RISK AND RESILIENCE
PATTERNS IN EQUITY RETURNS
SEPTEMBER 2013
BLACKROCK
INVESTMENT
INSTITUTE
Edward Fishwick
Co-Head of
BlackRock’s Risk
and Quantitative
Analysis Group
What is inside
FIRST WORDS AND SUMMARY........................................................................3
VOLATILE TRAITS.................................................................................................... 4-6
Russ Koesterich
BlackRock’s Global
Chief Investment
Strategist
RETURN DRIVERS................................................................................................ 7-10
Inflation and interest rates .................................................................................... 7
Economic growth...................................................................................................... 8
Dividends and earnings........................................................................................... 9
Currencies and capital structure......................................................................... 10
Ewen
Cameron Watt
Chief Investment
Strategist,
BlackRock
Investment Institute
COMPLICATION: CORRELATIONS.........................................................11-12
Correlations and returns ...................................................................................... 11
Portfolio allocation................................................................................................. 12
THE CURIOUS CASE OF LOW BETA................................................... 13-15
Volatility and bondification ............................................................................ 13-14
Low-volatility paradox........................................................................................... 15
}
Equities have generated strong returns over
the long run (in most countries).
}
Losses of 30% or more occur once a decade
on average in US equities.
}
Patient equity investors are usually rewarded.
}
Most equity markets have lagged US returns.
}
Equities are much more resilient to inflation
than bonds – but not bulletproof.
}
Equities are volatile compared with company
fundamentals and the business cycle.
}
Company fundamentals are prime drivers of
returns in the medium term.
}
Prices can take a long time to catch up with
corporate performance.
VS
PR O S
C ONS
EQUITIES
SUB TLE TIES
}
Index averages mask huge disparities
between countries, sectors and
companies.
}
High correlations do not always
mean similar returns – or low
dispersion of returns.
}
Currencies have a big impact on equity
returns – especially in the short run.
}
Low volatility has outperformed –
but is vulnerable to rising rates.
The opinions expressed are as of September 2013 and may change as subsequent conditions vary.
[2]
RISK AND RESILIENCE
First words
and summary
Stocks have always been volatile. Losses of 30% or
more have occurred roughly once a decade in US equity
markets – and more in some other countries.
The new millennium has not been kind to equity
investors. Two market crashes soured many on the
equity markets. Some cut their allocations to equities,
and others deserted the stock market altogether.
A global rally from the depths of early 2009 has made
up for the losses on paper – but it has not felt like a bull
market to many investors. Bonds became the kings of
the new millennium. They generated higher returns than
equities – with a lot less volatility.
3 EQUITY
INSIGHTS
History suggests that it is premature to throw in
the towel.
1
EQUITIES
ARE RISKY
Equities are volatile – and
have been throughout history.
Get used to it.
2
Yet patient investors are usually rewarded for staying
the course – provided they are able and willing to stick
around long enough for prices to catch up with
improving corporate earnings and balance sheets.
Warning: It can be a long wait.
What are the rules of this waiting game? We highlight the
inherent risks of stocks, detail drivers of equity returns
and flag complexities such as correlations and the
paradoxical outperformance of low-volatility strategies.
We do not discuss whether it is a good time to buy
equities – read our investment outlooks for those
insights. Nor do we propose a grand theory on equity
markets. Instead, we provide pieces of a dynamic puzzle
that investors will want to solve themselves:
PATIENCE
PAYS OFF
Investors willing to hold
equities for 10 years or more
have a high chance of earning
a positive real return.
}Inflation: Equities tend to do well when inflation is
in the sweet spot of 2%-3% or lower. If inflation
accelerates (especially over 4%), real returns dive –
but ­equities still outperform bonds. Bonds rule in
(severe) deflation.
} Real interest rates: High real interest rates usually
herald high equity returns and vice versa. One
explanation: The higher the real rate, the higher the
premium equities must offer to entice investors.
}Reinvested dividends: They account for the majority
of equity returns in the (very) long run. Yet corporate
earnings trends and financial conditions drive returns
in shorter timeframes, overshadowing dividends.
}Currencies: Foreign exchange swings can make all the
difference in the short term – especially in emerging
markets. Currency volatility tends to affect real
returns less over longer time periods.
}Success bias: Most equity analyses are skewed
toward US data. Long-term investors did not fare
nearly as well in most other countries.
}Growth (1): The level of economic growth matters
little for equity returns in the long run.
3
DIG BENEATH
THE SURFACE
Inflation, interest rates, growth,
currencies, correlations and
volatility can affect returns in
surprising ways.
}Growth (2): Growth direction and inflation levels
can affect short-term returns in eye-opening ways.
}Inside the index: Equity market averages mask huge
disparities in performance across different countries,
industries (who could forget the global tech bubble of
the late 1990s?) and sizes and types of companies.
}Capital structure: Equity holders are last in line when
it comes to corporate payouts. This means changes in
the capital structure (and the cost and duration of
companies’ debt) can affect equity returns.
}Correlations: Asset prices tend to move in lockstep
during crises. This does not mean diversification is
dead: Assets with high correlations can deliver very
different returns over time. And high correlations
do not necessarily mean returns are bunched
closely together.
}Free lunch?: Adding a dose of equities to a bond portfolio
can enhance real returns without increasing risk much.
}Low-beta paradox: Low-volatility stocks have
benefited from the bull run in bonds and (more
recently) the ‘bondification’ of the equity market.
They may struggle when interest rates rise.
PAT T E R N S I N E Q U I T Y R E T U R N S
[3]
Volatile traits
DRAWDOWNS ALL THE TIME
S&P 500 drawdowns from 5-year highs, 1871-2013
Bear markets and big losses have been around for
as long as bourses. Drawdowns of 30% or more are
common in the US equity market, occurring around
once a decade on average since the 1870s. See the
chart on the right. In extreme cases, the losses can
be catastrophic. Investors who bought at the market’s
peak in 1929 had lost more than 80% of their (nominal)
wealth by 1932. Stock markets elsewhere show even
greater volatility.
