Why Is Everyone Calling It The New Normal If It is Not Normal? CFA Quebec

Transcription

1 Why Is Everyone Calling It The New Normal If It is Not Normal? CFA Quebec Hillsdale Investment Management Harry Marmer, CFA, MBA Executive Vice President, Institutional Investment Services

2 Discussion Points What Is the New Normal? What Are We Concerned With? Investors In The New Normal The New Normal is Really The Great Deviation Institutional Portfolio Structuring for Turbulent Times 2

3 The New Normal Is The New Normal Means Slower Growth in the Years Ahead There Are Three Reasons for This: No. 1 is Deleveraging No. 2 Is Re-Regulation No. 3 is De-globalization. Various Countries Around the World Will Produce Slower Growth Than What We ve Grown Used To, and This Leads to Lower Returns on Assets This Is a FORECAST for the Economy and Markets 3 Source: Bill Gross in Barron s 2010 Roundtable, Part 3 The New Normal, Feb 1, 2010

4 We Are Concerned With Theories That Are Not Working In Reality Market Experiences That We Have Never Experienced Before Events Leading Up the New Normal Were Not Normal We Are Not Trying to Forecast What the Economy Should Do or What Asset Classes Returns Should Be Instead, We Are Concerned With What Markets Are Doing What Are The Implications for Investors? This is a EXAMINATION of the CURRENT Economy and Markets 4

5 The World As We Think Of It Equity Market Return = 8% Equity Market Standard Deviation of Returns = 14% 0.25 Standard Normal Return Distribution St. Dev +1 St. Dev St. Dev +2 St. Dev St. Dev +3 St. Dev Return (%) 68% 95% 98% St. Dev = Standard Deviation

6 The True Empirical Distribution of Returns for Equities S&P/TSX Monthly Return Relative Frequency % 10% 8% Significant Tail Events Oct Stock Market Crash (-22.5%) Aug Russian Financial Crisis (-20.1%) Mar Recession (-17.6%) Oct Credit Crisis (-16.9%) Sept Credit Crisis (-14.7) Feb Recession (-9.1%) 6% Jan 1975 Aug 1982 May % 2% Oct 1987 Aug 1998 Mar 1980 Oct 2008 Sept 2008 Feb % 6 The fact that stock returns are non-normally distributed is not a new statement. Academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years. Source: Fama, Eugene F. Feb My Life in Finance. Annual Review of Financial Economics. University of Chicago, Page 4. See as well, Perspectives on Institutional Investing by Harry Marmer, Rogers Publishing 2002, Page 105 and "How Normal Are Common Stock Returns in Canada" by R. Krishnan and P. Potvin in Canadian Investment Review, Fall 1990.

7 Stock Return Distributions Are Distorted by Black Swan Events 1. An Event that Is Beyond The Realm of Our Regular Expectations i.e. an Outlier 2. This Event Carries An Extreme Impact 3. After the Fact, We Rationalize The Event with Perfect Hindsight that Makes It Seem Predictable Examples of Black Swan Events: - The Personal Computer - The Internet - World Wars I and II - The Beatles - 9/11 7 Sources: THE BLACK SWAN The Impact of the Highly Improbable, By Nassim Nicholas Taleb, 366 pages. Random House, 2007; Black Monday and Black Swans by John C. Bogle, Financial Analyst Journal, Vol 64, # 2, pages 30 40, A Black Swan in The Money Market, by John Taylor and John Williams, Federal Reserve Board of San Francisco, April 2008

8 Black Swan Events in Financial Markets "Black Swan Events Cause Typical Asset Class Returns To Have Non Normal Return Distributions Bubbles, Fads and Fashions Real Unanticipated Events or Shocks Such As: Oct 87 Market Crash Aug - Sept 98 Russian Default/LTCM Crises Variation in the Active vs. Passive Premium 2008/09 Credit Crises The Great Deviation - Economic and Political Policies Have Become More Interventionist, Less Rules-Based and Less Predictable 8 Source: Taylor, John,. Macroeconomic Lessons From the Great Deviation, Stanford University, Page 1, 2010

9 The New Normal Is Really The Great Deviation We Came From An Economic Environment Known as The Great Moderation - Long Expansions with Short Recessions and Low Inflation The Current Environment Could Be Best Described as The Great Deviation: Economic and Political Policies Have Become More Interventionist, Less Rules-Based and Less Predictable i.e Uncertainty Rules 9 Source: Taylor, John,. Macroeconomic Lessons From the Great Deviation, Stanford University, Page 1, 2010

