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Going Beyond Style Box Investing NCPERS Presented by Erin Doyle Orekhov, Client Portfolio Manager May 22, 2017 For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. IM0517-34449-0518 NCPERS Session Description Going Beyond Style Box Investing While the advent of the style box in the 1990s has provided a useful framework for constructing a diversified equity portfolio, investing strictly within the style box framework may create portfolio gaps that can lead to unintended consequences. This presentation aims to help plan sponsors think about 1) how they can go beyond the confines of style boxes to help participants achieve a secure retirement; 2) how outcome oriented approaches can help balance between maximizing total return and minimizing volatility; and 3) what they should look for when evaluating outcome-oriented strategies. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 2 Table of Contents How we got here Why we need to think outside the box Thinking outside the box Thinking outside the box: a case study Key takeaways For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 3 How We Got Here For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 4 History of The Style Box Approach Morningstar Style Box TM Large Medium Small Value Blend Growth For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 5 A Strong Case for Diversification 2006 2007 2008 Emerging Market Equity Intermediate Bond 2009 Commodities Short Term Bond Emerging Market Equity 2010 2011 2012 2013 2014 TIPS Global Bonds High Yield Bond Developed International TIPS Senior Debt U.S. Small Cap REITs Global Bonds High Yield Bond U.S. Mid Cap U.S. Mid Cap TIPS Emerging Market Equity Emerging Market Equity Intermediate Bond Senior Debt REITs REITs Intermediate Bond Developed International Emerging Market Equity Global Bonds U.S. Mid Cap U.S. Small Cap Commodities High Yield Bond U.S. Small Cap U.S. Mid Cap REITs Developed International Short Term Bond U.S. Small Cap Developed International U.S. Small Cap U.S. Mid Cap Commodities U.S. Small Cap 15.8% 5.5% -37.0% 26.5% U.S. Mid Cap High Yield Bond 2015 2016 REITs U.S. Large Cap Calendar Year Returns 15.1% 2.1% 16.0% U.S. Small Cap High Yield Bond U.S. Mid Cap 32.4% 13.7% 1.4% 12.0% U.S. Mid Cap REITs Commodities High Yield Bond U.S. Mid Cap Commodities High Yield Bond Short Term Bond High Yield Bond Developed International Senior Debt Developed International TIPS Senior Debt Senior Debt Senior Debt High Yield Bond Intermediate Bond Short Term Bond Emerging Market Equity U.S. Mid Cap TIPS REITs U.S. Small Cap Intermediate Bond Senior Debt U.S. Small Cap Global Bonds Senior Debt TIPS Senior Debt REITs TIPS Senior Debt U.S. Small Cap REITs Global Bonds Developed International Global Bonds REITs Emerging Market Equity Intermediate Bond Intermediate Bond TIPS REITs Intermediate Bond Short Term Bond High Yield Bond Developed International Short Term Bond Global Bonds Developed International Short Term Bond Intermediate Bond Senior Debt TIPS Intermediate Bond Commodities Short Term Bond Commodities Commodities Global Bonds Short Term Bond U.S. Mid Cap Global Bonds Emerging Market Equity Global Bonds Global Bonds Short Term Bond TIPS Emerging Market Equity U.S. Small Cap Developed International Commodities Developed International High Yield Bond Commodities Emerging Market Equity Intermediate Bond TIPS Short Term Bond Emerging Market Equity Commodities Source: Morningstar Direct. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 6 Why We Need to Think Outside the Box For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 7 A Slightly Different Perspective on the Style Box Morningstar Style Box TM Large Medium Small Value Blend Growth For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 8 Challenges Facing Plan Sponsors in Today’s World The Search for Yield Volatility Interest Rate Risk Fiduciary Responsibility For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 9 Volatility: why do we care? Compounded returns for high volatility stocks are dramatically lower 12% Q5 (Highest Vol) Q1 (Lowest Vol) Return 10% Volatility Drag 8% Average Returns 6% Compounded Returns 4% 10% 15% 20% Risk 25% For illustrative purposes only. Data shown above represents performance for the Russell 1000 Index from 1/1/97 – 12/31/15. Past performance is no assurance of future results. Source: Voya IM and FactSet. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 10 30% Fees Active vs. Passive Management For illustrative purposes only. Source: Voya Investment Management and Zephyr Style Advisor. Category median represents the 50th percentile breakpoint for the Morningstar Large Cape Growth category at the end of each rolling 3-year period as calculated by Zephyr Style Advisor. Rolling 36-month data from December 1961-December 2015 completed monthly. Performance is no guarantee of future results. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 11 Thinking Outside the Box For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 12 How to Identify and Fill the Gaps: A New Paradigm Morningstar Style Box TM Large V O L A T I L I T Y FEE PRESSURE ETFs SMART BETA Medium Small Value Blend Growth For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 13 Building Blocks for Delivering Cost-Effective, Custom Solutions Thinking “outside the box” Willingness to consider a solution that does not fit in a style box and hire a manager based on back-tested results Collaboration Partnership between plan sponsor and manager Analytics Deeper due diligence and analysis on how a manager will fit into the overall portfolio For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 14 Back-testing: De-Mystifying the Black Box Look for managers that: • Use multiple factors • Test the efficacy of factors over a range of market environments • Look for factors that have low correlation to one another Look for managers that: • Provide transparency around methodology and results • Avoid “look ahead” bias, survivorship bias, and data mining • Use multiple factors, test the efficacy of factors over a range of market environments, and look for factors that have low correlation to one another For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 15 Assessing Multiple Factors Over a Range of Market Environments 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings momentum 0% 0% 0% 15% 17% 11% 5% 0% 0% Earnings growth 2% 0% 7% 0% 0% 0% 0% 0% 0% Price Momentum 2% 0% 1% 0% 0% 0% 0% 0% 0% Cash to EV 1% 0% 0% 0% 0% 0% 0% 0% 0% Tangible Book Yield 12% 25% 25% 16% 1% 6% 0% 7% 1% Dividend Yield 17% 5% 4% 10% 21% 12% 9% 11% 10% For illustrative purposes only. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 16 Thinking Outside the Box: A Case Study For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 17 Case Study: Building a Portfolio to Meet a Style Box Gap - Volatility Plan Sponsor Objectives Generate income Low volatility and strong downside capture (lower risk) Maximize total return “Off the Shelf” Solutions Large Cap Value (Style Box Solution) Custom Solution Low/Min Vol ETF (Passive Solution) Low beta Unintended Consequences: Robust alpha source No explicit beta target Above-benchmark dividend yield Overexposed to sectors that are interest-rate sensitive Sector-neutral For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 18 Case Study: Pitfalls of “Off the Shelf” Solutions Active Sector Weights (%) Sector crowding Defensive Cyclical 40 30 27.5% 24.1% 20 10 0 -10 -20 -30 -27.3% -40 S&P Low Vol vs. S&P 500 MSCI Min Vol vs. MSCI USA For illustrative purposes only. Source: Voya IM and FactSet. Data as of 1/1/98 -12/31/15. Past performance is no assurance of future results. Interest rate sensitivity measures the sensitivity of returns to the change in 10-year bond yields. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 19 -24.1% Case Study: Pitfalls of “Off the Shelf” Solutions Correlation to interest rates 0.15 0.10 Cyclical Interest Rate Sensitivity Energy 0.05 Diversified Materials Banks Discretionary Industrials 0.00 Tech Defensive Insurance Health Care -0.05 Staples Telecom -0.10 Real Estate -0.15 0.40 Utilities 0.60 0.80 1.00 1.20 1.40 Equity Market Beta (β) For illustrative purposes only. Source: Voya IM and FactSet. Data as of 1/1/98 -12/31/15. Past performance is no assurance of future results. Interest rate sensitivity measures the sensitivity of returns to the change in 10-year bond yields. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 20 1.60 Case Study: Pitfalls of “Off the Shelf” Solutions Managing downside protection 6.0% 4.3% 2.0% -2.0% -2.5% -3.0% -3.2% -6.0% 10-YR Yield Russell 1000 Index S&P Low Vol ETF S&P High Div Low Vol ETF For illustrative purposes only. Source: Voya IM and FactSet. Data as of 1/1/98 -12/31/15. Past performance is no assurance of future results. Interest rate sensitivity measures the sensitivity of returns to the change in 10-year bond yields. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 21 Case Study: A Different Framework for Evaluating an Outcome-Oriented Mandate, Focused on Desired Outcomes Higher Income Rolling 3-Year Average Dividend Yield Dividend Yield (%) 4 3 2 1 Sample High-Dividend low volatility strategy Voya Low Volatility R1000 Performance data from 01/01/97 – 12/31/15 is based on a simulated portfolio vs. Russell 1000 Index, rebalanced quarterly. Source: FactSet and Voya Investment Management. Past performance is no assurance of future results. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 22 Dec-15 Dec-13 Dec-11 Dec-09 Dec-07 Dec-05 Dec-03 Dec-01 Dec-99 0 Case Study: A Different Framework for Evaluating an Outcome-Oriented Mandate, Focused on Desired Outcomes Lower Risk Risk Reduction versus the Russell 1000 Index 3 Year Rolling Standard Deviation (January 1, 1997 - December 31, 2015) 0% -5% -10% -15% -20% -25% Dec-15 Dec-13 Dec-11 Dec-09 Dec-07 Dec-05 Dec-03 Dec-01 Dec-99 -30% Performance data from 01/01/97 – 12/31/15 is based on a simulated portfolio vs. Russell 1000 Index, rebalanced quarterly. Source: FactSet and Voya Investment Management. Past performance is no assurance of future results. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 23 Case Study: A Different Framework for Evaluating an Outcome-Oriented Mandate, Focused on Desired Outcomes Maximize Total Return Voya Volatility Equity vs. Russell 1000 Index Sample High-Dividend low volatility strategyLow vs. Russell 100 Index Manager Returns 3 Year Rolling Returns (January 1, 1997 - December 31, 2015) 35 30 25 20 15 10 5 0 -5 -10 -15 -20 93% Manager Outperformance vs. the Benchmark -20 -10 0 10 Index Returns 20 30 40 Performance data from 01/01/97 – 12/31/15 is based on a simulated portfolio vs. Russell 1000 Index, rebalanced quarterly. Source: FactSet and Voya Investment Management. Past performance is no assurance of future results. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 24 Key Takeaways For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 25 Why You Need to Think Outside of the Style Box 1 Unintended risks of pure style box approach 2 Changing market structure 3 Benefits of custom solutions 4 Last but not least… For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 26 The #1 reason we all need to think outside the box For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 27 Appendix For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 28 Disclosure This information is proprietary and cannot be reproduced or distributed. Certain information may be received from sources Voya Investment Management (“Voya IM”) considers reliable; Voya IM does not represent that such information is accurate or complete. Certain statements contained herein may constitute “projections,” “forecasts” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial data. Actual results, performance or events may differ materially from those in such statements. Any opinions, projections, forecasts and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. Nothing contained herein should be construed as (i) an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Voya IM assumes no obligation to update any forward-looking information. Past performance is no guarantee of future results. ©2017 Voya Investments Distributor, LLC • 230 Park Ave, New York, NY 10169. All rights reserved. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 29 Backtested Performance Information Backtested performance is NOT an indicator of future actual results. The results reflect the performance of a strategy not historically offered to investors and do not represent returns that any investor actually attained. Backtested results are calculated by retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and subject to losses. General assumptions include that the firm would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Changes in these assumptions may have a material impact on the backtested returns presented. Certain assumptions have been made for modeling purposes and are unlikely to be realized. No representations and warranties are made as to the reasonableness of the assumptions. This information is provided for illustrative purposes only. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Specifically, backtested results do not reflect actual trading or the effect of material economic and market factors on the decision making process. Since trades have not actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors may have had on a decision-making process. Further, backtesting allows the security selection methodology to be adjusted until past returns are maximized. Actual performance may differ significantly from backtested performance. Backtested results are adjusted to reflect the reinvestment of dividends and other income and except where otherwise indicated, are presented gross-of fees and do not include the effect of backtested transaction costs, management fees, performance fees or expenses, if applicable. No cash balance or cash flow is included in the calculation. For financial professional or qualified institutional investor use only. Not for inspection by, distribution or quotation to, the general public. 30