How effective is your method of managing portfolio risk? We compare and contrast different approaches – including fixed income, managed futures, low volatility equities, and tactical – to explore the relative protection they can deliver versus the return drag they can create.
What is an Indexed Annuity?
In recent conversations with current and potential clients, we have seen an uptick in the use of indexed annuities as a tool for risk management.
For the uninitiated, Fidelity succinctly described an indexed annuity in a recent blog post:
“An indexed annuity is a contract issued and guaranteed by an insurance company. You invest an amount of money (premium) in return for protection against down markets; the potential for some investment growth, linked to an index (e.g., the S&P 500® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.”
The rules that govern the performance credited to an indexed annuity account tend to be relatively simple and intuitive. A hypothetical example would be something like this:
- If the S&P 500 loses value over the policy year, the account is credited 0%.
- If the S&P 500 gains between 0% and 5% over the policy year, the policy is credited with the S&P 500’s gain.
- If the S&P 500 gains more than 5% over the policy year, the policy is credited with 5%.
In this example, the 5% figure is referred to as the “cap.”
While these rules may be simple and intuitive, the trade-offs inherent in such a contract are less clear.
Recently, I’ve been stealing the following phrase from my co-PM, Corey, quite frequently: “Risk cannot be destroyed, it can only be transformed.” I think this concept is especially applicable to indexed annuities.
Fortunately, indexed annuity-like payoff structures can be created with stocks, bonds, and options. By evaluating these replicating portfolios, we can start to develop a more complete cost/benefit analysis and perhaps better understand how these types of products may or may not fit into certain client portfolios.
For those not interested in the details, the takeaways are quite simple:
- Indexed annuities depend on interest income to finance investments in the equity markets.
- When interest rates are low, there is little capital available to make these equity investments.
- Limited capital means either (i) low equity participation rates or (ii) low caps that restrict potential upside.
- Low participation rates and/or low caps on index participation are a recipe for muted returns, which may make it difficult to stay ahead of inflation.
In short, indexed annuities suffer from many of the same problems that plague traditional asset classes in low interest rate and high valuation environments.
Example #1: Stocks and Bonds
Say we have $1,000,000 to invest. We want to invest it for ten years. We’d like some equity upside, but want to guarantee that we will get back our $1,000,000 at maturity. How might we go about doing this?
It’s not all that complicated. We just need to make two investments.
- Buy a Treasury STRIP that matures 10 years from today with face value of $1,000,000. Today, this would cost approximately $834,000.
- Invest the remaining $166,000 in the S&P 500 (or any other equity strategy).
10 years from now, the Treasury STRIP will be worth $1,000,000. As a result, we will breakeven even if we lose our entire equity investment. If equities end the period flat, we will have $1,166,000 – an annualized return of 1.55%. If equities appreciate over the next decade, our return will exceed 1.55%. The chart below plots the annualized portfolio return for various S&P 500 scenarios.
So where is the risk?
The portfolio consists of a 83.4% allocation to a zero-coupon Treasury bond and a 16.6% allocation to equities. For those familiar with indexed annuity lingo, this 16.6% is the participation rate. This is essentially a very conservative asset allocation model. It may be low risk, but it is certainly not risk-free despite the fact that the portfolio will be worth at least the minimum $1,000,000 in 10 years.
First, the value of the account can dip below $1,000,000 prior to maturity. Suppose that over the next year interest rates are unchanged and equities crash 50%. The account value will be $932,277, a 6.8% loss. On a side note, I actually think this may be one of the key benefits of an indexed annuity product: helping investors maintain a more optimal investment horizon by masking over short-term fluctuations.
Second, the go-forward appeal of this strategy will be highly dependent on interest rates. Higher interest rates will make the strategy relatively more attractive. Why?
Higher interest rates –> Lower STRIP prices –> More money to invest in equities
If 10-year STRIP rates were 5.00% instead of 1.83%, the STRIP would only cost approximately $614,000, leaving a $386,000 to invest in equities. Now instead of a 16.6%/83.4% stock/bond split, we get a 38.6%/61.4% split while still taking no risk of a 10-year loss.
