Why Real Return? Jeff Ptak, CFA Morningstar Investment Services Marta Norton, CFA Morningstar Investment Services

Transcription

1 Why Real Return? Jeff Ptak, CFA Morningstar Investment Services Marta Norton, CFA Morningstar Investment Services 2011Morningstar Investment Services, Inc. All rights reserved. Morningstar Investment Services is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar, Inc. The information contained in this presentation is the proprietary material of Morningstar Investment Services. Reproduction, transcription or other use, by any means, in whole or in part, without the prior written consent of Morningstar Investment Services is prohibited. Morningstar Managed Portfolios is offered by Morningstar Investment Services, and is intended for citizens or legal residents of the United States or its territories. This program can only be offered by a registered investment advisor or investment advisor representative.

2 Important Disclosures This presentation is for financial professional use only and should not be shared with current or potential clients. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use.

3 The Real Return Mandate Minimize the impact of inflation on clients assets Reduce dependence on any one type of inflation hedge Limit the volatility common among certain types of inflation hedges, including commodities

4 Why care about real return? The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. Warren Buffett, 1977

5 Inflation erodes purchasing power $10,000 after 10 years assuming different inflation rates $10, % Inflation $7, % Inflation $7, % Inflation $6,139 No Inflation Purchasing power of 10,000 at varying inflation rates

6 Inflation depletes fixed income and capital appreciation Real return of 60/40 stock/bond portfolio, 35-year scenarios 2.5% Inflation 3.5% Inflation 5.0% Inflation 10.1% 7.4% 6.4% 4.8% Nominal Return Real Return at varying inflation rates

7 Depletes fixed income and capital appreciation Growth of $10,000 in Real Terms, Commodities $30,000 $20,000 US Inflation US Sm. Cap Stock $10,000 Int-Term Govt. Bond US LT Corp Bond US Large Cap Stocks

8 Inflation Index, 1927 April % 70s Commodity supply shocks Coordinated wage increases 15% 10% 5% 0% -5% -10% 40s World War II Early 2000s Growing commodity demand High economic activity

9 Could inflation return? Record monetary stimulus? High debt levels? A weak U.S. dollar? Increasing commodity scarcity?

10 Building a Real Return portfolio

11 Objectives of Real Return portfolio Minimize the impact of inflation on clients assets Reduce dependence on any one type of inflation hedge Limit the volatility common among certain types of inflation hedges, including commodities

12 Why not just TIPS or commodities? TIPS Commodities Advantage Adjusted for changes in the Consumer Price Index Generally early responders to inflation spikes Disadvantage Vulnerable to increases in real (inflation-adjusted) interest rates Highly volatile

13 A toolkit approach to fighting inflation Bonds Alternatives Global Stocks TIPS High-Yield Bonds Floating-Rate Bonds Global Bonds Real Estate Commodities Emerging Market Currency Absolute Return Funds Global Stocks

14 Bonds: TIPS Exposure Adjusted for changes in the US Consumer Price Index Increasing Exposure Inflation Non-US Currency US Dollar US Interest Rates Credit TIPS Exposure

15 The Bond Market: Floating-Rate Bonds Coupons that adjust to changes in short-term rates Increasing Exposure Inflation Non-US Currency US Dollar US Interest Rates Credit Floating-Rate Bonds vs. TIPS Exposure

16 The Bond Market: High-Yield Bonds Corporate bonds with higher coupon payments to compensate for increased credit risk Increasing Exposure Inflation Non-US Currency US Dollar US Interest Rates Credit High-Yield Bonds vs. TIPS Exposure

17 The Bond Market: Global Bonds Introduces non-u.s. sovereign and corporate bonds Increasing Exposure Inflation Non-US Currency US Dollar US Interest Rates Credit Global Bonds vs. TIPS Exposure

18 The Bond Market: Inflation Protection in Aggregate Floating-Rate Bonds High-Yield Bonds Floating-rate bonds, highyield bonds, and global bonds help limit the portfolio s exposure to the U.S. dollar and its dependence on real interest rates. Global Bonds Inflation Non-US Currency US Dollar US Interest Rates Credit

19 Alternatives: Sources of Inflation Protection Real Estate Commodities Emerging-Market Currency Absolute Return Funds Advantage Rents can climb higher in response to economic activity. Tend to rise higher in the early stages of inflation. Stands to appreciate due to economic growth and low valuations regardless of U.S. inflation. Some types of absolute-return strategies have tended to perform well during inflationary periods.

