Mastering the New World of Advanced Asset Allocation Michael Nairne, CFP, CFA
Our Agenda Alpha Beta Separation Serving the Free Lunch Asset Liability Management A Taxing Matter Integrating Strategic and Dynamic AM Practice Advice Q&A
Beta Seems to Offer so Little Long-Term Real Returns IA SBBI S&P 500 Infl Adj TR USD IA SBBI US LT Corp Infl Adj TR USD IA SBBI US IT Govt Infl Adj TR USD IA SBBI US 30 Day TBill Infl Adj TR USD 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% Arithmetic Mean Geometric Mean Source: Ibbotson Associates, January 1926 to March 2009
The Alpha Reality The Sum Total of All Alpha is Zero
Management Performance Isn t Persistent How Top Quartile Managers Over Three Year Rolling Periods Performed in the Subsequent Three Years from December 1985 to December 2005. Source: https://www.alliancebernstein.com/cmsobjectab/research/value/pdfs/i_val_the%20perils%20of%20past%20performance_nd_080709.pdf
The Strategy of a $108.9 Billion Investor Our primary approach to equity investing is to create a portfolio that replicates the composition of major stock markets. Replicating broad market indexes is a cost effective approach for a long-term investor... In addition, our active overlay program places a layer of active selection over our public equity portfolio... - CPP Investment Board
What About $164.9 Billion? CalPERS is one of the largest institutional investors in both the U.S. and international stock markets. A large portion of our money invested in stocks is passively managed....our belief is that the market is relatively l efficient and that it is dff difficult to add value with active management. We do maintain some active equity management in areas where there appears to be the potential for managers to add value. - CalPERS
Institutional Investors Combine Beta and Alpha Source: Benefits Canada
The Beta Alpha Continuum Activeness Expected Return 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 Alternative Beta Quant Models Long Only Hedge Funds Private Equity 1.0 Classic 0.0 Beta -1.0 0.0 3.0 6.0 9.0 12.0 15.0 18.0 21.0 24.0 27.0 30.0 33.0 36.0 40.0 Standard Deviation (Risk) Alpha Quest
Alternative Beta Shows Up as Alpha Asset Class Alpha (%) T Statistic Beta IA SBBI S&P 500 TR USD 0 4.9683 1 IA SBBI US Small Stock TR USD 2.4352 4.574 1.2635 Fama-French Large Value TR USD 0.9377 4.5561 1.1964 Fama-French Small Value TR USD 3.6877 5.014 1.2771 Source: Analysis by Tacita Capital August 1927 February 2009
Alternative Beta Used to Be Alpha Arithmetic Mean 15.0% 14.0% 13.0% 12.0% 11.0% 10.0% 9.0% Alternative Beta - Returns and Risk August 1927 - February 2009 Fama-French Small Value TR USD REAL IA SBBI US Small Stock TR USD REAL Fama-French Large Value TR USD REAL 8.0% IA SBBI S&P 500 TR USD REAL 7.0% 20.0% 22.0% 24.0% 26.0% 28.0% 30.0% 32.0% 34.0% Source: Analysis by Tacita Capital Standard Deviation
High Dividend Yield is Alternative Beta High Dividend Yield vs. Value January 1997 - March 2009 Geometric Mean 6.0% 5.5% S&P SmallCap 600/Citi Value TR 50% 5.0% Russell Mid Cap Value TR USD 4.5% Russell 2000 Value TR USD Morningstar Dividend Leaders TR USD 4.0% 35% 3.5% Russell 1000 Value TR USD 3.0% Morningstar Dividend Composite TR USD 2.5% S&P 500 TR 2.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% Standard Deviation Source: Analysis by Tacita Capital
Beta Separates from Alpha Core Component Beta Alternative Beta Liability Matched Bonds Satellite Component Alpha Search Low Correlation Strategies Non indexable Assets Idiosyncratic Active Managers Alternative Investments