Despite harrowing drawdowns, the past century has
been (mostly) kind to US equity investors. US stocks
have delivered annualised total returns (nominal) of
9.4% since 1900, according to London Business School
(LBS) research. In slightly more than two-thirds of years,
returns were positive. Annual excess returns (returns
above the ‘risk-free’ rate on US Treasury bills)
of 10%-20% have been the most frequent pattern.
See the chart below.
These averages, however, mask huge variations within
any year and from one year to the next. Returns
ranged from a 44% loss in 1931 to a 57% gain in
1933. And these extremes were tame compared with
the experience of some equity investors elsewhere.
Japanese and German stocks, for example, were
pummelled during World War II and its aftermath, with
losses of 96% and 88%, respectively, between 1939
and 1948 (after accounting for inflation).
Excess returns of US equities, 1900-2012
1931
2008
1974
1937
1930
1907
2002
1973
1920
1917
2001
2000
1990
1981
1969
1966
1962
1957
1947
1929
1914
1913
1910
1903
2011
2007
2005
1993
1992
1986
1982
1978
1968
1959
1956
1948
1947
1939
1934
1926
1921
1916
1912
1911
1902
1994
1987
1984
1977
1970
1960
1953
1946
1940
1932
1923
1906
-50 -40 -30 -20 -10
0
10
2009
1997
1995
1991
1985
1980
1976
1967
1961
1955
1950
1944
1943
1938
1927
1925
1924
1922
1904
20
1970s
Stagflation
-60
WWI Aftermath
Financial
Crisis
Great Depression
-90
1871 1891 1911 1931 1951 1971 1991
2013
Sources: BlackRock Investment Institute and Robert Shiller, 31 July 2013.
Notes: Chart shows drawdowns in nominal terms from the high in the previous
five years. With contributions by Steve Satchell of Trinity College Cambridge.
MANIAS AND PANICS
What causes the bumpy ride? Equities are much more
volatile than bonds because their future cash flows are
much more uncertain (most bonds pay fixed coupons).
Shareholders are last in line to be paid when a company
goes bankrupt – but capture most of the gains when
businesses (and their cash flows) are growing. Individual
stock prices are ultimately determined by fundamentals
such as cash flows, earnings and sales (see page 9).
}Discount rates matter, especially for interest-ratesensitive sectors such as utilities (see page 15).
2003
1975
1945
1936
1928
1915
1908
30
}Stock markets have been prone to manias and panics
for centuries (Isaac Newton lost a fortune during the
South Sea Bubble of the 18th century). Prices deviate
from fundamentals as investor sentiment swings
between fear and greed.
1958
1954
1935
40
1933
50 60%
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business
School and Credit Suisse Global Investment Returns Sourcebook 2013.
Note: Returns are net of US Treasury bill rates.
RISK AND RESILIENCE
Dot.com
Bust
}Small changes in expectations of future earnings
growth (especially for high-flying growth equities) can
translate into big moves in share prices.
RETURN
[4]
-30
In the short term, however, prices can swing wildly.
Reasons:
THE GOOD, THE BAD AND THE UGLY
2012
2010
2006
2004
1999
1998
1996
1989
1988
1983
1979
1972
1971
1965
1964
1963
1952
1951
1949
1942
1919
1918
1909
1905
1901
1900
SIZE OF DRAWDOWN
0%
The last point is key. Equities are up to 13 times more
volatile than is justified by changes in fundamentals alone,
research by Robert Shiller shows. Shiller’s work triggered
a flood of papers arguing against or for the findings.
What is clear: Equities are inherently volatile.
STEADY WINS THE RACE
Click for
interactive data
Forward real returns of US equities, 1890-2013
1890s
1900s
1910s
1920s
1930s
1940–1951
6 Months
1 Year
3 Years
5 Years
10 Years
20 Years
1952–1959
1960s
1970s
1980s
1990s
2000s
2010–13
6 Months
1 Year
3 Years
5 Years
10 Years
20 Years
-72%
-25%
-15%
-10%
-5%
t REAL LOSSES
0%
15%
30%
70%
170%
1,072%
REAL GAINS u
Source: BlackRock Investment Institute, 30 June 2013.
Notes: The analysis uses Robert Shiller data. All returns are forward returns over the holding period indicated. Returns are from the start of the year and the midpoint.
Teal indicates a positive real return while orange indicates real losses. Magnitudes of positive and negative returns are indicated by colour shading, as in the legend above.
The index used is S&P 500 Total Return, adjusted for US inflation as represented by the Consumer Price Index. With contributions by Steve Satchell of Trinity College Cambridge.
STAYING THE COURSE
Bear markets do not last forever. US equities have
delivered positive real returns (returns after adjusting
for inflation) in almost any 20-year period since 1890
– a century that included two World Wars, the Great
Depression and the 1970s stagflation period. See the
chart above. There was one exception: The hapless
investor who bought US equities in mid-1901 was down
4% in real terms two decades later.
Investing in equities is an imprecise science over periods
of a year or less. Fundamentals are often swamped by
swings in market sentiment.
Investors in US stocks have made money two-thirds of
the time in any given year, with an average annual return
of 19% since 1890. But they lost an average of 14% a
year the remainder of the time.
The risk of losses declines as investors extend their
holding periods. Investors suffered losses in 23% of
five-year periods and 14% of 10-year periods. A small
probability, perhaps, but potentially an expensive one.
