Building Efficient Return Seeking Portfolios Jim C. Cole, VP - Fixed Income Étienne Dubé, VP - Fixed Income
Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Solvency Ratio Pension Plan Sponsors and Trustees A Dream Come True! 110 % Median Solvency Ratio of Canadian Pension Plans 100 % 93% 90 % 80 % 70 % 60 % 69% Source: Aon Hewitt
Why de-risk? Sources of Risk for a Traditional 60/40 Portfolio* Canada Bonds 1% Provincial & IG Corp Bonds 2% 19% Total 22% 0% 5% 10% 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 May 2002 Dec. 2013. CVaR calculated using the distribution of 12-month rolling returns. (4) Liabilities are assumed to have a 14-year duration. 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.
Why de-risk? Sources of Risk for a Traditional 60/40 Portfolio* Canada Bonds Provincial & IG Corp Bonds 1% 2% 60% of total assets in equities represents 90% of the risk budget! 19% Funding status can decrease by 22% in a bad year! Total 22% 0% 5% 10% 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 May 2002 Dec. 2013. CVaR calculated using the distribution of 12-month rolling returns. (4) Liabilities are assumed to have a 14-year duration. 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.
De-Risking Multiple Ways to De-Risk 100% Fixed Income! De-Risking Continuum Reduce Interest Rate risk Revisit 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
What are Return-Seeking Assets? A Rich Toolbox of Asset Classes and Strategies Pension Plan ABC Matching Assets Federal Bonds Provincial Bonds Domestic IG Corporate Bonds Strip Bonds Swaps, Forwards and other derivatives Smart Beta Equities Large Cap Small Cap Developed Markets Emerging Markets Return-Seeking Assets Global Credit Investment Grade High Yield Emerging Markets Private Loans Convertibles Low Volatility, Thematic, Momentum, Carry etc Liquid Alts Commodities REITs Currency Hedge funds
Expected 10-year Compound Return Risk-Reward Analysis* Revisiting the Portfolio 8.50% 8.25% 8.00% 7.75% 7.50% 7.25% 7.00% 6.75% 6.50% 6.25% 6.00% 5.75% Lower Volatility Strategies 5.50% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 16% 17% 18% 19% 20% Annual Standard Deviation Higher Octane Strategies Baseline Portfolio: 40% Domestic / 60% Foreign *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Expected 10-year Compound Return Risk-Reward Analysis Revisiting the Portfolio 8.50% 8.25% 8.00% 7.75% 7.50% 7.25% 7.00% 6.75% 6.50% 6.25% 6.00% 5.75% Only Large Cap 5.50% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 16% 17% 18% 19% 20% 30% Low Volatility 30% 25% Emerging Market Annual Standard Deviation Baseline Portfolio: 40% Domestic / 60% Foreign Small Cap *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Expected 10-year Compound Return Risk-Reward Analysis Adding Global Credit Helps at Lower Risk Levels 8.50% 8.25% 8.00% 7.75% 7.50% 7.25% 7.00% 6.75% 6.50% 6.25% 6.00% 5.75% + Global Credit Only Increases efficiency at lower risk levels Makes no difference at higher risk levels 5.50% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 16% 17% 18% 19% 20% Annual Standard Deviation Baseline Portfolio: 40% Domestic / 60% Foreign *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Expected 10-year Compound Return Risk-Reward Analysis Adding Global Credit Helps at Lower Risk Levels 8.50% 8.25% 8.00% 7.75% 7.50% 7.25% 7.00% 6.75% 6.50% 6.25% 6.00% 5.75% + Global Credit + Alts + Global Credit Only Efficient Zone 5.50% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 16% 17% 18% 19% 20% Annual Standard Deviation Baseline Portfolio: 40% Domestic / 60% Foreign *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Expected 10-year Compound Return Risk-Reward Analysis Improving Risk Adjusted Returns Through Beta Diversification 8.50% 8.25% 8.00% 7.75% 7.50% 7.25% 7.00% 6.75% 6.50% 6.25% 6.00% 5.75% + Global Credit + Alts + Global Credit Only Portfolio A Efficient Zone Portfolio A: Contained within the Efficient Zone 2/3 of the risk and a similar expected return 5.50% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 16% 17% 18% 19% 20% Annual Standard Deviation Baseline Portfolio: 40% Domestic / 60% Foreign *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Revised Return-Seeking Portfolio* Same Expected Return, 2/3 of the Risk! Baseline Portfolio Diversified Portfolio A 60% Foreign Low Volatility 20% Small Cap Emerging Market 40% Large Cap 20% Global Credit Domestic Liquid Alts Expected Return: 7.3% Volatility: 15.3% Sharpe Ratio: 0.4 12-month Downside: -34% Expected Return: 7.3% Volatility: 10.5% Sharpe Ratio: 0.6 12-month Downside: -22% *Risk-return modeling assumptions and asset class disclosures can be found in appendix. This analysis is for illustrative purposes only and not a guarantee of future returns or risk.
