alternative Asset Classes Favor real estate, hedge funds, infrastucture and selected private equity investments 9

10 Question & Answer Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer sessions. 10

11 Harvesting the Equity Insurance Risk Premium John Geissinger

12 An Investor Challenge Investors have been challenged to reduce portfolio sensitivity to equity markets without sacrificing long-term expected returns. Risk Parity solutions have gained traction as levered fixed income portfolios have outperformed as interest rates declined to historical lows. It is unclear how this solution will perform in rising interest rate environments. Another solution is to find unique sources of non-correlated returns. A wide net must be cast to capture these unique investments. There is no silver bullet. We believe the Equity Insurance Risk Premium is one such source of non-correlated returns. 12

13 Motivation for Strategy Implied volatility in equity index options systematically overestimates actual realized volatility 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Implied vs. Realized Volatility 01/02/90 01/02/91 01/02/92 01/02/93 01/02/94 01/02/95 01/02/96 01/02/97 01/02/98 01/02/99 01/02/00 01/02/01 01/02/02 01/02/03 01/02/04 01/02/05 01/02/06 01/02/07 01/02/08 01/02/09 01/02/10 01/02/11 01/02/12 VIX Realized 13 13

14 Review of Option Pricing: Black-Scholes Model Variables in option prices: Stock price-known Strike price-known Time to expiration-known Risk free rate-known Volatility of stock price-unknown Volatility estimates that are biased upwards, all else equal, create overpriced option prices

15 Explanation for Anomaly Lies within Behavioral Finance Individuals place different values on interim gains and losses relative to a reference point, rather than on final wealth. Loss aversion: Individuals value losses greater than an equivalent gain, relative to the reference point. Variable risk seeking behavior: Individuals prefer an uncertain gamble with an expected loss over a guaranteed loss of the same amount. Individuals subjective perception of probability differs from objective probabilities, specifically overestimating low probability outcomes and underweighting all others

16 Implications of Behavioral Finance on Option Pricing Prospect Theory: Loss avoidance (green area) valued more than gain foregone (red area), leading to higher value to option than under risk free arbitrage approach of Black-Scholes. Implied volatility is therefore biased upwards

17 Description of Strategy Invest 50% in the S&P 500 and sell out of the money calls with a probability of exercise of approximately 20% Invest 50% in cash and sell out of the money puts with a probability of exercise of approximately 20% 17 17

18 Hypothesis The presence of an insurance risk premium will reduce risk and add diversified return Covered Option Writing 100% Equity Add Insurance Risk Reduce Equity Risk 50% Equity/50% Bills 100% Bills 18 18

19 Historical Performance 40.00% Rolling 3 Year Returns 30.00% 20.00% 10.00% 0.00% % % 19 Option Strategy S&P 500 Equity/Bill Blend 19 12/01/92 09/01/93 06/01/94 03/01/95 12/01/95 09/01/96 06/01/97 03/01/98 12/01/98 09/01/99 06/01/00 03/01/01 12/01/01 09/01/02 06/01/03 03/01/04 12/01/04 09/01/05 06/01/06 03/01/07 12/01/07 09/01/08 06/01/09 03/01/10 12/01/10 09/01/11 Return

20 Historical Performance (1/90-3/12) Annualized Return Option Strategy S&P % S&P 500/ 50% Tbills 1yr 11.63% 8.54% 4.54% 3yr 18.14% 23.42% 11.55% 5yr 7.53% 2.01% 2.00% 10yr 8.32% 4.12% 3.31% 20yr 10.54% 8.59% 6.19% Inception 10.47% 8.71% 6.42% Annualized Standard Deviation Option Strategy S&P % S&P 500/ 50% Tbills 1yr 8.29% 16.08% 8.04% 3yr 8.18% 16.00% 8.00% 5yr 10.65% 18.92% 9.45% 10yr 8.86% 15.92% 7.96% 20yr 8.30% 15.03% 7.54% Inception 8.26% 15.15% 7.60% Sharpe Ratio Option Strategy S&P % S&P 500/ 50% Tbills 1yr yr yr yr yr Inception Diversification of equity insurance risk premium provides enhanced returns 20 20

21 Risks Short term underperformance in periods of sharp market movements when options will be exercised. Underperformance in a trending market with low volatility. These risks are mitigated to some extent through the use of one month options and dynamic strike prices

22 A Final Thought: Selling Insurance vs Buying Insurance Insurance Buyer Payoff Profile Insurance buyer payoff is replicated by buying high and selling low. Profitable long term strategy is to do the opposite: buy low, sell high 22 22

23 Question & Answer Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer sessions. 23

24 Conviction in Equity Investing Mike Sebastian

25 Classifications of Manager Skill Unskilled Underperform on average after fees and trading costs Net alpha < 0 No Evidence of Net Alpha Skilled Earn enough excess return on average to cover fees and costs, but no more Outperform on average net of fees and costs Net alpha 0 Net alpha > 0 Our research separates investment manager products into three categories based on statistical analysis of returns 25