Consider a retiree who invested in US equities in mid1972. A decade later, the real value of the portfolio
would have declined by 32% after inflation, which
peaked at double-digit rates during that decade. If the
retiree had the financial means and physical health to
wait an additional decade, the loss would have turned
into a real gain of 155%.
Timing is (almost) everything in investing. Those who
buy equities near peaks in the market’s valuation (or
ahead of big spikes in inflation and other calamities)
have to wait a long time before seeing the value of their
investments recover – especially after accounting for
the impact of inflation.
PAT T E R N S I N E Q U I T Y R E T U R N S
[5]
THE LUCKY (US) CENTURY
The past century has been relatively kind to US investors.
The United States has been the world’s largest political,
military and economic force for most of the period. A stable
political and legal system was fertile ground for strong equity
returns. This introduces a ‘success bias’ into the (many)
studies of equity returns that rely on US data only.
Equity investors in most other countries have not been so
lucky. In France, Italy, Belgium and Austria there have been
periods of 60 years or more when equity returns failed to
keep pace with inflation. See the chart on the right.
The longest period of losses averaged 40 years across 20
countries, based on reliable stock market data going back
to 1900. Most investors cannot wait that long (especially
retirees). Both shareholders and bondholders were wiped
out in the Russian and Chinese revolutions.
This illustrates a key point. Equities are usually a sound
investment over the long run – but only in countries with
stable political and legal frameworks. All bets are off in cases
of war, revolution or government expropriation of assets.
Diversification can help smooth the ride. The volatility of a
basket of global equities tends to be lower than that of any
individual market. Why? The global basket is exposed to a
much more diversified set of economic risks than any one
country. In addition, stock concentration in local markets is
much higher. The 10 largest stocks comprise 60% or more
of total market capitalisation in Australia, Germany and
Switzerland, and more than 80% in Russia – versus only
about 10% of total value in the global equity market, our
research shows.
WHAT BUBBLE?
US equity performance, 1999-2001
TOTAL CUMULATIVE RETURN
120%
Russell 1000 Tech
80
40
Russell 1000
0
Russell 1000 Ex-Tech
-40
1999
2000
2001
Sources: BlackRock Investment Institute and Bloomberg.
[6]
RISK AND RESILIENCE
TIME DOESN’T HEAL ALL WOUNDS
Longest periods of negative real returns, 1900-2012
Denmark
Canada
Australia
US
S. Africa
N. Zealand
UK
Switzerland
Ireland
Netherlands
Sweden
Finland
Norway
Japan
Germany
Spain
France
Italy
Belgium
Austria
Average Longest
Period Of Losses
0
20
40
60
80
100
YEARS
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Sourcebook 2013.
PEEK UNDER THE HOOD
Another caveat: Studies of equity returns are based on
broad market indices and, therefore, mask huge variations
in sector performance. This is especially true in shorter
time periods, when bubbles or panics can drive valuations
in certain sectors far from broader market averages.
The technology segment of the Russell 1000 Index soared
by 117% in 16 months during the late 1990s dot.com
bubble. See the chart on the left. Yet the broad index rose
just 27% over the same period. The subsequent technology
crash was similarly dramatic. Investors who had been
willing to pay top dollar for tech stocks marked them down
to almost zero. (This type of re-rating is an important driver
of equity returns, as we discuss in the next chapter.) In the
five years after the tech bubble, the contraction of earnings
multiples explained 54% of global stock performance.
Valuation says little about the short term – but everything
about the long term.
Cisco Systems is illustrative. The stock peaked at almost
$80 per share in March 2000. These days, its trailing
12-month earnings per share are almost four times as
high as they were back then. Yet Cisco’s share price has
collapsed to around $23. What changed? The earnings
multiple. Investors happily paid more than 200 times
earnings for the stock back in 2000, whereas they are
willing to pay only 13 times these days.
The lesson? Disparities between countries, sectors and
companies are huge. As a result, different exposures can
translate into radically different returns.
Return drivers
LOW RATES = LOW RETURNS
Real returns and real rates, 1900-2012
Corporate profit margins often expand in inflationary
periods. When inflation is rising, companies usually pass
on higher input costs to consumers by raising prices
(and their nominal debt loads are inflated away).
Corporate revenues tend to rise at a faster clip than
expenses because most companies do not like to raise
wages. This is bad news for employees but good news
for equity holders – up to a point. As inflation takes off,
investors usually become less willing to pay up for
future earnings (price-to-earnings multiples contract).
Hard assets such as real estate perform better in these
environments, and equities suffer losses. The sweet
spot for equity returns? Inflation of 2%-3% or lower.
INFLATION HURTS
Real returns and inflation, 1900-2011
20%
20%
18
8
0
0.6
1.9
2.9
10
4.5
0
-3.5
-10
-10
DEFLATION
-20
-26
INFLATION
Bonds
INFLATION RATE
REAL RETURN
10
-20
Equities
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business
School and Credit Suisse Global Investment Returns Yearbook 2012.
Notes: Study includes 19 countries and 2,128 country-year observations.
Inflation levels are minimums and in percentiles of the range over the period.
The top and bottom 5% occurrences are at the extremes while the remainder
is grouped in percentiles of 15%.
9.4
5
4.8
10%
5
2.9
1.5
0
0
0.1
-2.2
-5
-5
LOW
REAL RATES
REAL INTEREST RATE
Bonds are hit even harder by inflation (with the
exception of bonds whose principal or yield is tied to
inflation). This is because bond coupons and principal
are fixed and do not adjust to compensate investors for
any losses in purchasing power. Equities have
comfortably outperformed bonds in all inflationary
environments over the past century – and even in
periods of mild deflation.
10%
FUTURE 5-YEAR REAL RETURNS
High or sharply rising inflation is the enemy of equity
(and bond) markets. Equities have averaged a real
annual loss of 12% since 1900 whenever inflation
averaged 18% or more. See the chart below.