20 Global Stocks Expands investment opportunities Provides currency diversification Can offer exposure to firms with pricing power

21 Pricing Power Example: Delivery Services Delivery services can pass along higher motor fuel costs 40% Motor Fuel 30% 20% 10% Delivery Services 0% -10% -20% -30% -40%

22 Pricing Power Example: Wireless telephone services Wireless telephone services lack pricing power 1.0% 0-1.0% -2.0% -3.0% -4.0%

23 Asset Class Correlation with Inflation TIPS Floating Rate High Yield Global Bonds Commodities EM Currency Absolute Return Real Estate Global Stocks Inflation US Bonds US Stocks TIPS Floating Rate High Yield Global Bonds Commodities EM Currency Absolute Return Real Estate Global Stocks Inflation US Bonds US Stocks

24 Balancing Risk and Inflation Protection Swapping interest-rate risk for credit risk Minimizing U.S. dollar exposure Balancing volatile asset classes with moderate strategies Monitoring overall exposure to related sectors, asset classes

25 Hypothetical Real Return Portfolio Global Stocks 6% Alternatives 42% Bonds 52% TIPS 20% Floating-Rate Bonds 20% High-Yield Bonds 6% Global Bonds 6% Commodities 15% Emerging Mkt. Currency 12% Absolute Return Funds 10% Real Estate 5% Global Stocks 6%

26 How did the hypothetical portfolio fare? Jan 1999 August % 4.12% 5.90% 3.25% Nominal Return Real Return 1.74% Hypothetical Portfolio S&P % US Bond Index 6.85% 15.92% 3.66% Standard Deviation Inflation Correlation

27 Populating the portfolio

28 Selecting Real Return Fund Managers Prudent strategy Manager talent, resources Risk-adjusted performance Capacity Expenses Flexibility

29 Our current Real Return portfolio Fund Morningstar Category Allocation Expenses Vanguard Inflation-Protected Bond Inflation-Protected Bond 17% 0.11% Fidelity Floating Rate High Income Bank Loan 17% 0.73% Harbor High-Yield Bond High-Yield Bond 8% 0.67% Templeton Global Total Return World Bond 6% 0.84% PIMCO Commodity Real Return Strategy Commodities 11% 0.99% PIMCO Emerging Markets Currency Emerging Markets Bond 9% 0.85% Eaton Vance Global Macro Absolute Return World Bond 7% 0.71% Calamos Market Neutral Income Long Short 7% 1.14% Third Avenue Real Estate Value Global Real Estate 5% 1.14% Janus Money Market Money Market 1% 0.22% IVA Worldwide World Allocation 6% 1.06% T. Rowe Price New Era Natural Resources 6% 0.67% 100% 0.72%

30 A Sampling of Real Return Funds Fidelity Floating Rate High Income Vanguard Inflation- Protected Securities PIMCO Emerging Market Currency IVA Worldwide Conservative strategy, rigorous research Low cost, broad TIPS exposure Local emerging market currency, limited interest-rate exposure Global, flexible, experienced T. Rowe Price New Era Natural resource stocks, including precious metals

31 Using a Real Return portfolio

32 How to use a Real Return portfolio As a hedge to a diversified portfolio Limits the damage caused by inflation surprises Provides greater diversification As a larger allocation for retirees or those planning to drawdown their portfolios in the near term in an effort to preserve purchasing power

33 Example: Linda wants to hedge a diversified portfolio 55 years old At least 10 years away from retirement Higher prices at the gas pump and in the grocery store have Linda concerned about the prospect of rising inflation

34 Advisor suggestion for Linda s $500,000 portfolio Current Suggested 50% Stocks 50% Bonds 40% Stocks 20% Real Return 40% Bonds Retain the bulk of assets in the traditional portfolio for growth purposes Allocate a moderate slice of assets to Real Return to hedge inflation

