Equities have delivered strong returns since the market bottom in March 2009, and this beta trade has helped investors meet their targeted returns. At the same time, alpha or excess return from active managers has, on average, trailed equity indexes, resulting in skepticism about the benefits of active management over passively managed index-tracking strategies.
But in an environment of lower returns and higher volatility, alpha should play a larger role in investors’ core allocations. We believe there is a middle ground between active and passively managed equity strategies that can help either generate higher returns or minimize volatility.
In this article, we look at the evolving market environment, discuss strategies to add incremental alpha, mitigate volatility and consider portfolio implementations.
THE NEXT LEG OF THE MARKET CYCLE
Lower returns expected
The increase in equity valuations makes the prospect of double-digit equity market returns more uncertain. Going forward, investors should lower their return expectations for the Standard & Poor’s (S&P) 500 Index. We believe a single-digit return is the base case for 2015, which should still be attractive for most portfolios. But this means that finding opportunities to augment market returns is more important than ever.
Many readers will be familiar with J.P. Morgan Asset Management’s Long-term Capital Market Return Assumptions (LTCMRA), the firm’s annual assessment of its long-term outlook for major asset classes and alternatives. Reductions in the assumed rates of trend economic growth have resulted in lower expected returns across almost all asset classes. Today, a traditional balanced portfolio of 60% stocks and 40% bonds is now projected to generate a compounded return of 6%, compared with 6.7% using the 2014 return assumptions (EXHIBIT 1).
Investors should anticipate lower market returns
EXHIBIT 1: J.P. MORGAN ASSET MANAGEMENT’S 2015 VS. 2014 LONG-TERM CAPITAL MARKET RETURN ASSUMPTIONS
With return expectations from many asset classes expected to be below long-term averages, investors will be pressed to make their allocations work harder for them. In this low-return environment, not only will manager selection have a more meaningful impact, but even small variations from the benchmark can make a big difference.
Higher volatility on the horizon
Volatility, unavoidable in investing, is also on the rise. There are many measures of market volatility, including the standard deviation of returns, the CBOE Volatility Index (or VIX), implied options volatility and more. In recent years, the VIX has traded below its historical levels, but it should move higher toward its historical average of 16. Over the long term, the most meaningful measure of volatility may be the largest intra-year decline (or maximum drawdown), since it represents the largest loss an investor experiences during a given year. EXHIBIT 2 shows this measure relative to each year’s annual return.
Despite average intra-year drops of 14.2%, annual returns are positive in 27 of 35 years*
EXHIBIT 2: S&P 500 INTRA-YEAR DECLINES VS. CALENDAR-YEAR RETURNS
Such drawdowns can occur over days, weeks or months. Having the fortitude to stay invested during these periods requires discipline that has often been rewarded. For example, in 2013, the maximum drawdown of 5.8% during May and June occurred when the Federal Reserve began hinting at reduced asset purchases. Last year, investors saw a similar market pullback when the market fell 7.4% during October over a variety of global concerns. Despite the market reaction and subsequent volatility, neither episode reflected a change in the underlying economic growth trends. Consequently, those who stayed invested during each period benefited from the subsequent rebound in markets. Investors should continue to expect stock market volatility as valuation levels rise and the Federal Reserve prepares to raise rates. Periods of higher volatility also tend to result in higher dispersion levels, which reflect differences in performance within the market (EXHIBIT 3). As dispersion increases, this creates greater opportunities for active managers.
Higher dispersion creates more opportunities for active managers
EXHIBIT 3: SECTOR DISPERSION: STANDARD DEVIATION ACROSS ANNUAL S&P 500 SECTOR RETURNS
RE-EVALUATING YOUR CURRENT “CORE” EQUITY ALLOCATION
In a world of lower returns and higher volatility, investors may want to rethink their core equity allocation, as buying beta may not be enough. In recent years, some institutional investors have adopted a core-and-satellite approach for their equity allocation as a way to maximize their portfolios’ return potential for a given level of risk. Typically, the “core” allocation can be made up of passively managed securities that provide exposure to equity strategies that are more benchmark-oriented.
By contrast, the “satellite” portion can include strategies that have higher tracking error or higher “active share,” either of which has the potential to add higher alpha.
