The lines between active and passive, alpha and beta have become increasingly blurred over the past decade or so, as investors have started to think more about risk and less about asset class when allocating investments. The long-standing trend of indexation has made beta exposure cheap and easy-to-find, and studies have also exposed the majority of “alpha” as owing to the type of “systematic risk premia” captured by smart beta indices. Thus, true alpha is even rarer than previously thought.
S&P Dow Jones Indices, arguably the worldwide leader in market indices, has published a new white paper titled The Role of Multi-Asset Solutions in Indexing. In it, authors Xiaowei Kang, Aye M. Soe, and Keith Loggie examine the growing trend of indexation and how it is causing further delineation between the sources of returns, along with three case studies each looking at a different “outcome oriented” solution: risk parity, income generation, and inflation protection.
Risk parity is an investment strategy that allocates according to the amount of risk an asset brings to the portfolio, rather than by dollar amounts or percentages. For example, stocks generally contribute more risk than bonds, so a “60/40” (60% stocks, 40% bonds) portfolio will typically derive much more than 60% of its total risk from stocks.
According to the data reviewed by S&P Dow Jones, risk parity portfolios have outperformed traditional “60/40” strategies, as well as equal-weighted and volatility weighted strategies, across 5-, 10-, and 20-year time frames. What’s more, risk parity not only had higher returns than the other strategies, but also lower risk, a higher Sharpe ratio, and a lower maximum draw-down across all three time periods!
Amid the global environment of low interest rates, income-oriented investors have turned to alternative sources of income: Real estate investment trusts (REITs), master limited partnerships (MLPs), preferred stock, senior loans, and emerging market debt, among others.
These asset classes generally have different risk and return profiles, and they react differently to market events – they have low correlation to one another, and often to the broad markets, as well. For example, MLPs had the strongest returns for the 10 years ending 2012, averaging 15.7%, while preferred stocks and U.S. senior loans had the lowest returns of 5.6% and 5.8%, respectively. But while the latter two asset classes had similar returns, they had very different risk profiles, with preferred stocks averaging 19.4% and senior loans just 8.7%. MLPs averaged 16.6% risk for the period.
Similarly, REITs and emerging-market bonds had similar returns of 11.5% and 11.6%, respectively, but vastly different risk: REITs, at 26.7%, had the highest risk; while emerging-market bonds averaged just 8.9% risk, the second-lowest next to senior loans.
With the global economy stuck in a disinflationary rut, inflation-protection may seem like a remote concern, but it shouldn’t. Central banks around the world have engaged in unprecedented monetary stimulus since the start of the financial crisis in August 2007, and even some of the Fed’s deflation hawks begrudgingly acknowledge that disinflation / deflation could turn into an inflationary problem if bankers aren’t careful.
For this reason, investors are looking for inflation-protection solutions, and S&P Dow Jones Indices reviews several. First, the authors delineate between inflation-protecting assets (commodities, natural resource stocks, REITs, gold, and TIPS) and inflation-protection solutions (static allocation, risk parity, and tactical allocations), and find that each of the individual asset classes – except for TIPS (Treasury Inflation-Protected Securities) – beat inflation significantly less than the three strategic solutions:
- Commodities beat inflation 61% of the time;
- Natural resource stocks 65%;
- REITs 74%;
- Gold 77%;
- TIPS 82%;
- Static allocation 81%;
- Risk parity 88%; and
- Tactical allocation 82%.
Solutions, Not Products
The inflation-protection findings validate the white paper’s general thesis, which is that the market is evolving toward solutions rather than products. First, passive ETFs provided beta indexation, and then smart-beta indices gave investors an opportunity to further delineate between alpha and beta. Now, investment solution providers are targeting more specific solutions, rather than single-asset class products, for today’s investors.
For more information, download a pdf copy of the whitepaper.