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Risk Contributions of Equity/Bond Asset Allocation Portfolios

Getting Smarter About Saving for College: Part 2

India’s Growing Fixed Income Market

Getting Smarter About Saving For College: Part 1

Asset Class Correlations Affect Portfolio Volatility and Return

Risk Contributions of Equity/Bond Asset Allocation Portfolios

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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In a prior post, we reviewed the risk and returns of portfolios with different equity and fixed income combinations. We saw that while equities outperformed fixed income during the period studied, fixed income had a higher risk-adjusted return ratio (annualized return divided by annualized risk). Due to the low return correlation between the two asset classes, compared with when viewed in isolation, the blended portfolios resulted in two notable observations: 1) higher risk-adjusted returns for the 10/90 and 20/80 equity/bond combinations, and 2) higher absolute returns for the portfolios ranging from 30/70 to 90/10 equity/bond mixes.

In this post, to better comprehend the drivers of return and risk for the allocations, we calculated the marginal contribution to total portfolio risk for each asset class. Computationally, the marginal contribution of asset  to total portfolio risk can be defined as:[1]

We calculated the contribution to portfolio risk from 2000 to 2017 for each asset class and Exhibit 1 shows the average annual risk contributions for the 60/40 equity/bond portfolio.

For the classic 60/40 equity/bond portfolio, we see that the risk contribution for each asset class did not align with the weight allocations. While 60% weight was allocated to equities, the average contribution to risk was 102%, thus an average of -2% for bonds. The results show the importance of considering asset class volatility and their covariance. To understand how risk contributions change as weight allocations move from 0%-100% in equity (and 100%-0% in fixed income), Exhibit 2 shows the annual averages.

There is a clear non-linear relationship between the change in weight and the change in risk contribution. With equities being more volatile than bonds and the return correlation between the two being low, as the allocation to equities increases, its risk contribution to total portfolio volatility increases at a quicker pace. In the end, the point where the two asset classes most likely contribute equally would be at the 20/80 equity/bond mix.

Exhibits 1 and 2 in this post allow us to conclude that the risk contribution of asset classes can be meaningfully different from their weight allocations in a portfolio. In following posts, we will build upon the findings in this post and construct a basic three-asset risk parity strategy and compare it with an equal-weight portfolio.

[1]   = weight of asset i, σp = portfolio volatility, βi = beta of asset i to the portfolio, Cov(σip) = covariance of asset i to portfolio, and σp2 = portfolio variance.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Getting Smarter About Saving for College: Part 2

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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The stunning statistics on rising college tuition shown in Getting Smarter About Saving For College: Part 1 have led to a need for better ways to save for college.  To meet this demand, S&P Dow Jones Indices launched a new index based on research showing how tuition inflation is dependent on general inflation (linked bonds), stocks and corporate bonds.   The rationale is published in the second section of our paper summarized below:

THE THEORY BEHIND THE INDEX CONSTRUCTION
The first step in designing an index to track college tuition inflation over time is to understand how college tuition is set. Colleges are producing a product just like any other business, but the product is education. Just as in any business, they have expenses and revenues, so understanding what is driving those expenses and revenues is an important part of  understanding how to build such an index.

On the expense side, colleges have mostly labor costs, but they have a number of other things that go into creating the educational product.  According to American Institutes for Research (AIR), “More than one-half of total average spending by private research universities was dedicated to E&R [education and related spending] functions, and at private nonresearch colleges, E&R accounted for approximately 80 percent of total expenditures.” Collectively, those costs rise with general inflation, for example, the report shows that in 2013, E&R spending per full-time equivalent student increased an average of 2%-3% at public four-year institutions in 2013.

On the revenue side, colleges basically have two types—internal revenues and external revenues. The internal revenues are government appropriations for public universities, or the endowment returns for private universities. The external revenues come from college tuition. As noted in the Delta Cost Project, colleges and universities typically receive revenues to fund their educational mission from tuition, state and local appropriations, and income from endowments or investment returns.  So understanding how college tuition varies depending on how the appropriations or the endowment returns behave is the key to constructing the S&P Target Tuition Inflation Index.

Generally, there is an inverse relationship between tuition increases and funding by appropriations and endowments, where the health of the latter may be driven by investment performance. “Endowments are managed for the long-term to strike a balance between the competing demands of funding current operations and preserving purchasing power to fund future operations…. However, endowments are not immune from market risks. During the Great Recession, endowments lost an average of 3.0 percent from 2007-08 and 18.7 percent from 2008-09.”

One example of the long-term relationship between tuition and appropriation as a percentage of the budget comes from Penn State in Exhibit 4.

Additionally, the Economics of Education Review found that for every USD 1,000 cut from per-student state and local appropriations, the average student could be expected to pay USD 257 more per year in tuition and fees. Tuition increases can be traced to state budget cuts, has more than doubled since 1987, and remains at its highest level in the post-recession eraThese severe and sustained losses of public funding contributed to the rapid increase in net tuition revenue observed since the recession.