35 Linda s results Trailing 10-Yrs Ending August % 2.07% 5.02% 2.51% Nominal Return Real Return Current Suggested 7.98% 7.58% Standard Deviation Sharpe Ratio Inflation Correlation

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37 Fee Structure Maximum Fee Schedule Mutual Fund Portfolios Up to $500,000 Next $500,000 Next $1MM Over $2MM Morningstar Investment Services 0.40% 0.35% 0.30% 0.20% Advisory Firm ** 1.10% 1.05% 1.00% 0.90% Total Annual Fee 1.50% 1.40% 1.30% 1.10% Account Minimum, $50,000 (lower in family plan) Minimum Exceptions: Enhanced Portfolio Service, $1MM Client fee does not include the mutual funds expenses Advisor fee can be discounted in 5 bps increments *MIS Minimum Annual Fee is $200 for those accounts not held at PFPC. **Please note that fees may vary based on business relationships.

38 Our Sales Team General Information Internal Service Representatives Reach our sales team members at Aaron Peterson Ext. 1 aaron.peterson@morningstar.com Region 1 California, Oregon, and Alaska, Guam, Hawaii 2 Justin Stender Ext. 2 justin.stender@morningstar.com Region 2 Idaho, Illinois, Iowa, Michigan, Minnesota, Nebraska, North Dakota, South Dakota, Wisconsin 3 Steven Geiger Ext. 3 steven.geiger@morningstar.com Region 3 Delaware, Maryland, North Carolina, Pennsylvania, Virginia, West Virginia 4 Brad Murphy Ext. 4 brad.murphy@morningstar.com Region 4 Massachusetts, Maine, New Hampshire, Rhode Island, Vermont 5 Mike Reeves Ext. 5 mike.reeves@morningstar.com Region 5 Alabama, Florida, Georgia, South Carolina, Puerto Rico 6 John Green Ext. 6 john.green@morningstar.com Region 6 Arizona, Kansas, Missouri, New Mexico, Oklahoma, Texas Peter Dugery National Director peter.dugery@morningstar.com 7 Todd Schaul Ext. 7 todd.schaul@morningstar.com Region 7 Connecticut, New Jersey, New York 8 Sean Klock Ext. 8 sean.klock@morningstar.com Region 8 Arkansas, Louisiana, Mississippi, Tennessee 9 Adam Herakovich Ext. 9 adam.herakovich@morningstar.com Region 9 Ohio, Indiana, Kentucky 10 Aaron Pisani Ext. 10 aaron.pisani@morningstar.com Region 10 Idaho, Montana, Washington, Utah, Colorado, Wyoming

39 Disclosures This presentation is for financial professional use only and should not be shared with current or potential clients. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use.

40 Appendix: Performance Metrics Definitions Standard Deviation measures an investment s volatility or range of outcomes. The total returns of any given investment are expected to be within one standard deviation from its mean return about 68% of the time and within two standard deviations from the mean 95% of the time. Sharpe Ratio measures return per unit of risk. Equal to excess return (average monthly return less average monthly return of 90-day Treasury bill) divided by standard deviation. Inflation Correlation measures the degree of relationship between a particular asset class and the non-seasonally-adjusted U.S. Consumer Price Index, which serves as a common measure of inflation. The higher the correlation, the stronger the relationship between inflation and the asset class in question. Performance Imposition of advisory fees and other expenses incurred in the management of an account would cause actual performance to be lower than the performance shown. For example, if the one-year performance before such fees was 10% and the account assessed an annual fee of 1.50% deducted quarterly, the fee would reduce the performance approximately 8.36% annually.

