Alternatives:
An Answer to Risk Diversification
June 2015
®
Alternatives: An Answer to Risk Diversification
THE “WEALTH EFFECT”
On May 21, 2015, the S&P 500 Index crossed 2,130 to register its fourth
record close in six sessions. On May 27, 2015, the NASDAQ Composite
Index breached its record high to close at 5,106 as technology stocks
zoomed ahead. While everyone feels great about the increase in their
portfolio value, something feels artificial about the market. The artificialities
to which we refer are the price distortions caused by the unprecedented
intervention in the global financial markets by central banks in North
America, Europe and Asia. Since 2009, these central banks have been
engaged in a zero interest rate and quantitative easing policies in an effort
to spur economies by generating a so-called “wealth effect.” The theory
is that a central bank can stimulate the economy by purchasing risk-free
assets to a point where the diminished prospective returns of risk-free
assets drives private capital into risk assets such as the stock market or
venture capital. As prices for the risk assets rise with the influx of private
capital, the holders of these assets feel “wealthier” and therefore are more
likely to spend money freely, stimulating demand in the economy.
The effectiveness of this “wealth effect” policy in promoting general
economic growth is debatable; however, history has consistently shown
that when natural pricing mechanisms in markets are suppressed and
distorted, capital can be invested into inappropriate assets which leads to
further pain in the broader economy. Two examples of this are the housing
market prior to the 2008 financial crisis and the recent over-investment into
energy that lead to a dearth of supply and a violent crash in energy prices.
In the next few paragraphs, we will examine the impact of the “wealth
effect” on the bond and stock markets in an effort to provide perspective
on the distortions in the current market environment and the potential
impact these distortions may have on investment portfolios in the future.
Finally, we will conclude by suggesting that the relatively new asset class of
liquid alternatives may offer investors, and their advisors, a diversification
opportunity that has historically only been available to institutions and
high-net-worth investors.
QUANTITATIVE EASING & THE SEARCH FOR YIELD
From 2009 through 2014, the U.S. Federal Reserve increased the size of
its balance sheet by more than $3.5 trillion through bond purchases in
three rounds of quantitative easing. For reference, Germany is the fourth
largest economy in the world with a 2015-estimated gross domestic
product (“GDP”) of $3.4 trillion, $100 billion less than the aforementioned
increase in the U.S. Federal Reserve balance sheet over the last five years
ended 12/31/14. Of the $3.5 trillion in bond purchases, approximately $2.3
trillion were of U.S. Treasury bonds of various maturities. Obviously, these
purchases resulted in increased prices and reduced yields.
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Alternatives: An Answer to Risk Diversification
Table 1 below compares the average yield of selected maturity bonds
against the average of the monthly average yields from 1990 through April
2015 (304 months):
Table 1: Average Yield of Selected Maturity Bonds
Maturity
5 Year
7 Year
10 Year
20 Year
30 Year
April 2015 Yield
1.43%
1.79%
2.05%
2.49%
2.75%
Monthly Average Yield
(01/1990 -04/2015)
4.34%
4.66%
4.92%
5.05%
5.54%
Difference
2.91%
2.87%
2.87%
2.56%
2.79%
Source: Federal Reserve Bank of St. Louis
It is important to note that the difference between current yields and
historical averages is not solely due to quantitative easing. Part of the
difference is due to the secular decline in interest rates since the early
1980s when the rates on the maturities listed in the table reached yields
of approximately 15 percent. That said, we expect this secular trend of
declining yields to reverse given how low current yields are across all
maturities.
So what happens to the value of bonds should rates rise? Table 2 below
displays the magnitude of loss for each maturity, assuming a hypothetical
investor purchased a bond at face value at April 2015 yields and was
forced to sell the bond one year into the future at the average yield for
each maturity.
Table 2: Loss on Sale of Bond after One Year Holding Period1
Maturity Face Value
Coupon
Face Value Total Loss3
Loss
4/30/2015 Payments 4/30/20152
Percentage
5 Year
$1000.00
$14.30
$894.31
($91.39)
(9.14%)
7 Year
$1000.00
$17.90
$851.17
($130.93)
(13.09%)
10 Year
$1000.00
$20.50
$793.49
($186.01)
(18.60%)
20 Year
$1000.00
$24.90
$689.99
($285.11)
(28.51%)
30 Year
$1000.00
$27.50
$599.15
($373.35)
(37.34%)
Assuming hypothetical investor purchased bond at face value at April 2015 yields
Yields rise to average
3
Loss in value, net of coupon
1
2
While a reversion of yields to a long-term mean would be a large change
over the course of a year, moves such as this have occurred in the past.
