Indexology^® Blog

Quiet Before the Storm?

Global markets seemingly remain unperturbed—despite homing in on Election Day in the U.S.  Although dispersion ticked up globally from September month-end levels, it is still sitting at below average levels as of October 31 in the U.S. Similarly, correlation is also well below average. Together these coordinates are pointing to particularly peaceful times for U.S. equity markets on the dispersion-correlation map. On the international front, the story is similar. Though dispersion is above average in the Europe region, correlation is below average and is at the lowest level in more than 2 years. In Asia, both dispersion and correlation are close to record low levels.

Times of crisis are typically characterized by higher dispersion levels, as witnessed by years 2000 (tech bust) and 2008 (financial crisis). While dispersion has increased across the globe it is nowhere near crisis levels in the U.S. and Asia and somewhat higher in Europe.

Things could very well change—and change quickly. But for now, it’s all quiet around the world.

No other recent presidential elections have been as divided as this year’s.  As the objectivity and credibility regarding poll numbers and media coverage of the candidates are being questioned, the U.S. economy and the capital market are facing an unusual level of political risk.  Market participants may seek various tools to hedge the downside risk, such as put options.  The question is: to what degree a long put position can help to reduce overall portfolio volatility?  To help answer this, we examine a hypothetical portfolio that already has a risk control mechanism in place.

Let’s consider a typical multi-asset portfolio invested in the S&P 500® and five-year U.S. Treasuries (UST) with a fixed volatility budget.  When the realized volatility of the equity market exceeds the volatility budget, the portfolio is partially allocated to UST to keep the volatility under control; when the realized volatility of the equity market falls below the volatility budget, the portfolio is fully allocated to the S&P 500 to get 100%  equity market participation.  When the yield curve is inverted, all fixed income allocation will be shifted to cash.  We can further assume that there is no shorting and no borrowing.  The portfolio is rebalanced only when its realized volatility deviates more than 0.5% from the pre-specified volatility budget.

Overlaying this portfolio with a self-financed five-year synthetic put option on the portfolio struck at 80%, or in other words, assuming that we are able to pay x amount to buy a five-year put to protect 80% of the remaining portfolio (portfolio value minus x), we can observe the level of volatility reduction derived from this put overlay.

Exhibit 1 shows the statistics of the portfolio’s realized volatility before and after the put overlay.  The delta of the synthetic put drives risk reduction.  Higher volatility budge usually results in a more volatile portfolio and a higher delta of the put option, which, in turn, reduces more risk in ratio terms (1-Before/After Ratio).

Exhibit 2 shows the time series of the realized volatilities before and after the put overlay for a portfolio with a volatility budget of 22%.

As a rule of thumb, overlaying a put option on a ~20% volatility portfolio reduces about 6%-8% of the realized volatility over a 26-year period.  The good old put protection strategy has been working for decades, and it could still be a powerful volatility reduction tool no matter who becomes the next president.

Note: Realized volatility is defined as the maximum of the long-term volatility and short-term volatility in the S&P Risk Control Indices Model.  This is because this is usually the volatility that is used to adjust the portfolio allocation to meet the volatility budget.  For more information about the calculation, please refer to S&P Risk Control Indices.

Rates, volatility and a broad market rally have contributed to the factor’s late-summer slump

Late summer has not been fruitful for the low volatility factor. From July 6 to Sept. 9, the S&P 500 Low Volatility Index has fallen by 4.67%, while the S&P 500 Index gained 1.70%.¹ This is in sharp contrast to the second quarter, when the low volatility index returned 6.75%, and the broad-market index returned 2.46%.¹ Naturally, some investors are wondering what’s behind the shift.

Looking at market conditions during this time, I see three headwinds that were working against the low volatility factor:

• Interest rates rose. The 10-year Treasury yield rose from 1.31% on July 6 to a close of 1.67% on Sept. 9.¹
• Volatility was relatively flat. The CBOE Volatility Index (the VIX) was 14.96 on July 6 and was 12.51 on Sept. 8. before finishing at 17.5 on Sept. 9.¹
• The S&P 500 Index rallied. While the index gave back much of its earlier gains on Sept. 9, it had rallied for most of July and August.