Alternative Beta and Alpha Diversify Asset Class/Strategy N Periods Correlation to S&P/TSX Composite TR S&P/TSX Composite TR 638 1.0000 MSCI EAFE Small Cap USD CAD 195 0.5758 Credit Suisse Tremont Long Short Equity CAD 183 0.4607 FTSE NAREIT Equity REITs TR CAD 447 0.4040 S&P GSCI TR CAD 470 0.1195 West Texas Crude Oil BL CAD 589 0.04300430 London Fix Gold AM PR CAD 266-0.0987 Credit Suisse Tremont Global Macro CAD 183-0.0061 Credit Suisse Tremont Multi-Strategy CAD 180-0.2099 Credit Suisse Tremont Managed Futures CAD 183-0.3037 Source: Analysis by Tacita Capital
The Objective is a More Efficient Portfolio Expected Return 1.0 Core and Satellite Mix 0.9 Basic Asset Mix 0.8 0.7 0.6 05 0.5 0.4 0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 4.4 4.8 5.2 5.6 6.0 Standard Deviation (Risk) Source: Optimization Analysis by Tacita Capital Inc. Monthly Statistics for the 15 Year Period from Sept 93 to Aug 08. Based on Actual Indices except Hennessee Hedge Fund Index is reduced by.2% a month
The Free Lunch Is Highly Diversified Expected Return 1.0 0.9 0.8 0.7 Hennessee HF TR USD 0.6 TSX DEX Univ Overall Bond TR Core and Satellite Mix Basic Asset Mix MSCI Canada Value TR S&P/TSX Composite TR 05 0.5 TSX DEX ST Overall Bond TR MSCI EAFE TR in CA$ FTSE NAREIT Equity REITs TR CAD S&P SmallCap 600 TR CAD MSCI U.S. Small Cap Value TR CAD NB Canada Small Stk TR MSCI EM CAD S&P 500 TR CAD MSCI U.S. Value TR CAD MSCI EAFE Value TR CAD 0.4 0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 4.0 4.4 4.8 5.2 5.6 6.0 Standard Deviation (Risk) Source: Optimization Analysis by Tacita Capital Inc. Monthly Statistics for the 15 Year Period from Sept 93 to Aug 08. Based on Actual Indices except Hennessee Hedge Fund Index is reduced by.2% a month
We Aren t Really In the Asset Business Every Goal Is a Future Liability
Traditional Mean Variance Analysis Efficient Frontier Expected Return 18.0 17.0 Fama-French French Small Value TR USD 16.0 15.0 IA SBBI US Small Stock TR USD 14.0 13.0 Fama-French Large Value TR USD 12.0 11.0 IA SBBI S&P 500 TR USD 10.0 9.0 80 8.0 7.0 IA SBBI US LT Corp TR USD 6.0 IA SBBI US LT Govt TR USD 5.0 IA SBBI US IT Govt TR USD 4.0 3.0 IA SBBI US 30 Day TBill TR USD 2.0 0.0 3.0 6.0 9.0 12.0 15.0 18.0 21.0 24.0 27.0 30.0 33.0 36.0 40.0 Standard Deviation (Risk) Source: Optimization Analysis by Tacita Capital Inc. Monthly Statistics for the Period from August 1927 to February 2009.
Weights 100.0% 90.0% 0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% Looking at the Frontier Asset Mix Frontier Area Graph - Historic Optimization 0.0% 0 10 20 30 40 50 60 70 80 90 100 Position IA SBBI US 30 Day TBill TR USD IA SBBI US IT Govt TR USD IA SBBI US LT Govt TR USD IA SBBI US LT Corp TR USD IA SBBI S&P 500 TR USD Fama-French Large Value TR USD IA SBBI US Small Stock TR USD Fama-French French Small Value TR USD
Asset Liability Modelling Optimizes the Surplus Efficient Frontier Expected Surplus 12.0 11.0 Fama-French Small Value TR USD 10.0 9.0 IA SBBI US Small Stock TR USD 80 8.0 7.0 Fama-French Large Value TR USD 6.0 5.0 4.0 IA SBBI US LT Govt TR USD IA SBBI S&P 500 TR USD 30 3.0 2.0 1.0 0.0 IA SBBI US LT Corp TR USD -1.0 IA SBBI US IT Govt TR USD -2.0 20-3.0 IA SBBI US 30 Day TBill TR USD -4.0 0.0 3.0 6.0 9.0 12.0 15.0 18.0 21.0 24.0 27.0 30.0 33.0 36.0 40.0 Surplus Standard Deviation (Risk) Source: Surplus Optimization Analysis by Tacita Capital Inc. Monthly Statistics for the Period from August 1927 to February 2009.