Below, we plot what our hypothetical indexed annuity replicating portfolio would have looked like historically over different interest rate regimes.
Unsurprisingly, the performance of the hypothetical indexed annuity tends to lag in strong equity markets and shine when equity markets crash. That being said, the simulated performance is quite compelling on a risk-adjusted-basis.
The picture changes, however, when we re-run the historical simulations using today’s interest rates. The average annual return drag increases from just 1.05% with historical rates to a whopping 6.40% with current rates. 6.40% of drag vs. equities is especially problematic once we factor in low expected equity returns and inflation. While the risk of capital loss may be effectively mitigated, we have just substituted it for the risk that we fail to meet our growth objectives.
Once again, risk cannot be destroyed, it can just be transformed.
Indexed annuities are not immune from the low interest rate malaise currently gripping the markets.
I think it’s also important to consider the appropriate benchmark for this type of investment. In my view, ending the 10-year period with $1,000,000 is not “breaking even.” In our initial example, we could have avoided equities entirely and used all of our capital to buy a Treasury STRIP. Today, our $1,000,000 could purchase approximately $1,199,000 notional of these bonds. In other words, if we stick to our 10-year investment horizon, then we can guarantee that our account is worth $1,199,000 10 years down the road. This equates to a 1.83% annualized return. This is our benchmark.
When we plot the simulated performance (assuming today’s interest rates) vs. this breakeven benchmark, we see that performance did in fact slip below 1.83% for investor’s that initiated their investment between October 1998 and January 2001. These investors would have struggled because they experienced both the popping of the tech bubble and the global financial crisis. Lo and behold, risk exists. In essence, the replicated indexed annuity is investing the future interest to be earned on the STRIP investment in equities. If this investment isn’t profitable, the investor would have been better off sticking the Treasuries.
Example #2: Options and Bonds
One way we can deal with the low equity participation rates caused by low interest rates from our first example is to introduce leverage. Specifically, we can do so by using equity index options.
Again assume that we have $1,000,000 to invest for ten years. We still want to impose a $1,000,000 floor on our account value at the end of the period, but now we want 100% participation with equity gains (at least up to some cap).
How would we go about doing this?
We start by buying $1,000,000 of 10-year Treasury notes at par. Today, the interest rate on this investment would be 1.88%. Treasury bonds pay interest semi-annually and so the investment will generate $9,400 in interest payments every six months.
To get our equity participation, we will use this cash flow to buy at-the-money call options on SPY that expire in six months. Let’s say each of these options costs $10, so we can buy 940 options. This is problematic. We want 100% participation in equity gains. To get this at SPY’s current price of around $206, we need to buy 4,854 options ($1,000,000 divided by $206).
940 options gives us a participation rate of less than 20%, not too much different than our portfolio in Example #1 above.
Fortunately, we can solve our issue with a bit of financial engineering. Say that call options with the same expiry and a strike of $209 (about 1.5% out-of-the-money) are trading at $8. If we sell one of these options for each $206 strike call we buy, we have created a bullish call spread. These call spreads only cost $2 each, allowing us to buy the 4,854 units we need.
We now get 100% participation in equity gains. However, we have paid a price for this. Namely, we only get 100% participation for gains up to 1.5%. We have sold the rights to any gains in excess of 1.5% in order to finance our call purchases. We have “capped” our six equity return at 1.5%.
At the end of six months, we will re-invest any option payoffs into Treasury notes/bills. As a result, we may have slightly more than $9,400 to buy options for the next six-month period.
We continue this process for ten years (or 20 six-month periods). Even if the worst case scenario plays out and the market goes down each and every period, we will still receive our $1,000,000 principal back from the 10-year Treasury note investment.
Below, we again simulate how such an approach would have hypothetically performed relative to the S&P 500.
