BALANCED PORTFOLIOS. Safer without bonds? Tommaso Mancuso, Head of Hermes Multi Asset December

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1 BALANCED PORTFOLIOS Safer without bonds? OUTCOME #16 Investing in a global wind turbine company, providing benefits for investors as well as the wider world. Tommaso Mancuso, Head of Hermes Multi Asset December 2017 For professional investors only

2 2 HERMES MULTI-ASSET KEY POINTS uuthe stock-bond correlation is unstable across economic regimes, so investors should not assume that bonds will continue to act as a good hedge to their equity exposure uuthe key factors affecting the correlation of stock and bond returns are risk aversion, inflation, policy rate and economic growth. Which factor dominates the relationship at any point in time is dependent on the prevailing economic regime u u Given the not negligible risk of a regime shift in the near future, it could be prudent for investors to consider alternatives to bonds in order to maintain a balanced portfolio Focusing on the correlation between stocks and bonds, in this paper we first examine how unstable their relationship has been in the past. We then assess the risk-return profiles of a traditional stock-bond portfolio, a risk-parity portfolio and a risk-managed stock-cash portfolio in a number of regimes. We focus on their performance in the US, but in the appendix we also illustrate how similar conclusions can be drawn in the UK. STOCK-BOND CORRELATIONS: IDENTIFYING MAJOR REGIME SHIFTS To begin, we identified eight shifts, or reversals, in the correlation between US stocks and bonds since The chart opposite shows the forward-looking, three-year rolling stock-bond correlation and the probability of a negative stock-bond correlation regime, as computed by our regime-switching model 3. Ignoring shifts in correlations that lasted three years or less, in the remainder of this paper we focus on the four major regimes shown in the table to the right below. INTRODUCTION Asset diversification is a key element of sound risk management. Harry Markowitz famously labelled diversification as the only free lunch in finance although how gratifying this lunch is depends to a large extent on how stable cross-asset relationships prove to be. Over the past 20 years, investors in balanced portfolios have been able to rely on the complementary behaviour of stocks and bonds to moderate both volatility and drawdown risk. What s more, the spectacular bull market we have seen in bonds meant that the reduced risk this diversification resulted in came at a negligible cost in terms of returns. The multi-decade stability of the negative correlation between stocks and bonds has gradually led multi-asset portfolios to come to rely on the diversification benefits of this correlation, i.e. the flight-to-quality narrative. With sufficient time and empirical evidence backing them up, such investment narratives can erroneously be taken as absolute truths. As authors Daniel Kahneman and Nassim Nicholas Taleb have highlighted, people have a natural need to make sense of the world through simplified narratives, which can obfuscate rational decisionmaking processes 1. History is littered with examples of established investment narratives being replaced by new ones 2. When such shifts occur, the reaction can be abrupt consider the tumultuous transition from the Great Moderation to the New Normal. For most investors, correlations can serve as a valuable tool to help manage volatility and drawdown risk. And yet correlation is not always founded on stable causality. In fact, the narrative of the stock-bond relationship was discount-factor-driven in the 1960s through to the 1980s; that is, increasing yields caused both stocks and bonds to fall in price. Changes in the market regime can cause structural shifts in correlations and, in time, the prevalent investment narrative. This means that diversifying across stocks and bonds is no substitute for active risk management. Figure 1: US stock-bond correlation regimes since 1929 Correlation 100% 80% 60% 40% 20% 0% -20% -40% -60% -80% Rolling Correlation (36m) Stock-Bond Correlation Regimes (Forward looking by 36 months) Negatively Correlated Regime Source: Bloomberg, AQR, Hermes Regime Switching model as at October % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Probability of Negatively Correlated Regime 1 See The Black Swan by Nassim Nicholas Taleb or Thinking Fast and Slow by Daniel Kahneman. 2 For example, there was a common belief that it was impossible for there to be a nationwide decline in US home prices, as stated by Ben Bernanke, then President Bush s Chairman of the Council of Economic Advisers, in a 2005 interview with CNBC ( Also, the rise and decline of various narratives related to hedging strategies, e.g. the portfolio insurance hedging strategies in the eighties which failed spectacularly in 1987 contributing to the worst day in history for the S&P500 (-20% on October 19th). 3 The regime switching model is based on Markov chain, which is a statistical process to determine the probability of switching from one state to another given the probability of remaining in the current state.

