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Multi-asset income investing
The need for a long term, active approach
White Paper April 2017
Authored by:
Joseph Little, Global Chief Strategist
Jane Davies, Senior Portfolio Manager
Any views expressed were held at the time of preparation,
reflected our understanding of the regulatory environment; and
are subject to change without notice. The value of investments
and any income from them can go down as well as up and
investors may not get back the amount originally invested.
For professional clients only
2
Income investingThe need for a long-term view
Demographics and pensions uncertainty are changing clients’ needs 4
Not as good as they seem: current solutions have clear weaknesses 6
Total return with an income orientation: a credible option 9
Conclusion 11
Introduction
Multi-asset income is a popular strategy today.* The
demand stems from the low yield available on
traditional safety assets and conventional retirement
products like annuities.
Standard liquid return-seeking asset classes have
not provided the return stability investors were
seeking. Since 2000, equity investors have endured
two large bear markets, significant volatility, and
relatively low total returns.**
Against a backdrop of heightened political and
economic uncertainty, a desire for stability and
income seems like a natural response1.
However, we believe it is a mistake to invest
indiscriminately in income strategies. Many popular
income “solutions” artificially boost the regular income
they provide at the expense of longer term returns.
In an environment where life expectancy and
longevity are increasing long term capital appreciation
should not be sacrificed to maximise short term
distribution yield.
Investors need a sustainable income stream to fund
their retirement. But they also need income sources
that will grow over time. In this paper we discuss how
they can achieve this in the current environment.
* Multi-asset income funds are in the top 5 sectors in terms of net sales and assets in both 2015 and the latest 2016 Fund Radar Second Sight reports
** Total returns on the US S&P500 have been 5% nominal since 2000
We acknowledge the research support of Kim Kooner (Global Investment Strategy) in writing this paper.
3
Executive summary
The risk of greater longevity
Across advanced economies, life expectancy is
increasing. Forecasts may still underestimate
longevity; in the future, retirements could last
upwards of 30 years.
But at the same time, lower birth rates, shrinking
working age populations and weak productivity
diminish potential GDP growth rates. Linked to this,
an environment of historically-low bond yields implies
that the sustainable investment return across a range
of asset classes is compressed versus the returns
that investors have enjoyed in the past.
Moreover, there is no longer a set and rigid
retirement path. Investors need retirement solutions
that can be flexible and that can provide the income
needed for a longer retirement.
Limitations of current solutions
This perspective highlights the limitations of many,
currently popular, multi-asset retirement solutions.
For example, so-called “glide-path” strategies (or
Target Date Funds) structurally favour traditional
safety assets, such as Gilts, at retirement. But
historically low bond yields imply that investors are
being required to significantly over-pay for perceived
safety. And the recent sell-off in global government
bonds starting in Q4 2016 reminds us that over-
paying for any asset class embeds a risk of (short
term) capital loss in our portfolio.
Other popular strategies which aim to enhance short
term income (such as capital distribution or covered
calls) come with a significant cost. They compromise
long term savings objectives and may undermine
investors’ ability to support a long retirement.
The benefits of a total return approach
To meet the challenge, investors need a solution
which provides an income source that will grow over
time.
We believe that a total return approach, combined
with a sustainable income goal, is the right
investment strategy. Even at retirement, today’s
retirees are effectively “long-horizon investors”. Our
approach ensures we provide an attractive current
level of income, makes an efficient use of the
portfolio risk budget, and seeks to provide adequate
capital growth and income into the medium term.
A key part of this approach is to widen our
investment universe. A number of less mainstream
sources of income can bring stable yield to a
portfolio.
We also need to recognise that standard definitions
of safety do not incorporate current market pricing.
Our long-term view and active approach to asset
allocation means that we design portfolios to be tilted
toward attractively-valued asset classes, where
returns are more secure.
We can further support the income properties of our
portfolios by thinking hard about how we fulfil our
desired asset class “beta” exposures.
4
In fact, these projections may even be understating
the scale of the longevity challenge.
Exhibit 3 shows how projections of the UK population
aged 65 and older have been revised substantially
over time. For example, in 1981 it was estimated that
the number of over 65s in the UK by 2050 would be
11 million. In fact, today, the OECD places this
estimate at nearly 19 million!
Separately European academics2, have suggested
that official measures of longevity are systematic
underestimates. Quite possibly, this tendency to
under-estimate may be symptomatic of other
developed countries too. In other words, the balance
of risks lies to still greater longevity.
