Indexology^® Blog

Recently I visited a few pension plans and it amazes me how the policy views on risk differ to meet seemingly similar return goals. The National Association of State Retirement Administrators (NASRA) reported earlier this year that of 126 major state and municipal systems, 32 had set an assumed rate of return between 7.5% and 8%, 37 had set a rate between 7% and 7.5% and 45 had an 8% rate.  However, the risks the plans are taking to make their return goals differ significantly and may be the result of an evolution of risk-awareness.

According to one of the pension executive directors, “1/2% [assumed rate of return] won’t change anything about how we invest… we take as little risk as possible to get to our 8% goal and would never invest in risky assets [like commodities, the way another pension would].”  This particular pension manages risk mostly from a liquidity perspective with three main buckets being “liquid”, “illiquid” and “moderately liquid” – where about 60% of the assets are allocated. The “liquid” is mostly cash, the “illiquid” contains private assets and real estate, and the “moderately liquid” contains mostly equities and credit.

“Another pension” with the same return goal of a real rate of return (the rate by which the long-term total return exceeds the inflation rate) of at least 5.5% per year claimed, “their peers will follow in their footsteps but someone needs to go first.”  Follow in their footsteps to do what? Manage risk. Their target allocation is based on risk parity, just like Texas Teachers announced today, and the asset allocation target looks much less like the traditional stocks, bonds, real estate and alternatives like in the “conservative plan” described above. Texas Teachers’ has five different buckets, which is one less than “another pension” but is comparable.

Some of the noticable capital allocation differences are in the inflation linked bonds, commodities and global equities. In the self-described “conservative” plan, there is a policy of about 45% equities, 5% TIPS and no commodities. In the “risk-based plan” that describes themselves as flexible to take advantage of changing market conditions, equities get a target of about 10%, 30% TIPS and 8% commodities that mirrors Texas Teachers’ much more closely.

According to Cerulli Associates, since the early 1970’s, Modern Portfolio Theory has influenced asset allocation. Institutions looked to increase diversification and reduce risk by allocating to a broad number of diverse asset classes typically defined by underlying security type and marketability. However, the severe market stress and extreme volatility experienced in the global financial crisis of 2007-2009, caused many correlations between asset classes to rise that not only increased risk but lowered returns.

Today, institutional investors are under pressure to increase returns, while keeping risk unchanged, forcing many institutions to rethink their approach to portfolio construction. Many institutions and investment consultants are giving a face-lift to their traditional asset allocation classification approach for a “role bucketing” or risk-based approach, identifying the risks of an investment rather than which asset class it falls in. With the objective of generating more consistent returns across different economic environments, a growing number of institutions are changing their framework for asset allocation using a risk-based lens, reclassifying assets by factors that explain their risk and return characteristics.

Eighty-five percent of consultants surveyed by Cerulli consider asset allocation and diversification of investment portfolios according to underlying risk factors, as opposed to using the traditional style boxes. Of those 85%, 75% of gatekeepers indicated that they currently use a risk-based approach for constructing portfolios, and have made changes to clients’ investment policy statements and asset allocation accordingly.

This is a big change from the 60% stock / 30% bond / 10% alternative average allocation of ten years ago.

Chinese bonds continue to attract attention from global investors as they offer relatively higher yields, what’s more, Chinese bonds also have historically demonstrated low correlations with global markets.

Exhibit 1 shows the correlation of the S&P China Sovereign Bond Index with major sovereign bond indices in global markets. While the index has a low correlation of 0.09 with the developed sovereign bonds, it exhibits a negative correlation of 0.12 with the Eurozone developed sovereign bonds.

Thus, Chinese bonds do not only provide the portfolio diversification through the exposure to local rate, credit and currency, they would also be a good hedge to the global fixed income portfolio. And of course, not to mention, China has a higher credit rating than most countries.

The S&P China Sovereign Bond Index currently tracks CNY 9.3 trillion of sovereign bonds. As of Dec 4, 2014, the index has delivered a YTD return of 9.48%.  The index’s yield-to-worst is at 3.54% with the modified duration of 5.55.

Exhibit 1: Correlation Chart

Please click here for more information on the S&P China Sovereign Bond Index.

November Highlights:

• Islamic Indices Continue to Outperform Conventional Benchmarks Globally
• U.S. Markets Power Higher While Europe, Asia-Pacific and Emerging Markets Weaken
• MENA Equity Markets Sell off Sharply in October & November, Trimming 2014 Gains

Most major Shariah-compliant benchmarks continue to outperform their conventional counterparts in 2014 as Information Technology and Health Care – which tend to be overweight in Islamic Indices – have been sector leaders, and Financials – which are underrepresented in Islamic indices – have experienced some weakness. One notable exception has been in the Middle-East where equity markets have very little exposure to Information Technology and Health Care and thus Shariah-compliant indices have not benefited from the strength in these sectors.

