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A Performance Analysis of Variable Annuities With Risk Control

The Value of Research: Skill, Capacity, and Opportunity

The S&P/BMV IPC Turns 40

Defense Beyond Bonds: Defensive Strategy Indices

Indexing Risk Parity Strategies

A Performance Analysis of Variable Annuities With Risk Control

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Alan Grissom

Managing Director, Head of Client Coverage Americas

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Hong Xie

Senior Director, Global Research & Design

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Aye Soe

Managing Director, Global Head of Product Management

EXECUTIVE SUMMARY

  • A variable annuity is a tax-deferred retirement vehicle with account values linked to the performance of underlying investment options, typically mutual funds.
  • A variable annuity with risk control framework has the added feature of providing caps and floors to the investment performance, which in turn is linked to the performance of the underlying investment options, typically a price index.
  • We construct hypothetical portfolios that allocate between a variable annuity with a risk control mechanism and a blended portfolio of stocks and bonds. Historical performance for the hypothetical portfolios with allocation to products with a risk control feature showed better downside protection than a stock portfolio or a traditional 60/40 stock/bond portfolio in some scenarios.

INTRODUCTION OF VARIABLE ANNUITIES WITH RISK CONTROL

A variable annuity is a tax-deferred retirement vehicle with account values linked to the performance of the investment options chosen by the market participant. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

A variable annuity that uses a risk control framework has the added feature of providing caps and floors to investment performance that are linked to the performance of the underlying investment options. If the underlying index delivers returns greater than the cap level or lower than the floor level, market participants will receive guaranteed payments at the cap or floor level, respectively. Therefore, variable annuities with risk control offer downside protection to investors at the expense of forgoing a degree of upside return. They offer market participants better visibility and predictability on future cash flows from annuities by effectively incorporating risk management tools in investment products.

A variable annuity with risk control features shares the same concept as and similar structure to those of risk control indices. Risk control indices are designed to measure the performance of underlying equity or futuresbased indices at specified volatility levels. As a benchmark provider of risk control indices, S&P Dow Jones Indices finds it relevant and meaningful to investigate the impact of incorporating a risk control framework into investment products, such as variable annuities, in a portfolio context.

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The Value of Research: Skill, Capacity, and Opportunity

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Anu R. Ganti

Senior Director, Index Investment Strategy

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Hamish Preston

Associate Director, U.S. Equity Indices

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Tim Edwards

Managing Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

EXECUTIVE SUMMARY

How much should a portfolio manager be willing to pay for research?

The question is of importance to any manager, but has become particularly pertinent since newly imposed European rules require that the costs of investment research—previously offered by many investment banks as an in-kind consideration in return for brokerage business—be unbundled from trading.

Unfortunately, attempts to determine a fair value for research in the most general circumstances are doomed to fail. Even if we only consider direct recommendations to buy or sell certain securities, the value of such recommendations to a portfolio manager will vary according to the absolute size of positions taken in response. Instead, we provide a framework for estimating relative research values across markets and constituents, under certain stylized (but reasonable) assumptions.

Exhibit 1 provides a summary of our main result—comparing the putative value of recommendations in selected markets, expressed as a multiple of the equivalent measure applied to stock-based recommendations within the S&P 500® .

INTRODUCTION: THE IMPACT OF “UNBUNDLING” RESEARCH COSTS

The Markets in Financial Instruments Directive (MiFID) II is an updated version of a regulation that has been in force throughout the European Union (EU) since November 2007.1 The update came into effect on January 3, 2018, and seeks “to reform market structures, bring more transparency to the trading of financial instruments, and strengthen investor protection.”2

For our purposes, the relevant regulatory change is that execution costs and charges must be separated, or “unbundled,” from the cost of research, and that investment managers must either absorb research costs or explicitly pass them on to their clients under pre-agreed terms.3 Since investment managers were formerly allowed to pay for research by the allocation of client trading commissions, MiFID II has the potential to produce major changes in the economics of research sales.

While these rules are of most immediate concern to institutions operating in the EU, MiFID II has potential global implications: the updated directive applies to all firms that conduct business in Europe, and many expect the legislation to be extended to other regions.4,5

From a practical perspective, MiFID II requires managers to set research budgets and to decide where to spend them. Obviously, the size of a particular research budget will depend on idiosyncratic factors, such as a firm’s assets under management. But when it comes to allocating resources, the relative value of research is likely to be comparable—if I find one analyst’s recommendations to be worth double those of other analysts, it is reasonable to hypothesize that these recommendations would also prove to be twice as valuable to anyone else.

This paper argues that the relative value of research is driven by a combination of three things: the information content of the research, the dispersion within the market where recommendations are made and implemented, and the capacity of each market to allow for active positions of varying sizes. While we do not claim to offer a universally applicable framework for setting research budgets, we hope to offer a practical and useful way to think about the value of signals for markets of varying size, concentration, and risk levels.

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The S&P/BMV IPC Turns 40

A benchmark index represents the performance of a specified securities market, market segment, or asset class. The S&P/BMV IPC seeks to measure the performance of the largest and most liquid stocks listed on the Mexican Stock Exchange (Bolsa Mexicana de Valores; BMV). The index is designed to provide a representative, investable, and replicable measure of the Mexican equities market.