Falling birth rates
At the same time, birth rates have fallen in developed
economies. As shown in Exhibit 4, the “dependency
ratio”, which measures the number of young and
elderly dependents relative to the size of the working
population, is expected to increase dramatically over
the coming decades.
9
11
13
15
17
19
21
2010 2020 2030 2040 2050 2060
2015
2004
2000
1996
1992
1989
1985
1981
Population 65+
(millions)
Demographics and pensions uncertainty are changing clients’ needs
Meeting investment objectives in an environment of
changing demographics and pension reforms
requires a strategy that aims to deliver income over
the long term.
The risk of greater longevity
Exhibits 1 and 2 show life expectancy trends in
OECD countries. From birth, life expectancy has
been increasing by almost 2.5 years every decade
since the 1950s.* At age 65, life expectancy has
been increasing by around 1 year per decade. This
rising longevity across the OECD reflects
technological, medical and nutritional advances. It is
unambiguously good news, but poses challenges in
terms of how we might fund longer retirements.
Moreover, projections show this trend of rising
longevity continuing well into the future. Forecast
data suggests that by 2060, average OECD life
expectancy at age 65 will be 25.8 years**, and as
much as 29.7 years for Japan.
* OECD (2014), Pensions Outlook 2014
** OECD (2014), Pensions at a glance
Exhibit 1: Life expectancy at birth for OECD countries
Source: Human mortality database, December 2014
Exhibit 2: Life expectancy at 65 for OECD countries
Exhibit 3: Official projection of population aged 65+ by year
of publication
Source: OECD Pensions at a Glance (2011) & OECD Stat 2015
55
60
65
70
75
80
85
1950 1960 1970 1980 1990 2000 2010
France JapanSpain United KingdomUnited States SwedenNetherlands
Life expectancy at birth
(increase = 2.4 yrs per decade)
10
12
14
16
18
20
22
24
1950 1960 1970 1980 1990 2000 2010
Life expectancy at 65
(increase = 1.1 yrs per decade)
Source: Human mortality database, December 2014
5
An analysis of long-term growth dynamics suggests
that growth trends in developed markets and many
emerging markets will be damaged by falling
working-age population numbers.3 Estimates on the
breadth of the impact and the prognosis for secular
growth vary but shrinking labour forces create a clear
structural headwind for growth.4
Consequently, research from the OECD forecasts
medium-term, inflation-adjusted growth rates in
advanced economies of only 1.8% (and as low as
1.2% for economies like Japan. Meanwhile, with still
greater pessimism, US economist Robert Gordon
projects US growth rates of around half the OECD
forecast.5
The work of Prof Gordon is not universally accepted
among academic and market economists. But the
OECD growth scenario and the downside risk raised
by Gordon’s analysis brings into acute focus the
question of how individuals can prepare for a
situation where life expectancy will be 95 years (with
the additional costs it induces such as care and
medical bills), while the economy lingers in a weak
growth equilibrium.
Economics Nobel Laureate Prof Robert Merton has
put the choice for today’s investors even more
bluntly, “…there are only three things they can do:
save more, work longer, or take more risk”.6
Merton’s first two points are intuitive. But taking more
investment risk is not always beneficial. The “efficient
markets” school of thought implies that risk is always
rewarded. But, in reality, we know that the price of
risk varies significantly over time and is something
that investors must be aware of.
Retirement is changing
For pension providers, the difficulty lies in offering
their members solutions which are able to deliver
income over the long term.
In parallel, pensions reform or uncertainty in many
countries around the world (in the UK or Greece)
mean that investors need both guidance and access
to the right products. Typically, low engagement
levels and pronounced risk-aversion in the
accumulation phase have reinforced the problem and
heightened this need.
Moreover – and crucially – retirement is changing;
there is no longer a set path or a given retirement
date but, on the contrary, increasing numbers
continue to work part-time or become self-employed
after their official retirement date. This calls for
solutions to be managed throughout the retirement
lifecycle.
The key consequence of increasing life expectancy,
a shrinking working population, and uncertainty
around pensions policies is that it is not in clients’
best interests to take a short-term view of
investments at retirement:
Conventional wisdom in the industry still seems
geared towards offering short-term focused
solutions when aiming to achieve an income
objective. Investors close to, or at the point of
retiring, are in fact likely to enjoy a long
retirement, of perhaps 30 years, and will need to
see their income continue to grow over time to
protect from the effects of inflation.