A Very Different Asset Mix Weights 100.0% 0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 0% 20.0% 10.0% Frontier Area Graph - Historic Optimization 0.0% 0 10 20 30 40 50 60 70 80 90 100 Position IA SBBI US 30 Day TBill TR USD IA SBBI US IT Govt TR USD IA SBBI US LT Govt TR USD IA SBBI US LT Corp TR USD IA SBBI S&P 500 TR USD Fama-French Large Value TR USD IA SBBI US Small Stock TR USD Fama-French Small Value TR USD
ALM is Replacing Simple AA Planning Goal-based planning Hierarchy and term structure t of liabilities Historic simulations Stochastic models (e.g. Monte Carlo analysis) Investments Time-horizon funds Cash flow matching (e.g. laddered bonds) Structured notes Annuities Guaranteed income products Reverse mortgages g
Tax Planning Must Be Integrated Wealth Planning Portfolio Management Investment Management
Two Frontiers Exist Pre-Tax & Post-Tax Expected Return International Equity CAD PRE-TAX FRONTIER US Equities CAD Canadian Equity Bonds 10.0 95 9.5 9.0 8.5 8.0 Cash 7.5 7.0 POST-TAX FRONTIER 6.5 6.0 5.5 50 5.0 Bonds 4.5 4.0 3.5 3.0 Cash Canadian Equity US Equities CAD International Equity CAD 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 22.0 Standard Deviation (Risk) Source: Historic Optimization by Tacita 1980 to 2006. Taxes are estimated based on current rates. Annual returns and SDs.
Looking Under The Pre-Tax Frontier Weights 100.0% 90.0% 0% 80.0% 70.0% 60.0% 0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0 10 20 30 40 50 60 70 80 90 100 Position Cash Bonds Canadian Equity US Equities CAD International Equity CAD Source: Historic Optimization by Tacita 1980 to 2006. Taxes are estimated based on current rates. Annual returns and SDs.
The Post-Tax Asset Mix Changes Materially Weights 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0 10 20 30 40 50 60 70 80 90 100 Position Cash Bonds Canadian Equity US Equities CAD International a Equity CAD Source: Historic Optimization by Tacita 1980 to 2006. Taxes are estimated based on current rates. Annual returns and SDs.
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A Marriage of Strategic and Dynamic Rebalances to target allocation Assumes changes in investor s risk tolerance Buy and Hold Strategic Dynamic Integrated No Yes Yes Yes Yes No No Yes Anticipates No No Yes Partial changes in capital markets Works best in Trending Oscillating Strategy Dependent Allocation Dependent Source: Adapted from Fundamentals: The Benefits of Asset Allocation and Rebalancing, UBS Financial Services Inc. www.ubs.com/nancialservicesinc
Practice Advice Examine your investment philosophy Shift to a beta alpha portfolio structure Transition to a fee only ypractice Assess platforms and alliances Improve your asset liability planning tools Integrate tax and investment planning Evaluate dynamic options Revise your value proposition
In Conclusion It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change. - Charles Darwin
Contact Information Michael Nairne 416-640-9961640 mnairne@tacitacapital.com
Disclaimer The information contained herein was obtained from sources believed to be reliable but we cannot represent that it is accurate or complete. Neither the information nor any opinion expressed constitutes a solicitation by Tacita Capital Inc. for the purchase or sale of any securities or financial products. Management fees and expenses are associated with investing. The analysis contained in this presentation ti is for illustration ti purposes only. Past performance is not indicative of future results. All investments involve risk including loss of principal.