HIGH
-10
-10
-11
Bonds
Equities
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business
School and Credit Suisse Global Investment Returns Yearbook 2013.
Notes: Returns are annualised over the subsequent five years. Study includes
19 countries and 2,160 country-year observations. Real interest rates are
minimums and in percentiles of the range over the period. The top and
bottom 5% occurrences are at the extremes while the remainder is grouped in
percentiles of 15%.
Equities have averaged real returns of more than 10%
in deflationary periods, the bottom chart shows. One
caution: Most of these instances took place in the
prewar period and were extreme. For example, nominal
returns on UK equities were flat in 1921. Yet investors
ended up with a 35% real gain due to severe deflation,
LBS data show.
Recent history shows some very different results. Take
Japan. The Nikkei 225 Index is still 65% below its 1989
peak in nominal terms and Japanese policymakers have
been battling bouts of deflation since the late 1990s.
Caution is needed in interpreting these results, too.
Japan’s equity market has descended from sky-high
bubble era valuations (showing the importance of both
valuations and the right entry point).
Interest rates are another key to equity returns. Equities
tend to post strong returns in the five years after high
real interest rates. See the chart above. One reason:
Equities are much more risky than government bonds.
This means they have to offer a premium over the
inflation-adjusted ‘risk-free’ rate to entice investors.
(They have to offer compelling value.) The higher the
risk-free rate, the higher the hurdle for equities (and vice
versa). Periods of low real interest rates, by contrast,
often coincide with high inflation (but not always, as we
have seen in recent years).
BL ACKROCK INVESTMENT INSTITUTE
[7]
OF TORTOISES AND HARES
HIGHER GROWTH, LOWER RETURNS
So how can investors decide in which countries to invest?
Let us start with one (discredited) strategy: Buy equities of
the fastest growing economies. Intuition tells us faster
growth should equal higher returns on equities. History
tells a different story.
Equity returns by GDP growth quintile, 1900-2009
25%
20
ANNUAL RETURN
Since 1900, the countries with the slowest trailing GDP
growth have delivered the same returns as the ones that
grew at the fastest clip. See the chart on the right. This
counterintuitive trend has been even stronger since 1972.
Nominal annual returns averaged 25% a year in the slowestgrowing economies, compared with 18% in the fastest.
Stocks in middle-of-the-road economies fared the worst.
lobalisation means bellwethers in slow-growing
G
economies (think Toyota) can boost earnings even while
their domestic economy is sluggish. Similarly, companies
in some country indices represent only a small portion of
the economy (think emerging markets).
The level of economic growth may have little impact on
equity returns in the long run, but its direction (expansion
versus contraction) matters in the short term – especially
in combination with inflation. The sweet spot for (monthly)
developed equity performance has been a combination of
10
5
hy? The equities of the slowest-growing countries are
W
often shunned – just like out-of-favour value stocks that
tend to subsequently outperform. By contrast, investors
are often willing to pay a premium for (expected) growth.
Similar to growth stocks that are ‘priced for perfection,’
equities of fast-growing countries can get overheated.
Betting on growth alone often does not work because
markets have already factored in economic performance.
Only surprise growth will likely affect returns.
ast-growing emerging economies are capital hungry.
F
Their bond markets are immature, so new (and existing)
companies must issue shares to raise capital. This dilutes
existing shareholders and tends to lower returns.
15
0
LOW
HIGH
LOW
19 Countries
1900–2009
HIGH
83 Countries
1972–2009
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Yearbook 2010.
Note: Countries are divided into quintiles by trailing five-year GDP growth rates.
global economic expansion and declining US inflation in
the past 25 years. For emerging market stocks, falling
inflation has been the key driver. See the table below.
The interaction of growth, inflation and other macroeconomic factors on asset prices can have surprising
results – especially in the short run. US government bonds,
for example, have tended to perform well in months of rising
inflation since 1988. One reason: US inflation was subdued
throughout the period. In addition, global quantitative easing
by central banks in recent years has kept bonds well bid.
Bottom line: Growth is good for equities – but is often
priced in fast. Growth can affect equity returns, depending
on the time horizon, the type of growth signal and the
interplay with related factors such as inflation.
SHORT-TERM SURPRISES
Monthly asset returns in various growth and inflation scenarios, 1988-2013
Growth
Developed Emerging
Equity
Equity
US Gov.
Bonds
US IG
Bonds
US High
Yield
US MBS
Energy
Gold
US Cash
0.52%
0.94%
0.66%
0.28%
0.6%
2.49%
0.69%
0.34%
1.57%
1.56%
0.43%
0.62%
1.25%
0.43%
1.09%
0.33%
0.28%
38
-0.66%
-0.80%
1.16%
0.74%
0.55%
0.76%
-1.97%
-0.46%
0.41%
54
0.62%
2.25%
0.70%
1.14%
0.93%
0.65%
-0.53%
0.78%
0.31%
Inflation
Occurrences
Expanding
Rising
112
-0.07%
Expanding
Falling
101
Contracting
Rising
Contracting
Falling
Source: BlackRock Investment Institute, June 2013.
Notes:Rising or falling inflation is defined by a trailing three-month average change in the US Consumer Price Index. Expanding or contracting growth is defined by the monthly level
of the JP Morgan Global PMI Manufacturing Index. Data through May 2013. Returns based on indices from MSCI, Ibbotson, Merrill Lynch, Standard & Poor’s and Bloomberg.
[8]
RISK AND RESILIENCE
The power of dividends has been drilled into investors’
minds. Reinvested dividends make all the difference in
equity returns over the (very) long run, many studies show.
Returns on equities can be split into three components:
dividend yield, divided growth (after inflation) and multiple
expansion (the increase in the price investors are willing to
pay for earnings or dividends). Dividends usually increase
over time, in line with corporate earnings and cash flows.