Revised Return-Seeking Portfolio A More Balanced Total Risk Budget* Canada Bonds Provincial & Foreign Credit 1% 2% 2% Equities now represent 67% of the risk budget (instead of 90%)! Alternatives 1% 10% 32% reduction in funded status risk due only to revamped returnseeking portfolio Total 0% 5% 10% 20% 25% * Risk Budget of the Excess Return according to the Annual CVaR 95 (1) See 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 May 2002 Dec. 2013. CVaR calculated using the distribution of 12-month rolling returns. (4) Liabilities are assumed to have a 14-year duration. 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.
Ontario Teachers Pension Plan Asset Mix as of December 31, 2012 140% 120% 9.7% 1.7% 7.5% Absolute Return Strategies Timberland Infrastructure 100% 13.3% 5.5% Real Estate Commodities 80% 24.4% Real Return Product But 60% 22.7% Bonds 40% 20% 37.8% Non-Canadian Equities 0% 9.0% Canadian Equities -20% -31.6% Money Market & Liabilities -40% Total Net Assets: $127.3 billion Source: Ontario Teachers Pension Plan Annual Report (2012)
Ontario Teachers Pension Plan Asset Mix as of December 31, 2012 140% 120% 9.7% 1.7% 7.5% Absolute Return Strategies Timberland Infrastructure 100% 13.3% 5.5% Real Estate Commodities 80% 60% 24.4% 22.7% Real Return Product Bonds Ontario Teachers has 900 employees! 40% 20% 37.8% Non-Canadian Equities 0% 9.0% Canadian Equities -20% -31.6% Money Market & Liabilities -40% Total Net Assets: $127.3 billion Source: Ontario Teachers Pension Plan Annual Report (2012)
Looks Great on Paper What About Implementation? Many Important Issues for Plan Sponsors to Consider 15 Managers Benchmarking Liquidity Derivatives, Leverage, Shorting Management Fees Governance Budget Nontraditional Asset Classes Rebalancing 10 Asset Classes Monitoring Tactical Asset Allocation
One Potential Solution: Diversified Growth Funds (DGF) What are they? Return-Seeking Assets A mix of equities, credit, real estate, commodities, hedge funds, Target equity-like returns over the long-term with less risk Tend to be dynamically managed First DGFs appeared in UK in early 2000 Now much more popular and growing quickly Portfolio A is a good example of a potential DGF!
Diversified Growth Funds Simplifying Asset Mix Decisions and Manager Structure Lower Degree of Manager Flexibility Higher Multiple Specialist Mandates Diversified Growth Fund Equities Global Credit Alternatives Etc Blend of Growth Strategies Including Equities, Credit, Alternatives Etc Trustees Responsibility for Asset Allocation Managers
Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Illustration of a Static DGF: Diversified Portfolio A Back-testing with Expected Returns* 225 200 175 Baseline Portfolio (TARGET) Portfolio Statistics TARGET PORT A Volatility 11% 150 125 100 75 *See disclaimers and methodology described in appendix. This analysis is for illustrative purposes only and not a guarantee of any future performance. Drawdown -41% -28% Return 7.2% 7.1% Desired Characteristics Lower Volatility than Equities Lower Drawdown than Equities Similar Return to Equities Static DGF offers attractive risk reduction but will still have a strong correlation with market risk Can we do better?
Dynamic DGF Using Risk Allocation to Enhance Downside Protection Basic Principle of Risk Allocation WHEN RISK WHEN RISK = RISK OFF = RISK ON Objective: Winning by not Losing
Theoretical Illustration of a Dynamic DGF A Simple and Naïve Risk-Based Strategy Define a defensive portfolio for a Risk-Off capital markets environment Risk-On (Diversified Portfolio A) Risk-Off (Illustrative Defensive Portfolio) Low Volatility Small Cap 20% 20% Emerging Market Global Credit Low Volatility Small Cap 25% Emerging Market 7.5% 7.5% 10% 20% Global Credit Liquid Alts Liquid Alts Cash Large Cap Large Cap Look at the moving average and moving volatility of the VIX as a simple indicator of potential changes in risk environment* *See disclaimers and methodology described in appendix. This analysis is for illustrative purposes only and not a guarantee of any future performance.
Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Dec 2013 Theoretical Illustration of a Dynamic DGF Back-testing with Expected Returns* 225 200 175 Baseline Portfolio (TARGET) Diversified Beta Portfolio (PORT A) Dynamic Beta Portfolio Risk OFF Risk OFF 150 Risk ON Risk ON 125 100 75 Risk ON Risk Metrics Calendar Year Volatility 15.2% 11.1% 9.1% Max Drawdown -41% -28% -21% Drawdown Cycle (mnths) 21 16 10 *See disclaimers and methodology described in appendix. This analysis is for illustrative purposes only and not a guarantee of any future performance.
Conclusion 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 Diversified Growth Funds (passive or active) should be considered when time, resources and governance are important plan sponsor issues