3 HERMES MULTI-ASSET 3 Major Regimes Regime Start Date Years Correlation 1 Aug Oct Mar Sep [ ] Data sources: US equities: From January 1988, S&P 500 Total Return Index. From Feb 1962 to January 1988, we used the S&P 500 Index with the total return component estimated using average dividends from 1988 through 2017 (2.2% p.a.). Before Feb 1962, we used AQR s US Equity return series. US bonds: From February 1999, Bloomberg Barclays US Government 10 Year Term Total Return Index. Before February 1999, we estimated the total return using the 10-year yield, duration and estimated coupon. While regime-switching models can be effective in helping us make sense of the past, they are less useful in identifying future shifts. However, understanding which factors drive such shifts can help us forecast the future. TRACKING THE STOCK-BOND CORRELATION Several academic and practitioner studies 4 show that at a fundamental level, the key factors driving the prices of stocks and bonds are risk aversion, which affects the equity risk premium (ERP); inflation and expected real policy rates, which affect the bond term premium; and to a lesser extent, economic growth. Stocks and bonds have an analogous sensitivity to inflation and real policy rates, and opposing sensitivities to growth and risk aversion. Our analysis of the relationship of the stock-bond correlation with these factors is largely in line with the existing literature, and is presented in figure 2. We show the forward-looking three-year regression analysis of correlations from 1951, when the US Treasury and Federal Reserve agreed to separate government debt management from monetary policy, laying the foundation for the modern Fed. 5 3 R 2 : A statistical measure that represents the percentage of the stock-bond correlation that can be explained by changes in the variable. R-squared values range from zero to one, with an R-squared of one meaning that all movements of the correlation are completely explained by movements in the variable. Source: Bloomberg. Hermes computation as at October % 60% 40% 20% 0% -20% -40% -60% -80% -100% -120% 12/ / / / / / / / / / / / / / / / / / / / / / / / / / /2013 Rolling Correlation (36m) Regression fit Dependent variable: forward-looking three-year stock-bond correlation aversion: forward-looking three-year volatility of stocks Policy rate: forward-looking three-year short-term rate minus inflation : forward-looking three-year average inflation (CPI YoY) Growth: forward-looking three-year average growth (read GDP YoY) Even so, an R 2 of just 0.52 highlights that a simple linear regression on these factors does not tell the full story it explains just over half of the relationship. The crucial point is that the stock-bond correlation is unstable: it is a function of which factor dominates the relationship at any point in time and this is, in turn, dependent on the prevailing economic regime. Perhaps the best way to describe this is through a graphical representation: Figure 3. How economic conditions and factors drive the stock-bond correlation Figure 2. Stock-bond correlation, 1951-present Aversion Real Policy Rate Growth Rising inflation Policy rate and inflation dominate Correl(S,B)>0 31/01/ /10/ 2014 Coefficient T-Stat r Co-efficient: represents the gradient of the regression line. It is a measure of how much the change in the stock-bond correlation can be explained by the difference in the variable (risk aversion, policy rate, inflation and growth) in question. A beta of one indicates that the stock-bond correlation is fully explained by the variable, while zero indicates no explanation. Slowing inflation Policy rate and equity risk premium dominate Correl(S,B)>0 Slowing Growth AcceleratingGrowth Growth 2 T-stat: a measure of the statistical significance of the coefficient. The greater the T, the higher the confidence level, and scores greater than two indicate a statistically significant relationship. For illustrative purposes only. 4 See references on p.9 for a list of selected readings. 5 Starting in 1926 would yield similar results, in terms of the sign, significance and relative importance of each factor, but the R-squared would be halved.

