and returns

Whitepaper

This document is for Professional Clients in the UK only and is not for consumer use

“An investment in knowledge always pays the best interest.”

Benjamin Franklin

Georgina Taylor Risk and returns Product Director – Multi Asset, What do investors require from an investment in order to allocate Invesco Perpetual capital? A combination of risk and returns is a basic starting point. But in assessing what an asset class or fund can offer going forward, history will typically play a role in assessing the risk versus return trade off.

In this paper, we discuss the and Sortino ratio as two ways of assessing the risk-return profile of equities and bonds. On this basis, asset classes are fairly well balanced with both global equities and bonds showing the same amount of on the upside as the downside over time. But of course this can change for short periods of time – particularly, for example, during and since the recent financial crisis.

At a regional level, the picture is different. Different regional equity markets display different levels of volatility. The US may look very attractive from a risk/return perspective but the dynamics of the market have been changing – downside volatility in the US has been higher than for emerging markets over the past few years.

This all holds implications for how we assess markets and the embedded within them. Assessing risk is a dynamic process and investors need to be wary about how they take a view on risk going forward.

01 Risk and returns March 2014 The risk premium The risk premium has become a generic term, and is often referred to with little regard for the assumptions underlying it. Here we start with an ex-post measure of the premium relative to a 3-month Treasury Bill reference rate. The annualised net total return of the MSCI World global equity index in US dollars relative to 3-month Treasury Bills since 2004 has been 4.9%. This represents the excess return equities have delivered over time - it is the equity risk premium with the benefit of hindsight. What it fails to do is help us understand what is required from investors going forward in order to allocate capital to a particular asset class or fund.

Figure 1 Global equities, total Net total return of global equities relative to 3-month Treasuries return relative to 3-month Treasuries

Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec 03 04 05 06 07 08 09 10 11 12 13

200

150

100 Annualised returns = 4.9%

50

0

Source: Thomson Datastream 31 December 2003 to 29 January 2014.

For the Invesco Perpetual Global Targeted Returns Fund we aim to achieve a gross return of 3-month UK Libor (or an equivalent reference rate) plus 5% on a rolling, three- year annualised basis.1 In other words, we are looking to deliver equity-like returns over the long-run, which is supported by the ex-post equity risk premium above. Global equities have delivered just under 5% versus 3-month Treasuries over the past ten years on an annualised basis to the 30th January 2014. Importantly however, we also aim to deliver this equity-like return with less than half the volatility of global equities. What we are trying to do is improve the risk/return profile for the fund versus simply holding equities over the longer term.

The reason this is important is that global equities have delivered just under 5% over the past ten years on an annualised basis, but their volatility has meant that perhaps this return has not compensated investors fully for the level of risk that they have taken over that time period. If investors need access to their capital, either for personal financial planning reasons, or a corporate or government pension fund needs to ensure that it can honour its pension commitments, this return versus volatility profile can pose a significant problem.

In the past, bond investments have been held to mitigate some of these risks. A balanced has been the key to ensuring diversification with the aim of smoothing the risk/ return profile over time. However, if the dynamics of bond markets are changing, can investors rely on bonds to dampen volatility within a multi asset portfolio?

Here, we discuss a couple of different ways to assess the risks embedded within asset classes and highlight how the historical period used plays a huge part in determining where the potential risks could lie within a portfolio.

1 Please note there is no guarantee the fund’s performance target will be achieved.

02 Risk and returns March 2014 Returns relative to risk-free assets – the Sharpe ratio The Sharpe ratio reflects returns relative to risk, and anchors returns not around a benchmark but around a risk-free return such as 10-year government bonds. The ratio is calculated by dividing the relative returns of a fund or asset type versus the returns of a risk-free asset class, by the realised volatility of the fund or asset type. Arguably this analysis is somewhat out of date given the risks that are embedded within government bond markets today – “return free risk” has been quoted numerous times over the past couple of years in reference to the higher risk now associated with government bond investments. For the purposes of this paper, we focus on the return of equities relative to 3-month Treasury bills, because arguably Treasury bills, or short-term interest rates, are a fairer reflection of a risk-free rate, at least for now. For equities as an asset class, or indeed funds that are trying to target equity-like returns over the long term, this is a helpful starting point for considering required returns going forward.

In Figure 2 we show historical returns and volatility for various asset classes.