10 Uncertainty Distorts Normal Return Distributions As Unknown Events or Shocks Are More Prevalent Potential for Much Larger Loses Than Anticipated i.e. Negative Skewness - Picking Up Nickles In Front of a Steam Roller 1 Greater Potential for Unanticipated Returns with Higher Risk of Extreme Moves, Also Known As Fat Tails and i.e. Positive Kurtosis Page 7 from Idiosyncratic Ideas: Managing Black Swan Risk Macquarie Research, May 7, Statistically speaking, Kurtosis is a joint measure of tail fatness and peakedness of the distribution, See page 48 in Fat- Tailed and Skewed Asset Return Distributions by S. Rachev, C. Menn and F. Fabozzi, Wiley Finance, 2005

11 The Credit Crises and High Yield Bond Risk An Event Beyond The Realm of Our Normalized Expectations Bank of America Merrill Lynch High Yield Master II Monthly Returns June 1986 June % 10% 5% 0% -5% -10% -15% Statistics Mean 0.7% Median 1.0% Stdev 2.5% Max 11.5% Min -16.3% Lowest Level in 25 Years -20% Jun-86 Dec-86 Jun-87 Dec-87 Jun-88 Dec-88 Jun-89 Dec-89 Jun-90 Dec-90 Jun-91 Dec-91 Jun-92 Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Recession Periods 11

12 The New Normal Has Been Characterized By Jumps in Observed Risk 100% S&P Day Rolling Volatility Jan 1928 June 30, % Great Depression 1987 Crash Credit Crisis 60% 40% 20% 0% Recession Periods 12 Source: S&P Index Services

13 In The New Normal, the Investors Fear Gauge Has Been on a Rollercoaster Ride Chicago Board Options Exchange Volatility Index (VIX) Daily, Ending Sep 3, Statistics Mean 20.4 Median 19.0 StDev 8.3 Max 80.9 Min 9.3 Asian Contagion, Long Term Capital 9/11, Enron, Worldcom, Iraq Subprime, Bear Stearns, Morgan Stanley, Fannie And Freddie Lehman Euro Contagion VIX Average 13 VIX Definition: An implied volatility index that measures the market s expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P 500 options. Source: Chicago Board Options Exchange

14 In A Turbulent New Normal, Wild Swings in the VIX Make Traditional Money Management Hazardous 50 Chicago Board Options Exchange Volatility Index (VIX) Daily, Ending June 30, Flash Crash Concerns Over German Vote on EU Bailout Statistics Mean: 26.4 Median: 26.9 Stdev: 7.8 High: 45.8 Low: S&P Cuts Greece to Junk Bond Status Apr 01 Apr 08 Apr 15 Apr 22 Apr 29 May 06 May 13 May 20 May 27 Jun 03 Jun 10 Jun 17 Jun 24 VIX Long Term Average 14 VIX Definition: An implied volatility index that measures the market s expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P 500 options. Source: Chicago Board Options Exchange

15 Typical Fundamental Factors May Not Be Rewarded Quarterly Earnings Growth (Trailing) Top 30 Stocks Bottom 30 Stocks, 6 Months Rolling 60% 50% 40% Statistics Mean 9.5% Median 9.7% Stdev 14.1% High 50.2% Low -36.7% 30% 20% 10% 0% -10% -20% -30% -40% -50% Stock Universe is the TSX Composite Index. Top 30 stocks are the largest or highest. Bottom 30 Stocks are the Smallest or Lowest. Portfolios are Equally Weighted. Data as of June 30, 2010

16 Leading the Charge: High Frequency Traders, Hedge Funds and Day Traders Such As Andy Day Traders 2.0: Wired, Angry and Loving It. Andy Lindloff with his daughter, Juliana, as he trades stocks from home. He says he earns six-figure returns, which would put him in the rarefied category of profitable day trader. (NYT, March 27, 2010) 16

17 Sponsors Are Very Concerned About Pension Risk Ranks As One Of The Top 3 Challenges More Severe Than Before The 2008 Financial Crisis Volatility Of Funding Contributions/Accounting Expenses 91% 77% Cost Of Maintaining/Funding DB Plans 88% 80% Imbalance Between Funding Risk and Reward (Asymmetry) 48% 37% Complying With Fiduciary and Governance Responsibilities and Disclosure Guidelines The Move To International Accounting Standards By The Canadian Institute Of Chartered Accountants (CICA) 28% 22% 37% 51% 17 Source: Towers Watson: 2010 Survey on Pension Risk Highlights From Recovery to Sustainability