When we use historical interest rates, the results are once again pretty compelling. On average, the simulated indexed annuity trails the S&P 500 by less 1% per year, while providing nice downside protection.
Unfortunately, when we repeat the simulation using today’s interest rates, we see that this simulation has the same shortcomings as our first one.
When interest rates are low, our Treasury bond position throws off very little cash. With low cash flow, we aren’t able to buy very many at-the-money call options. As a result, we need to sell calls with strikes that are quite close to today’s equity prices in order to finance our at-the-money call purchases. This effectively sets our cap very low and puts strict limits on how much equity upside can be realized. The annualized drag to the equity markets is now nearly 5% per year.
Once again, risk has not been eliminated. Our “reward” for buying the Treasury bond is the interest payments. We use these interest payments to get leveraged market exposure through options. If the market declines, the options will expire worthless and we have lost our interest payments.
The commonsense benchmark for this portfolio is just a 10-year Treasury bond. The 3/31/16 rate that was used in the simulation was 1.78%. This 1.78% is our benchmark. We see below that the simulated indexed annuity barely beats out this benchmark in most cases.
A Word About Dividends
Research Affiliates estimates that U.S. large-cap equities have a 10-year expected return of 1.3% after inflation. On a nominal basis – or adding back in inflation of 2.0% – this number becomes 3.3%. Of this 3.3%, they believe that inflation will contribute +2.0%, dividends will contribute 2.2%, and growth will contribute 1.3%. But, this adds up to 5.5%. What gives? Research Affiliates believes that equity valuations will gradually revert back to historical norms. They estimate that this will be a 2.2% annualized drag on performance.
As you can see, dividends are a crucial part of equity returns. If we remove the 2.2% dividend yield, the above expected return number drops from an already meager 3.3% to only 1.1%.
This is problematic for indexed annuity investors, since credits are often based on price, not total, return of the equity index.
To test the impact of this, we can perform some Monte Carlo simulations using the Research Affiliates capital market assumptions. We compare a 20/80 S&P 500/Barclays Aggregate portfolio to the following indexed annuity (note: we took this structure from a popular product in today’s market):
- 4% bonus on initial investment
- 100% participation rate on S&P 500 with a cap of 2.5%
- S&P 500 return is measured using the annual, point-to-point methodology (i.e. we compute the return using just the beginning of year and end of year S&P 500 values)
We performed 10,000 simulations of 10-year periods. The following histogram plots the annualized out/underperformance of the 20/80 portfolio vs. the indexed annuity over 10-year periods. Positive numbers mean the 20/80 portfolio outperformed. Negative numbers mean the indexed annuity outperformed. All returns are annualized.
On average, the 20/80 returned 3.45% per year over a 10-year period. The indexed annuity returned 1.89% per year. The 20/80 portfolio beat the indexed annuity in 88.8% of the simulations.
Indexed annuity proponents may point to the risk management benefits of the product in trying to reconcile these statistics. There are a few problems with this argument.
First, the 20/80 portfolio isn’t all that risky to begin with. It only lost money over 10-years in 1.1% of the simulations. And this is using today’s capital market assumptions where both U.S. stocks and bonds are overvalued and therefore offer low future expected returns.
Second, and much more importantly, we have to consider inflation. To see why, consider the simplest form of risk management, holding cash. This will guarantee that you protect your capital, until you wake up a decade later only to realize that inflation has eroded your purchasing power.
If we deduct 2.0% of inflation per year, the “risk management” scoreboard changes dramatically. The 20/80 loses money on an inflation-adjusted basis in 15.9% of the simulations, while the annuity fails to keep up with inflation 59.9% of the time! In our experiment, you are more likely to lose money than make money with the annuity over a decade. Hardly risk-free!
Conclusion
Risk cannot be destroyed, it can only be transformed. Warren Buffett famously said, “If you’ve been playing poker for half an hour and still don’t know who the patsy is, you’re the patsy.” The same idea holds true with any financial product. There is always risk somewhere. If someone selling a product says otherwise, then be very, very suspicious.