The need to deliver income over the long term
means that pension funds, like individuals, need
to consider sustainable solutions
Exhibit 4: Projected old-age dependency ratio
(Over 65s as % of 15-64s)
Source: Eurostat
2015 2020 2040 2060 2080
EU (28) 28.8 31.8 45.9 50.2 51.0
France 29.2 32.6 44.0 42.9 46.4
Germany 31.9 35.8 55.6 59.2 59.9
Italy 33.6 34.9 49.9 53.1 56.8
UK 27.4 29.5 39.1 42.7 44.7
6
Conventional approaches face a range of problems
1. A glide path without a valuation discipline
So-called “glide path” strategies typically reduce the
allocation to equities and favour developed market
bonds for investors nearing retirement.* This is a
problem: (i) the key asset allocation decision is made
without a valuation framework and (ii), risk is
dangerously simplified to being a fixed concept –
equities are “risky” and bonds are “safe”.
Core government bonds currently trade at historically-
low yields, even when we examine data going back to
the 18th century – or even earlier**. In other words, in
order to access the conventionally-assumed “safety
asset class” in their retirement, investors will have to
substantially over-pay for this privilege (see exhibit 5).
And having now overpaid, the recent rise in yields
reminds us that this strategy remains vulnerable to
short term capital losses. It is far from a “safe”
investment.
2. Different investors, different preferences?
Another school of thought is that income investors
have a different set of preferences to long-term
investors. For example, many income strategies
come with a range of settings which might imply
maximising for yield. However, there are no free
lunches and such a strategy comes at a cost. Do
income investors really place more value on current
income than on gains tomorrow? Are they willing to
pay higher taxes in order to achieve a stable
income? Are they willing to suffer high levels of risk
(i.e. volatility of the underlying asset) as long as
portfolio yields remains relatively high and constant?
None of these cases seem particularly plausible to
us.
Such approaches (glide paths into long bonds and
maximising for yield) suffer from the pitfalls of a
short-term perspective of income. As explained
above, it seems likely to us that investors who are
retired or approaching retirement will still be focused
on long-term returns – at least for a portion of their
asset allocation – while also being preoccupied with
generating a sustainable income stream to match
this longer investment horizon.
3. Using capital distributions to enhance yield is
not a true income strategy
Another temptation is to use capital to support (or
“guarantee”) a yield on a given portfolio. If investors
have been emotionally scarred by past investments
in equity markets, their likely aversion to volatility
would make such an offering attractive. It also seems
like an easy way for pensions to meet their short-
term obligations.
However, technically speaking, capital-distribution
strategies fail the classic definition of “income” set
out in the 1930s by economist Sir John Hicks.
Consequently, we doubt whether they should be
regarded as legitimate income strategies at all.
"The purpose of income calculations in practical
affairs is to give people an indication of the amount
which they can consume without impoverishing
themselves. Following out this idea, it would seem
that we ought to define a man's income as the
maximum value which he can consume during a
week, and still expect to be as well off at the end of
the week as he was at the beginning"
John Hicks 1939, Value and Capital
Exhibit 5: Long run government bond yields
(US Treasuries and UK Consols)
Source: Global Financial Data, March 2017
* This is the asset allocation formula for a target-date fund strategy based on the number of years left to the target date.
** For example, we have studied data on the Venice loan market (Venice Prestiti yields) between 1285 and 1502. The lowest yield was 4.88%, with an average of 6.8%.
0
2
4
6
8
10
12
14
16
18
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
US 10Y Government Bond Yield
0
4
8
12
16
20
1729 1759 1789 1819 1849 1879 1909 1940 1970 2000
UK Consol Government Bond Yield
7
Indeed, the main problem with this approach comes
from the prospect of substantially higher-than-
expected longevity; you can’t divest indefinitely, or
even for the long run.
Moreover, if we are right that retirees should still
consider themselves as “long horizon investors”, then
there is a significant opportunity cost from divesting
to boost short-term income. We can illustrate this
with a simple example.
We assume an investor has £100 to invest and
returns on the stock market are 6% annually for the
foreseeable future. This return includes a dividend
yield of 2.5%. Using a ‘total return’ approach means
we will keep the 2.5% dividend as income for
spending, but leave the rest of the capital (i.e. the
initial capital plus the 3.5% return) invested in the
market.