When has low volatility outperformed?
The low volatility factor has tended to shine when interest rates are flat to lower, stock prices are falling and volatility is rising.  We can see this in the table below, which examines the performance of the S&P 500 Low Volatility Index during extreme moves in the S&P 500 Index, the VIX and 10-year Treasury yields from May 2011 through August 2016. In that time frame, there were 64 months of returns. The table examines low volatility performance during the most extreme months (the top 25%) in terms of the largest increases and decreases in each index.

Examining low volatility results

• By volatility. During the 16 months when the VIX had its largest percentage increases, the S&P 500 Low Volatility Index outperformed the S&P 500 Index 62.5% of the time, with an excess return of 51 basis points (bps). In contrast, during the 16 months when the VIX had its largest percentage drops, the low volatility index outperformed the broad market just 25% of the time, with an average lag of 107 bps.
• By rates. During the 16 months when the 10-year Treasury yield had its largest percentage increases, the S&P 500 Low Volatility Index outperformed the S&P 500 Index just 25% of the time, trailing by an average of 169 bps. During the top months of yield declines, the low volatility index outperformed the broad market 87.5% of the time, with an average excess return of 241 bps.
• By market performance. During the 16 months when the S&P 500 Index had its largest declines, the S&P 500 Low Volatility Index outperformed 87.5% of the time, with an average excess return of 176 bps. In contrast, during months when the S&P 500 Index gained the most, the low volatility index outperformed 12.5% of the time, with an average underperformance of 156 bps.

Bottom line: Low volatility is performing as expected|
When you look at the market conditions experienced in late summer, it’s no surprise that low volatility shares underperformed the broad market. This is by design. However, it’s important to remember that the low volatility factor does occasionally outperform in up markets and occasionally lag in down markets.  And while higher rates and a lower VIX have been headwinds for low volatility, the results are not absolute. There are exceptions. Understanding market trends and the potential for exceptions can help investors set proper expectations for low volatility performance.

In my last post, I discussed variability in cost and affordability of retirement income.  I used some data from S&P STRIDE, our new benchmark that provides a cradle-to-grave yardstick for wealth accumulation and income generation.  This week, I will look a little closer at how we measure retirement income, as well as its present value or cost.  To begin with, defined contribution retirement plan participants and IRA investors must convert their accumulated savings into an income stream when they enter retirement.  Things may be simpler for people with defined-benefit pensions that pay out monthly benefits according to the plan’s vesting schedule and benefit formula.  However, even though defined benefits are expressed as monthly income, they have a present value, which is simply the stream of their expected future cash flows expressed as a discounted lump sum.

If you were to ask people of my parent’s generation, “What is your net worth?” they probably would not count the present value of their pension benefits.  They may view it as part of their personal income statement but not their balance sheet.  However, if you asked people in my generation the same question, I bet they would include the value of their 401(k).  They are thinking of it as a balance sheet item, but many have not yet considered that it needs to become an income statement item upon retirement.

When considering the convertibility of lump sums into income streams and vice versa, it may help to think about how the bond market works.  When you buy a bond, you convert a given amount of liquid funds into future cash flows, and when you sell a bond, you convert future cash flows into readily available capital.  As we know, bond prices vary with interest rates, and the same applies to future retirement income.  The bond market analogy is relevant because at S&P DJI, we calculate the value of retirement income exactly like the value of a bond.  However, we define a special “bond” called the generalized retirement income liability (GRIL) as a particular set of cash flows.  Specifically, GRIL is defined as USD 1 per year of inflation-adjusted income starting at age 65 and continuing for 25 years.  We discount GRIL’s cash flows using the U.S. Treasury Inflation-Protected Securities (TIPS) yield curve.  This results in a transparent, precise method for evaluating the cost of future inflation-adjusted (real) income.  We calculate the present value of GRIL for various starting points, each corresponding to specific target years within the S&P STRIDE Indices.  Currently, they range from 2005 to 2060.  For example, if you plan to retire around 2035, you can find the cost of retirement income as we calculate it on our website under the “additional info” menu.  Exhibit 1 shows the cost of 2035 GRIL since January 2016:

