Building a Balanced Portfolio in an Environment of Expensive Defensives Leigh Gavin Frontier Advisors
Agenda The Challenge of Expensive Defensives Are there any cheap defensives left? Investing in Volatility Potential role of volatility strategies Volatility strategies Vanilla volatility Variations on the theme Conclusions 2
The Challenge of Expensive Defensives The challenges of building a diversified portfolio (of liquid assets at least) in the current environment Australian Equities Forward Earnings Yield versus 10 Year Bond Yield Yield (%) 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Yield (%) 10.0 US Equities Forward Earnings Yield versus 10 Year Bond Yield 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 3 Source: Datastream, IBES IBES Australian Index Forward Earnings Yields Aust Govt 10-Year Nominal Bond Yields S&P 500 Forward Earnings Yield US Govt 10-Year Nominal Bond Yields
The Challenge of Expensive Defensives Relative pricing of growth and defensive assets is as wide as it has ever been Hence the temptation to increase exposure to growth assets (e.g. listed equities) However, most funds still need to build a balanced portfolios (or at least a balanced growth portfolio) And be cognisant of the left-tail risks of an increasingly growthy portfolio (especially post-gfc) This issue of expensive defensives is a challenge for all investors at present And the risk is that investors get squeezed into equities, due to a lack of suitably valued alternatives Funds may also have an upper limit on illiquidity, exacerbating the squeeze 4
The Challenge of Expensive Defensives The investment recommendations made by many financial commentators are now dominated by cross-asset class relative valuation rather than the fundamentals of the investment itself. A typical refrain runs something like this: buy X because it is cheaper than other things out there. This is an understandable approach as unusual central bank activism has artificially elevated certain asset prices. Yet the dominance of this increasingly popular advice comes with potential risks that need to be well understood and well managed. Mohamed El-Erian, Beware the central bank put, Financial Times, 7 January 2013 5
The Challenge of Expensive Defensives Many imperfect defensive assets (e.g. credit, high quality property and infrastructure) are also being increasingly priced off record low bond yields % 20.0 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 6 Source: Bloomberg, Datastream, NAREIT, Credit Suisse Jan-04 Jan-05 Bank Loan Current Yield (US$) ASX 200 A-REIT Div. Yield (A$) US AAA (Moody's) Corporate Bond Yields (US$) US 10Y Govt. Bond (US$) Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 US High Yield (US$) NAREIT Div. Yield (US REITs) (US$) US BAA (Moody's) Corporate Bond Yields (US$)
The Challenge of Expensive Defensives And in a yield-seeking world, have we returned to the cavalier days of good ol 2006/07? Here we go again??? Source: Datastream, Credit Suisse Excerpt from a US Real Estate Fund Teaser Fund XYZ is targeting a mid-teens (14-16%+ p.a.) gross IRR with a high current income component from inception while maintaining conservative leverage of 60% of total cost 7
Are there any cheap defensives left? One asset class that is relatively inexpensive at present is volatility Australian VIX versus ASX 200 1999 to present US VIX versus S&P 500 1999 to present Source: Bloomberg Source: Bloomberg The most obvious strategy to invest in volatility is to purchase VIX Futures (and related ETFs) The most commonly used derivative to capitalise on cheap volatility is to buy put options on an equities portfolio - insured equities or protected equities 8
Investing in Volatility Investing in Volatility could take various forms, for instance: A simple long volatility investment (i.e. buying VIX futures) Or active management on a long volatility investment Variations on the theme: Using options to put a floor under equity returns Or active hedging/tail-risk hedging overlays Hedge fund strategies (e.g. CTAs, some Global Macro strategies) Investing in equities strategies that typically benefit from low volatility (e.g. minimum variance) 9
Potential role of volatility strategies Volatility strategies have specific roles at certain times or for certain members, for instance: Using Long Volatility Strategies as a proxy for bonds Using protected equities in a DAA role as a less-growthy asset class For members in or approaching the retirement phase who have a low tolerance for left-tail risk For funds who have serious concerns about the consequences of (another) catastrophic market event and returns All about trade-offs Can the cost of portfolio protection be borne? Can slightly lower returns over the long-term can be justified in exchange for some portfolio protection in extreme events? Are you prepared to give up some of the right-tail for left-tail protection? Long volatility strategies and buying put options (somewhat of a variation on the theme) are generally unprofitable strategies over the long-term 10