An investor seeking a 5% yield can supplement the
2.5% dividend income by drawing down an additional
2.5% from the total invested capital each year.
Exhibit 6 shows the impact on the portfolio’s value
after 5 years and 25 years.
After 5 years, the total wealth under both approaches
is fairly similar. However, over a longer timeframe,
the lack of capital invested in the market causes an
investor’s overall wealth to shrink relative to the total
return approach. Cash distributions are lower under
this “total return” approach (note the height of the
grey bars), but overall wealth is 24% higher. In fact,
after 30 years of investment, the total cash amount
paid out each year from this approach is actually
greater than under the capital distribution strategy.
This is in spite of the higher percentage distribution
rule. These effects become even more pronounced
when market returns are stronger than 6%, or if a
large disbursement occurs early on.
Using capital to fund a yield today therefore seems
incompatible with the prevailing demographic forces.
Because investors nearing pension age will require
income sources that grow over time, a more durable
solution is required.
A true income strategy should be able to provide a
good running yield without “impoverishing” our future
selves.
4. Covered calls do not guarantee investment
income
Many income strategies use covered call writing as a
key structural feature. The historic performance of
covered call writing has been very strong. We
calculate that the historic (ex post) Sharpe ratio of
so-called “buy-write” strategies is 0.54 and compares
favourably with long-only US equities (S&P500
Sharpe ratio is 0.45, data since 1990). On the basis
of impressive historic performance, it could be
argued that asset managers should embed covered
call writing as a strategic part of their multi-asset
income process.7
In principle, covered call strategies (that is to say,
writing call options on an underlying equity position)
offer the opportunity to increase the portfolio yield.
We gain a premium from selling call contracts but
give up the capital upside from a naked equity
position.
For purely income-focused investors, this could be a
reasonable trade-off. Indeed, it is a technique used
by many well-known asset managers for income
enhancement.
Yet historic returns are not a reliable indicator of
future performance. A recent academic study8 has
demonstrated that, like other asset classes, the
expected return of a covered call strategy is not
static. Rather, it is determined by a combination of
the risk-free rate, the equity risk premium and the
implied-to-realised volatility spread. The author
concludes his article:
“In order for investors to find the CC (covered
call) strategy attractive, they must be convinced
that, going forward, implied volatility will be
higher, on average, than the corresponding
realised volatility. In addition, this volatility spread
needs to be high enough to counteract the negative
influence that the equity risk premium has on the CC
strategy relative to the stock index.”
Exhibit 6: The Impacts of Capital Drawdown
Source: HSBC Global Asset Management, March 2017
0
100
200
300
400
Strategy withCapital
Distributions
Total ReturnApproach
Strategy withCapital
Distributions
Total ReturnApproach
total capital invested sum of cash payments
5 Years
25 Years
To
tal
Wealt
h
8
This is very interesting and useful because it gives us
a clear framework to assess the prospective
attractiveness of the covered call strategy, rather
than merely relying on historical experience.
A covered call strategy makes sense if we expect
implied volatility to be greater than future realised
volatility (IV > RV) and we identify an inadequate
equity risk premium.
As exhibit 7 shows, implied volatility on the equity
market is variable over time. It tends to cluster and
then mean-revert, but it is not classically stable like a
sine wave. This is intuitive as perceptions of risk shift
around a lot over the market cycle.
To us, this implies that, like other aspects of our
asset allocation strategy, we need to constantly
review the attractiveness of covered calls. If investors
tend to form their assessment of asset class risk in a
backward-looking fashion9 then, following a volatility
spike, implied volatility will be higher than future
realised volatility. But this will not always be the case
and being active is key.
Moreover, since a covered call strategy caps the
upside, investors are losing the right-hand tail of the
future return distribution. The remaining exposure is
significantly concentrated in downside risk. This is
only somewhat mitigated by the revenue associated
with call writing, dispelling the view that covered calls
provide downside protection.10 Another way to see
this is that downside correlations of covered call
strategies are nearly perfect with a long equities
strategy. A better diversifying option, therefore, would
be to express a volatility view through a variance
swap (which removes the equity directional element).