For indexed annuities, the main risk is that potential returns are severely limited when interest rates are as low as they are now. High interest rates are the fuel that may allow these products to deliver equity-like returns with less downside risk. Without high interest rates, however, you are going nowhere fast. Going nowhere fast is a problem when inflation is always nipping at your heels. Downside risk management is great, until it restricts your growth so much that your purchasing power erodes over time.
Data Sources and Disclosures
Data comes from the Federal Reserve, Research Affiliates, CBOE, and Morningstar. Calculations were performed by Newfound Research.
Index annuity guarantees are subject to the credit of the issuing insurance company.
All returns are hypothetical and backtested and reflect unmanaged index returns. Returns do not reflect fees. Past performance does not guarantee future results. Results are not indicative of any Newfound index or strategy. Hypothetical performance results have many inherent limitations and are not indicative of results that any investor actually attained. An investor cannot invest directly in an index. Index returns are unmanaged and do not reflect fees and expenses.
For the options analysis, we use historical VIX levels with a 20% premium applied to reflect the higher implied volatility typically associated with longer-term options.
In a commentary a few weeks ago entitled Growth Is Not “Not Value,” we discussed a problem in the index construction industry in which growth and value are often treated as polar opposites. This treatment can lead to unexpected portfolio holdings in growth and value portfolios. Specifically, we may end up tilting more toward shrinking, expensive companies in both growth and value indices.
The picture of what we want for each index looks more like this:
The overlap is not a bad thing; it simply acknowledges that a company can be cheap and growing, arguably a very good set of characteristics.
A common way of combining growth and value scores into a single metric is to divide growth ranks by value ranks. As we showed in the previous commentary, many index providers do something similar to this.
Essentially this means that low growth gets lumped in with high value and vice versa.
But how much does this affect the index allocations? Maybe there just are not many companies that get included or excluded based on this process.
Let’s play index provider for a moment.
Using data from Morningstar and Yahoo! Finance at the end of 2015, we can construct growth and value scores for each company in the S&P 500 and see where they fall in the growth/value planes shown above.
To calculate the scores, we will use an approach similar to the one in last commentary where the composite growth score is the average of the normalized scores for EPS growth, sales growth, and ROA, and the composite value score is the average of the normalized scores for P/B, P/S, and P/E ratios.
The chart below shows the classification when we take an independent approach to selecting growth and value companies based on those in the top third of the ranks.
In each class, 87% of the companies were identified as only being growth or value while 13% of companies were included in both growth and value.
The next chart shows the classifications when we use the ratio of growth to value ranks as a composite score and again select the top third.
Relative to what we saw previously, growth and value now extend further into the non-value (expensive) and non-value (cheap) realms of the graph, respectively.
There is also no overlap between the two categories, but we are now missing 16% of the companies that we had identified as good growth or value candidates before. On the flip side, 16% of the companies we now include were not identified as growth or value previously in our independent sort.
If we trust our independent growth and value ranking methodologies, the combined growth and value metric leaves out over a third of the companies that were classified as both growth and value. These companies did not appear in either index under the combined scoring scheme.
With the level of diversification in some of these indices, a few companies may not make or break the performance, but leaving out the top ones defeats the purpose of our initial ranking system. As with the NCAA March Madness tournament (won by Corey with a second place finish by Justin), having a high seed may not guarantee superior performance, but it is often a good predictor (since 1979, the champion has only been lower than a 3 seed 5 times).
Based on this analysis, we can borrow the final warning to buyers from the previous commentary:
“when you’re buying value and growth products tracking any of these indices, you’re probably not getting what you expect – or likely want.”
… and say that the words “probably” and “likely” are definitely an understatement for those seeking the best growth and value companies based on this ranking.
This commentary is available as a PDF here.
Summary
- Style boxes give us the impression that “growth” and “value” sit at opposite ends of the spectrum.