Should economic data become increasingly positive, the Federal Reserve
may be forced to increase interest rates and normalize its balance sheet
at a faster rate than anticipated. A similar situation occurred in 1994 when
rates on the 10-year Treasury increased by 286 basis points from their lows
in October 1993 to their highs in November 1994, in response to strong
economic data.
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Alternatives: An Answer to Risk Diversification
MARKET REALITIES
A new variable to consider is liquidity in the fixed income markets.
Historically, the fixed income market has been a very large and deep
pool of liquidity that could easily accommodate the private capital that
sought investment, but with the Federal Reserve and other central banks
absorbing a large portion of liquidity, participants in fixed income markets
have become concerned. Should there be a significant dislocation in the
market for risk assets, there may not be enough risk-free bonds to satisfy
all investors seeking safety. Liquidity in the secondary market for other
bonds, such as corporates and municipals, has also thinned in recent years.
Fixed income markets have traditionally been structured as an over-thecounter principal market where the market maker, usually a bank, acquires
an inventory of bonds and is compensated for its market making services
through the bid-ask spread when transacting with investors. As a result of
the myriad of new financial regulations since the financial crisis, inventories
of bonds that banks are allowed to warehouse are diminished. Once again,
significant dislocations in the financial markets could generate increased
volatility that could lead to unforeseen negative consequences.
The Federal Reserve has also made a significant impact on the U.S. equity
market. Company earnings have substantially grown since the dark days
of 2008, and have been a key driver in the rise of the equity market, but
there are other signs of distortion caused by the Federal Reserve. Capital
returned to shareholders in the form of dividends and share buybacks
has increased 90 percent over the last five fiscal years for the current
constituents of the S&P 500. Figure 1 below illustrates this rise:
Figure 1: Capital Returned to Shareholders by Current Constituents of
the S&P 500 Over the Last Five Fiscal Years
1,000,000
900,000
800,000
300,764
700,000
336,820
$ Millions
600,000
228,011
500,000
400,000
266,741
197,477
300,000
200,000
408,844
381,669
Fiscal Year -3
Fiscal Year -2
571,435
571,875
Fiscal Year -1
Fiscal Year -0
281,893
100,000
-
Fiscal Year -4
Share Repurchases
Dividends
Source: S&P Capital IQ, Cognios Analysis 05/22/2015
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Alternatives: An Answer to Risk Diversification
The rapid rise in capital returned to shareholders has not been matched
by a commensurate increase in cash generated from operations. Over
the last five fiscal years, the cumulative cash flow from operations for the
companies rose to $1.687 trillion from $1.415 trillion, meaning that capital
returned to shareholders as a share of cash from operations rose to 54
percent from 34 percent five years ago. Meanwhile, capital expenditures
for these same companies have increased only 50 percent over the same
period to $706.9 billion in the last fiscal year from $471.1 billion five
fiscal years ago. The lack of capital expenditures may be due to a scarcity
of promising expansion opportunities, but another explanation is that
dividends and share buybacks are extremely attractive to investors in a
yield-starved world. Why would a management team risk termination
over a botched capital project when they can boost share price by simply
writing a bigger check to shareholders?
Valuation statistics also indicate that equity markets are overvalued. The
ratio of the total stock market value compared to U.S. GDP is a popular
metric among analysts to gauge valuation of the market as a whole. The
chart below uses the cumulative value of the Wilshire 5000 Total Market
Index as the proxy for the total value of the U.S. stock market. Market
observers tend to become concerned about overvalued equity markets
when the ratio crosses above 1.00x. As the accompanying chart indicates
based on market value and GDP data from Q1 2015, the ratio of market
value to GDP is at an all-time high of 1.37x since the Wilshire 5000 Index
was constructed in the early 1970s.