As of November 21, 2014, the Dow Jones Islamic Market World and S&P Global BMI Shariah Indices gained 6.6% and 6.1%, respectively, for the year, each outperforming their conventional counterparts by about 250 basis points. However, performance has been highly divergent across regions with the U.S up double-digits, while European regional indices are in the red. The Dow Jones Islamic Market Asia Pacific had been outperforming the U.S. and other developed market regions through late August. However, Asian markets have cooled in the past 3 months, while the S&P 500 Shariah has reached new highs following a short-lived bout of volatility in October. Outside of MENA, where the S&P Pan Arab Composite Shariah has underperformed the conventional S&P Pan Arab Composite, all other major regional Shariah-compliant indices remain ahead of their conventional counterparts through November 21.

MENA equity markets have cooled markedly following substantial gains earlier in the year. After peaking on September 8, up nearly 26% for the year, the S&P Pan Arab Composite Shariah declined 14.3% through November 21, leaving its year-to-date gain at a more tepid 7.8%. Weakness was experienced across the region, although Saudi Arabia was a major driver of the negative performance.

The CBOE Volatility Index, or what many investors have come to know as VIX, is the index many follow as a volatility indicator for the stock market. The benefit besides printing the “implied” or expected volatility for prices over the next 30 days, giving a range of expected prices 30 days from now, is that it has acted as a portfolio hedge.

Luckily for commodity investors, especially those in oil right now (and gold last year), there are volatility indices that may hedge losses like the VIX has done for the S&P 500.  Notice the in the chart below, the opposite movements with correlation of -0.58 of the S&P GSCI Crude Oil versus the OVX, CBOE Crude Oil Volatility Index.

Historically when the S&P GSCI Crude Oil lost in a month, it lost 5.4% on average. During those months, the OVX returned 7.5% on average. However, when the S&P GSCI Crude Oil lost more than 5.0% in a single month, the OVX provided even more protection with an average return of 16.4%. This is exactly the kind of protection investors may look for in order to hedge the downside risk of the oil price drops. The worst month in history (since Sep 2010) for the S&P GSCI Crude Oil was in May 2012 when the index lost 17.5%. During that month the OVX returned 38.3% and continues to provide strong protection as evidenced by the 118.6% gain since Aug 2014 when the S&P GSCI Crude Oil lost 23.3%. If as an investor since Sep 2010, 10% of OVX was taken from an allocation to the S&P GSCI Crude Oil then the return would have improved from -7.8% to 4.0%, swinging the pendulum from red to black.

The same argument holds true for the relationship of the S&P GSCI Gold and GVZ, CBOE Gold ETF Volatility Index.  Notice the in the chart below, the opposite movements with correlation of -0.59 of the S&P GSCI Gold versus the GVZ.

Historically when the S&P GSCI Gold lost in a month, it lost 4.3% on average. During those months, the GVZ returned 5.2% on average. However, when the S&P GSCI Gold lost more than 5.0% in a single month, the GVZ provided even more protection with an average return of 16.7%. Again, this is exactly the kind of protection investors may look for in order to hedge the downside risk of gold price drops. The worst month in history (since Sep 2010) for the S&P GSCI Gold was in June 2013 when the index lost 12.2%. During that month the GVZ returned 40.3% and provided strong protection as evidenced by the 48.5% gain in 2013 when the S&P GSCI Gold lost 28.3%, the worst year in history since 1981. If as an investor since Sep 2010, 10% of GVZ was taken from an allocation to the S&P GSCI Gold then the return would have improved from -8.6% to 19.1%, an astonishing capital preservation measure in my opinion.

The US dollar has strengthened against most other currencies in recent months.  Over the last year the dollar is up 5% against the British pound, 7% versus the Canadian dollar, 8% over the Australian dollar, 9% ahead of the euro and 16% against the yen.  Movements this big shouldn’t be ignored – foreign investors with funds tracking the S&P 500 are doing much better than their domestic American counter parts while Americans in funds tracking some foreign indices are losing ground because of the dollar’s renewed strength. Further, if it seems some analysts following oil in other countries aren’t as excited as analysts in the US, the answer also is the dollar: Brent crude prices are down about 36% for dollar-based purchasers but only 24% for those based in yen.

The first chart compares the performance in the last 12 months of an investment tracking the S&P 500 for investors in various currencies.  Tracking the S&P 500 in any of the other currencies than the dollar came out ahead.

The second chart shows how US dollar-based investors would have missed out on the recent surge in the S&P TOPIX 150 due to the yen’s weakness.  The gains of the last month or two would have been lost in the translation from yen to dollars.

While investing outside the US is less attractive for many American-based investors as foreign currencies weaken, there is a benefit to investors in the US: the rising dollar makes American equities more attractive to the rest of the world and draws in investment funds which can drive up stocks prices here. The US markets now represent about 50% of the S&P Global BMI index series, the highest proportion in over 20 years – some of that is market gains and some is dollar gains.