Building Efficient Return Seeking Portfolios Reassessing the Equity Allocation Paul M. Martin, CFA Vice President & Portfolio Manager Phillips, Hager & North Investment Management
Sources of Risk in a Traditional 60/40 Portfolio Canada Bonds Provincial & IG Corp Bonds Equity 0.7% 2.8% 60% of total assets in equities represents 85% of the risk budget! 19.6% Funding status can decrease by 23% in a bad year! Total 23.1% 0% 5% 10% 15% 20% 25% Risk Budget of the Excess Return according to the Annual CVaR 95 (1) Traditional portfolio assumed to be 40% FTSE TMX Canada Long Bond Overall Index, 25% S&P/TSX Capped Composite Index, 35% MSCI World Index (CAD). (2) CVaR 95: Average loss during the worst 5% of historically observed outcomes. (3) PH&N IM analysis using historical data over the period Jan 2001 March 2015. CVaR calculated using the distribution of 12-month rolling returns. (4) Liabilities are assumed to have an approximately 15-year duration as at March 31, 2015. Liability returns are approximated by using a set of assumed plan cash flows and applying the Canadian Institute of Actuaries prescribed discount rate methodology for solvency valuations. (5) This example is for illustrative purposes only and not intended to be representative of the performance of any actual or future investments. 2
De-Risking Multiple Ways to De-Risk 100% Fixed Income! De-Risking Continuum Reduce Interest Rate risk Revisit Equity Portfolio Diversify Return- Seeking Assets Risk Transfer Solutions Higher fixed income exposures Extended duration Different exposures across geography, capitalization, style, smart beta, etc Lower correlation strategies that offset market risk Buy-in / Buy-out Longevity Swaps 3
Low Volatility Equity Strategies Focus To Date Has Been On Returns Large body of research supporting the notion that low volatility stocks and portfolios would have earned higher returns historically Growing body of theory to explain this phenomenon Much of the marketing has focused on this aspect Black, Jensen, Scholes (1972) Haugen, Baker (1991) Fama, French (1992) Clarke, De Silva, Thorley (2006) Ang, Hodrick, Zing, Zhang (2006) Blitz, van Vliet (2007) Baker, Bradley, Wurgler (2010) There has been less research and emphasis on the risk part of the equation 4
Low Volatility Equities as a De-Risking Tool Testing the Robustness Different Definitions of Risk Volatility Drawdowns Prolonged poor returns Different Market and Economic Environments Rising interest rates or inflation Periods of general market stress Methodology Behind Our Low Volatility Equity Simulation Simple minimum variance portfolio Dataset: Canadian equity market prices, dividends, sectors, book value and earnings, January 1957 to March 2015 Simple risk model Sector, security, size limits, trading costs 5
Annualized 3yr Standard Deviation of Monthly Returns Volatility Consistent Reduction 30% Rolling 3 Year Volatility Dec 1962 Mar 2015 25% Low Vol Simulation S&P/TSX Composite Index 20% 15% 10% 5% Dec-62 Dec-67 Dec-72 Dec-77 Dec-82 Dec-87 Dec-92 Dec-97 Dec-02 Dec-07 Dec-12 Note: for illustrative purposes only. S&P/TSX Index is represented by the S&P/TSX Capped Composite for the time periods where the capped existed, and the S&P/TSX Composite Index for the periods prior 6
1yr Loss of Value Drawdowns More Resilient than the Broad Equity Market Five Worst 1 year Drawdowns in the S&P/TSX Composite Index Dec 1960 Mar 2015 10% 0% Early 80 s Recession 6/30/81 6/30/82 Financial Crisis 2/29/08 2/28/09 Oil Crisis 9/30/73 9/30/74 Early 70 s Recession 5/31/69 5/31/70 Tech Crash 9/30/00 9/30/01-10% -20% -30% -40% S&P/TSX Composite Index Low Vol Simulation -50% 1982/06/30 2009/02/28 1974/09/30 1970/05/31 2001/09/30 Note: for illustrative purposes only. S&P/TSX Index is represented by the S&P/TSX Capped Composite for the time periods where the capped existed, and the S&P/TSX Composite Index for the periods prior 7
Performance Indexed to 100 Performance Indexed to 100 Prolonged Poor Returns Path Of Returns is Steadier 160 140 120 100 80 May 1969 April 1974 5.6 yrs 60 May-69 May-70 May-71 May-72 May-73 May-74 110 +2.6% 100 +0.7% -1.7% 140 130 120 90 80 70 Jul 1987 Feb 1993 5.6 yrs 60 Jul-87 Jul-88 Jul-89 Jul-90 Jul-91 Jul-92 +5.0% 160 140 120 100 Apr 1998 Oct 2002 4.5 yrs +5.0% +0.1% 270 240 210 180 150 Aug 2000 Feb 2009 8.5 yrs +6.6% 80 120 90 +0.1% 60 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 60 Aug-00 Aug-02 Aug-04 Aug-06 Aug-08 Low Vol Simulation S&P/TSX Composite Index Note: for illustrative purposes only. All returns are annualized. S&P/TSX Index is represented by the S&P/TSX Capped Composite for the time periods where the capped existed, and the S&P/TSX Composite Index for the periods prior 8