Understanding tuition inflation as a function of general inflation as measured by CPI plus a spread is the beginning of the S&P Target Tuition Inflation Index construction. The spread is a flexible combination of short stocks, long corporate bonds, and cash, based on stock market
performance since there is an inverse relationship between endowment and appropriation performance and tuition inflation. Though allocations varied to U.S. equities of endowments surveyed by the 2017 NACUBO-Commonfund Study of Endowments, and the U.S.-dollar-weighted average was 16%, the smaller endowments allocated over 40% to U.S. equities. While the U.S. equities allocations were smaller in the largest plans, allocations of up to 20% in alternative strategies including long/short equity and 130/30 may also carry a significant amount of equity market risk.  From these relatively large exposures to equities, endowment (and appropriation) performance was largely driven by equity returns. So when the stock market declines, endowments and appropriations suffer, and tuition inflation generally increases to cover the shortfall.

To learn more about the index model development, index methodology and performance results, please see our educational paper, Getting Smarter About Saving For College.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

India’s Growing Fixed Income Market

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Alka Banerjee

Managing Director, Product Management

S&P Dow Jones Indices

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The Indian debt market has grown to USD 1.5 trillion over the past decade, largely due to the issuances from the central and state government. The ratio of government securities to corporate issuances is about 75 to 25, reflecting the subdued state of corporate bond markets in India. With a lack of participation, the Indian debt market remains smaller than the equity market—an anomaly among other global markets. Most corporates in India tend to fund themselves through bank borrowings, and, with lax controls and tortuous legal processes, this has led to underperforming assets in bank balance sheets, putting the stability of the Indian banking structure at considerable risk. Pushing corporates to fund themselves will encourage more accountability, responsibility, and a healthier means of financing.

Indian investors with rich equity returns, high interest rates, and booming property prices haven’t ventured to the fixed income market due to a lack of understanding, access, and liquidity. Due to caps on the amount of foreign fund flows permissible into the sovereign and corporate Indian rupee-denominated securities, these have been limited too. While caps have incrementally risen recently, these haven’t been enough to include Indian bonds in global emerging market fixed income indices. In 2016, some impetus was given when the Reserve Bank of India allowed banks to use their corporate bond holdings as collateral against their overnight repo credit facility and corporates to issue Indian-rupee-denominated bonds in offshore markets. Still, with a GDP to corporate bond ratio of about 20%, one of the lowest in the world, an urgent need is felt to stimulate the demand and supply of corporate issuances.

Most of India’s debt market remains outside the reach of domestic investors due to its illiquid nature and large issuance size. Even institutional investors in India tend to buy sovereign issuances and rarely follow the “mark to market” policy as practiced by investors globally. The illiquidity of the fixed income space was a theme even in developed markets, but, about a decade ago, the concept of fixed income ETFs gained traction and is now a booming concept in most developed markets.

Bond ETFs can bring liquidity and accessibility to markets with inherent opacity due to lack of exchange trading on the underlying securities. Indices standardize and democratize an investment space, consolidating the information in a consistent, transparent manner. When buying a bond, investors may be forced to hold to maturity. Bond ETFs predefine the term of the bonds to be held, and maintain a consistent, fixed-term range. New bonds are constantly bought and old ones sold to maintain this consistency and give investors access to a diversified, continuously renewed portfolio. Even if an underlying bond is illiquid, the bond ETF remains liquid. Over the past decade, the U.S. bond ETF AUM have grown to USD 600 billion and are growing faster than equity ETFs.

In order to kick start the corporate Indian debt market, the government is thinking of working with an asset manager to launch a bond ETF with securities from corporates, in which the government has large stakes. Similar to the S&P BSE Bharat 22 Index and S&P BSE CPSE, a cycle of corporate issuances can be used to constantly feed the ETF. This has several advantages. Corporate bonds can be sold more effectively, with a wider reach than single issuances. Domestic liquidity can be created in the market with involvement from institutional investors. Finally, corporates can create a regular cycle of issuances with a consistent stream of funding.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Getting Smarter About Saving For College: Part 1

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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Did you know there is now about $620 billion more of student loan debt than total U.S. credit card debt?

Here are some more astounding statistics highlighted in our new paper:

Costs associated with college tuition and fees, as measured by the U.S. Bureau of Labor Statistics, have far outpaced general U.S. inflation as measured by CPI (5.9% versus 2.6%, annualized from January 1987 to June 2018; see Exhibit 1). So for individuals saving for college, growing assets on pace with tuition inflation is possibly challenging without a college inflation protection security.

Unfortunately, most market participants saving for college only have some combination of the available investments today, perhaps in a 529 plan or “qualified tuition plan” that are made up of just traditional stock and bond funds.