18 This Has Led Them to Review Investment Strategies With A Focus on Allocating Away From Equities Into Fixed Income Taken In Past 12 Months Implementing In Next 12 Months Considering For The Future Changes Unrelated To Cost And/Or Volatility 9% 15% 14% Actions Targeted At Containing Cost And/Or Volatility 37% 33% 52% Switching/Converting To CAP/DC 4% 6% 13% Plan Design Changes Excluding Move To CAP/DC 1 9% 7% 23% Investment Strategies 27% 25% 34% Investment Strategy Changes Include Increasing Fixed Income Weighting, Lengthening Fixed Income Duration, Employing Cash Flow Matching Strategies, Annuitizing Liabilities and Other Liability-Driven Strategies Changes include reduction in ancillary benefits and primary retirement benefits for current employees and increase in required employee contributions. Source: Towers Watson: 2010 Survey on Pension Risk Highlights From Recovery to Sustainability

19 Sponsors, Consultants and Managers Are All Doing The LDI Dance Corporate Plans Jumping to LDI (Pension and Investments, March 22, 2010) Opportunity Comes Knocking for Consultants (Pension and Investments, March 22, 2010) Managers Prep Marketing for Looming LDI Wave (Fundfire, March 10, 2010) Pension De-Risking (Federated Press Conference, June 17, 2010) The Business of Re-Risking Defined Benefit Plans (Pension Trends, May 2010) Dynamic De-Risking (Canadian Investment Review, March 5, 2010) Growth Sparks Consultant Hiring Spree (Fundfire, March 22, 2010) 19

20 With The Slope of the Yield Curve at Peak Is Now the Time To Consider Moving Out of Stocks and Into Fixed Income? Government of Canada Long Term Bond 90 Day T-Bill Yield Spread Monthly, Jan 1976 Sept % 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% Jan-76 Jan-77 Jan-78 Jan-79 Jan-80 Jan-81 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Recession Periods 20 *Selected Government Of Canada Benchmark Bond Yields, Long Term (

21 More Portfolio Structuring Ideas For Turbulent Times Cash Derivative Based Strategies or Swaps Equity Minimum Risk Strategy A Left Tail Hedge Combining Strategies that Work Well Under Turbulent Conditions (Outperform in Both Tails) Equity Minimum Risk Strategies + Trading Strategies 21

22 An Equity Minimum Risk Portfolio Has the Potential to Significantly Reduce Equity Volatility As of Sept 30, 2010 Risk of Market Portfolio: 15.4% Minimum Risk Portfolio: 11.4% S&P/TSX Composite Annualized Volatility 15.4%* Minimum Risk Portfolio Annualized Volatility 11.4%* IT 2.4% Telecom 4.5% Utilities 1.7% Energy 25.7% IT 0.3% Telecom 12.6% Utilities 2.8% Energy 27.5% Financials 29.4% Healthcare 0.8% Cons Staples 2.7% Cons Disc. 4.5% Industrials 5.7% Materials 22.6% Financials 29.6% Healthcare 0.0% Cons Staples 1.6% Cons Disc. 14.3% Materials 6.2% Industrials 5.1% 22 *Based on monthly data from Jan 1990 Sept The Equity Minimum Risk portfolio is based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the system are based on specified investment objectives covering both return and risk metrics.

23 The Portfolio Holdings Of The Market and Minimum Equity Risk Portfolio Are Mirror Images As of Sept 30, 2010 TSX Composite Stocks Sector Percentage Royal Bank of Canada Financials 7.2% Toronto-Dominion Bank Financials 6.2% Bank of Nova Scotia Financials 5.4% Suncor Energy Inc. Energy 4.9% Barrick Gold Corp Materials 4.4% Potash Corp. of Sask. Materials 4.1% Cdn. Natural Resources Energy 3.7% Bank of Montreal Financials 3.2% Goldcorp Inc. Materials 3.1% Cdn. National Railway Industrials 2.9% Canadian Equity Min Risk Stocks Sector Percentage Shaw Communications Discretionary 5.5% TransCanada Corp. Energy 5.2% BCE Inc. Telecom 5.0% Enbridge Inc. Energy 4.9% Tim Hortons Inc. Discretionary 4.3% TELUS Corporation Telecom 4.3% Thomson Reuters Corp Discretionary 3.7% Rogers Communications Inc.Telecom 2.9% Fortis Inc. Utilities 2.7% Toronto-Dominion Bank Financials 2.6% 23 *Data as of Sept 30, The Equity Minimum Risk portfolio is based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the system are based on specified investment objectives covering both return and risk metrics.

24 The Equity Min Risk Portfolio Has Significantly Lower Risk Than the Market 30% Simulated Return and Risk in an Optimized Framework Average 3 Year Monthly, Jan 1999 Sept 2010 Return 20% 10% 0% Hillsdale Cdn Min Risk (13.0%, 9.7%) S&P/TSX TRI (6.9%, 14.6%) Cdn Maximum Risk Portfolio (8.4%, 19.7%) -10% 0% 5% 10% 15% 20% 25% 30% Risk (Standard Deviation) 24 The Equity Minimum Risk performance is based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the system are based on specified investment objectives covering both return and risk metrics. Past performance is not indicative of future performance. Returns are gross of fees.

