JUly 2015
STORM TRACKING
Forecasting and managing risk
seth J. masters
Chief Investment Officer
Bernstein Private Wealth Management
daniel J. loewy
Chief Investment Officer
Multi-Asset Solutions
Executive Summary
Volatility is volatile. During market upsets, balanced portfolios can be
more volatile than equities alone typically are (Display 1), prompting
investors to sell stocks at low prices and miss the next rally.
We introduced Dynamic Asset Allocation five years ago to mitigate the
impact of extreme markets, reducing overall portfolio volatility without
sacrificing long-term returns. We have achieved these goals over the
past five-year period. Clients received a smoother ride—and the return
benefit of maintaining stock exposure during a historic rally.
Market risk will rise again from recent lows. This review of how we
managed the market tumult of the past five years should provide insight
into how we will manage the upsets to come.
display 1: The Problem With Traditional Asset AllocatIon
Realized Volatility of a Moderate Portfolio Since 1970*
25
Percent
20
Long-Term
Equity Volatility
15
10
5
Long-Term
Portfolio Volatility
0
70
75
80
86
91
97
02
07
13
Years
Through December 31, 2014
*Rolling realized one-year volatility. Static portfolio results are based on a portfolio that is
invested 60% in global equities and 40% in global bonds (as adjusted to reflect duration only) and
rebalanced monthly. Average equity volatility is based on global equity returns.
Source: Barclays, Morgan Stanley Capital International (MSCI), and AB
2
STORM TRACKING
When the weather is balmy and dry, it’s easy to forget
about patching the roof, keeping your insurance up to
date, and checking the weather forecast to see if you
should shut the windows before leaving the house. This
spring’s torrential rains were a sharp reminder not to
neglect such precautions.
to add another layer of risk management to client
portfolios. We believed that we could mitigate extreme
market outcomes by shifting your portfolio away from
your strategic asset allocation when our research
suggested that market conditions were likely to become
hostile (Display 2).
Similarly, when the capital markets are calm (as they
have been for most of the past three years), it’s easy to
forget about risk and just reach for return. But market
risk will inevitably return to normal, or higher. You need
to be ready.
DAA’s goal is to reduce the pain of big market sell-offs,
even though that might mean missing the early stages
of a recovery. Our research suggested that by mitigating
extreme market outcomes and providing more consistent
investment results, DAA could provide clients with two
important benefits:
At Bernstein, we always keep an eye on risk. We help you
to weigh risk against potential return when you choose
your long-term strategic asset allocation, and we weigh
risk against potential return when choosing securities
within actively managed portfolios.
We also weigh risk against return in our Dynamic Asset
Allocation (DAA) service, which we launched in April 2010
„
It could reduce the risk that clients who are
spending from their portfolios would suffer large,
permanent losses from withdrawals at market
bottoms.
„
It could give clients greater confidence about
adopting—and sticking to—a strategic asset
allocation with the risk they need to achieve their
long-term return objectives.
diSplay 2: daa obJEcTiVES, EXpEcTaTionS, and bEnEFiTS
Portfolio with DAA
Objectives
Frequency
Portfolio
Without DAA
Less
Volatility
Reduce volatility over the long run
Mitigate extreme outcomes
Better risk-adjusted returns
Expected Performance Patterns
Limit downside in sustained
bear markets
Potential to lag in sharp rebounds
Low
High
Returns
Source: ab
STorm Tracking 3
DAA has achieved all of its goals over its first five years:
It has reduced clients’ overall portfolio volatility and
maintained returns, and thus improved risk-adjusted
returns. As expected, DAA detracted from portfolio
returns in some periods and added to returns in others,
but most Bernstein clients benefited because they
maintained their exposure to stocks during one of the
greatest stock-market rallies ever.
This paper reviews how DAA responded to changing
market conditions over the last five years and how it is
addressing market challenges today. We know the future
won’t be a repeat of the past, but we hope to help you
understand how we will seek to track future storms and
steer the ship when markets become more turbulent.
Philosophy and Approach
The DAA team starts each day by asking two simple
questions: “How much risk are clients taking in their
portfolios?” and “Are clients likely to be compensated
enough for taking that risk?”
These basic questions may sound like Investing 101,
but they’re hard to answer. Before launching DAA, we
dedicated three years of intensive research to devising
the tools that DAA uses to answer them. We have
continued to enhance our tool set ever since.