Over the long run, global equities have delivered a very poor Sharpe ratio. Annualised returns have been 3% versus 3-month Treasury bills, but volatility has been 16.2%. The Sharpe ratio has been 0.19 since 1989. Now of course, this figure uses average volatility and returns since 1989, and for certain periods global equities have more than compensated for the level of risk taken by an investor. But this gives a starting point for long-term investors looking across asset classes.

US 10-year government bonds have delivered a much more attractive risk/return profile and the Sharpe ratio for the asset class has been 0.71 over time. Over the past 25 years, returns have gone a long way to compensate investors for the level of risk taken. But as we describe below, that profile has changed markedly in more recent times.

One way to use the Sharpe ratio is to look at the potential volatility of an asset class and then determine what returns are required going forward to compensate for that level of risk. If historic volatility for equities has been around 16%, it would be reasonable to suggest that equity investors would look for annual returns of around 12-13% from global equities if we apply the same Sharpe ratio to equities that 10-year government bonds have delivered over time.

Figure 2 Historical returns, volatility, Sharpe and Sortino ratios by asset classes

US 10-year Global Global Government corporate Equities Bonds bonds* Commodities Since 1989 Annualised returns 3.0 5.2 3.2 4.3 Annualised volatility 16.2 7.2 5.5 21.0 Annualised downside volatility 17.4 7.4 5.4 22.2 Sharpe ratio 0.19 0.71 0.58 0.20 Sortino ratio 0.17 0.70 0.60 0.19

Since 2004 Annualised returns 4.9 4.7 3.4 -0.02 Annualised volatility 18.6 7.5 5.9 24.7 Annualised downside volatility 20.8 7.4 6.0 27.7 Sharpe ratio 0.26 0.63 0.58 0.00 Sortino ratio 0.24 0.64 0.57 0.00

Past 3.5 years Annualised returns 13.3 0.4 5.0 0.7 Annualised volatility 15.7 7.7 5.1 17.8 Annualised downside volatility 16.2 8.4 5.0 20.1 Sharpe ratio 0.85 0.05 0.99 0.04 Sortino ratio 0.82 0.05 1.01 0.04

Source: Thomson Datastream, 6 January 1989 to 29 January 2014. Global equities represented by: MSCI World (net total return), Global Corporate bonds: BofAMerill Lynch Global Broad Corp (total return) and Commodities: S&P GSCI Commodity (total return).

* since 1996, since the index was created.

03 Risk and returns March 2014 Good versus bad volatility – the Sortino ratio The Sharpe ratio is an intuitive way of thinking about returns relative to risk. However, let us consider carefully why it is important for an investor to analyse the returns of an investment relative to its volatility. Typically, volatility on the upside is not an issue for investors. It is volatility on the downside that poses a problem.

The Sortino ratio deals with this issue. Instead of calculating returns relative to volatility when markets are rising and falling, the Sortino ratio calculates returns relative to volatility based only on the negative returns that the asset class delivers over time.

Figure 2 also includes this information. At an asset class level over the past 25 years, there has not been a significant difference between upside and downside volatility. For equities, volatility has been 16.2% overall, and has risen to 17.4% during periods when markets have been falling. For US government bonds, volatility has been 7.2% over time, and has risen only marginally to 7.4% when bond markets have fallen. Therefore the Sharpe ratio and the Sortino ratio have been very similar.

However, analysing the very long term potentially masks some important changes, which have become visible across asset classes more recently. If we use the same methodology but only over the past 3.5 years, government bonds in particular look quite different. Firstly, returns have been much lower therefore the risk/return profile for government bonds has deteriorated sharply. This should not come as a surprise as we can observe what has happened in markets. But volatility has also changed. Volatility for equities has been fairly consistent – volatility overall has been 15.7% and on the downside has been around 16.2%, so not that much higher. But for government bonds volatility has been 7.7% but has been 8.4% when bond markets have sold off – a much higher difference than the asset class has displayed over the longer term.

Another interesting observation, however, is that this change has only occurred in the government bond space, not for corporate bonds. Over the past 3.5 years, volatility has been fairly consistent for corporate bonds. This captures how so many of the risks associated with policy stimulus have potentially changed the outlook for the Government bond sector. Other asset types, at least for a time, may need to step up to the plate and offer diversification benefits within a multi asset portfolio.