Lastly, and related to the above, a covered call
strategy exhibits negative skew and high kurtosis
(i.e. heightened drawdown risk and fat tails). It is
somewhat similar to a carry strategy in currencies
which itself is likened to “picking up pennies in front
of a steamroller”. It has been met with forceful
criticism from finance philosopher Nassim Taleb11:
“For a mutual fund manager, doing such “covered
writing” against his portfolio increases the
probability of beating the index in the short run,
but subjects him to long-term underperformance
as he will give back such outperformance during
large rallies.”
Taleb’s point is profound. Even at retirement,
investors need to be long run focused.
In summary, although option selling generates a
positive cash flow, it is incorrect to conclude a
covered call strategy guarantees investment income.
In order for there to be investment income, the
option must be sold at a favourable price. This
strategy generates income only to the extent that
any other strategy generates income – by buying or
selling mispriced securities or securities with an
embedded risk premium.12
Exhibit 7: US implied equity volatility
0
10
20
30
40
50
60
70
80
1990 1995 2000 2005 2010 2015
CBOEVIX
Source: Bloomberg, March 2017
9
As explained in the previous sections, the changing
demographics and retirement landscape mean that,
even at retirement, investors should still be long run
focused.
Imposing an income target is a heavy-handed
solution
By imposing an income constraint on the strategy,
the mathematical reality is that our ability to achieve
the “Maximum Sharpe Ratio” portfolio13 is
compromised.
Exhibit 8 illustrates the problem. Adding binding and
heavy-handed constraints drag us away from making
the best use of our risk budget. It leads to a sub-
optimal portfolio. For a given level of risk, we will
achieve lower returns than we otherwise could.
As a consequence, whilst the clearest way to achieve
an income target is to simply impose an income
constraint, it comes at a cost. In order to avoid a
highly-inefficient use of the risk budget, some careful
calibration of this income constraint is required. The
portfolio must balance the need for capital growth
with a heightened preference for income return.
In our view, the solution is to set the income target at
a sustainable level, not too far from the “natural yield”
of an efficient total return-focused portfolio.*
A credible solutionTotal return with an income orientation
Exhibit 8: Constraints impair our ability to achieve the MSR
Source: HSBC Global Asset Management, March 2017
* For example, we currently believe that a high dividend equity strategy without a deleterious reduction in quality can sustainably yield 3.5%
Active Asset Allocation
Asset allocation is the key determinant of portfolio
success and we believe that it should not be
neglected by investors. The typical “set-and-forget”
approach to establishing strategic asset mixes is
inappropriate for an investment environment where
the return profile (risk premium) to an asset class
varies dramatically over time. Asset allocation needs
to be a dynamic decision and be regularly revisited.13
Our approach to multi-asset investing is grounded in
asset valuation and economic analysis. Academic
studies have confirmed that asset returns are
predictable (in the medium term) based on starting
valuations.14 There is an “excess volatility” across
bonds, credits, equities and alternative asset classes.
What’s more, a valuation perspective provides a
disciplined and structured framework for us to build
multi-asset portfolios. It forces us to pay attention to
how “the odds” implied by the market are moving.14
This philosophy underpins our entire approach to
portfolio management. From thinking about
benchmark construction, strategic asset allocation
and portfolio rebalancing; to actively managing
tactical asset allocation overlays; to selecting
fulfilment vehicles and portfolio assembly.
Widen the investment universe
The historically-low level of global government bond
yields and compressed risk premium in global credits
and, to a degree, in global equities creates a
challenging environment for investors today.
Sustainable returns across core asset classes are
low, especially when compared with the kind of
excess returns that investors have enjoyed over the
last 30 years.
An obvious opportunity is to widen the typical
investment universe to include, for example, a more
significant allocation to emerging market asset
classes and also to liquid alternatives (including
factor exposures).
Our point from above is that the perceived safety of
Gilts or Treasuries is challenged by the high price we
are required to pay to access this safety today. This
means that the sustainable return on developed
True Efficient
Portfolio (MSR)
Return
Risk free
rate
Risk
Global Min
Variance
Portfolio
Unconstrained
Frontier
Constrained
Frontier
10
As can be seen below, these stocks often go on to
decline significantly in price and deliver lower levels
of total return.
Instead, we believe three attributes are key to
achieving sustainable equity income whilst also
considering valuations: (i) high dividend yield, (ii)
cash flow yield and (iii) return on investment capital.
The first directly pursues stocks with an attractive
level of current income. The second and third
incorporate an element of quality into stock selection,
ensuring the sustainability of income and the potential
for capital appreciation.