Outcomes across countries vary significantly, but overall
dividends have accounted for four-fifths of equity returns
since 1900. See the chart below.
Yet there is a rub: Equities are volatile. Market swings can
swamp the impact of dividends in any single year – many
times over. Many investors don’t have the luxury or
patience to wait decades for their dividends to compound.
In addition, companies reinvest their capital to boost
growth (some more successfully than others). Google has
increased its share price around tenfold since it went
public in 2004 – without paying a cent in dividends.
Take a simple example of a portfolio of two $100 stocks.
One pays no dividend and rises 10%. The other has a 5%
payout but drops 10%. The total return on this $200
portfolio is 2.5% – with the dividend yield equalling 100% of
the return. Yet which stock would you rather have owned?
DIVIDENDS DOMINATE – OVER TIME
Contribution to 5-year MSCI World returns, 1996-2012
100%
Dividend Yield
80
Multiple Expansion
60
40
20
Earnings Change
0
1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: BlackRock Investment Institute, June 2013.
Note: Measures contributions of growth in earnings per share, change in the
price-to-earnings ratio and dividend yield to returns over rolling five-year periods.
With contributions by Steve Satchell of Trinity College Cambridge.
EARNINGS REALLY RULE
Fundamentals – metrics that gauge corporate
performance – usually win in the medium term. Changes
in corporate earnings explain around two-thirds of relative
stock performance in the MSCI World Index since 1996
measured over five-year periods, our research shows.
Dividends explain just a small sliver. See the chart above.
Equity valuation is not all about earnings. It is also about
how much investors are willing to pay for those earnings.
When investors are feeling exuberant, they are often
willing to pay more for stocks (and vice versa). The multiple
expansion (or contraction) explains half of the MSCI World’s
performance in some five-year periods.
Composition of annualised equity returns, 1900-2012
5%
4.1%
4
EXPLANATORY POWER
SHARE OF RETURN
DIVIDEND AND RULE?
3
-2
This makes life a bit more complicated for equity investors.
It is hard enough to correctly forecast a company’s
earnings. It is near impossible to predict the mood of
investors and how much they will be willing to pay for a
company’s earnings in the future. Multiples can contract
across the board in periods of risk aversion. Even
companies with strong fundamentals are punished then –
at least temporarily.
Dividend Yield
Yet even when investors awarded many companies rich
valuations in the late 1990s, changes in earnings still
accounted for the majority of returns over five-year
periods. The recent bull market has been underpinned
by a steady rise in earnings, as the chart shows.
2
1
0.4%
0
0.5%
Real Dividend Growth
World
S. Africa
US
Australia
New Zealand
Canada
UK
Japan
Switzerland
Germany
Italy
France
Austria
-1
Multiple Expansion
Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School
and Credit Suisse Global Investment Returns Sourcebook 2013.
Notes: Multiple expansion measures the change in the price-to-dividend ratio.
Conclusion: Dividends account for a fraction of equity
returns over (relatively short) periods of five years.
Earnings trends and sentiment shifts are the real drivers.
BL ACKROCK INVESTMENT INSTITUTE
[9]
FLUMMOXED BY FX
RISING FROM THE BOTTOM
Foreign exchange swings can make all the difference in
equity returns – especially in the short to medium term.
The currency impact takes place on two levels:
Changes in corporate debt levels and servicing costs can
also influence equity returns. Equity holders are at the
very bottom of the capital structure, giving them a claim
on corporate cash flows only after all creditors have been
paid off. The value of the equity claim rises if the company
reduces obligations to debt holders.
2.Currencies also directly influence asset prices. A
strong US dollar, for example, tends to hurt emerging
market assets, as detailed in What’s Developing in April
2013. Currency movements can also affect corporate
earnings and valuations. A strong yen, for example, has
historically hurt Japanese equities.
The impact of exchange rate swings appears to subside in
the long run as currencies adjust to relative inflation rates.
Annualised local equity returns have not differed markedly
from US dollar returns in real terms since 1900, LBS data
show. The reason: Real exchange rates averaged a change
of less than 1% a year versus the US dollar in the period.
Australian equities, for example, generated annualised
real returns of 7.3% from 1900 to 2012, LBS data show.
The Australian dollar gained an annual 0.12% against the
US dollar over the same period, so the total return to a
US investor would have been 7.42%. Yet over shorter time
periods, the currency impact can be crucial. Consider the
Aussie moved 45% in nominal terms from peak to trough
against the US dollar in the past five years.
To hedge or not to hedge? There is no clear-cut answer.
Considerations include:
}The investment horizon is key. Currency exposure
appears less risky in the long run than in the short term.
}Currency risk can be greatest in the medium term,
if recent history is any guide. Currency fluctuations
contributed an average of 14%-16% to equity risk
across 27 countries in rolling periods of up to 2 years
since 2001, our research shows. Yet over five- and
10-year rolling windows, they averaged 27% and 21%,
respectively. Caution: The benefits of hedging on
average disappear after 8 years when using longer
data series (40 years or more), LBS research shows.
}There is a cost to hedging – which adds up over time. Hedging where you need it most (in emerging or illiquid
markets) is often expensive.
}Hedging is not always the most effective way to reduce
currency risk. Diversification through holding assets in
multiple currencies can reduce volatility.
[10]
RISK AND RESILIENCE
How does this work in practice? Consider some recent
history. Companies have been strengthening their balance
sheets and reducing leverage since the 2008 financial
crisis. The net debt of S&P 500 companies, for example,
has fallen 61% in the period. See the table below.