26 Manager Skill, % 90% 80% 82.4% 70% 60% 50% Start of HEK Study 40% 30% 20% 15.9% 10% 0% 1.6% Unskilled (BSW) No Evidence of Net Alpha (BSW) Skilled (BSW) Unskilled (HEK) No Evidence of Net Alpha (HEK) Skilled (HEK) Manager skill has steadily declined since the 1990s, and we estimate that only about 2% of products demonstrate evidence of true skill today. Success with active management requires a high bar. 26

27 How Investment Committees Spend Time Clients spend significant resources overseeing active managers; there is a fixed element to these soft costs that suggests an efficiency argument for using more active management if any is used at all 27

28 Evidence on Outperformance of Higher Active Risk Managers Study Amihud and Goyenko [2012] Baks, Busse and Green [2006] Brands, Brown and Gallagher [2005] Cremers, Ferreira, Matos and Starks [2011] Da, Gao and Jagannathan [2010] Duan, Hu and McLean [2009] Huij and Derwall [2011] Ivkovic, Sialm and Weisbenner [2008] Jiang, Verbeek and Wang [2011] Kacperczyk, Sialm and Zheng [2004] Petajisto [2010] Wang and Zheng [2012] Wermers [2000] Finding Funds with lower R 2 (greater deviation from the market) outperform Managers willing to take big bets outperform More concentrated funds outperform The most active funds outperform; closet indexers underperform High active share and aggressive growth managers outperform Managers exhibit stock picking ability only in high-volatility stocks Fund managers willing to take big bets, and with broader investment strategies, outperform Households with more concentrated stock holdings earn better returns Managers highest-conviction stock holdings outperform More concentrated funds outperform The most active stock pickers outperform; closet indexers underperform Hedge funds with strategies more distinctive from peers outperform Funds that trade more actively outperform There is significant evidence of a link between investment manager products with higher active risk (higher conviction on the part of the manager) and value added 28

29 Active Manager Value Added and Active Risk Average Annualized Alpha 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% Alpha by Level of Active Risk (Manager's Chosen Benchmark) Closet Indexing Strategies -0.3% -0.3% -0.1% -0.1% 0.2% 0.0% 0.7% 0.8% 1.0% High Conviction Strategies -0.6% -0.5% 1 (Lowest) Deciles of Active Risk (Highest) Our research finds a strong link between active risk and performance relative to the benchmark 29

30 Active Manager Value Added and Active Risk (cont.) 1.5% Alpha by Level of Active Risk (Fully Style Adjusted) Average Annualized Alpha 1.0% 0.5% 0.0% -0.5% -1.0% Closet Indexing Strategies -0.7% -0.8% -0.7% -0.4% -0.6% -0.2% -0.3% -0.5% -0.4% 1.0% High Conviction Strategies 1 (Lowest) Deciles of Active Risk (Highest) When fully adjusting for manager style and risk, we find value added only among the managers who take the most significant active bets 30

31 Active Manager Skill and Active Risk 16% 14% Skill Percentage by Level of Active Risk 13.9% Skill Percentage 12% 10% 8% 6% 4% 2% 0% Closet Indexing Strategies 0.0% 0.0% 0.0% 2.0% 0.0% 2.4% 3.6% 2.4% High Conviction Strategies 5.2% 1 (Lowest) (Highest) Deciles of Active Risk Evidence of true skill is much stronger among the most active managers 31

32 A Risk Puzzle Institutional investors spend significant time and resources on active management But active management accounts for only a small amount (5% or less) of typical total fund risk Investors portfolios are positioned to earn less alpha than they expect 32

33 A Solution We recommend that investors consider one of two directions with their public equity investments: An Efficiency equity portfolio that is 100% indexed to a broad global equity benchmark An Opportunity portfolio that maximizes the odds of success from active management in a high-conviction approach that is 80% or more actively managed We believe that the Efficiency model is optimal for most investors. Efficiency investors demonstrate conviction through a bold course of action of differing from peers who subscribe to the current model of active equity management. For investors unwilling to go to such extremes, at a minimum consider a strategy that combines indexing with high-conviction active strategies and avoids the expensive diversification of low active risk strategies and multitudes of actively managed portfolios. 33

34 A Call to Action We call on the major players in active equity management to step up their game: Investment managers must focus on higher-conviction strategies that allow their skill to flow through to client returns, and reject low active risk strategies whose alpha is eaten up by fees and trading costs. Consultants must also act with greater conviction, putting forward only their strongest recommendations, avoiding safe managers and being willing to recommend indexing instead in areas where credible products are lacking, or closed to new investors. Asset owners must look within themselves to discover whether they are true believers. Those who are (the Opportunity investors) must demand conviction from managers and consultants, but also defeat their own valuedestroying tendencies to chase returns and fire underperformers. 34

35 Thank you. Question & Answer Questions may be submitted at any time during the web seminar by typing the question in the "Ask a Question" text field and clicking "Submit." Questions will be answered live as time permits during the question and answer sessions. 35

36 Our next investment strategy update call is scheduled for Wednesday, December 19th, at 10 a.m. CST. 36