10yr Canada Bond Yield Rising Interest Rates or Inflation Not As Large A Driver As You Might Expect 20% 10yr Canada Bond Yield, Dec 1959 to March 2015 18% 16% 14% Jun 1979 Sep 1981 S&P/TSX Index 11.4% Low Vol Simulation 10.1% Sep 1981 Mar 1987 S&P/TSX Index 17.7% Low Vol Simulation 22.7% 12% 10% 8% Dec 1959 Jun 1979 S&P/TSX Index 9.6% Low Vol Simulation 11.1% Mar 1987 Mar 2015 S&P/TSX Index 8.3% Low Vol Simulation 11.0% 6% 4% 2% Dec 1980, TSX was: 24% Oil and Gas Producers 16% Base Metals 5% Gold 4% Paper and Forest Products 0% Dec-59 Dec-63 Dec-67 Dec-71 Dec-75 Dec-79 Dec-83 Dec-87 Dec-91 Dec-95 Dec-99 Dec-03 Dec-07 Dec-11 Note: for illustrative purposes only. All returns are annualized. S&P/TSX Index is represented by the S&P/TSX Capped Composite for the time periods where the capped existed, and the S&P/TSX Composite Index for the periods prior 9
Annual Returns Annual Returns General Market Stress Low Volatility Earns Its Keep in Risk Off Environments 20% 10% 0% -10% Relative Performance: Low Vol Simulation vs the S&P/TSX Index -20% -30% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 30% 20% 10% 0% -10% Relative Performance: High Yield Bonds vs. the Universe Bond Index -20% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bloomberg, RBC GAM High Yield Bonds represented by the Merrill Lynch US High Yield Master II index (CAD), Universe bonds represented by the FTSE TMX Canada Universe Bond Index 10
All That New Found Room In The Risk Budget! How To Spend It Less Overall Risk Small Cap Stocks More Equities Other Alternatives Emerging Market Bonds More Hedge Funds Core Plus Bonds Emerging Market Equities High Yield Bonds 11
Cutting or Re-Allocating The Risk Budget Baseline Equity Portfolio Low Volatility Equity Portfolio Diversified Return-Seeking Portfolio 40% 60% Foreign Equity 40% 60% Foreign Low Volatility Equity Low Volatility Equity 50% 20% 15% Small Cap Equity 15% Emerging Market Equity Domestic Equity Domestic Low Volatility Equity Global Credit Baseline Portfolio Low Volatility Equity Portfolio Diversified Return-Seeking Portfolio Expected Return 7.3% 6.5% 7.2% Expected Volatility 14.6% 9.1% 10.1% Expected Sharpe Ratio 0.5 0.7 0.7 Expected downside** -23.1% -13.6% -16.9% Note: only the 60% return seeking portion of the portfolio is shown. Portfolio also contains a 40% allocation to long bonds. See appendix for details including risk-return modeling assumptions and asset class disclosures. **CVaR 95: Average loss during the worst 5% of historically observed 12-month outcomes. This analysis is for illustrative purposes only and not a guarantee of future returns or risk. 12
Portfolio with Diversified Return-Seeking Assets A More Balanced Total Risk Budget* Canada Bonds 0.6% Provincial & IG Corp Bonds Foreign Credit 2.7% 2.5% Equities now represent 66% of the risk budget (instead of 85%) 27% reduction in funded status risk but similar expected return Equity 11.1% Total 16.9% 0% 5% 10% 15% 20% 25% * Risk Budget of the Excess Return according to the Annual CVaR 95 (1) See slide 2 or appendix for the assumed composition of the revised return-seeking portfolio. (2) CVaR 95: Average loss during the worst 5% of historically observed outcomes. (3) PH&N IM analysis using historical data over the period January 2001 March 2015. CVaR calculated using the distribution of 12-month rolling returns. (4) Liabilities are assumed to have an approximately 15-year duration as at March 31, 2015. Liability returns are approximated by using a set of assumed plan cash flows and applying the Canadian Institute of Actuaries prescribed discount rate methodology for solvency valuations. (5) This example is for illustrative purposes only and not intended to be representative of the performance of any actual or future investments. 13
Considerations for Investors What is your goal? Are equities the only piece of the puzzle needing addressing? What are your beliefs on expected return and risk? What is your approach to benchmarking? How will you define success? Communication with constituents, present and future Selecting a low volatility equity strategy 14
Return Low Volatility Equity Strategies Are Not All The Same Think About Process and your Definition of Success 16% Low Volatility Global Equity Strategies ($USD) Risk and Return for 3 Years 15% 14% 13% 12% 11% 10% 9% 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% Standard Deviation MSCI World Min Volatility MSCI World Manager A Manager B Manager C Manager D Manager E Manager F Manager G For the three years ended March 31 st, 2015. Source: evestment 15