With our measure of sustainable dividend yield, we
simply seek to build highly diversified portfolios which
exhibit a broad tilt to this factor. We maximise
exposure to the income factor while minimising other
systematic risks (like sectors, countries and other
factors). This process aims to maximise exposure to
the most attractive income stocks whilst managing
risk and creating well-diversified portfolios.
With robust quantitative research, smart beta equity
income strategies can find the right balance to
achieve efficient income “beta capture” without
compromising dividend sustainability or embedding
unintended systematic risks.
A credible solutionTotal return with an income orientation
market bonds is low and the distribution of return
outcomes is skewed to the downside (i.e. there is
scope for capital loss). Notions of safety, in other
words, cannot be viewed independent of valuation.
This means that asset classes that we would
conventionally regard as “risky” can actually be
sources of safety, depending on how the market is
pricing them. For example, at the start of 2016, Brazil
local-currency bonds were unloved and under-owned
and trading on a yield of 16%. Investors perceived
this asset class as highly risky. But the reality was,
even when confronted with further bad news about
the economic and political outlook, the asset class
was able to rally strongly. By the middle of 2016,
investor total returns in USD terms were c.50%. The
pricing of the asset class at the start of 2016 already
embedded a large margin of safety and, from a
valuation perspective, it already looked low-risk.
Liquid alternatives are a potentially important part of
the opportunity set too. Once again, a valuation
discipline is critical. We have to make sure that we
are not caught up in fashions and fads. And we must
ensure that we do not over-pay for the asset class.
But given a need for income and a desire to build a
portfolio with effective diversification, the ability to
allocate to a range of liquid alternatives must make
sense.
Yield-orientated fulfilment
A further and important consideration is the use of
fulfilment vehicles. Across our multi-asset platform we
make extensive use of low-cost passive and
enhanced passive (smart beta) fulfilment vehicles, as
well as active funds.
Designing an appropriate and cost-efficient “beta
capture” is a regular part of our multi-asset process.
Why should multi-asset income strategies be any
different?
As such, we can make use of fulfilment tools such as
high dividend strategies, among others, to support the
income objective.
The power of smart beta income equity fulfilment
Cost-efficient “beta capture” in an equity-only context
can enable investors to achieve equity income in a
sustainable yet affordable manner.
There is, however, an upper limit to sustainable
dividend yield. Simply buying companies with the very
highest yield will entail holding high income
generators without the cash flow to sustain it.
3%
5%
7%
9%
11%
Low Yield 2 3 4 High Yield
CA
GR
Dividend Yield Quintile
Exhibit 9: CAGR of Equal Weight Portfolios Grouped by
Divided Yield Quintile
Source: HSBC Global Asset Management, March 2017
11
Conclusion
Rising longevity means that today’s retirees have to
focus on capital growth alongside income. They need
to find income sources that will grow over time.
Our analysis suggests that a number of popular
strategies in the market (such as providing income
from capital distributions) are inappropriate. They
achieve the income objective in the short term, but at
a significant cost to the investor.
Today’s retirees are set to enjoy retirements of 30
years or more. They need to think like long run
investors. Our solution is to adapt a total return based
approach to portfolio management.
Imposing an unrealistic income objective imposes
inefficiencies on the portfolio construction process.
We need to think carefully about the type of yield that
is sustainable.
Traditional notions of safety ignore price. Many
retirement solutions emphasise developed market
bonds as the core safety asset class. But the low
current market yields mean that we are being asked
to pay a high price to access this safety.
We take a structured, disciplined and coherent
approach to multi-asset investing based around
valuation and economic analysis.
An important step is to widen and broaden the
investment universe as much as possible. Many
income strategies still focus on traditional asset
classes, but extending the opportunity set to include
more emerging markets and strategies like liquid
alternatives must make sense.
Finally, it is important to think hard about fulfilment
strategies (including smart beta). Yield-focused
vehicles can be income and return enhancers.
12
Authors
Joseph Little
Global Chief Strategist
HSBC Global Asset Management
Jane Davies
Senior Portfolio Manager
HSBC Global Asset Management
Joseph joined HSBC's Asset Management business in
2007. He is currently Chief Global Strategist,
responsible for leading our work on macroeconomic
and multi-asset research, and for developing the house
investment strategy view. He was previously Chief
Strategist for Strategic Asset Allocation and a Fund
Manager on HSBC's absolute return Global Macro
fund, working on Tactical Asset Allocation. Prior to
joining HSBC, he worked as a Global Economist for JP
Morgan Cazenove.