In response to this, S&P Dow Jones Indices partnered with Enduring Investments to develop the S&P Target Tuition Inflation Index, which comprises underlying inflation bond, corporate bond, and equity indices and is designed to reflect changes in college tuition and fees over long term periods.

Over longer time periods, the likelihood of tracking tuition inflation with the S&P Target Tuition Inflation Index increased. For example, when two-year periods were measured, the index only tracked the College Tuition and Fees U.S. City Average CPI within 2% during 43.7% of the period studied.  When the time periods were lengthened to over eight years, the index tracked within 2% of tuition inflation nearly 100% of the time. This was a significant improvement over a typical 60/40 stock/bond mix that is usually intended to provide better risk-adjusted returns. Since most of the contribution to risk in the traditional 60/40 stock/bond allocation comes from equities, its tuition inflation matching capability was comparatively volatile.

Not only will the traditional mix by definition decline with falling equities, but an acceleration of general inflation may adversely affect the performance of equities and bonds. Also, in a declining equity environment, tuition inflation will likely accelerate, partly driven by rising general inflation plus demand growth for education, as well as endowment and appropriation underperformance.

Please stay tuned for Part 2 of this series that will describe the theory behind how the index keeps pace with tuition inflation.  If you can’t wait, it is all posted now in our research here.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Asset Class Correlations Affect Portfolio Volatility and Return

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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In recent years, the term “risk parity” has become a catch-all phrase to describe strategies that attempt to allocate based on risk. The launch of the S&P Risk Parity Indices last week is a testament to the proliferation and the popularity of the style. As we noted in a prior blog, there is a lack of proper benchmarks to measure the effectiveness of such strategies.

Therefore, it is worthwhile to take a step back and examine the empirical basis that gives rise to risk parity strategies (i.e., the notion of equal risk contribution). From there, we can dive deeper into the properties of risk parity strategies and the characteristics that one should be mindful of.

As a starting point, we looked at the historical correlations between different asset classes (see Exhibit 1).[1] [2] [3]

For the 18-year period, there were strong positive correlations between the equity regions, ranging from 0.75 to 0.87. Additionally, equities had moderately positive correlations to real estate, commodities, and high yield bonds. However, in contrast, equities were negatively correlated with investment grade bonds, which implies that adding investment grade bonds, particularly to an equity portfolio, could lower portfolio volatility and potentially deliver higher returns per unit of risk.

To evaluate the effect that asset-pair correlations have on portfolio volatility, we constructed a two-asset portfolio consisting of U.S. equity and investment grade bonds. In addition to the classic 60/40 equity/bond mix, additional portfolios were created in 10% weight increments, resulting in 11 total portfolios.

Equities outperformed bonds over the 18-year period, but that excess performance came with significantly higher volatility (left chart). The risk-adjusted return ratios (right chart) show the return per unit of risk for each portfolio—bonds had a significantly higher risk-adjusted ratio of 1.62 versus 0.45 for equities. Thus, on a risk efficiency basis, bonds fared better than equities. Given the low correlations and higher risk-adjusted return ratio for bonds, combining the two assets led to several allocation mixes with even higher risk-adjusted ratios (e.g., 10/90 equity/bond and 20/80 equity/bond). In fact, the 10/90 equity/bond portfolio had lower volatility relative to bonds along with higher returns—this led to the highest risk-adjusted return ratio (1.82) out of all the mixes. Starting from an initial 100/0 equity/bond portfolio and progressively increasing weight to bonds led to higher absolute returns (until 60/40) and higher risk-adjusted return ratios (until 10/90). These results show how effective combining low-correlated assets together in a portfolio could be.

In a future post, we will review the contribution to total risk of selected portfolio mixes, as the contribution to total portfolio risk for each asset class can be expected to be different from their portfolio weights.

[1]   Markowitz, H. “Portfolio Selection.” The Journal of Finance, Vol. 7, No. 1. (March 1952), pp. 77-91.

[2]   Modern Portfolio Theory states that non-perfect correlations between different assets underpins the notion of portfolio diversification—whereby increased diversification results in higher returns for a given level of risk.

[3]   The S&P 500 represented U.S. Equities, the S&P Developed Ex.-U.S. BMI represented International Equities, the S&P Emerging BMI represented Emerging Market Equities, the Dow Jones U.S. Real Estate Index represented Real Estate, the Dow Jones Commodity Index represented Commodities, the S&P U.S. Treasury Bond Index represented Investment Grade Bonds from Dec. 31, 1999, to April 30, 2002, and then it was represented by the S&P U.S. Aggregate Bond Index, the S&P U.S. High Yield Corporate Bond Index represented High Yield Bonds, and the S&P Global Developed Sovereign Ex-US Bond Index represented International Sovereign Bonds.

The posts on this blog are opinions, not advice. Please read our Disclaimers.