Figure 2: Ratio of Market Value to GDP
1.600
1.400
Ratio of Market Value to GDP
1.200
1.000
0.800
0.600
0.400
0.200
0.000
Source: Federal Reserve Bank of St. Louis as of March 31, 2015
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Alternatives: An Answer to Risk Diversification
Price-to-earnings multiples also indicate that there may be an
overabundance of capital invested in equity markets. Many equity
analysts use trailing 12 months or estimated next 12-month results for the
“earnings” portion of the ratio, but this approach can be flawed due to the
cyclicality of earnings. A truer indicator of the long-term earnings power
of a representative index of companies, such as the S&P 500, is to use
the Cyclically Adjusted Price to Earnings (CAPE) ratio. At the beginning of
2015, the CAPE ratio was 26.79x. The table below shows the annualized
price return for the S&P 500 based on the CAPE ratio at the beginning of
the year over the last 87 years:
Table 3: Annualized Return of S&P 500 (price only)
For Next 5 Years Since 1928
CAPE
Ratio Range
(Beginning of Year)
5.0x - 10.0x
10.0x - 15.0x
15.0x - 20.0x
20.0x - 25.0x
>25.0x
Average
Median
Max
Min
Negative
Returns
Count
15.99%
14.48%
7.72%
8.91%
0.19%
15.03%
14.26%
9.37%
7.84%
(0.24%)
21.26%
23.90%
16.44%
28.30%
10.61%
13.16%
3.49%
(12.71%)
(10.65%)
(11.98%)
3
2
6
10
23
22
16
11
Source: Cognios Analysis as of 05/22/2015
This table shows that the higher the CAPE is at the start of the period,
the lower investment returns will be over the following five years and
the greater the chance of having a negative return over those five years.
Approximately half of the time when the investment period started with
a CAPE over 25x, which it is today, the next five years delivered negative
equity returns. Based on the historical evidence presented above, we
believe that equity investors should lower their expectations regarding
future returns from the equity markets.
Based on margin debt balances, it would appear that investors are poorly
positioned for the future. According to the New York Stock Exchange, total
margin debt in brokerage accounts was at a record high of $507.2 billion
as of April 30, 2015. Margin debt, net of cash, in brokerage accounts was
also at a record high of $227.4 billion. An account with margin debt can be
forced into liquidation should the prices of its underlying holdings move
adversely, which can greatly magnify market volatility.
THE ROLE OF ALTERNATIVES IN AN UNCERTAIN MARKET
What should an investor do should he or she be worried about the future
of the equity market? In our opinion, the obvious first step is to eliminate
any margin debt balances through stock sales or other proceeds. There is
always safety in cash but a large cash position can be a hard position to
hold, especially when markets continue to rally, even if irrationally.
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Alternatives: An Answer to Risk Diversification
We believe that alternative strategies that participate in market rallies but
also seek to provide protection in market downturns should be considered
a critical component of one’s portfolio re-balancing strategy. Alternatives
can potentially enhance risk-adjusted returns of a portfolio and be used
as a portfolio diversifier for both fixed income and equity allocations.
Historically, alternative funds were only available to wealthy and
institutional investors through hedge funds, but powerful structural forces
are now accelerating the adoption and availability of alternatives among
all investors. This is done through the introduction of liquid alternatives
(alternative strategies that are available in a mutual fund rather than a
hedge fund structure). Investors that focus on the alignment of alternative
strategies with desired investment outcomes should see portfolios that
provide a more stable return profile, coupled with lower volatility and
correlation to their traditional investments.
In the past, the primary fascination with hedge funds was centered on
the potential for turbocharged performance results that were primarily
achieved through highly leveraged, concentrated and illiquid investments.
Overwhelmed by the global financial crisis, the prolonged period of market
volatility and the macroeconomic uncertainty that followed, investors are
now seeking consistent, risk-adjusted returns that are uncorrelated to the
market. Further, investors are also looking for returns that are independent
of broad market and macro events.
Coupled with the disappointing performance of traditional asset classes
in a time of increased volatility, economic uncertainty and geopolitical
turbulence, investors and investment advisors are now using alternatives
as a diversification tool to dampen portfolio volatility, reduce portfolio
correlation to the overall market and generate a more predictable return
profile. An increasing number of institutional investors express interest
in abandoning traditional asset-class definitions, instead embracing riskfactor based methodologies, a trend that repositions alternatives from
a small portfolio allocation to a central part of the investment portfolio.1
Theoretically, a risk factor-based investment approach enables the investor
to focus less on asset class and more on the underlying risk factors that
influence risk, return and correlation in the portfolio. This should lead to
greater diversification and more efficient portfolios than could be achieved
by looking only to traditional asset classes for diversification. Seemingly
diverse asset classes can have unexpectedly high correlations—a result of
the significant overlap in their underlying common risk factor exposures.
Generally, alternative managers design strategies that when implemented
into a diversified portfolio will increase diversification and potentially
provide a return that is non-correlated to the other investments in the
portfolio.
Market data suggests that the alternative mutual funds have the potential
to become six percent of the size of the U.S. mutual fund industry by the
end of 2015, up from three percent at 2013 year-end, and 0.5 percent in
2008.2 Market neutral, long/short equity and event-driven strategies are
expected to be the most “sought-after liquid alternative strategies over
the next year,” according to a Deutsche Bank study.3
Risk Factors as Building Blocks for Portfolio Diversification. Callan Investments Institute, June 2012.