On the risk side, we started with a simple insight: Risk
tends to build like a hurricane. You can usually see it
coming, so you can take action in advance to protect
your home and family.
What are early warning signs of risk ahead? We take cues
from the markets, which quickly respond to information.
We also discuss fundamentals with our investment teams
to understand the risks their research uncovers.
To assess risk, we analyze volatility (price fluctuations)
and the correlation of returns among asset classes (their
4
tendency to move up and down together). When volatility
is higher than usual, there’s a greater risk of loss. When
correlations are higher than usual, diversification doesn’t
reduce overall portfolio volatility as much as usual.
Historically, volatility has been sticky for all asset classes.
After periods of very high risk, volatility has generally
remained elevated before gradually declining toward
normal. Likewise, after periods of low risk, volatility has
remained subdued before gradually rising toward normal
(Display 3). Correlations have also exhibited sticky
behavior over time.
To assess whether investors are likely to be adequately
compensated for taking risk, we consider market data
that indicate the strengths and weaknesses of asset
classes and the health of the market environment,
and talk to our investment teams about their research
findings.
Valuations, corporate balance-sheet strength, and
earnings quality capture intrinsic qualities of various
asset classes. Corporate and sovereign credit conditions,
current yields, and recent changes in yield provide
information on the market environment’s health.
Changes in growth, inflation, or government stimulus
are also important, although each asset class responds
differently to them.
Systematic analysis of all these data streams makes
it possible to digest far more information than would
otherwise be possible. It allows us to assess the risk
and return potential of each asset class relative to its
own history and to other asset classes, and adjust client
portfolios accordingly.
A portfolio’s overall mix of stocks and bonds tends to be
the single biggest driver of risk, so most of the moves
DAA makes in response to market conditions involve the
display 3: volatility is “sticky” AND hence predictable
Annualized Volatility: Percent
S&P 500: 1929–2009
40 Past Realized Volatility
Global Fixed Income: 1970–2009
Forward Volatility
10
Highest Volatility Quintile
20
5
Long-Term Avg.
0
0
Lowest Volatility Quintile
3
6
9
12
0
3
6
9
12
0
Months Forward
Months Forward
Currencies: 1974–2009
Commodities: 1970–2009
16
12
8
4
0
3
6
9
12
Months Forward
25
20
15
10
5
0
0
3
6
9
12
Months Forward
Through June 30, 2009
Historical data are for illustrative purposes.
Each observation is ranked by past volatility at the end of the month and sorted by quintile (except currencies, which are sorted by tercile).
Past volatility is an exponentially weighted average using daily data with a three-week half-life (5% decay per day). All metrics are
annualized. Currency returns are returns of currency forwards (long forwards and short the US dollar).
Source: Barclays, FTSE NAREIT, Global Financial Data, and AB
stock/bond mix. But we also adjust regional exposures,
currency positions, commodities, and other exposures,
as needed, given our assessment of the risks within the
underlying portfolios, and the likely compensation for
holding them.
Since risk tends to trend, we tend to make many small
adjustments. We don’t wait for risk to reach hurricane
levels (or extreme lows) to act—and we generally don’t
make big, sudden moves, though we can. We designed
DAA to be nimble when needed.
THE FIRST FIVE YEARS
DAA deliberately reduced portfolio risk over an initial
period of elevated market risk, from DAA’s launch in April
2010 through the end of 2012. It added a bit to portfolio
risk over the course of the sustained period of market
calm that followed.
In both periods, DAA gave clients a risk experience closer
to the one they signed up for when they adopted their
long-term asset allocation. In both periods, DAA also
reacted to some relatively short-lived shocks. Here’s how
we handled a few of them.
storm tracking 5
EUROPE’S SOVEREIGN DEBT CRISES
Over the last five and a half years, a series of crises has
unfolded in Europe related to the possibility that Greece
and other countries might default on their enormous
debt loads, and thereby destabilize the European banking
system and fracture the European currency union
(Display 4).