As the market moves into a lower-return environment, the contribution from any excess return becomes a more meaningful contributor to the overall return. Over the past three years ending March 2015, the S&P 500 Index returned 16% on an annualized basis. If an active manager had been able to provide an additional 1% above this return, the manager’s contribution to the overall return would have been 1/17, or 6%, of the total return. Going forward, if we are moving into a 6% return environment, then the manager’s contribution becomes 1/7, or 14%, of the total return. Beta continues to represent the largest portion of the total return, but as beta, or market return, becomes less important, excess return, or alpha, becomes more important. While an incremental 1% appears to be insignificant, through the power of compounding, this contribution becomes significant. For a $200 million investment, for example, that 1% differential can result in an extra $38.4 million in additional alpha over a 10-year period and an additional $284.2 million over 25 years (EXHIBITS 5A and 5B).
The difference 1% can make: Hypothetical scenarios that show the range of alpha that can be earned through compounding over time
EXHIBIT 5A: WHAT AN ADDITIONAL 1% RESULTS IN OVER 10 YEARS BASED ON DIFFERENT STARTING INVESTMENTS
EXHIBIT 5B: WHAT AN ADDITIONAL 1% RESULTS IN OVER 25 YEARS BASED ON DIFFERENT STARTING INVESTMENTS
One problem with seeking alpha, however, is that it can be hard to find, especially strong risk-adjusted alpha net of fees. If consistently outperforming active managers in the core space were common, there would be no need to discuss a rethinking of one’s core. Most people envision the opportunity set for investment management to look something like that shown in EXHIBIT 6A. In the graph, passive managers are represented in the lower-left-hand corner, while active managers, who are taking on more risk, are moving up toward the right-hand corner as they add ever-increasing excess returns. In reality, the investment management in the core equity space looks more like that shown in EXHIBIT 6B.
How active management should look
EXHIBIT 6A: EXCESS RETURN VS. TRACKING ERROR
How active management actually looks
EXHIBIT 6B: EXCESS RETURN VS. TRACKING ERROR
Source: J.P. Morgan Asset Management; analysis as of June 2015. For illustrative purposes only.
Source: J.P. Morgan Asset Management; analysis as of June 2015. For illustrative purposes only.
So why have active managers done so poorly on a relative basis? While there is no all-encompassing answer, the explanations tend to fall into one of two camps. First, proponents of passive investing believe the core space is too efficient and too well analyzed to be able to identify and maintain an information advantage. While those in the second camp believe that the first camp is correct to a degree, the “second campers” also believe that the fault lies in the risk taken to capitalize upon the information advantage. Most active managers take on too much risk relative to the benchmark, which leads to inconsistent returns and difficulty in consistently outperforming after fees. In other words, the problem is not in the analysis but in the portfolio construction. Do managers have a process in place to capitalize on their insights in a risk-controlled framework on an after-fee basis?
Indeed, 2014 was one of the worst years for active managers in general due to the uncompensated risks they took, including holding small cap stocks, non-U.S. stocks or even cash, all of which were a drag on performance. All three of these increased risk relative to the benchmark and were uncompensated sources of risk. In 2014, for example, while the S&P 500 Index returned 13.7% for the year, stock pickers struggled to keep up. Just 19.9% of U.S. equity fund managers bested their benchmarks, according to Morningstar.
Despite the evidence that institutional investors tend to fare better1 than retail investors, the historical performance of active management in the core space has, in general, pushed investors toward benchmark-oriented solutions. But with changing market conditions, one may question if passive is the best solution going forward. Some investors, for example, may have been lulled into a sense of complacency, believing that the low fees for passive management, combined with the mental energy it takes to search for good active managers, justify spending their risk budget (and time) on other parts of their asset allocation.
We believe there is a middle ground between active and passive. What if there were solutions that didn’t take excessive benchmark relative risks but added some incremental returns? In addition, just as one does when picking stocks, one needs to look at the risk taken for the reward received.
This active/enhanced mix often results in a superior information ratio.
Rather than seeking the high-octane alpha associated with active management, investors can seek to incrementally boost returns in the active space. An often overlooked participant in the active and passive trade-off is enhanced index funds, which are good index fund surrogates as well as a more cost-effective solution to alternative investments. These funds are designed to look similar to the index in regard to their risk characteristics but also seek to add some incremental returns to aid in the compounding of the portfolio’s returns. The higher information ratio of enhanced index-tracking strategies is key to this shift. In fact, an active/ enhanced mix may offer better returns than an active/index mix for equal levels of risk. This active/enhanced mix often results in a superior information ratio.
