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Failing conventionally and succeeding unconventionally in asset allocation
R. Scott Hixon, CFAPortfolio Manager,Head of Investment ResearchInvesco Global Asset Allocation
This presentation is for Professional Clients only and is not for consumer use. The CFA® designation is globally recognized and attests to a charterholder’s success in a rigorous and comprehensive study program in the field of investment management and research analysis.
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Sources: Invesco analysis and DataStream. Stocks are represented by the MSCI World Index. Bonds are represented by the FTSE All Government Stocks Bond Index. For illustrative purposes only. *Alternatives within the risk contribution chart above are represented by a combination of hedge funds, commodities and managed futures.
Asset AllocationUNDERSTANDING RISK CONTRIBUTION
0%
20%
40%
60%
80%
100%
Stocks
Bonds
We
igh
t %
Weight
Bonds
Stocks
Risk Contribution
Traditional Portfolio
(The Bicycle Seat)
Weight Risk Contribution
0%
20%
40%
60%
80%
100%
Investment Grade Bonds High Yield Emerging Market Bonds Developed Market Equities
REITs Commodities Inflation Linked Securities Managed Futures
Hedge Funds Emerging Market Equities Cash *Alternatives
We
igh
t %New
Balanced(The Dorky Pants)
Weights drive risk allocation
Weights drive risk allocation
Portfolio ConstructionRISK, RETURN & CORRELATION ASSUMPTIONS
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• Private Equity: Cambridge U.S. Private Equity Index
• Developed Equity: MSCI World Index
• Emerging Equity: MSCI Emerging Equity Index
• Hedge Funds: HFRI Fund of Funds Composite Index
• Commodities: S&P GSCI Index
• Inflation-Linked Bonds: Barclay’s Global Real Bond Index
• G7 Long Bonds: Barclay’s G7 Long Treasury Index
• Emerging Debt: JP Morgan EMBIG Index
• High Yield Debt: Merrill Lynch High Yield Master II
Index
Source: Invesco Analysis. Based upon data covering the period 31 March 1986 through 30 June 2012. For illustrative purposes only.
Asset Risk
Private Equity
Developed Equity
Emerging Equity
Hedge Funds (HFRI)
CommoditiesInflation-Linked Bonds
G7 Long Bonds
Emerging Debt
High Yield Debt
Private Equity 17.3% 1.000 0.659 0.530 0.344 0.183 0.031 -0.168 0.402 0.435
Developed Equity 30.5% 1.000 0.720 0.081 0.125 -0.006 -0.061 0.490 0.631
Emerging Equity 47.4% 1.000 0.028 0.125 -0.072 -0.188 0.608 0.630
Hedge Funds (HFRI) 12.9% 1.000 0.268 -0.028 -0.031 -0.085 0.055
Commodities 41.6% 1.000 0.111 -0.197 0.178 0.158
Inflation-Linked Bonds 6.2% 1.000 0.562 0.236 0.152
G7 Long Bonds 16.5% 1.000 0.048 -0.014
Emerging Debt 23.2% 1.000 0.516
High Yield Debt 16.9% 1.000
Risk is multi-dimensional. Our goal is to construct practically optimal portfolio structures that consider both Sharpe Ratio and risk concentration.
Risk, Return & Correlation Assumptions
Equal-WeightedSolutions
Balanced-RiskSolutions
OptimizedSolutions
Portfolio ConstructionRISK, RETURN & CORRELATION ASSUMPTIONS
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For illustrative purposes only.
Known Unknown
Risk
Return
Correlation
Known Unknown
Risk
Return
Correlation
Known Unknown
Risk
Return
Correlation
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Source: Invesco analysis. For illustrative purposes only.
Portfolio ConstructionDIVERSIFICATION FRAMEWORK
Growth Assets
Deflation Hedges
Inflation Hedges
Non-Inflationary Growth
• Developed Equities
• Emerging Equities
• Private Equity
• High Yield
• Emerging Debt
• Hedge Funds
Recession
• Long-Term Government Bonds (hedged)
Inflationary Growth
• Commodities
• Inflation-Linked Bonds
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Hedge Funds, Private Equity & Equity Beta
• Skill is defined by both a high Information Ratio as well as independence from market returns (Beta)
• Though often considered “Alpha” strategies, both hedge funds and private equity have a high Beta component
• Hedge funds and private equity, on average, struggle during equity market turmoil
Sources: Invesco analysis. Performance returns shown are from 1/31/90 through 12/31/11. Hedge fund returns are represented by HFRI Fund of Funds Composite Index. Private equity returns are represented by The Cambridge Associates LLC U.S. Private Equity Index. Past performance does not guarantee comparable future performance; an investment cannot be made directly into an index.
RETURNS BY EQUITY MARKET ENVIRONMENT
Lowest 20%
60th to 80%
40th to 60th
20th to 40th
Highest 20%
-15
-10
-5
0
5
10
15
20
25
30
35
Hedge Funds Private Equity
Annualiz
ed R
etu
rn
S&P 500 Return by Quintile
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Credit Spread & Equity Beta
• Credit risk is equity risk that masquerades as fixed income risk.
• Credit asset classes, on average, struggle during periods of equity market turmoil.