CAPITAL STRUCTURES
S&P 500 metrics and global credit maturity, 2003-2013
S&P 500 Metric
2003
2008
2013
Free Cash Flow
$45
$68
$112
EBITDA
$134
$211
$203
Book Value
$341
$530
$680
Net Debt
$642
$977
$383
P/E Ratio
20
17
16
8.5
MATURITY IN YEARS
1.When investors hold foreign assets, currency
fluctuations will affect returns in their base currency.
UK equities, for example, have gained 41% over the
past five years. Yet the return was just 19% for US
dollar investors as the British pound steadily declined.
8.25
8
7.75
2009
2010
2011
2012
2013
Sources: BlackRock Investment Institute and Bloomberg, August 2013.
Notes: The S&P 500 metrics are per share as of the end of June each year.
The average corporate bond maturity is represented by the corporate credit
component of the Barclays Global Aggregate Index.
With less debt on their books (and interest rates at
historically low levels), companies are spending less on
debt service – and have more left over to pay shareholders
in the form of share buybacks and dividends. Companies
have also been refinancing much of their debt (cheaply),
pushing maturities further into the future. See the chart
above. This has the potential to enhance shareholder value.
Similarly, companies (and equity returns) have to be viewed
in conjunction with the economy. If governments spend
freely (as many have done since 2008), corporate cash
flows and margins can get a boost. This virtuous circle
may reverse when governments tighten their belts.
Complication:
correlations
Correlations spiked. Irish and Italian equities traded
with a weekly correlation of 90% in the one-year period.
See the table below.
Diversification – across different sectors, companies
and asset classes – can lessen volatility. The problem:
When investors need diversification most (during
financial crises), correlations tend to rise sharply.
Asset prices moved in lock-step, often in violent ‘riskoff/risk-on’ swings during and in the aftermath of the
global financial crisis. This pattern dominated global
markets until signs of a shift emerged this year, as
detailed in Exit, Entry and Overshoot in June 2013.
When equities, credit markets, commodities and
currencies collapse at once (as they did in 2008), even
diversified portfolios will likely stomach losses. The
financial crisis showed real diversification is tough
to come by.
Another simple, but often overlooked point: High
correlations between two sectors or asset classes do
not necessarily mean similar returns. Highly correlated
assets can rise and fall pretty much in tandem – but the
result of these moves can be very different over time.
Correlation is not causation.
The equities of Greece and other European peripheral
markets are a good example. Investors deserted these
markets in droves in 2011 on worries these nations
could not refinance their huge debt loads.
Yet their performance was vastly different. Irish stocks
declined just 3.3%, while Italian stocks collapsed 37.5%.
See the line chart below. Neighbours Portugal and Spain
had a lower correlation of 82% over the same period, but
their equity markets posted almost identical returns.
The conclusion: Correlations can be misleading in
predicting returns. They show direction, not magnitude.
IT’S COMPLICATED
Correlations can also change dramatically over time.
Correlations between US large cap equities have ranged
from less than 10% to more than 50% over the past three
decades. They hit the lowest levels since 2007 this year.
See the left chart on the following page. The trend was
even more pronounced in global markets: Correlations on
the MSCI World recorded 7%, also a six-year low.
Surely this must be a great time for stock pickers?
Fundamentals such as corporate earnings reign supreme
when equities are not moving in lockstep – and positive
earnings are usually rewarded with higher share prices.
Know your companies, and you will outperform, the
theory goes.
The reality is a little more complicated. Low correlations
do not necessarily translate into a wider dispersion of
returns than in other periods, our research shows. And high
correlations do not herald a bunching up of returns. The
reason? Periods of market stress (and high correlations)
are usually characterised by outsized returns.
CORRELATION DISCONNECT
European equities: correlations and cumulative returns, 2011–2012
Ireland
Italy
Spain
Greece
Portugal
Ireland
100%
90%
86%
50%
71%
Italy
90%
100%
95%
55%
81%
Spain
86%
95%
100%
51%
82%
Greece
50%
55%
51%
100%
55%
Ireland
0%
Portugal
TOTAL RETURN
-20
Italy
-40
Spain
-60
Greece
Portugal
71%
81%
82%
55%
100%
-80
Jul 2011
Jan 2012
Jul 2012
Sources: BlackRock Investment Institute and Bloomberg. Notes: Country returns are in euros and based on respective MSCI indexes for each country.
Correlations are based on weekly returns and measured over the period 1 July 2011 to 6 July 2012.
BL ACKROCK INVESTMENT INSTITUTE
[11]
STOCK PICKERS WELCOME
Correlations and return dispersions of US large caps, 1989-2013
Median Return
HIGH
50%
CORRELATION
CORRELATION
40
30
20
LOW
10
0
-20
1989
1995
2001
2007
2013
0
20
40%
DISPERSION OF 12-MONTH RETURNS
Sources: BlackRock Investment Institute, Russell Investments, IDC and Thomson Reuters, August 2013.
Notes: Chart shows the average correlation of pairs of stocks in the Russell 1000 over a 12-month window. Data are monthly through July 2013 and equal weighted.
The bars on the right chart represent the interquartile range, or middle 50%, of 12-month Russell 1000 stock returns in each correlation decile over the 1989­-2013 period.
When correlations of Russell 1000 stocks were highest in
the past 25 years, dispersion (in the interquartile range –
the middle 50%) was actually at its widest. See the right
chart above. This means active investors cannot blame
high correlations for poor (relative) performance.
ADDING RISK … BUT STAYING SAFE
A FREE LUNCH?
Return-to-risk for UK equity/bond portfolios, 1899-2012
RETURN-TO-RISK RATIO
.33
.23
ALL BONDS
50/50
ALL EQUITIES
.13
Sources: BlackRock Investment Institute and Barclays Capital, August 2013.
Notes: The chart shows the annualised risk-return ratio for various blended
gilt/equity portfolios over five-year periods. The ratio is derived by dividing the
portfolio’s annualised return by the annualised volatility.