Enhanced index-tracking strategies attempt to limit their tracking error relative to the benchmark and, in so doing, tend to avoid the pitfalls (or uncompensated risks) that are the downfall of many active managers. Like an index fund, enhanced indexed-tracking strategies are close to fully invested at all times, with sector weights that are tightly controlled relative to the index’s sector weights. Their rigorous risk-management results in portfolios that look like the index in terms of risk, yet are designed to offer potential excess returns. As a result, investors receive virtually the same diversification benefits from enhanced index-tracking strategies, which are highly correlated with their benchmarks, only with consistent outperformance. To be sure, as with any active or passive investment, the measure of success is return net of fees relative to risk taken. By blending enhanced index-tracking strategies with more active funds or by using them as a partial allocation within a passive mandate, investors may end up with a more efficient core allocation.
Combining these risk diversification benefits with the strategies’ excess returns results in the efficient frontiers depicted in EXHIBIT 7. This exhibit compares efficient frontiers using 100% actively managed equity strategies, a mix of active and enhanced index-tracking strategies and a portfolio of 100% enhanced index-tracking strategies. Including the enhanced index-tracking strategies raises the aggregate return, with only a small corresponding increase in the aggregate risk when compared with a mix of active and passive equity strategies alone. We believe this increase in risk is a small price to pay for the increase in returns. Regardless of the strategy, there is a significant improvement in return with a minimal corresponding increase in risk.
Enhanced indexing can serve as a middle ground in volatile markets
EXHIBIT 7: EXCESS RETURNS VS. TRACKING ERROR
Source: J.P. Morgan Asset Management; analysis as of June 2015. For illustrative purposes only.
For those who believe that alpha generation is too difficult to consistently achieve in the core space, volatility reduction is another alternative that can improve the risk/return trade-off. As discussed earlier, we believe we are moving into an environment of lower returns and higher volatility. While investors can find efficient solutions through enhanced index-tracking strategies that provide higher returns, strategies that reduce volatility can also improve investors’ risk-adjusted returns. There are many means available to reduce portfolio volatility, but two of the more popular solutions are low-volatility portfolios and portfolios that intentionally and explicitly provide downside protection.
Taking a long-only approach
Strategies that reduce volatility by taking a long-only approach are often designed to capitalize on the mispricing of, and overreliance on, beta in the investment world. Rather than constraining themselves to capitalization-weighted bench-marks, low-volatility strategies capitalize on the inefficiencies in beta as a risk measure. The result can be a strategy with a similar return profile to the benchmark with approximately 20% less volatility.
As the name implies, low-volatility strategies combine securities with lower volatility into a portfolio that experiences only a portion of the market’s volatility. While these portfolios will be correlated with the market, if they can offer a return comparable to the market with a fraction of the volatility, one ends up at a more optimal risk-to-reward allocation, as shown in EXHIBIT 8.
Managing risk by balancing volatility with return potential: A long-only approach
EXHIBIT 8: EFFICIENT FRONTIERS OF BONDS AND S&P 500 USING J.P. MORGAN ASSET MANAGEMENT’S LONG-TERM CAPITAL MARKET RETURN ASSUMPTIONS
Explicit downside protection using hedging
Another risk-reduction strategy recognizes that upside volatility is more palatable than downside volatility. In other words, investors can tolerate more volatility when returns are greater than zero than they can when returns are less than zero. In order to reduce overall portfolio volatility, these strategies hedge downside risk by explicitly buying downside protection using options or other derivatives. This protection dampens the downside volatility which, over time, reduces the portfolios’ overall volatility. Since these actively managed hedges aim to provide higher risk-adjusted returns over long-only strategies, investors can use them to meet a variety of investment objectives, from de-risking and re-risking to serving as a liquid alternative to hedge funds.
There are several equity hedging strategies—long/short, options overlays and covered call writing—that aim to reduce portfolio risk through shorting and options. Determining the appropriate strategy depends on the investor’s strategic objectives, risk profile and desired beta exposure. Unlike the process used with shorting securities, hedged equity strategies (sometimes known as options overlay strategies) reduce risk by trading put and call options around an underlying stock index. In some cases, the manager may implement an equity collar by buying put options to protect an underlying equity portfolio and offsetting the cost of the put by selling call options.2
EXHIBIT 9 provides an example of how this type of strategy outperformed more tactical long/short hedge fund managers. Many of the long/short managers reduced their net equity market exposure in 2008 and 2009 and, as a result, missed out on the S&P 500 Index’s subsequent rebound. Usually, the price that one pays for this downside protection involves selling some upside participation away, but there are optimal trade-offs between the two.
Staying invested during volatile periods
EXHIBIT 9: RETURNS OF S&P 500 INDEX, HFRX EQUITY HEDGE INDEX AND A LOWER-VOLATILITY OPTIONS OVERLAY STRATEGY
Note: Options overlay strategy returns are shown net of fees. Based on J.P. Morgan’s analysis using back-tested data of an options overlay, or hedged equity, index.