- In reality, whether a company is growing or shrinking (“growth”) is independent of whether a security is cheap or expensive (“value”).
- To align with the single axis expectation of “growth versus value,” most index providers combine a growth score and a value score together to create a composite score, which is projected upon the “growth / value” spectrum.
- In doing so, most value indices are laden with cheap, shrinking companies and most growth indices focus on expensive, growing ones. Neither truly represents a value or growth approach to investing.
What are Growth and Value?
By Nathan Faber
On March 28, 2016
In Risk & Style Premia, Value, Weekly Commentary
This commentary is available as a PDF here.
SUMMARY
In our commentary a few weeks ago, we pointed out a key flaw that many index providers have in their growth and value style indices. The industry norm lumps “low value” in with “growth” and “low growth” in with “value” when, in reality, growth and value are independent characteristics of companies. The result is that many of the growth and value ETFs that track these indices are not giving investors what they expect – or what they want.
Final index construction aside, let’s go down to a more fundamental level: what are growth and value in the first place, and how do we measure them?
Intuitively, growth refers to companies that are growing and expected to continue, and value refers to companies that are currently cheap relative to their fair price.
Simple enough.
But a quick survey of index providers finds that the characteristics they use to measure a stock’s growth and value characteristics vary across the board:
Growth Characteristics:
Value Characteristics:
Only one metric on each list is common to all four index providers (Sales per share growth trend for growth and book-to-price ratio for value).
So who is right?
We can test the performance of many of these metrics using data readily available online. The forward-looking growth data are more difficult to find historically, but general financial statement data is available on Morningstar’s website.
To keep matters simple, we will look at three metrics for each of growth and value. For growth: 3-year EPS growth, 3-year sales per share growth, and ROA. For value: the P/E, P/S, and P/B ratios.
And to keep things as realistic as possible, we will evaluate the stocks in the S&P 500 as they stood at the end of 2014. Relative to the current set of companies in the S&P 500, we added back in some companies that dropped out of the S&P 500 (mainly energy and materials companies) in 2015. Some mergers and acquisitions also make getting data for the companies more difficult. For example, Covidien was bought by Medtronic, AT&T bought DirecTV, and Kraft merged with Heinz. Since we will be focusing on relative performance differences rather than on absolute ones, we will simply reconstruct a proxy S&P 500 index using the data that is available. In all, our universe contains 481 companies.
Using the fundamental data from December 2014, we can sort based on each metric and select the top 160 companies (about one-third of the universe) and see how that “value” or “growth” portfolio would have performed in 2015. Within each portfolio, we equally weight for simplicity. Results are compared to an equal-weight benchmark to control for any out or underperformance arising from the equal-weight allocation methodology as opposed to stock selection.
There is significant variation during the year depending on which metric was used.
Source: Data from Yahoo! Finance and Morningstar, calculations by Newfound
Source: Data from Yahoo! Finance and Morningstar, calculations by Newfound
For growth, all of the portfolios tracked each other until mid-March when the portfolio formed on sales growth began to diverge. The portfolios formed on EPS growth and ROA continued to track each other until mid-June. At this time, ROA rallied hard, eclipsing the sales growth portfolio in the 4th quarter of 2015.
On the value front, the P/S ratio led through most of the year before falling back to the pack in the Fall. The P/E and P/B portfolios ended the year in very similar places, with the P/S portfolio eking out a ~65bp benefit over the other two portfolios.
Which Metric to Choose
One year is hardly enough data to make a sound judgment as to which metric is the best for selecting growth and value stocks. As we have said many times before, even though we may know a factor (e.g. value) has outperformed in the past and is likely to do so in the future based on behavioral evidence, stating whether that factor will outperform in any given year is tough.
Likewise, deciding which measure of a factor will outperform in a given year is also difficult. Even with value companies, a metric like P/E ratio may not work well when companies with strong sales experience short-term earnings shocks or when companies are able to inflate earnings based on accounting allowances. The P/B ratio may not work well in periods when service oriented companies, which rely on intangible human capital as a large driver of growth, are being rewarded in the market.