[12]
RISK AND RESILIENCE
More correlation food for thought: The dispersion
of returns is pretty stable regardless of the level of
correlations between different companies. In other
words, good stock pickers should be able to outperform
regardless of the market environment – in theory, at least.
Literature about asset allocation could fill the (classical)
Alexandria library. We limit ourselves to one simple point:
Even conservative investors can benefit from adding
some equities to their portfolios. Take a UK investor with
a portfolio invested 100% in gilts. Allocating a moderate
portion to equities would have increased returns without
adding much volatility over the past century. See the chart
on the left.
The reason? Equities and bonds tend to move in opposite
directions. This helps smooth the ride for investors. A
caveat: Correlations between asset classes are not static.
If bonds and equities start moving in lockstep (as they
did from the late 1960s through the early 1990s), the
portfolio suddenly looks a lot more risky. The benefits of
diversification also fade as the equity portion rises: Riskadjusted returns hit a ceiling once equities made up more
than half of the portfolio.
When stocks rise, investors forget just how volatile
equities can be. They are rudely awakened every once in
a while (usually when the consensus says equities are a
sure thing).
The new millennium dealt investor psychology not one,
but two blows: two market crashes with peak-to-trough
losses of more than 40% (the collapse of the tech
bubble and the global financial crisis).
Many investors ran for the (apparent) safety of bonds.
Cumulative money flows into US fixed income funds and
exchange-traded products have exceeded flows into US
equities by a factor of 2.4 since 2005. See the chart below.
The real story has been a $1.3 trillion outflow from US
money market funds since risk assets hit bottom in
early 2009 and rates headed mostly lower, as detailed in
Forget Rotation: Think Risk Mitigation in February 2013.
US bond funds attracted $1.2 trillion over this period
whereas equities drew a measly $234 billion. This is why
the current equity market rally – which saw the S&P 500
more than double from its 2009 lows – does not feel like
a bull market: Many investors missed the boat.
Cumulative money flows Into US funds, 2005-2013
Money Market
$1,500
1,000
BILLIONS
Fixed Income
Equity
500
0
2007
2009
2011
Annual returns and volatility, 2000–2013
10%
Emerging Market Debt
8
US High Yield
Emerging
Market Equity
Inflation-Linked Debt
6
Global Investment Grade Bonds
4
Developed Government Debt
Developed Market Equity
US Cash
2
0
5
10
15
20%
ANNUAL VOLATILITY
Source: BlackRock Investment Institute and Bloomberg, 31 July 2013.
Notes: Nominal returns. Based on benchmark indexes from MSCI, Barclays,
Citigroup and JP Morgan.
A LOST DECADE?
Who can blame disillusioned equity investors? Developed
market equities have delivered paltry annual returns of
just 3.5% since 2000 – barely enough to keep pace with
inflation. See the chart above. Equities underperformed
every major bond market over the same period.
Even worse: Equities were far more volatile. Developed
market stocks, for example, notched average volatility of
17% a year. Only emerging market stocks were more
volatile, but only by less than one percentage point.
BONDS RULE(D)
2005
THE VOLATILE MILLENNIUM
ANNUAL RETURN
The curious
case of low Beta
2013
Sources: BlackRock Investment Institute and Investment Company Institute (ICI),
31 July 2013.
Notes: Combines cumulative flows into actively managed US funds (ICI data)
and into US-listed exchange traded products (BlackRock data).
By comparison, the riskiest bond market sector (emerging
market debt) delivered annual returns of 10%, with just
half the volatility of developed equities. US high yield
bonds delivered double the annual return of developed
stocks at less than a third of the volatility. The result:
Many investors lost faith in equities.
Shift the time period, and the case for equities looks much
stronger. Equities had comfortably outperformed 10-year
government bonds in both the United States and the UK
over periods of 1, 3, 5, 10, 20 and 30 years by the end of
August 2013. US equities beat Treasuries by 37 percentage
points in the last decade, while UK stocks outperformed
gilts by 53%.
How is that for a lost decade in stocks?
It underscores the importance of the right entry point –
as well as the dangers of focusing on standard return
periods (or track records).
BL ACKROCK INVESTMENT INSTITUTE
[13]
Volatility is rarely enjoyable. Markets tend to climb slowly
and steadily – but fall with a thud.
Equities have always been more volatile than bonds, but
have generated enough returns to compensate investors
for the anxiety. Risk-adjusted US equity returns (excess
returns divided by volatility) consistently beat those of
bonds from 1960 to 2000. See the chart below. This was
especially true in the 1970s, when bonds were slammed
by double-digit inflation.
The trend reversed in the new millennium, with bonds
recording superior risk-adjusted returns. Investors
took notice. Low returns are bad. Low returns with high
volatility are worse. New regulations also encouraged
financial institutions to minimise asset volatility, making
it harder to maintain large equity allocations.
Pension funds have shuffled more money into bonds over
the past decade. European pension funds have reduced
their equity allocations to below 40% – the lowest level
in at least 10 years, according to consulting firm Mercer.
Bonds provide greater certainty of future cash flows,
making them ideal for matching long-term liabilities.
But it is not a one-way street for bonds. With interest rates
near record lows, bond yields had only one way to go: up
(and prices down). Equities looked poised to start offering
better risk-adjusted returns.
RETURNS THAT REALLY MATTER
Risk-adjusted US returns, 1959-2013
1.5
SHARPE RATIO
60%
40
20
0
-10
1973
1983
1993
2003
2013
Sources: BlackRock Investment Institute and MSCI Barra.
Notes: The chart shows the difference in cumulative return between the top
10 and bottom 10 beta industries in the MSCI Barra US Equity Model over the
period. Industries without full histories are excluded. The gold and oil services
industries are excluded from the low-beta basket because their volatility exceeds
the broad market’s. Monthly data through 31 May 2013.