What does Exhibit 1 tell us?  GRIL is 25 US dollars of inflation-adjusted retirement income spread over 25 years—USD 1 per year.  To buy that income stream at the end of January 2016 would have cost USD 17.40, but as of September 2016, its cost increased to USD 20.68.  Therefore if you held $1 million in US T-Bills (potentially the safest investment one can find, from the perspective of investment volatility), in January 2016, you could have acquired $57,471 of today’s US dollars per year starting in 2035 and lasting until 2060.  The calculation is USD 1 million / USD 17.40.  However, because real interest rates trended down since the start of the year, increasing the cost of income, as of September 2016 that same $1 million T-Bill portfolio would only have bought $48,356 of future income (USD 1 million / USD 20.68).  When viewed through the lens of income affordability, it is therefore clear that investing in T-Bills and other short-term obligations is not risk free.

The annual rebalancing of the Dow Jones Sustainability Indices (DJSI), the most famous benchmark for corporate sustainability in the world, took place on September 8^th 2016. With nearly 2,000 companies analyzed currently and another nearly 2,000 to be analyzed in RobecoSAM’s 2016 Corporate Sustainability Assessment (CSA), it is clear that sustainability is no longer something “nice to have,” but rather a necessity in order to remain cutting-edge. Likewise, the growing number of requests for new indices proves that there is appetite for fresh products among investors. At the core of this positive trend is the recognition that long-term sustainability factors are the key to long-term value creation. This has set the stage for exciting new developments.

S&P Long-Term Value Creation Index
RobecoSAM had the opportunity to work together with the Canada Pension Plan Investment Board (CPPIB) a leading supporter of the long-term investing movement. The belief that sustainability is by definition something that can and will play out over a long time horizon also attracted the interest of S&P Dow Jones Indices. The result was the S&P Long-Term Value Creation Index, an innovative product that has garnered much investor attention. This index focuses not only on the long-term financial viability of a company, but also on its sustainability performance.

New questions
RobecoSAM introduced a number of new questions to its CSA in 2016, including questions on the sources of long-term value creation, how goals are aligned with remuneration, and how transparent companies are in discussing progress towards sustainability goals. These new questions, found within the new “Materiality” criterion, were the product of discussions about what the sources of long-term management creation really are.

Impact measurement
Another area of development in this year’s CSA was impact measurement. While the term has gained traction within the investment community, impact measurement is often backward-looking. Thus, the “Impact Measurement & Valuation” criterion introduced in the CSA rests on major global drivers such as the United Nations Sustainable Development Goals (SDGs). These goals provide companies and investors with a compass to steer their sustainability initiatives towards global challenges. RobecoSAM regards these goals as essential for companies to ensure that they are generating value for all stakeholders. As investors also begin to align their strategies towards the UN SDG’s, companies that can demonstrate they are thinking long-term will have the upper-hand.

Conclusion
Looking back over 2016, we can see that progress has been made to encourage long-term strategies among companies and investors. But more work needs to be done. With new products like the S&P Long-Term Value Creation Index, the JPX/S&P CAPEX & Human Capital Index, the S&P DJI Fossil-Fuel Free index series and the Dow Jones Sustainability Indices, we have taken steps towards offering investment opportunities focused on long-term sustainability themes. RobecoSAM believes that creating long-term value and solving the world’s biggest sustainability challenges are not things that should be tackled in isolation, but rather tackled at both ends, where investors and companies each do their part to ensure a viable future.

Legal Information: The information and opinions contained in this publication constitutes neither a solicitation, nor a recommendation, nor an offer to buy or sell investment instruments or other services, or to engage in any other kind of transaction. RobecoSAM AG and its related, affiliated and subsidiary companies disclaim all warranties, expressed or implied, including, but not limited to, implied warranties of merchantability and fitness for a particular purpose. In no event shall RobecoSAM AG and its related, affiliated and subsidiary companies be liable for any direct, indirect, special, incidental or consequential damages arising out of the use of any opinion or information expressly or implicitly contained in this publication. © 2016 RobecoSAM AG.