Investing in Vanilla Volatility The most obvious strategy to invest in volatility is to purchase VIX Futures (or related ETFs) The VIX is listed on the CBOE, based on real-time prices of S&P 500 30-day options VIX Futures are relatively simple, transparent and cheap However: Only gives exposure to implied volatility, not realised volatility Generally a highly unprofitable strategy over the long term (due to negative carry ) Basis risk to the S&P 500 and larger basis risk to other equities markets The VIX is an entirely artificial asset class with no tangible value, pricing is almost entirely driven by capital flows Therefore, not deemed a suitable strategy, at least most of the time and at least not passively Active (but still Long-Only) Volatility Strategy Can look for points in the curve where the slope may be flatter (e.g. further out in time) to reduce the negative carry, or look to other asset classes, or relative value trades to a limited degree 11
Volatility variations on the theme Hedge Funds/Absolute Return Strategies Some strategies typically benefit from a move from low to high volatility, and/or have low equity market beta. For instance: Managed Futures/CTAs 1 Strategies typically perform well in strongly negatively trending markets Global Macro Very manager-specific and defensive characteristics depend on the manager s style and product design, but the manager generally has the ability to change the Portfolio very quickly, can short, and can therefore profit from falling equity markets and mispricing opportunities Multi-Strategy Main benefit is diversification, but some are designed to exhibit a low (or even negative) equity market beta Dedicated Short Biased Equity Generally not a profitable strategy through time, but clearly negatively correlated to equity markets. Equity Market Neutral May have low correlations to equities (although this wasn t the case in 2008) For investors with fee constraints, alternative beta strategies may combat this while still capturing the desired risk premia (e.g. CTAs) but without the alpha. Fees still not cheap however (circa 0.5% - 1.0% + 10%) 12 1. CTAs Commodity Trading Advisors, although today s CTA managers typically invest in multiple asset classes, more than just commodities.
Volatility variations on the theme (cont d) Hedge Funds/Absolute Return Strategies Some correlation between some hedge fund strategies and the VIX Index through time Credit Suisse/Tremont Hedge Fund Indices versus US S&P 500 and US VIX Index 13 Source: Bloomberg, Credit Suisse
Volatility variations on the theme (cont d) Buying put options over equity portfolios The clearest way to build a floor under equity returns (or tail-risk hedging) Our modelling suggested an ASX 200 Protected Portfolio (with 90% put options) would have underperformed the ASX 200 by only 0.5% p.a. (7.7% vs 8.2% p.a.) over the 14 years to June 2011 With lower volatility (10.0% p.a. versus 13.3% p.a. standard deviation) But, it had underperformed by 1.7% p.a. for the ten years to December 2007 A protected portfolio will likely have inferior returns to vanilla equities over the long-term, as will an equities/bonds portfolio 14 ASX 200 versus Protected Portfolio and a 75/25 Equities/Bonds Portfolio Rolling 12 month Returns Source: Citi, Bloomberg, Frontier calculations
Volatility variations on the theme (cont d) 15 With the VIX very low, pricing is lower than average at present The long-term return leakage always sounds expensive, but Could an investor use some of the current circa 30%+ ASX 200 rally to buy insurance on the ASX 200? Could an investor consider using some of the 1.5% - 2% yield premium (before franking credits) over cash/bonds to buy insurance? Equity Index Option Quotes at 7 May 2013 (source: Citi Research) MSCI World ex-aust Total Return Index 1 US S&P 500 Total Return Index 1 Aust. S&P/ASX 200 Accum. Index 100% strike puts, with expiry: 19-Sep-13 3.50% 3.56% 3.19% 19-Dec-13 4.65% 4.88% 4.08% 19-Jun-14 6.64% 7.21% 5.39% 90% strike puts, with expiry: 19-Sep-13 1.16% 1.12% 1.06% 19-Dec-13 2.01% 2.00% 1.66% 19-Jun-14 3.62% 3.79% 2.75% 1. Foreign indices include an estimate of the $A conversion
Volatility variations on the theme (cont d) Historical comparisons There are clearly times where one would be far better selling rather than buying insurance 12 month puts remain relatively expensive versus 3 month puts (although less so than early-2013) General consensus is that participants aren t worried about 2013 insurance (as central banks are providing it), so implied volatility is higher in 2014+ Relative pricing of put options (relative to calls) is also becoming more favourable ASX 200 12 month European Put Options: Pricing at 85, 90% and 95% levels ASX 200 European Put Options: Time Spreads (3m vs 12m) and Skew (Put/Call pricing) 16 Source: Citi Research, Goldman Sachs
Volatility variations on the theme (cont d) Active hedging/tail-risk hedging overlays Either over equities or the entire portfolio, such as: Target volatility Adjusts the exposure of a growth portfolio to be less risky when equity volatility rises Market Regime Indicators Tries to identify regimes and specific portfolios for each regime Tail-risk Protection Extends on the options overlay concept as discussed, but may include options on bonds, currencies, etc. TAA Overlay Adjusts the exposure of a growth portfolio based on risk, return or other (e.g. momentum) models Most overlays tend to be momentum-based, which could be a good complement to a more valuation-based SAA/DAA process, but could also get whipsawed Most TAA strategies have historically not performed well over the long-term Lower Beta options within equities products There is an increasing number of lower beta versions of an Australian Equities Manager s flagship fund (via wider cash limits and/or derivatives overlay) With a sufficient size mandate, Beta (and left-tail protection) can be tailored to the client s requirements, within the mandate 17