Let’s take a closer look at some popular ways of quantifying the value factor.
“Value”, as it stands in academic literature, is commonly measured using the P/B ratio. This is what the famous Fama-French Three Factor Model uses as its basis for calculating the value factor, high-minus-low (HML).
However, using data from Kenneth French going back to 1951, we can see that, for long-only portfolios, those formed both on P/E and P/S actually beat the portfolio formed on P/B both on an absolute and risk-adjusted basis.
Furthermore, AQR showed in their 2014 paper, “The Devil in HML’s Details,” that not only does the metric matter, but the method of calculating the metric matters, as well. While Fama and French calculated HML using book value data that was lagged by 6 months to ensure that data would be available, they also lagged price data by the same amount. The AQR paper proposed using the most recent price data for calculating P/B ratios and showed that their method was superior to the standard lagged-price method because using more current price data better captures the relationship between value and momentum.
The P/S and P/E ratios used in the table above are also calculated using lagged price data. Based on AQR’s research, we expect that those results might also be improved by using the current price data.
Different Measures of Factors May Ebb and Flow
We should be careful not to rush to judgment though. The fact that P/B has underperformed the other value metrics does not mean we should drop it entirely. It is helpful to remember that individual factors can go through periods of significant underperformance. The same is true for different ways of measuring a single factor. For example, over rolling 12-month periods, the return difference between portfolios formed portfolio on P/B, P/S, and P/E – all “value” metrics – has often been in excess of 2000bp!
Put bluntly: your mileage may vary dramatically depending on which value metric you choose.
Source: Data from Kenneth French Data Library, calculations by Newfound
With our 2015 example, we saw that P/S resulted in the best performing portfolio, but as we said before, different measures tend to cycle unpredictably. We can see which ones have been in favor historically by comparing each individual portfolio to the average of all three portfolios.
Source: Data from Kenneth French Data Library, calculations by Newfound
The fact that many index providers combine multiple metrics into a composite growth or value score is an acknowledgement of this unpredictability.
Averaging the different value portfolios would have led to a fraction of outperforming periods on par with the best individual portfolios, higher average outperformance than the P/S portfolio, and lower average underperformance than all three individual portfolios.
Source: Data from Kenneth French Data Library, calculations by Newfound
If you read our previous commentary about multi-factor portfolio construction, you’ll notice that the averaging we did above is approach #1 (the “or” method). In effect, we are investing in companies that have either low P/S, P/B, or P/E ratios. One way to implement this would be to form portfolios based on each metric and then average the allocations into a final value portfolio.
In practice, most index providers score companies based on each selected metric, normalize the scores, and then average them (sometimes using different weightings). The portfolio is then formed using this composite score. This is more in line with approach #2 from the commentary (the “and” approach), which favors companies that have some degree of combined strength across multiple metrics.
While we used value and momentum in the commentary to illustrate why using the “and” approach is problematic in multi-factor portfolios, using this approach isn’t as bad when attempting to identify a single factor. The problem with value and momentum stemmed from the difference in time that each factor took to mature. Using the “and” approach introduced drag from the shorter maturity factor.
If there is no convincing argument that an individual growth or value measure takes longer to mature than another (for instance, does P/S normalize faster than P/B), then taking the “and” approach is not likely to result in a worse outcome. In this case, where we are simply trying to identify growth or value, we care more about the predictive nature of each metric that goes into forming the portfolio.
The index providers vary considerably in regards to what characteristics they look at and how they weight them to arrive at a final portfolio. If you believe that the P/B ratio is the best determinant of company value then you will get the purest exposure with Russell. If you think return on assets is an important contributing factor to company growth, CRSP’s index will be more in line with your view.
However, if you are like us and concede that while there are many ways to quantify growth and value, no one method can outperform over every single period, a diversified approach may be your best option.