RETURNS BY EQUITY MARKET ENVIRONMENT
Lowest 20%
60th to 80%
40th to 60th
20th to 40th
Highest 20%
-40
-30
-20
-10
0
10
20
30
40
50
High Yield Debt Emerging Debt
S&P 500 Return by Quintile
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Sources: Invesco analysis. Performance returns shown are from 1/31/90 through 12/31/11. High yield returns are represented by Bank of America Merrill Lynch High Yield Master II Index. Emerging debt returns are represented by the J.P. Morgan EMBI Global Composite Index. Annualized returns are excess returns versus the Barclays US Treasury Index. Past performance does not guarantee comparable future performance; an investment cannot be made directly into an index.
Annualiz
ed E
xcess
Retu
rn(v
s. B
arc
lays
US
Tre
asu
ry In
dex)
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Risk Parity
Weight MCR
Private Equity 8.41% 0.91%
Developed Equity 4.59% 0.91%
Emerging Equity 3.30% 0.91%
Hedge Funds 17.52% 0.91%
Commodities 5.12% 0.91%
Inflation-Linked Bonds 29.81% 0.91%
G7 Long Treasuries 16.71% 0.91%
Emerging Debt 6.25% 0.91%
High Yield Debt 8.28% 0.91%
TOTAL 100.00% 8.19%
Source: Invesco analysis. MCR refers to Marginal Contribution to Risk. For illustrative purposes only.
Risk Parity Implementation – Example “A”CAPITAL & RISK ALLOCATION WITHOUT A DIVERSIFICATION FRAMEWORK
Risk Parity
Weight MCR %MCR
Non-Inflationary Growth 48.35% 5.48% 66.67%
Inflationary Growth 34.94% 1.83% 22.22%
Recession 16.71% 0.91% 11.11%
TOTAL 100.00% 8.19% 100.00%
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Risk Parity
Weight MCR
Private Equity 6.07% 0.44%
Developed Equity 3.13% 0.44%
Emerging Equity 2.54% 0.44%
Hedge Funds 11.05% 0.44%
Commodities 7.31% 1.33%
Inflation-Linked Bonds 33.01% 1.33%
G7 Long Treasuries 27.83% 2.67%
Emerging Debt 3.75% 0.44%
High Yield Debt 5.30% 0.44%
TOTAL 100.00% 8.00%
Source: Invesco analysis. MCR refers to Marginal Contribution to Risk. For illustrative purposes only.
Risk Parity Implementation – Example “B”CAPITAL & RISK ALLOCATION INCLUDING A DIVERSIFICATION FRAMEWORK
Risk Parity
Weight MCR %MCR
Non-Inflationary Growth 31.84% 2.67% 33.33%
Inflationary Growth 40.33% 2.67% 33.33%
Recession 27.83% 2.67% 33.33%
TOTAL 100.00% 8.00% 100.00%
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Source: Invesco analysis. MCR refers to Marginal Contribution to Risk. For illustrative purposes only.
Risk Parity ImplementationCAPITAL & RISK ALLOCATION
Risk Parity Example “B”
Weight MCR %MCR
31.84% 2.67% 33.33%
40.33% 2.67% 33.33%
27.83% 2.67% 33.33%
100.00% 8.00% 100.00%
Risk Parity Example “A”
Weight MCR %MCR
Non-Inflationary Growth 48.35% 5.48% 66.67%
Inflationary Growth 34.94% 1.83% 22.22%
Recession 16.71% 0.91% 11.11%
TOTAL 100.00% 8.19% 100.00%
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Source: Invesco analysis. For illustrative purposes only.
Strategic Risk Parity ImplementationONLY A STARTING POINT
Engineer for ReturnPrepare for risk
Strategic allocation
Design a portfolio ofrisky assets with positive long-term return expectations
Pair risky assets with long-term government bonds
Adjust tomarket
conditions
Tactical allocation
Evaluate market conditions and adjust portfolioallocations
Non-Inflationary Growth
Recession Inflationary Growth
0%
10%
20%
30%
40%
50%
Ris
k (%
)
33% strategic allocation
Tactical
0%
2%
4%
6%
8%
10%
8.0%
Ris
k (%
)
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Tactical Range
Source: Invesco analysis. Above figures do not represent specific time periods or actual portfolio results. For illustrative purposes only. Asset classes are subject to change and are not buy/sell recommendations.
STRATEGIC VS. TACTICAL ASSET ALLOCATION
Non-Inflationary Growth
Recession Inflationary Growth
0%
11%
22%
33%
Ris
k (%
)
Composition of Risk
Strategic
Strategic
0%
2%
4%
6%
8%
10%
8.0%
Ris
k (%
)
Level of Risk
Strategic
Tactical Range
• Strategic Allocation
is calculated
through volatility
and correlation
estimates
• Active positioning
allows the asset
weights to deviate
from the long-term
strategic allocation
Risk Parity Implementation
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Additional Information
Any simulation presented here was created to consider possible results of a Risk Parity Strategy (not previously managed by Invesco for any client). These performance results are hypothetical (not real) and were achieved by using a balanced risk optimization model. It may not be possible to replicate these results. The hypothetical results were derived by back-testing using a simulated portfolio. There can be no assurance that the simulated results can be achieved in the future. While the balanced risk optimization model was used to reflect the investment process for a Risk Parity Strategy, this model does not factor in all the economic and market conditions that can impact results.
Important information
This presentation is for Professional Clients only and is not for consumer use.
Where R Scott Hixon has expressed views and opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.
Where securities are mentioned in this document they do not necessarily represent a specific portfolio holding and do not constitute a recommendation to purchase or sell.
Further information on our products is available using the contact details shown.
Invesco Perpetual is a business name of Invesco Asset Management LimitedPerpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UKAuthorised and regulated by the Financial Services Authority.
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