4 4 HERMES MULTI-ASSET Figure 4. The instability of stock-bond correlations Regime 1 Aversion Real Policy Rate Growth Correlation 31/08/ /09/1952 Coefficient T-Stat r Avg. 21.4% -1.7% 2.3% 4.6% Std. 42.5% 16.0% 15.2% 22.6% 0.13 Regime 2 Aversion Real Policy Rate Growth Correlation 31/10/ /02/1960 Coefficient T-Stat r Avg. 11.7% 1.0% 1.5% 3.1% Std. 3.9% 1.9% 2.6% 2.6% Regime 3 Aversion Real Policy Rate Growth Correlation 31/03/ /08/ /09/ /10/2014 Coefficient T-Stat r Avg. 14.3% 2.1% 4.7% 3.5% Std. 11.8% 6.3% 9.4% 4.7% Regime 4 Aversion Real Policy Rate Growth Correlation Coefficient T-Stat r Avg. 14.4% -0.2% 2.2% 2.1% Std. 15.5% 4.9% 2.3% 4.2% In a market regime characterised by high uncertainty about inflation, inflation is likely to make the stock-bond correlation positive by affecting the term premium (TP); both the prices of stocks and bonds would fall if the TP increases. In such a scenario, the prevalent narrative would be driven by the discount rate. In a market regime characterised by lower inflation and lower yields, the equity risk premium (ERP) would gradually come to dominate the stock-bond relationship, resulting in a negative correlation. In such a scenario, the choice between stocks and bonds would be driven by investors risk appetite and the prevalent narrative would be the flight-to-quality one, characterised by a negative correlation between stocks and bonds. This has been the prevalent narrative in thecurrent regime. Splitting the regression across the four major regimes highlights the coefficient s inherent instability. Real Policy rate is the most stable coefficient, as it is positive and statistically significant (as the T-stat is >2) in all regimes. In other words, the stock-bond correlation increases as the real policy rate rises. aversion shows an inverse relationship in regime 2, 3 and 4; whereby the stock-bond correlation falls as volatility increases. This relationship is more statistically significant in regimes 2 and 4. Strangely, though, this relationship was inverted in regime 1; that is, during this period the stock-bond correlation rose as volatility increased. This may be explained by average risk aversion being extremely high over the 1929 depression and wartime periods. shows a positive relationship in regime 1, 2, and 3; whereby the stock-bond correlation increases as inflation increases. This relationship is more statistically significant in regimes 1 and 3. However, the coefficient was negative in the last regime and was not significant in the second. In regimes 2 and 4, the volatility of inflation was extremely low compared with the other two regimes. In a scenario in which inflation uncertainty is low, the level of inflation seems to be less relevant to the stock-bond relationship. This would suggest that as long as central banks maintain credibility in their ability to control inflation, inflation may continue to be a minor factor. Growth is the least stable of all factors, indicated by both positive and negative coefficients and lower T-stat scores. This finding is consistent with other research on the topic 6.

5 HERMES MULTI-ASSET 5 While no one knows when the market regime will change or what it will change to it can be safely assumed that if the current regime of low growth and lower inflation/policy rates persists, the stock-bond correlation is likely to remain negative. 7 Bonds may still provide positive returns in a scenario of recession or risk aversion, but it would take a deflationary scenario for bonds to replicate the returns they have achieved since So while there is a good argument to be made for accepting lower returns from an asset that can serve as a reliable hedge, bonds are unlikely to provide the same punch they have delivered in the past 20 years as yields are already extremely low. PREPARING FOR A NEW REGIME Let s now consider an alternative scenario characterised by a moderate inflation surprise. There are some similarities between today and the early 1960s. Like today, inflation was low in 1960: it had been averaging 2% over the previous decade; similarly, it has averaged 1.7% over the past 10 years 8. only exceeded 2% in February 1966, a level it stayed above until Compared with 1960, equities look pricier today from an earnings yield perspective, although comparatively less so than both cash and bond yields. In fact, as was the case in 1960, earning yields are higher than bond yields today. Figure 5. Retro style: There are some similarities between the financial conditions of the 1960s and those of today (YoY) GDP (YoY) Short Term Rate Trailing Earming Yield Govt Bond Yield Mar % 4.9% 3.8% 6.1% 4.7% Aug % 4.3% 5.5% 4.6% 6.3% Sep % 2.2% 1.2% 4.7% 2.3% As a direct consequence of the significant uncertainty surrounding inflation from the late 1960s until the early 1980s, the term premium in the yield curve was significantly higher in 1997 than in 1960, contributing to bond yields being substantially higher. Today, bond yields are not pricing in the potential for growth and/or inflation surprises. What s more, the stated intention of central banks to tighten policy gradually is likely to weigh on bond returns. In a recent research note, the Fed estimated the term premium of 10-year Treasuries to be 1% higher if quantitative easing was removed. 