The S&P/BMV IPC was launched on Oct. 30, 1978, as part of a Mexican market revolution, and it has been the icon of the Mexican equity market ever since. In the middle of a long inflationary period, between the devaluation of the Mexican peso and changes in monetary policy regarding the exchange rate, 1978 was a decisive year for the Mexican economy. The country’s central bank implemented new economic and financial policies, marking a new regulatory environment that included tax exemption on capital gains, the approval of the revaluation of certain assets to support listed companies facing a delicate financial situation, and the “Mexicanization” of foreign capital through the stock exchange.1

INDEXING IN MEXICO

The need to measure the evolution of the Mexican equity market existed even before the launch of the Índice de Precios y Cotizaciones (IPC), which is now the S&P/BMV IPC. The first attempt of one of the S&P/BMV IPC’s predecessors, the Promedio de hechos de la Bolsa index from 1910, was calculated as the annual arithmetic average of the values traded by each listed company. However, this first approach was unstable due to the lack of liquidity in the market and the frequent change of listings.

Later on in 1958, the universe was restricted to 11 industrial companies, and the calculation was based on the daily average price. As the capital market grew, the sample of 11 companies became rather unrepresentative. As a result, in 1966, the sample size was changed to 30 constituents, and the calculation methodology was changed to link the average price with the previous value and to introduce adjustments for corporate actions such as splits.2

In October 1978, the BMV started the calculation of the IPC in parallel, making it public on September 1980. Over the course of the past 40 years, the index has evolved, keeping its representation and objectives aligned with the market. In this paper, we highlight the four decades of index history and major milestones, in addition to examining the characteristics of the S&P/BMV IPC as the iconic symbol of the Mexican equity market.

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Defense Beyond Bonds: Defensive Strategy Indices

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Fei Mei Chan

Director, Index Investment Strategy

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Craig Lazzara

Managing Director, Global Head of Index Investment Strategy

EXECUTIVE SUMMARY

  • The S&P 500® was up more than 20% in 2017 and entered the 10th year of a bull market cycle in 2018. Since bottoming in 2009 after the global financial crisis, the index has gained more than 300%. Risk mitigation might understandably be at the forefront of investors’ awareness, as worries of froth and volatility grow increasingly prominent.
  • Bonds have been the conventionally-favored tool for portfolio risk reduction. But bonds have enjoyed a secular bull market since the 1980s and, with interest rates still near record lows, they may be a less appealing asset class now than they have been historically.
  • We explore ways of utilizing defensive strategy indices in order to improve the risk/return profile of a traditional 60/40 equity/bond allocation mix.
  • Defense need not be limited to long equity strategies. By combining long and short positions in certain factor indices, the result could look strikingly similar to a defensive strategy like low volatility—and offer the same benefits.

  • IS IT TIME TO BE DEFENSIVE?

    In 2017, the S&P 500 was up 22%, augmented by another 11% through the first nine months of 2018. Since bottoming in March 2009, the index has gained more than 300%, and in 2018 it entered the 10th year of a bull market cycle. While bull markets do not automatically die of old age, recent turbulence in the equity market has reminded us all of the unpredictable nature of stocks.1

    Investors who are unwilling or unable to bear the full risk of the equity market have traditionally constructed balanced portfolios of stocks and bonds. In the 30+ year bull market in bonds that began in 1981, such defensive allocations did not require a major sacrifice in returns. As Exhibit 2 illustrates, the 10-year U.S. Treasury rate hit a peak of 15.3% in 1981 and declined until bottoming out at 1.5% in July 2016. Rates increased to 3.0% as of September 30, 2018.

    We’re not in the business of forecasting the bond market, but a glance at Exhibit 2 will confirm that, unless rates reverse and start to go negative, we are much closer to the bottom of the range than the top. If rates continue to rise, bond values will decline—meaning that the efficacy of bonds as a defensive asset class will be less than it has been historically. Investors concerned about the level of equity prices might understandably be interested in other defensive alternatives.2

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    Indexing Risk Parity Strategies

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    Berlinda Liu

    Director, Global Research & Design

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    Phillip Brzenk

    Senior Director, Strategy Indices

    INTRODUCTION

    Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, sets the framework for building optimal portfolios in which market participants can potentially maximize portfolio returns for a given level of risk. The theory introduces the notion of portfolio diversification by holding non-correlated assets. At the core, one should not view individual asset returns and volatilities in isolation; rather, one should take into account the co-movements, or correlations, of asset returns that comprise a portfolio.

    The theory, along with the expectation that long-term asset class Sharpe ratios are similar (Dalio et al. 2015), act as foundational pieces of risk parity. Risk parity strategies propose that portfolio diversification, defined as achieving the highest return per unit of risk, can be maximized when a portfolio’s assets contribute equally to total portfolio risk.

    Since the launch of the first risk parity fund—Bridgewater’s All Weather Fund—in 1996, many asset managers have offered their version of risk parity to clients. The risk parity industry has especially gained traction in the aftermath of the 2008 global financial crisis, growing to an estimated USD 150 billion-175 billion at year-end 2017 according to the IMF (Antoshin et al. 2018).

    In the past, such strategies lacked an appropriate benchmark, leaving most investors to benchmark against a traditional 60/40 equity/bond portfolio. The issue with this approach is that a 60/40 portfolio reflects neither the construction nor the risk/return characteristics of risk parity strategies. Generally considered to be diversified in dollar terms, the reality is that nearly all of the portfolio risk arises from the 60% allocation to equities. When a portfolio is equal-risk weighted as opposed to equal weighted, it may lead to superior risk-adjusted return.

    With the purpose of providing a transparent, rules-based benchmark for risk parity strategies, we introduced the S&P Risk Parity Index Series. These indices construct risk parity portfolios by using futures to represent multiple asset classes and attempt to reflect the risk/return characteristics of funds offered in the risk parity space. Cognizant of the fact that risk parity funds in the industry can have different volatility targets, the index series consists of three indices with different target volatility (TV) levels: 10%, 12%, and 15%.

    In the first part of this paper, we cover the economic rationale for implementing a risk parity approach in a multi-asset portfolio construction. In the second part of the paper, we give an overview of the S&P Risk Parity Indices.

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