Volatility variations on the theme (cont d) Minimum Variance Our research to date has found the optimal time to enter Min. Variance strategies within global equities portfolios tends to be when the VIX is low However, when the VIX is this low, defensive stocks tend not to be so relatively expensive ASX 200 Forward P/E Ratios by Sector (as at May 2103) S&P 500 Forward P/E Ratios by Sector (as at May 2013) 18 Source: Citi Research Source: Factset
Conclusions The issue of expensive defensives is perhaps the single biggest challenge facing institutional investors in 2013 And how to build a diversified portfolio in this environment All cross-asset class comparisons (e.g. the equity risk premium) point to higher allocations to growth assets (e.g. listed equities) However, the squeeze into equities may ignore the fundamentals of the asset class itself The flight to yield is seeing valuations expand/yields compress all over the world And potentially some return to the cavalier 2006/07 days (e.g. declining covenants on loans, leveraging up yield, etc.) Here we go again??? 19
Conclusions (cont d) In lieu of attractively valued defensives (e.g. sovereign bonds with duration), there is no one solution But rather a toolkit of solutions that could be used by institutional investors Which tool suits will likely be driven by the investor s tolerance for liquidity, higher fees, higher complexity, peer risk, ability to bear a slightly lower long-term return for left-tail protection, etc. etc. Our preferred option remains unlisted infrastructure and property, which should also provide some inflation protection (given the uncertain outlook for inflation) But many funds are at their upper limit of illiquidity And watch valuations (as seen by recent transactions) For clients who don t want to/can t take on more illiquidity risk, our preferred option is higher allocations to alternative strategies (e.g. some hedge fund strategies, where MER budgets will allow) and a watching brief on protected equities, especially as equity valuations continue to rise 20
Long versus short volatility Before we discuss the options, it is important to explain both sides of the asset class Consider volatility as a form of insurance contract, where those who are long volatility own the insurance contract, and those who are short volatility provide the insurance (and bear the left-tail risk) The same applies to option contracts A long volatility strategy will generally be unprofitable over the long-term (especially in a buy & hold approach) Those providing the insurance need to be incentivised to do so, so they underwrite left-tail events to occur more frequently than they do i.e. The implied volatility in a 90% put option (i.e. 10% out of the money) implies a -10% fall in the stock market occurs more often than it actually does (i.e. realised volatility) Difference between implied and realised volatility is the volatility risk premium However, most defensive asset classes (e.g. long duration sovereign bonds) come at a cost, relative to growth assets over the long-term And at the moment, that cost is very high 21
Long versus short volatility (cont d) The Volatility Risk Premium Implied Volatility - Realised Volatility = Volatility Risk Premium Averages 2.7% p.a. over the last 30 years Volatility Risk Premium on S&P 500: 1983-2012 22
Volatility Harvesting The more profitable long-term strategy is effectively the opposite strategy (i.e. to be short volatility) i.e. Write (sell) put options, which need to be fully cash backed Would have to be funded from growth assets (e.g. equities) and housed in growth Bears an almost identical left-tail risk as equities, but return profile is foreign to most investors mindset and foreign to the typical growth asset i.e. the left-tail risk with little right-tail potential But, unlike equities, a move sideways scenario (i.e. low & slow growth) is very profitable The writer of a put option makes the same profits whether the S&P 500 returns 0% or 20% p.a. Returns are generally superior to long equities, especially when the cash return on the collateral is added on (as puts are backed by cash) Are you genuinely long-term enough??? S&P 500 versus the Return on a Selling Puts or Buying Calls Strategy Source: GMO, Option Metrics, CME, as at November 2012 Note (from GMO): The performance relating to Puts and Calls represents the performance that would have been obtained by selling puts or buying calls, respectively, solely on the S&P 500. All performance is presented ex-cash. For purposes of removing the cash component from performance, cash rates are assumed to be 3 month USD LIBOR. Those lines that represent included costs assume transaction costs and bid/ask spreads. Those lines that represent no costs exclude transaction costs and bid/ask spreads. Option strike is that closest listed option available to ATM on day of sale. Positions are rolled 2 days before expiration. Options are all 1-month options or durations close to 1 month. Benchmark is a total return index. All returns are in USD. 23