9 Moreover, should the US economy embark on a moderate inflationary cycle with uncertainty about inflation picking up, inflation (through the TP) may become a more important factor than risk aversion (through the ERP) in determining the price of stocks and bonds. In such a scenario, the correlation of their returns is likely to turn positive, thereby reducing the diversification benefits of investing in both in a balanced portfolio. As figure 5 shows, the reactivity of bonds to negative stock returns is already decreasing. In a market regime in which bonds generate lower expected riskadjusted returns and potentially reduced diversification benefits, a balanced portfolio could very well be better off without bonds. Figure 5. Average bond returns when stocks are down, January August % 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% -0.8% 31/12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ /12/ week average weekly bond return when stocks are down Bond beta relative to stocks Source: Hermes analysis based on weekly data from the S&P500 Total Return Index and Bloomberg Barclays US Government 10-Year Term Total Return Index, from 10 January to 1992 to 11 November ANALYSIS OF PORTFOLIO RETURNS IN DIFFERENT MARKET REGIMES In this section we compare the returns from investing in stocks or in bonds with the returns achieved by adopting a traditional balanced portfolio (), a risk-focused balanced portfolio ( ) and an actively risk-managed stock-cash portfolio (). The latter is representative of a strategy in which an investor holds just stocks and cash in a variable proportion, with the aim of achieving volatility of 7% (if stock volatility increases, the investor reduces the allocation to stocks and vice versa). We consider such an approach a simple form of active risk management 10. So while the traditional portfolio relies largely on stock-bond diversification 11, the stock-cash portfolio relies largely on active risk management, while risk parity adopts both approaches. We evaluate these three approaches across each of the four regimes we have defined. 6 See reference on p.9 for a list of selected readings. 7 See Illmanen (2003), Stock-Bond Correlations, for extensive analysis of stock and bond returns in different regimes. 8 Through September Brian Bonis, Jane Ihrig, Min We (September 2017), Projected Evolution of the SOMA Portfolio and the 10-year Treasury Term Premium Effect, 10 Some would consider this as reactive risk management whereas in reality, most investors engage in some form of proactive risk management based on forward-looking return considerations. Our goal here is simply to attempt to make a distinction between pure asset diversification and pure active risk management. 11 To some extent, the traditional portfolio also carries a value bias as it reallocates from the asset that has outperformed to the asset that has underperformed prior to each rebalancing period.

6 6 HERMES MULTI-ASSET Figure 6. Regime 4 ( ): The golden age for stock-bond balanced portfolios (CPI) Annualised Return 2.1% 7.3% 6.0% 7.8% 7.3% 4.9% Annualised Volatility 1.3% 14.9% 6.5% 8.4% 5.3% 7.5% Return/Volatility Maximum Drawdown -4% -51% -7% -28% -11% -33% Average Turnover 4% 8% 18% Methodology: Based on monthly data. Stock and bond returns are representative of a buy-and-hold strategy using the S&P 500 Total Return and Bloomberg Barclays US Government 10 Year Term Total Return indices respectively, when available. Where returns are not available, we used the same proxies detailed in Figure 1. The balanced portfolio is based on a split of the same indices. The portfolio is based on equal risk weighting of these indices given their average rolling volatility (using 1 and 3-year look backs). The -Managed Stock-Cash portfolio targets 7% volatility based on average rolling volatility (using 1 and 3-year look backs). No portfolios use leverage and are based on quarterly rebalancing assuming a 20bps gross trading cost. Cash is assumed to yield one-month Libor. During this regime, the correlation between equities and bonds was The spectacular bull market in bonds over the period also meant that the traditional stock-bond portfolio benefited from significantly reduced risk at virtually no cost in terms of returns. These riskreduction effects were greatly amplified by adopting a risk parity approach. In fact, so great was the risk-reduction benefit that risk parity strategies typically used leverage over this period, delivering remarkable results. However, this effectively involved taking a leveraged bet on the stability of the stock-bond correlation or, at the very least, a bet that any changes in the correlation would only occur gradually. The Stock & Cash portfolio substantially underperformed both traditional and risk parity approaches. Figure 7. Regime 3 ( ): When inflation mattered (CPI) 0-40 Annualised Return 4.6% 10.2% 6.6% 9.3% 8.1% 8.7% Annualised Volatility 1.1% 14.5% 8.3% 10.1% 8.3% 7.7% Return/Volatility Maximum Drawdown -1% -44% -20% -28% -16% -22% Average Turnover 4% 11% 18% The stock-bond correlation was 0.31 over this period. The real return of bonds was just half that of in Regime 4, and they were also much less useful in their role as a complementary exposure to equities: while the maximum drawdown experienced by a traditional balanced portfolio was lower than that of a simple investment in stocks, this can be almost entirely ascribed to the reduction of volatility resulting from adding a less volatile asset. In fact, during the worst 10 months for stocks over this period, bonds lost an average of -0.4% per month (see figure 8 below). By contrast, between 1997 and 2017 they gained an average of 1.1% per month in the 10 worst months for stocks. The portfolio, meanwhile, outperformed both alternatives in terms of its risk-adjusted return. It is interesting to note that the key difference between the two periods was that bonds were more volatile in Regime 4, whereas the risk profile of stocks was more consistent.