The first crisis hit just after DAA was launched: Stockmarket volatility rose on fears of a Greek bond default,
and DAA reduced equity exposure. DAA mitigated the
impact on client portfolios of a nearly 16% global stock
drawdown, adding 1.2% to the returns of balanced taxaware accounts.*
The second euro crisis was even worse: Global equity
markets fell 23% from early August to early October
2011—and subdued equity-market volatility earlier
that year didn’t provide the danger warning we would
generally expect. Fortunately, we saw other flashing
lights: Credit spreads on European sovereign bonds were
ballooning, particularly for Greece, Portugal, Spain, and
Italy, the countries under the greatest economic stress.
DAA de-risked client portfolios by moving them below
their strategic allocation to stocks and above their
strategic allocation to US bonds. We also hedged some
euro exposure. Both shifts mitigated client losses as
global stock markets plunged and the euro depreciated,
adding more than 1% to the returns of balanced, taxaware accounts in just two months.*
Of course, we haven’t always been right—and more
often than not, when we have erred it was on the side
of caution. For example, in mid-2012, we saw trouble
brewing again in Europe: Greece couldn’t form a
government, and we perceived a greater chance that
Greece would exit the currency union, with dire potential
consequences across Europe. What if the European
Central Bank (ECB) didn’t do enough to protect Europe’s
fragile economic recovery?
Fortunately, Greece did form a new government and
the ECB said it would “do whatever it takes” to keep the
currency union intact. The ECB announced unlimited
support for debt-burdened countries with bailout plans.
In this case, the hurricane moved out to sea. Our
defensive move resulted in a modest give-up in return.
THE US FISCAL CLIFF
In late 2012, shortly after the third European sovereign
debt crisis was averted, market fears shifted to the US.
Would Congress and the President agree on a deficitreduction deal before January 2, 2013, the “fiscal cliff,”
when roughly $500 billion in tax increases and acrossthe-board spending cuts were scheduled to take effect?
If not, would markets take a swan dive on fears that
the tax hikes and spending cuts would derail the US
economic recovery?
At that point, stock-market volatility was sufficiently low—
and valuations, sufficiently attractive—that we thought
DAA should overweight equities, but the small chance
of a very bad outcome gave us pause. We also noticed
that low stock-market volatility made buying equity put
options much less expensive than usual. After much
discussion, we decided to overweight equities, while
buying equity put options as insurance against the risk
that political deadlock would precipitate a market drop.
Once again, the hurricane moved out to sea. At the
eleventh hour, Congress passed a budget and tax
package that the President accepted. Stock markets
rallied, volatility declined—and our options expired
unused. Buying the options cost clients a little of the
upside, but without that insurance, DAA wouldn’t have
tilted to stocks, given the fiscal-cliff risk. Overall, our
carefully calibrated overweight was a benefit to clients.
*Return premium is for a 60/40 stock/bond tax-aware account with DAA relative to the same allocation without DAA.
6
display 4: Steering Portfolios Through Market Shocks
equity-Market Volatility Since DAA Inception
Elevated Risk
Average Volatility: 22.1%
50
Percent
1st Euro Crisis
May–Jun 2010
Calm Markets
Average Volatility: 14.6%
2nd Euro Crisis
Aug–Oct 2011
3rd Euro Crisis
May–Jul 2012
30
US Fiscal Cliff
Dec 2012–Feb 2013
Oil Price Collapse
Oct 2014
10
Apr 10
Dec 10
Aug 11
Apr 12
Dec 12
Aug 13
Apr 14
Dec 14 Jun 15
Past performance does not guarantee future results.
Through June 30, 2015
Equity-market volatility is represented by the CBOE Volatility Index (VIX).
Source: Bloomberg, CBOE, MSCI, and AB
THE OIL PRICE PLUNGE
In early October 2014, global equities sold off nearly
5%, and volatility spiked on fears that plunging oil
prices reflected falling global demand and an economic
slowdown. In this case, risk hit without warning—more
like an earthquake than a hurricane.
„„
Japan and Europe were showing early signs of
economic recovery, and the US economy was on
solid footing.
„„
Low interest rates and inflation were likely to be
supportive of stocks, and strong corporate
balance sheets justified above-average stockmarket valuations.
Since we didn’t see the earthquake coming, we didn’t
reduce risk ahead of the market drop. After it hit, we
decided to retain DAA’s equity overweight, because our
research indicated that:
For about a month, DAA’s equity overweight worsened
the impact of the stock-market drop. Then, stock markets
rebounded and went on to set new highs.
„„
Demand for oil had fallen only slightly, and falling oil
prices were primarily the result of increased supply,
due to improved drilling and pumping technology.