41 Appendix: Market Index Descriptions Index Returns Individual index performance is provided as a reference only. Each index is unmanaged and is not available for direct investment. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although Index performance data and expense ratios of passive index mutual funds are gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. S&P 500 Index The Standard & Poor's index of 500 stocks is a popular standard for measuring stock market performance among the biggest, most broadly-based companies in the U.S. BarCap Aggregate Bond Index - A market value weighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year. U.S. Inflation We use the non-seasonally-adjusted (NSA) U.S. Consumer Price Index (CPI) as a proxy for U.S. inflation. The NSA U.S. CPI is produced by the Bureau of Labor Statistics and is a monthly index tracking the changes in prices paid by U.S. urban consumers for a representative basket of goods and services. Dow Jones UBS Commodity Index -- A broadly diversified index composed of futures contracts on physical commodities. The index is designed to minimize concentration in any one commodity or sector. The index is not highly concentrated in any single commodity type. The weightings for each commodity included in the Index are calculated in accordance with rules that ensure that the relative proportion of each of the underlying individual commodities reflects its global economic significance and market liquidity. S&P Goldman Sachs Commodity Index A world-production weighted index in which the quantity of each commodity in the index is determined by the average quantity of production in the last five years of available data. The index contains 24 commodities from all commodity sectors: six energy products, five industrial metals, eight agricultural products, three livestock products, and two precious metals. Barclays Capital Global Inflation-Linked US TIPS Index This index includes securities that offer the potential for protection against inflation as their cash flows are linked to an underlying inflation index. U.S. Small Cap Stock U.S. Small Cap Stock refers to the Ibbotson Associates SBBI U.S. Small Cap Stock Index, which measures the performance of U.S. small company stocks. U.S. Long-Term Corporate Bond U.S. Long-Term Corporate Bond refers to the Ibbotson Associates SBBI U.S. Long-Term Corporate Bond Index, which is a custom index designed to measure the performance of U.S. corporate bonds.

42 Appendix: Market Index Descriptions Index Returns Individual index performance is provided as a reference only. Each index is unmanaged and is not available for direct investment. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although Index performance data and expense ratios of passive index mutual funds are gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. U.S. Intermediate-Term Government Bond U.S. Intermediate-Term Corporate Bond refers to the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index, which is a custom index designed to measure the performance of intermediate-term U.S. government bonds. Motor Fuel The price U.S. urban consumers paid for motor fuel according to the Bureau of Labor Statistics. Delivery Services The price U.S. urban consumers paid for delivery services according to the Bureau of Labor Statistics. Wireless Telephone Services The price U.S. urban consumers paid for wireless telephone services according to the Bureau of Labor Statistics. Floating-Rate Bonds We use the S&P/LSTA Leveraged Loan Index to measure the performance of the floating-rate bond market. The index tracks syndicated senior secured loans with a minimum initial term of one year. The loans must have a minimum initial spread of 125 basis points over LIBOR, be denominated in U.S. dollars, and have a par amount outstanding of $50 million or greater. The index is market-value weighted. High-Yield Bonds We use the Barclays Capital U.S. Corporate High-Yield Bond Index to track the high-yield bond market. The index is an unmanaged total return performance benchmark that covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Global Bonds We use the Barclays Capital Global Aggregate Bond Index to measure the performance of the global bond market. The index provides a broad-based measure of the global investment grade fixed-rate debt markets. It requires an investment-grade rating using the middle rating of Moody s, S&P, and Fitch, at least one year until final maturity, fixed-rate and step-up coupons, and currency in one of 23 eligible currencies. Emerging-Market Currencies We track the performance of emerging-market currencies using the JP Morgan Emerging Local Markets Index Plus. The index tracks total returns for local-currency-denominated money market instruments in emerging markets. Absolute Return We use the Morningstar, Inc. long/short equity category average to approximate the performance of absolute-return funds.

43 Appendix: Market Index Descriptions Index Returns Individual index performance is provided as a reference only. Each index is unmanaged and is not available for direct investment. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although Index performance data and expense ratios of passive index mutual funds are gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. Real Estate We use the S&P Developed Property Index to measure the returns of the global real estate market. The index includes approximately 400 stocks from 22 countries. To qualify for inclusion in the index, a company must derive more than 60% of revenue from real estate development, management, rental, and/or direct investment in physical property. Real estate agents, brokers, appraisers, and companies that build residential units homes, apartments, and condominiums for the purpose of selling to homeowners are excluded. Global Stocks We use the MSCI AC (All Country) World Index to measure the performance of the global stock market. The index is a free floatadjusted market-cap weighted index that consists of both developed and emerging markets. It currently consists of 24 developed countries and 21 emerging countries. The developed countries include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The emerging countries include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.