7 HERMES MULTI-ASSET 7 Figure 8. The decades to be in bonds and those not to Oct % 5.7% -10.7% -4.6% -8.1% Sep % 1.7% -5.6% -1.7% -5.5% Nov % 0.6% -6.1% -3.4% -6.9% Mar % 1.2% -5.4% -2.9% -4.5% Aug % -2.8% -6.4% -4.6% -3.2% Oct % -2.2% -6.3% -3.9% -4.4% Apr % -4.7% -7.2% -6.4% -4.6% Aug % -1.0% -5.5% -3.2% -4.3% May % 0.0% -4.9% -2.2% -5.9% Sep % -2.6% -6.0% -5.3% -4.7% Average -10.7% -0.4% -6.4% -3.8% -5.2% Oct % -0.7% -10.4% -5.6% -9.3% Aug % 4.4% -6.0% -0.6% -7.4% Sep % 4.1% -4.2% 0.4% -4.5% Feb % -1.0% -6.5% -3.9% -4.1% Feb % 1.4% -4.6% -0.8% -3.4% Sep % 0.0% -5.1% -2.8% -5.1% Jun % 1.0% -4.5% -2.1% -5.7% Jan % -3.9% -6.6% -5.4% -4.5% Sep % 2.5% -3.4% 0.6% -2.7% May % 2.8% -3.4% -0.3% -3.3% Average -10.4% 1.1% -5.5% -2.0% -5.0% Figure 9. Regime 2 ( ): When bond returns disappointed (CPI) Annualised Return 1.3% 16.6% 0.8% 10.7% 6.0% 11.7% Annualised Volatility 1.0% 11.4% 5.1% 6.7% 4.4% 7.4% Return/Volatility Maximum Drawdown -1% -15% -11% -9% -7% -8% Average Turnover 5% 11% 18% During this period, the stock-bond correlation was -0.24, and yet bond returns were lower than the rate of inflation. So while they fulfilled their role as a hedge to equities, this protection was expensive. As a result, risk parity performed poorly over this period, while the stockcash portfolio outperformed both the traditional balanced and risk parity approaches in absolute terms. The traditional balanced and stock-cash portfolios were evenly matched in terms of their riskadjusted returns.