The overweight added to returns throughout the
recovery, recouping the losses incurred in the
brief downturn.
storm tracking 7
DAA seeks to smooth the ride, but it can’t completely
absorb every shock—particularly very short, sharp ones
like this one. If we had sold into the market drop, clients
would have realized losses and missed the rapid rebound
that followed.
calm before the storm?
The market calm that has prevailed with few interruptions
since late 2012 became an extraordinary stillness in 2015.
The VIX, an index of US equity-market volatility, fell to
almost 12% in May. It has been that low in only 10% of
all readings since 1991.
Investors have had good reason to be complacent.
The Federal Reserve’s experiments with untraditional
economic stimulus over the last six years—from dropping
interest rates to historic lows to buying unprecedented
amounts of bonds—have given investors the comforting
sense that if economic growth doesn’t pick up, the Fed
will try something else.
Central banks in Europe and Japan have also committed
to massive stimulus through multiple actions. Japan
revived its bond-buying strategy to beat deflation and
improve growth in late 2014; the ECB followed suit in
March 2015.
And, of course, stock markets have rebounded massively
from their early 2009 lows in response to surging
corporate earnings and dramatically improved corporate
balance sheets.
Stocks still looked attractive in mid-June 2015: Low
volatility, low interest rates, low inflation, and strong cash
flows were all good for stocks. But continued market
gains made stocks more expensive than average, and
two short-term risks loomed:
„„
8
The likelihood that the Federal Reserve would begin
to raise short-term US interest rates, and
„„
The possibility that the latest tug-of-war between
Greece and its creditors would end with Greece
defaulting on its debt and perhaps leaving the
currency union.
Given these concerns, in late June DAA trimmed its
position in return-seeking assets to neutral and lowered
its exposure to US stocks to a slight underweight for the
first time in nearly three years. We kept a modest tilt
toward Japan, because yen depreciation makes Japanese
companies more competitive at home and abroad. We
also retained partial hedges on the euro against the
US dollar.
To directly address downside risk, DAA once again took
advantage of low volatility to buy options at reasonable
prices. This time, we bought call options to address our
concern that bad news might prompt heavier-than-usual
selling pressure and a steep market drop, because almost
all active asset allocators have been overweight stocks.
By replacing some of our stock holdings with call options,
we preserved upside potential in a stock-market rally, but
modestly limited potential losses in a market drop.
On June 30, it finally happened: Greece defaulted on a
debt payment to the International Monetary Fund. Then,
on July 5, Greece voted “No” in a referendum on whether
to accept the EU’s conditions for continued support.
Stock markets and the euro fell on concerns about what
this might mean for the future of the currency union
and Europe’s economic recovery. Eliminating our equity
overweight and hedging euro exposure blunted the
impact on client portfolios in the run-up to default.
If Greece does exit the euro—which is not certain—we’d
expect a period of volatility for markets globally. Europe
is in a far stronger position now than it was a few years
ago, so we expect contagion to be limited. Still, we’re
continuing to monitor the situation closely, and will
respond as best we can to provide protection.
display 5: our comprehensive risk management framework
OBJECTIVES
APPROACH
STRATEGIES
Minimizing
Short-Term Losses
Reducing
Volatility
INSURE
ADAPT
Options
Allocation Shifts
Meeting
Long-Term Returns
DIVERSIFY
Alternatives and Real Assets
As of June 30, 2015
Source: AB
Three Complementary Strategies
Bernstein seeks to deliver integrated risk management
to our clients. We do this by carefully calibrating clients’
strategic asset allocation to their goals, circumstances,
and risk tolerance. Then, we deploy DAA to position
portfolios to better withstand the impact of short-term
events. Our risk-management tactics fall into three
broad categories: diversifying, insuring, and adapting
(Display 5). Each approach has limitations, but the three
work better in combination than any one does alone.
Diversifying across assets with low or negative
return correlations is the foundation of investment
planning. We use this approach when we help you to
choose a strategic, long-term asset allocation that can
meet your return goals without greater odds of a large,
temporary loss than you could tolerate.