Bary, Emily. “A Big Week For Bullish ‘Alternative’ Views.” Focus on Funds RSS. Barrons, 8 Aug. 2014.
3
“Deutsche Bank Provides Hard Numbers on Liquid Alts Growth - DailyAlts.” DailyAlts. N.p., 10 Sept. 2014.
1
2
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Alternatives: An Answer to Risk Diversification
Figure 3: Growth of Liquid Alternatives
Source: Morningstar
As investors become less focused on diversification across traditional asset
classes and begin to focus on diversification of risk factors in the portfolio,
it is expected that alternatives will no longer be looked at as a separate
asset class; rather, alternative allocations will be funded from equity and
fixed income “buckets” of the portfolio. A Cerulli study showed that nearly
50 percent of financial advisors intend to source alternative allocations
from U.S./international equity and 13 percent intend to source from fixed
income, though another 37 percent intend to allocate from new investments/
cash.4 Although the liquid alternatives industry is still in its infancy, investors
equipped with the proper tools and analytical framework can overcome
the deficiencies currently present in this market to achieve results more
representative of the hedge fund universe.
To support this shift to alternatives, managers of alternative strategies will
need to demonstrate a fiduciary mindset as well as show a disciplined pursuit
to offer differentiated strategies that add clear value to investor portfolios.
Further, alternative managers should ensure alignment of incentives with
investors through a commitment to high standards of product transparency,
regulatory compliance and investor education.
“Retail Liquid Alternatives A $2T Trillion AUM Opportunity: Goldman.” Retail Liquid Alternatives A $2T
Trillion AUM Opportunity: Goldman. N.p., 10 Sept. 2014. Web.
4
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Leawood, KS 66211
913.214.5000
©2015 Cognios Capital
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Alternatives: An Answer to Risk Diversification
Glossary of Terms
S&P 500 Index - The index includes 500 leading companies and captures
approximately 80% coverage of available market capitalization.
NASDAQ Composite Index - A market-capitalization weighted index of the
more than 3,000 common equities listed on the Nasdaq stock exchange.
Wilshire 5000 Total Market Index – Full market capitalization index that
measures the performance of all U.S. equity securities with readily available
price data.
Basis Point – One basis point is equal to 1/100th of 1%, or 0.01% (0.0001),
100bp=1.00%.
Price-to-earnings ratio / Price-to-earnings multiple – A valuation metric of a
company’s current share price compared to its earnings per share.
Trailing 12-month P/E – Price-to-earnings calculated using the last 4 quarters’
earnings.
Forward 12-month P/E – Price-to-earnings calculated using estimates of
earnings expected in the next four quarters.
Cyclically adjusted price-to-earnings ratio “CAPE” - share price divided by
the average of ten years of earnings. The long term average is intended
to smooth out short term volatility of earnings and medium term business
cycles.
Margin debt – The aggregate value of securities purchased on margin.
Margin debt carries an interest rate, and the aggregate value of margin debt
changes daily as the value of the underlying securities change.
Correlation – Statistical measure of how two securities move in relation to
each other.
®
11250 Tomahawk Creek Parkway
Leawood, KS 66211
913.214.5000
©2015 Cognios Capital
This information is provided for informational purposes only and nothing herein constitutes
investment, legal, accounting or tax advice, or a recommendation to buy, sell, or hold
a security. Information is obtained from sources deemed reliable, but there is no
representation or warranty as to its accuracy, completeness or reliability. All information is
current as of the dates noted and is subject to change without notice. Any views or opinions
expressed may not reflect those of the firm as a whole. This material may include estimates,
outlooks, projections and other forward-looking statements. Due to a variety of factors,
actual events may differ significantly from those presented. Investing involves risk, including
possible loss of principal. Investments in hedge funds and private equity are speculative
and involve a higher degree of risk than more traditional investments. Alternative products
typically employ more complex trading strategies, including short selling that may change
with market conditions. Investors considering alternatives should be aware of their unique
characteristics and additional risks from the strategies they use. Diversification does not
guarantee profit or protect against loss in declining markets. There is no guarantee that
hedged strategies will protect against losses, perform better than non-hedged strategies or
provide consistent returns. Past performance is no guarantee of future results.
This material may include or reference third-party information. Cognios Capital has
not sought to independently verify any such third-party information and does not make
any representation or warranty as to the accuracy, completeness, or reliability of such
information. Nothing herein implies any endorsement, approval, investigation or verification
by Cognios Capital of any third-party materials, products or services.
Cognios Capital is an SEC Registered Investment Advisor.
SEC registration does not imply a certain level of skill or training.
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