8 8 HERMES MULTI-ASSET Figure 10. Regime 1 ( ): A tumultuous period (CPI) Annualised Return 1.9% 5.4% 3.4% 6.4% 4.4% 3.7% Annualised Volatility 2.9% 25.7% 4.1% 15.7% 5.6% 7.8% Return/Volatility Maximum Drawdown -27% -83% -8% -58% -12% -32% Average Turnover 5% 8% 14% During Regime 1, the stock-bond correlation was The combination of asset diversification and active risk management, particularly for the risk parity approach, was helpful in maximising riskadjusted returns. While a traditional balanced portfolio would have outperformed purely from a return perspective, risk parity produced substantially better risk-adjusted returns. The portfolio underperformed over this period. RECOGNISE REGIMES, AND REACT If we compare the three methodologies over the full period from a traditional balanced portfolio would have delivered the highest returns, but also with the highest risk. parity and Stocks & Cash would have delivered similar returns, but risk parity would have achieved better risk-adjusted returns. We can conclude that the prevailing market regime dictates which of the methods is the most appropriate. It is up to investors to choose the right strategy. Figure 11. The long-term performance of balanced portfolios throughout stock-bond correlation regimes (CPI) Annualised Return 3.0% 8.7% 5.1% 8.3% 6.7% 6.7% Annualised Volatility 1.8% 18.1% 6.7% 11.3% 6.8% 7.7% Return/Volatility Maximum Drawdown -27% -83% -20% -58% -16% -33% Average Turnover 4% 9% 17% The relationship between stocks and bonds is not stable through time and is a function of the prevailing economic regime. On a three-year rolling basis the correlation between US stocks and bonds has gone through four major regime shifts since These regimes have tended to be long-lasting, stretching over multiple decades. The apparent stability in the relationship between stocks and bonds during these periods may have caused investors to invoke the narrative of the time as an absolute truth. Regime shifts are hard to predict. Equally valid arguments can be made about whether the regime in which we currently find ourselves the lower-for-longer narrative will continue, and investors are more concerned with economic growth than inflation risks. In a regime where bonds produce lower expected risk-adjusted returns and potentially reduced diversification benefits, like in regimes 2 and 3, a balanced portfolio could very well be better off without bonds. In such a scenario, an actively risk-managed stock-cash portfolio has the potential to deliver more attractive risk-adjusted returns. In other words, maintaining a stock-bond allocation is an implicit bet that the current regime will persist, while moving to a stock-cash portfolio is an implicit bet on a switch to a more volatile inflationary regime. A prudent approach could be to adopt a mixed strategy.

9 HERMES MULTI-ASSET 9 WHAT ARE THE ALTERNATIVES TO BONDS? This analysis has focused on the stock-bond relationship to make the point that while it has served investors well for a long time, it is no substitute for active risk management as indicated by the strong riskadjusted returns of the risk parity and stock-cash portfolios over the entire period. Most multi-asset portfolios today are dominated by assets from developed markets and constructed based on the negative correlation between stocks and bonds. And yet with growth and inflation regimes across developed economies becoming increasingly synchronised, diversification across developed markets may offer little benefit when the correlation reverses. Allocating to emerging markets may help investors better diversify their portfolios as they provide exposure to different inflation and growth dynamics. As part of our own active risk management, we determine the sensitivity of assets to major factors such as growth, inflation, risk aversion and policy rates. In our asset allocation, we have supplemented bonds with alternative sources of decorrelation such as cross-asset momentum and relative-value strategies, representing a more diverse set of tools to maintain the diversification of a balanced portfolio across different market regimes. REFERENCES Andersson, Krylova, Vähämaa (2008) Why does the correlation between stock and bond returns vary over time?, Applied Financial Economics Bonis, Ihrig, We (September 2017), Projected Evolution of the SOMA Portfolio and the 10-year Treasury Term Premium Effect Illmanen (2003), Stock-Bond Correlations, The Journal of Fixed Income, 13 (2) Kahneman (2012), Thinking Fast and Slow Baele, Bekaert, Inghelbrecht (2009), The Determinants of Stock and Bond Return Comovements, NBER Working Paper Series Johnson, Naik, Pedersen, Sapra (2013), The Stock-Bond Correlation, Pimco Quantitative Research Rankin, Shah Idil (2014), A Century of Stock-Bond Correlations, Reserve Bank of Australia Taleb (2007), The Black Swan: The Impact of the Highly Improbable Summary of previous research pieces Asset allocation: in defence of