Conclusions Pension plans currently have a fantastic opportunity to de-risk There are many different ways for a plan to de-risk Return-seeking assets should not be neglected Low volatility equities a simple, robust, low cost way to meaningfully reduce and rebalance portfolio risk Can enable the pursuit of higher returns in other equity strategies or other asset classes 16
Appendix
Low Volatility Equity Portfolio Simulation Summary Statistics Jan 1960 to Mar 2015 Low Volatility Portfolio Simulation TSX/TSE Index Sharpe Ratio 1.057 0.599 Information Ratio 0.320 Realized Standard Deviation 11.49% 14.94% Realized Tracking Error 6.95% Annual Rate of Return 12.14% 8.95% One-Way Turnover 41.15% Total Return 56,128% 11,271% Max Drawdown 34.55% 49.75% Drawdown Detection Threshold 5.00% 5.00% Number of Drawdowns Over Threshold 36 35 18
Assumptions and Disclosures for Slides 2, 12 and 13 Capital Market Assumptions Asset Category Asset Class Representative Data Series Expected 10-yr Annualized Return Assumed Annual Volatility Large Cap Equity Canadian Equities S&P/TSX Capped Composite Index 7.0% 16.9% Large Cap Equity U.S. Equities S&P 500 Index (CAD) 7.0% 14.3% Large Cap Equity International Equities MSCI EAFE Index (CAD) 7.0% 18.0% Low Volatility Equity Canadian Low Vol Equities RBC QUBE Low Volatility Canadian Equity Fund* 6.3% 12.6% Low Volatility Equity Global Low Vol Equities RBC QUBE Low Volatility Global Equity Fund* 6.3% 10.7% Small Cap Equity Canadian Small Cap Equities BMO Small Cap Index 8.0% 25.4% Small Cap Equity U.S. Small Cap Equities Russell 2000 Index (CAD) 8.0% 18.4% Emerging Market Equity Emerging Market Equities MSCI Emerging Markets Index (CAD) 9.0% 21.3% Global Credit High Yield Bonds Custom Index** 5.0% 11.5% Global Credit Emerging Market Debt JP Morgan Government Bond Index-Emerging Markets Broad Diversified (USD) 5.5% 9.4% *Simulated data used prior to fund inception. This information is meant for investors with sophisticated investment knowledge sufficient to fully understand the risks and limitations of simulated performance data. Simulated performance data is for illustrative purposes only and not indicative of actual results. Please refer to the simulation disclosure at the end of this presentation for complete disclosure notes and simulated performance information. **50% BoA/Merrill Lynch U.S. High Yield Master II Index (USD), and 50% BoA/Merrill Lynch Global High Yield Index (USD) Assumptions represent the views of PH&N for the purposes of illustrating and understanding the potential risk-reward trade-off of different portfolio decisions. Investors should be aware of the limitations using forwardlooking assumptions in that there is absolutely no guarantee that future performance will occur according to any ex-ante expectation. 19
Canadian Equities U.S. Equities (CAD) Int'l Equities (CAD) Canadian Low Vol Equities Global Low Vol Equities (CAD) Canadian Small Cap Equities US Small Cap Equities (CAD) Emerging Market Equities (CAD) Emerging Market Debt (USD) High Yield Bonds (USD) Assumptions and Disclosures for slides 2, 12 and 13 Capital Market Assumptions Correlations Canadian Equities 1.0 U.S. Equities (CAD) 0.6 1.0 Int'l Equities (CAD) 0.7 0.8 1.0 Canadian Low Vol Equities 0.7 0.4 0.5 1.0 Global Low Vol Equities (CAD) 0.0 0.6 0.5 0.2 1.0 Canadian Small Cap Equities 0.9 0.4 0.6 0.7 0.0 1.0 US Small Cap Equities (CAD) 0.6 0.8 0.7 0.5 0.4 0.6 1.0 Emerging Market Equities (CAD) 0.8 0.6 0.8 0.5 0.3 0.7 0.6 1.0 Emerging Market Debt (USD) 0.5 0.2 0.4 0.5 0.1 0.5 0.3 0.6 1.0 High Yield Bonds (USD) 0.7 0.4 0.5 0.5 0.0 0.7 0.5 0.6 0.7 1.0 20
Assumptions and Disclosures for Slides 2, 12 and 13 Composition of the revised return-seeking portfolio Low Volatility Equity Portfolio 40% FTSE TMX Canada Long Term Overall Bond Index 25% RBC QUBE Low Volatility Canadian Equity Fund 35% RBC QUBE Low Volatility Global Equity Fund Diversified Return-Seeking Portfolio 40% FTSE TMX Canada Long Term Overall Bond Index 15% RBC QUBE Low Volatility Canadian Equity Fund 15% RBC QUBE Low Volatility Global Equity Fund 9% Russell 2000 Index (CAD) 9% MSCI Emerging Markets Index (CAD) 6% Custom Global High Yield Bond Index* 6% JP Morgan GBI-EM Broad Diversified (USD) *50% BoA/Merrill Lynch U.S. High Yield Master II Index (USD), and 50% BoA/Merrill Lynch Global High Yield Index (USD) 21
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Building Efficient Return Seeking Portfolios Reassessing the Equity Allocation Paul M. Martin, CFA Vice President & Portfolio Manager Phillips, Hager & North Investment Management