Applying an options-based hedging strategy to an existing portfolio has several benefits:
- It provides consistent downside protection, especially during large, negative market moves.
- It provides a range of investment outcomes that is more defined and predictable than the outcomes of other long/ short strategies because the limits are set by the exercise prices of the put and call options.
- It provides a more cost-effective way to hedge an equity portfolio than shorting borrowed securities. With an options overlay strategy, the costs of buying put options on the underlying equities to provide downside protection are offset by income from the sale of call options.
In general, the risk associated with low-volatility and hedging strategies is that whenever one deviates from the benchmark, one is taking on risk relative to the benchmark (i.e., tracking error). Since these strategies are lower volatility by design and definition, they all exhibit defensive characteristics. This means that when the overall market is falling, they usually won’t fall by as much. The opposite is also true, however. When the overall market is rising, low-volatility strategies tend to trail the benchmark. This means that if we were to enter a sustained bull market, low-volatility strategies would lag the cap-weighted benchmark on a return basis. As with any active strategy, one must question the reward received for the level of risk taken.
PORTFOLIO CONSTRUCTION CONSIDERATIONS
Adding enhanced index-tracking strategies as a substitute or complement to a passive equity allocation in investors’ core equity allocations has the potential to enhance long-term portfolio returns and reduce risk, while also lowering sensitivity to market and interest-rate fluctuations. In fact, the strategies’ diversification and transparency can benefit a broad range of investors and add a new dimension to asset allocation.
Traditional portfolio construction techniques have long emphasized the role of asset allocation to determine optimal risk/return profiles. When constructing a portfolio, investors aim to include asset classes that have a low correlation to one another, thereby enhancing diversification and reducing volatility. The idea is to combine investments that don’t move up or down at the same time, or at least by the same degree. Doing so can smooth out returns, hedge portfolios against big losses on single investments and position investors to benefit if one corner of the market posts outsize gains.
Investors should aim for assets that are uncorrelated with one's other investments in their portfolios
It is important, however, not to confuse correlations (which measure direction) with magnitude. An asset can be perfectly correlated with an investment and therefore move in the same direction, but the magnitude of that move may vary. For examaple, assume that the S&P 500 Index loses 1% every month for a year. A hedged equity strategy would be 100% correlated with the S&P 500 Index if it lost one basis point (bp) every month over the same time period. In this example, the result is a 12bp loss over a full year for the hedged equity strategy versus a 12% loss in the S&P 500 Index. Most investors would be satisfied with a 12bp loss in a hedged equity strategy that is perfectly correlated with the S&P 500 Index when the market has lost 12%. Therefore, investors should aim for assets that are uncorrelated with one’s other investments in their portfolios and not necessarily investments that are uncorrelated with the broader market.
Meanwhile, historical correlation levels have not been as robust in recent years and can also vary over time, depending on the market environment. EXHIBIT 10 shows the average correlation of equities to select asset classes (commodities, currencies, U.S. high yield, U.S. investment-grade debt and U.S. Treasuries), as well as the maximum and minimum levels from 1996 to 2015.
Historical correlations can vary over time (1996–2015)
EXHIBIT 10: AVERAGE, MAXIMUM AND MINIMUM LEVELS OF CORRELATIONS BETWEEN EQUITIES AND OTHER ASSET CLASSES
A key assumption behind diversifying across asset classes is that correlations remain constant over any one investment horizon. But, depending on the market and volatility regimes, the spreads can vary widely. EXHIBIT 11 highlights the correlation levels across different periods of extreme market stress or euphoria, such as the Asian financial crisis (mid- 1990s), the Internet bubble (late 1990s to early 2000s) and the recent financial crisis (2007 to 2008). The point is that correlations are dynamic and can rise or fall, raising concerns about relying solely on diversification across asset classes, as well as highlighting the need to consider other hedges to further reduce risk. Diversifying within the same asset class through the use of equity hedges, for example, can reduce investors’ dependence on correlation levels and dampen volatility in a more systematic, controlled and cost-effective manner, resulting in returns that are slightly more certain and predictable than returns from traditional asset allocation.
Spreads between correlations vary widely in periods of extreme stress or euphoria
EXHIBIT 11: CORRELATIONS BETWEEN SELECT ASSET CLASSES (APRIL 1996 TO MARCH 2015)
Few people believe that the recent past in either the fixed income markets or the equity markets is a true reflection of what the future holds. In an environment of lower returns and higher volatility, investors may want to consider equity strategies that can either add incremental alpha or minimize volatility to improve their risk-adjusted returns.