complexity, Q The value provided by active relative to passive asset allocation methodologies seems to have vanished Our analysis suggests that such value is cyclical and tends to cluster around market inflection points A comprehensive shift to passive asset allocation strategies would carry the risk of being short-sighted Portfolio construction methodologies: looking beyond the good, the bad and the ugly, August 2015 No portfolio methodology is wholly superior across market regimes As is very much the case for any asset, they are subject to biases and cyclicality There is significant value in diversifying risk across different methodologies tracking the spectre stalking your portfolio, February 2015 Different assets respond differently to different inflationary environments No asset can deliver consistent real returns across market regimes This calls for a diversified, dynamic solution

10 10 HERMES MULTI-ASSET APPENDIX We have identified four major stock-bond correlation regime shifts in the UK since Figure 1. Stock-bond correlation regimes in the UK Correlation 100% 80% 60% 40% 20% 0% -20% -40% -60% Stock-Bond Correlation Regimes (Forward looking by 36 months) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Probability of Negatively Correlated Regime Major Regimes Regime Start Date Years Correlation 1 Feb Nov Dec Sep [ ] UK Equity: From January 1986, FTSE All-Share Total Return Index. Before January 1986, we used the FTSE All-Share Index with the total return component estimated using average dividends from 1986 through 2017 (0.3% p.a.). UK Bonds: From January 1992, Bloomberg Barclays UK Government 7-10 Years Total Return Index. Before January 1992, we estimated the total return using the 10-year yield, duration and estimated coupon. -80% 0% Rolling Correlation (36m) Negatively Correlated Regime Figure 2. Regimes 2 ( ) and 4 ( ): The golden age for stock-bond balanced portfolios Regime 2: (RPI) UK Stocks (ASX Index) UK Bonds Annualised Return 4.2% 20.4% 13.0% 18.7% 15.0% 16.7% Annualised Volatility 1.5% 22.9% 5.5% 14.1% 8.0% 11.2% Return/Volatility Maximum Drawdown 0% -34% -4% -19% -8% -16% Average Turnover 4% 8% 13% Regime 4: (RPI) UK Stocks (ASX Index) UK Bonds Annualised Return 2.8% 7.5% 6.7% 7.8% 7.6% 6.1% Annualised Volatility 1.3% 13.4% 5.3% 8.0% 5.1% 7.7% Return/Volatility Maximum Drawdown -4% -43% -7% -21% -6% -25% Average Turnover 4% 9% 20% Methodology: Based on monthly data. Stock and bond returns are representative of buy-and-hold investments in the FTSE All-Share and Bloomberg Barclays UK Government 7-10 Years Total Return indices respectively. The traditional balanced portfolio is based on a split between equities and bonds. The risk-parity portfolio is based on equal-risk weighting of equities and bonds based on their average rolling volatility (using 1 and 3-year look backs). The risk-managed stock-cash portfolio targets 7% volatility based on average rolling volatility (using 1 and 3-year look backs). All portfolios use no leverage and are based on quarterly rebalancing assuming a 20bp gross trading cost. During these periods, the stock-bond correlations for regimes 1 and 2 were 0.10 and respectively. As in the US, the bull market in UK bonds has enabled the traditional portfolio to outperform and the risk-parity portfolio to deliver remarkable risk-adjusted results. The stock-cash portfolio has underperformed during regime 4.

11 HERMES MULTI-ASSET 11 Figure 3. Regimes 1 ( ) and 3 ( ): When inflation mattered Regime 1: (RPI) UK Stocks (ASX Index) UK Bonds Annualised Return 11.8% 12.2% 11.6% 13.5% 12.9% 12.0% Annualised Volatility 2.6% 26.7% 6.9% 17.3% 9.0% 8.2% Return/Volatility Maximum Drawdown 0% -67% -6% -46% -16% -19% Average Turnover 6% 9% 13% Regime 3: (RPI) UK Stocks (ASX Index) UK Bonds Annualised Return 4.9% 15.6% 11.3% 14.4% 13.0% 12.8% Annualised Volatility 1.9% 15.8% 6.2% 10.9% 7.3% 6.3% Return/Volatility Maximum Drawdown -1% -27% -12% -14% -12% -12% Average Turnover 4% 12% 22% During these periods, the stock-bond correlations were 0.46 ( ) and 0.51 ( ). The drawdowns experienced by a traditional portfolio were lower than a simple investment in stocks. The stock-cash portfolio outperformed both other approaches in terms of risk-adjusted returns. Figure : targeting was a valid option for the full period (RPI) UK Stocks (ASX Index) UK Bonds Annualised Return 5.7% 10.8% 9.3% 11.1% 10.4% 9.4% Annualised Volatility 2.1% 19.0% 6.0% 12.2% 7.0% 7.9% Return/Volatility Maximum Drawdown -4% -67% -12% -46% -16% -25% Average Turnover 4% 9% 18% Comparing the three methodologies over the full period under examination, we found that the traditional balanced portfolio produced the highest returns but also the highest level of risk. would have generated the most attractive risk-adjusted returns followed by Stock & Cash. As was the case with US equities, the market regime dictates which of the methods is the most appropriate.

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