Joseph holds an MSc in Economics from Warwick
University and is a CFA charterholder.
Jane is a Senior Portfolio Manager and has been
managing the World Selection Portfolios and Global
Strategy Portfolios since launch. Her previous roles
include Head of Global Investment Solutions, Head of
Multimanager for the UK and Middle East, and working
within the Tactical Investment Unit of HSBC Global
Asset Management. Prior to this, Jane was a tutor in
Statistical Research Methods with the Institute of
Public Administration and Management MBA
programme.
Jane is a qualified Chartered Financial Analyst (CFA),
holds the Investment Management Certificate (FSA,
UK), is a Member of the Society of Technical Analysts
(MSTA), and holds a First Class BSc (Hons.) degree in
Psychology and Philosophy (University of Leeds).
13
1. Indeed, this is well understood in the psychology literature. See Kahneman and Tversky (1979), “Prospect
theory: an analysis of decision under risk”, Econometrica & Kahneman (2011), “Thinking Fast and Slow” –
chapter 29
2. Ediev (2011), “Life expectancy in developed countries is higher than conventionally estimated. Implications
from improved measurement of human longevity”, Population Ageing
3. OECD (2015) Economic Outlook & IMF (2015) World Economic Outlook. Ball (2014), “Long term damage
from the Great Recession in OECD countries”, JHU Working Paper & Hall (2014), “Quantifying the harm to the
US economy from the financial crisis”, NBER Working Paper
4. Solow (1956), “A contribution to the theory of economic growth”, QJE
5. Gordon (2012), “Is US economic growth over? Faltering innovation confronts six headwinds”, NBER working
paper, and Gordon (2014), “The demise of US economic growth: restatement, rebuttal and reflections”, NBER
working paper
6. Merton (2014), “The crisis in retirement planning”, Harvard Business Review
7. Ilmanen “Expected Returns”, 2010 – see chapter 15 on covered call writing
8. Figelman (2008), “Expected Return and Risk of Covered Call Strategies”, Journal of Portfolio Management
9. Ang et al (2014), “Asset Allocation and Bad Habits”, Rotman International Journal of Pension Management
10. Israelov and Nielsen (2014), “Covered call strategies: One fact and eight myths”, Financial Analysts Journal
11. Taleb (2004), “Bleed or Blowup? Why do we prefer asymmetric payoffs?”, Journal of Behavioural Finance.
Taleb argues that much of the literature points to a utility-based explanation for covered calls. Investors
psychologically benefit from capping further upside since the marginal utility of gains decreases as asset prices
rise
12. Israelov and Nielsen (2014), “Covered call strategies: One fact and eight myths”, Financial Analysts Journal
13. Formally, the Sharpe Ratio reads as follows:
And we can define the MSR portfolio, in the absence of weight constraints as follows:
14. "Long‐horizon investors have an edge. They can ride out short‐term fluctuations in risk premiums, profit
from periods of elevated risk aversions and short‐term mispricing” – Ang and Kjaer (2011), “Investing for the
long run”
15. For a broad and deep review see Cochrane (2007), “Portfolio Theory” or Cochrane (2009), “Portfolio
Formation in the new Financial World”. The same portfolio construction methodologies apply in a more dynamic
setting – see Cochrane (2014), “A mean-variance benchmark for inter-temporal portfolio theory”, Journal of
Finance
References
𝑺𝑹𝒑 =𝝁𝒑 − 𝒓𝒇
𝝈𝒑=
𝒊=𝟏𝒏 𝒘𝒊𝝁𝒊 − 𝒓𝒇
𝒊,𝒋=𝟏𝒏 𝒘𝒊𝒘𝒋 𝝈𝒊𝝈𝒋𝝆𝒊,𝒋
=𝝈𝒊,𝒋
=𝒘′(𝝁 − 𝒓𝒇𝟏)
(𝒘′𝚺𝐰)𝟏/𝟐
𝒘𝑴𝑺𝑹∗ = 𝒇 𝝁𝒊, 𝝈𝒊, 𝝆𝒊,𝒋 =
𝚺−𝟏(𝛍 − 𝒓𝒇 𝟏)
𝟏′𝚺−𝟏(𝛍 − 𝒓𝒇 𝟏)
14
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