BONDIFICATION
Equity market volatility not only sent many investors
scurrying for the safety of bonds; it led some to reshuffle
their equity allocations as well. Investors flocked to
dividend stocks, defensives and ‘quality’ equities with
steady earnings and low volatility.
This ‘bondification’ of parts of the equity market led to
stark performance differences. The minimum-volatility
counterparts of equity indices outperformed their plainvanilla peers – with much lower volatility. See the chart on
the left of the next page.
0.5
0
The new mantra of equity investing became:
Low risk = high return.
-0.5
US Bonds
-1
1959
1970
1980
1990
2000
2010 2013
Sources: BlackRock Investment Institute, Kenneth French and Federal Reserve
Bank of St. Louis.
Notes: Total returns in five-year rolling Sharpe ratios. Returns are annualised
and minus the yield on three-month US Treasury bills. Bonds are represented
by 10-year US Treasuries. Equities are represented by the Fama/French model.
Data through 30 June 2013.
[14]
Cumulative excess return of low-beta US stocks, 1973-2013
Low-volatility, or ‘low-beta’ strategies outperformed
more volatile equities. Excess returns from the first group
accelerated in the new millennium. See the chart above.
US Equities
1
LOW BETA WINS – FOR NOW
CUMULATIVE RETURN
VOLATILITY BLUES
RISK AND RESILIENCE
This posed a conundrum for standard investment thinking.
Theory says the expected return of an equity should be
proportional to its risk over time. Riskier (or ‘higher-beta’)
equities should offer investors greater returns over time to
compensate for their higher volatility (and vice versa).
Yet the investor experience has been different – at least in
recent times.
Why has taking risk not paid off? The bondification of the
equity market is part of the answer. In periods of large
interest rate changes, relative repricing of low- and highvolatility strategies may drive performance. We can think
of this as a kind of ‘equity duration.’
Consider two hypothetical companies: an oil explorer and
an electric utility. The oil explorer offers a risk premium
(after inflation) of 10%, compared with 2% for the utility.
The explorer has a big potential payoff if it strikes oil –
but this is a big ‘if.’ The regulated utility offers more
predictable cash flows, but much lower returns.
THE REAL MULTIPLIER EFFECT
Hypothetical stock performance as rates decline
$400
UTILITY
Real Risk Premium=2%
PRICE OF SECURITY
EXPLAINING THE UNEXPLAINABLE
300
REAL RISK-FREE RATE DECLINE
200
OIL EXPLORER
Real Risk Premium=10%
WHEN RISK DOESN’T PAY
Minimum volatility indices, 2003-2013
20%
100
6
ANNUALISED PERFORMANCE
MSCI EM
Minimum
Volatility
5
4
3
2
1
0%
Source: BlackRock Investment Institute, 2 August 2013.
Notes: Hypothetical utility with a real risk premium of 2% and oil explorer with a
real risk premium of 10%. For illustrative purposes only.
15
MSCI
Emerging
Markets
MSCI Europe
Minimum
Volatility
S&P 500
Minimum
Volatility
10
MSCI
Europe
MSCI World
Minimum
Volatility
MSCI
World
5
10
15
Low-beta plays could become a lot tougher – and less
rewarding. Volatile assets could once again start
compensating investors for the additional risk (and
anxiety) they take on.
POWERED BY RATES
S&P 500
20
What happens when interest rates rise?
US utilities price-to-book vs. S&P 500, 1997-2013
25%
90%
Sources: BlackRock Investment Institute, MSCI and Standard & Poor’s.
Notes: Data from 28 June 2003 to 28 June 2013. Total returns and volatility
are annualised and in US dollars.
When interest rates decline (making it harder to earn
attractive income from bonds), the utility’s stable cash
flows become more valuable. Investors bid up the utility’s
shares in a grab for yield. See the chart on the top right.
This is not just theory. The valuation of US utilities
(represented by the price-to-book ratio) has moved in the
opposite direction of real interest rates since 1997. See the
chart on the bottom right.
A shift in the risk-free rate is an afterthought for the oil
explorer. The most important driver of this company’s stock
is whether or not it strikes oil. (Unless the explorer carries
a huge debt load: Debt becomes cheaper to finance and
easier to roll over when risk-free rates drop.)
RELATIVE PRICE-TO-BOOK RATIO
ANNUALISED VOLATILITY
30 Jun, 2008
80
70
60
31 Jul, 2013
50
40
31 Dec, 1999
30
-1
0
1
2
3
4
5%
10-YEAR TIPS YIELD
Sources: BlackRock Investment Institute and Bloomberg, August 2013.
Notes: The relative price-to-book (P/B) ratio is the P/B of US utilities divided by
the P/B of the S&P 500 Index. Real rates are represented by the yield on 10-year
Treasury Inflation-Protected Securities (TIPS). Monthly data through 31 July 2013.
BL ACKROCK INVESTMENT INSTITUTE
[15]
Why BlackRock
As the world’s largest investment manager, we believe it’s our
responsibility to help investors of all sizes succeed in the New World of
Investing. We were built to provide the global market insight, breadth of
capabilities, unbiased investment advice and deep risk management
expertise these times require.
BlackRock. Investing for a New World.
BLACKROCK INVESTMENT INSTITUTE
The BlackRock Investment Institute leverages the firm’s expertise across
asset classes, client groups and regions. The Institute’s goal is to produce
information that makes BlackRock’s portfolio managers better investors
and helps deliver positive investment results for clients.
EXECUTIVE DIRECTOR
CHIEF STRATEGIST
EXECUTIVE EDITOR
Lee Kempler
Ewen Cameron Watt
Jack Reerink
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