25 An Equity Min Risk Portfolio Can Reduce the Occurrences of High Risk, Low Return Outcomes 30% Simulated Return and Risk Over Monthly Rolling 3 Year Periods Jan 1999 Sept % Return 10% 0% -10% -20% 5% 10% 15% 20% 25% Risk (Standard Deviation) Hillsdale Cdn Min Risk TSX TRI 25 The Equity Minimum Risk performance is based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the system are based on specified investment objectives covering both return and risk metrics. Past performance is not indicative of future performance. Returns are gross of fees.

26 The Result: A Better Hedge Against Negative Tail Risk 50% 45% Monthly Return Frequency Canadian Equity Min Risk vs. S&P/TSX Monthly, Jan 1999 June 2010 Equity Minimum Risk 40% 35% 30% 25% 20% 15% S&P/TSX 10% 5% 0% -23% to -20% -19% to -16% -15% to -12% -11% to -8% -7% to -4% -3% to 0% 1% to 4% 5% to 8% 9% to 12% 13% to 16% Canadian Equity Min Risk S&P/TSX 26 The Equity Minimum Risk performance is based on a simulation where stocks are selected based on a multi-factor ranking system. The drivers of the system are based on specified investment objectives covering both return and risk metrics. Past performance is not indicative of future performance. Returns are Gross of fees. *Frequency results have been smoothed

27 Client Needs that Suggest Considering An Equity Minimum Risk Strategy Capture the Equity Risk Premium with Less Volatility Define Risk as Volatility and Not Deviation From Index Disappointed with Active Management But Desire the Equity Risk Premium Looking for a Better Equity Match for Liabilities A Hedge For Downside or Left Tail Risk 27

28 How to Successfully Manage The Tails Dynamic Combination of Equity Minimum Risk Portfolio with Large Cap Trading Strategy Strategy Holding Period Principal Factors Representative Stock Equity Minimum Risk Strategy 2 Years Risk Modeling TransCanada, BCE, Bank of Nova Scotia, Loblaw, TD, Tim Hortons, CIBC Canadian Large Cap Trading 6 Months Technical Factors Advantage Oil&Gas, Agrium, BCE, Manulife, Western Coal, Yamana Gold 28

29 Concluding Thoughts The New Normal Is Not Normal The Current Environment Can Be Best Described As The Great Deviation Now Is Not The Time to Move Out of Equities and Into LDI Capture the Equity Risk Premium Thru Min Risk Equity Portfolios Better Yet, Employ Strategies That Perform Well in The Tails Turbulent Times Require Thoughtful Strategies You ve Got To be Very Careful If You Don t Know Where You re Going, Because You Might Not Get There Yogi Berra 29

30 The Great Deviation Was Caused by Policy Actions and Interventions Including Interventions by the Federal Government to Encourage Fannie Mae and Freddie Mac to Purchase High Risk Mortgages Decisions by U.S. Financial Regulatory Agencies to Let Banks Deviate from Rules-Based Regulations by Allowing Risky Off Balance Sheet Activity Deviation from the Monetary Policy of the Great Moderation, Term Auction Facility (TAF), Created by Federal Reserve, 2007 U.S. Discretionary Fiscal Stimulus, 2008 On-Again/Off-Again Interventions of Financial Firms by the Fed, 2008 Money Market Mutual Fund Liquidity Facility, 2008 Commercial Paper Funding Facility, 2008 U.S. Discretionary Fiscal Stimulus Agreement, 2009 MBS Purchase Program of the Fed, Trillion Dollar European Rescue Package, 2010 The ECB Joining the Rescue Package by Buying Distressed Debt, 2010 The Fed Joining the Rescue Package by Making Swap Loans 30 Source: John Taylor, Macroeconomic Lessons From the Great Deviation, Stanford University, 2010

31 Bio Harry Marmer, BBA, MBA, CFA, Executive Vice President, Institutional Investment Services, Partner. Mr. Marmer heads up the institutional business of Hillsdale. Prior to joining Hillsdale, he was Senior Vice President, Institutional Investment Services at Franklin Templeton Investments. Prior to that, Mr. Marmer was Director at Russell Investment Group. Before this, he co-led Mercer's Investment Consulting Practice in Canada and was a Principal. Mr. Marmer is a frequent conference speaker and has authored more than 47 articles. His book, "Perspectives in Investment Management," was published by Rogers Media in September He has served on a number of industry boards. Mr. Marmer is a recipient of the Volunteer of Distinction award given by the CFA Society and is a past President of CFA Society Toronto. Harry joined Hillsdale in February