But the benefit of diversification fluctuates over
time. (That’s why we launched DAA.) This year and
last, extremely low interest rates made bonds both
expensive and more correlated to stocks than usual, so
DAA diversified your portfolios a bit further in October
2014 and at the end of June 2015 by adding a modest
exposure to cash.
storm tracking 9
Insuring against sharp, short-term market drops
by buying options is usually prohibitively expensive, and
the costs mount over time. As a result, we generally
advise clients not to include options in their strategic
asset mix, and DAA only deploys the insurance approach
when insurance is less expensive than usual and there is
reason to fear a short, sharp price decline.
The cost of options tends to be driven by market volatility
and interest rates, both of which have been quite low for
most of the last three years. With insurance reasonably
affordable, DAA bought put options as a defense against
two potential crises in 2012, and call options in mid-2015.
Adapting portfolio allocations to changing market
conditions is something we do gradually in strategic
asset allocation. For example, over the past few years we
10
have added allocations to inflation-protective real assets
and other diversifiers to our advice.
But DAA is our key tool for adaptive risk management.
DAA reduces portfolio risk in challenging markets, and
adds a bit to portfolio risk when we expect markets to
remain calm relative to their own history and their
return potential.
Needless to say, the DAA team will continue to watch for
signs of a hurricane. We’ll put plywood over the windows,
when we think that’s called for, keeping in mind that
plywood has a cost. And, if danger mounts enough, we’ll
move you to relative safety.
By protecting you from the full impact of the inevitable
capital-market storms, DAA aims to help you stay
invested, so you can reach your long-term goals.
Want to Learn More?
Go to http://blog.abglobal.com
context
/
The AB Blog on Investing
Greek Moves Test ECB Resolve on Europe
By Darren Williams | Published June 29, 2015
Greece’s five-year debt crisis is escalating fast. A default on the IMF now looks almost certain, and the country is
taking a big step toward a possible exit from the euro area. What really matters now, though, is the impact on
other countries—and how the ECB will respond.
Is the Air Getting Thin for Japanese Stocks?
By Katsuaki Ogata and Masahide Ooka | Published June 8, 2015
The rapid surge of Japanese equities in recent years has left many investors worried that they may have missed
the bus. We believe big changes under way can support further profitability improvements and push the market
higher.
Sharpening Conviction in Equity Allocations
By Dianne Lob and Nelson Yu | Published June 1, 2015
Across the capital markets, it’s getting harder to find returns. But don’t despair. By taking a fresh look at highconviction strategies, we believe investors can discover more effective active routes within equity allocations to
reach diverse destinations.
Puerto Rico Bonds: Put Your Money Elsewhere
By Guy Davidson and John Ceffalio | Published June 1, 2015
Puerto Rico is facing well-publicized financial stress. Despite a recent rally, bond prices have declined over the last
year and yields have jumped. Is it time to buy Puerto Rico’s bonds? Our answer is no.
A Wild Ride for Global Bond Yields
By Seth Masters | Published May 11, 2015
Bond yields in key markets around the world have been on something of a roller-coaster ride, moving up quickly in
recent months. Ten-year Treasury rates closed at 2.28% on May 11, up from 1.65% at the end of January.
storm tracking 11
Dynamic Asset Allocation Overlay
The Dynamic Asset Allocation (DAA) Overlay is implemented by investing your account in portfolios of the Sanford C. Bernstein Fund, Inc.,
mutual fund, which will complement the other asset classes in which your account is invested. Before instructing your Bernstein Advisor to
implement DAA for your Bernstein accounts, you should read and understand the description of, and risks relating to, DAA in Bernstein’s
“Investment-Management Services and Policies” brochure. You should also receive and read the prospectus for the Sanford C. Bernstein Fund,
Inc., which contains important additional information relating to the Dynamic Asset Allocation Overlay portfolios of the Sanford C. Bernstein
Fund, Inc.
There is no guarantee that the intended objectives of the Dynamic Asset Allocation Overlay will actually be achieved.
Bernstein does not offer tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with
professionals in those areas before making any decisions.
MSCI Disclosure
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data
contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial
products. This paper is not approved, reviewed, or produced by MSCI.
Note to All Readers: The information contained here reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are
reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data.
There is no guarantee that any projection, forecast or opinion in this material will be realized. Past performance does not guarantee future
results. The views expressed here may change at any time after the date of this publication. This document is for informational purposes only
and does not constitute investment advice. AllianceBernstein L.P. does not provide tax, legal or accounting advice. It does not take an investor’s
personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate
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