We have also included commodities within the table. One observation here is that over the past 25 years, the profile of commodities based on the Sharpe ratio and the Sortino ratio is not dissimilar to equities. But over more recent history, commodities have behaved quite differently and have had a far poorer risk/return profile. Just because the two asset classes have been correlated in the past, does not necessarily mean they will be going forward.

Art and science in multi asset Up until this point, we have highlighted the merits and the drawbacks of a couple of different ways of analysing risks versus returns. But does it really matter? Would using the Sortino ratio rather than the Sharpe ratio have altered investor behaviour over time? When we launched the Global Targeted Returns strategy in September 2013, we published a book entitled “Investing in ideas: Art and science in multi asset”. The concept of marrying art and science is relevant here.

In Figure 2, we have illustrated these ratios and how they change over time by referencing historic data series to determine both returns and volatility. But of course for investment purposes, investors also need to anchor return projections and portfolio decisions around what may happen going forwards, and not entirely rely on what has happened in the past despite it being a helpful indicator.

From this perspective, we would argue that the most useful aspect of these ratios is the difference in how they calculate volatility. This in our view helps to highlight how dynamic markets are and how they change over time. Perhaps we can illustrate this with a regional example. Very simply we have looked at three equity markets – Europe, Emerging Markets and the US.

In Figure 3, for each equity index, we have calculated the same historic data as for the asset classes in Figure 2. There are some interesting observations. Firstly, the US and Europe have had very similar risk/return profiles over the past ten years – their Sharpe ratios and Sortino ratios are exactly the same. However, Emerging Markets, because of their outperformance pre-crisis and somewhat defensive qualities throughout the financial crisis (largely centred on developed markets), have delivered a much better risk/return profile over that period.

04 Risk and returns March 2014 Figure 3 Historical returns, volatility, Sharpe and Sortino ratios of equities by region

Emerging US Europe Markets Since 2004 Annualised returns 5.2 4.8 8.9 Annualised volatility 18.3 17.0 18.5 Annualised downside volatility 20.8 19.2 20.8 Sharpe ratio 0.28 0.28 0.48 Sortino ratio 0.25 0.25 0.43

Past 3.5 years Annualised returns 17.1 8.8 3.6 Annualised volatility 14.5 16.0 14.3 Annualised downside volatility 15.8 16.6 14.2 Sharpe ratio 1.18 0.55 0.25 Sortino ratio 1.08 0.53 0.25

Source: Thomson Datastream. MSCI indices total returns in local currency, as of 29th January 2014.

We have calculated the same data over the past 3.5 years. One broad initial observation is that, over the past 3.5 years, the difference between overall volatility and downside volatility has been much lower – we have been in a very low volatility world, which must not make us complacent as investors.

Secondly, if we only focus on the ratios, we would say that it is in Emerging Markets where there has been the biggest deterioration in the risk/return backdrop. The region’s Sharpe ratio has dropped from 0.48 over the past ten years to 0.25 over the past 3.5 years and, in fact, the US is now the most attractive region based on this analysis.

However, taking the output of this type of analysis without examining the component parts could be dangerous. Over the past 3.5 years, the US equity market has displayed greater volatility on the downside versus Emerging Markets: 15.8% versus 14.2% in local currency terms. So, despite returns compensating for that risk when we look back, investors should be wary of that change in volatility profile going forward. To be fair, the volatility in emerging markets is also potentially too low given a number of risks in the region. But investors should not underestimate that even a fairly robust market such as the US can see a change in its dynamics, dependent upon where the risks in the global economy lie.

Conclusions The conclusion from this analysis is threefold. Firstly, investors need to be aware of how the risks embedded within asset classes change over time. Secondly, investors need to carefully consider which risk metrics are most helpful for analysing potential returns of a fund or asset class going forward. The Sharpe ratio is helpful, primarily because of its simplicity. But the Sortino ratio really gets to the heart of what investors want to achieve – participation on the upside but some defence from the downside. More specifically, separating out different ways of calculating volatility when markets are falling or rising can be helpful in highlighting where potential risks could lie within a multi asset portfolio. Finally, all of this analysis underpins what the Invesco Perpetual Multi Asset team is trying to achieve over time: equity-like returns, with less than half the volatility of global equities, but with the flexibility to move between asset types, dependent upon these forever changing risk and return characteristics.

05 Risk and returns March 2014 Contact us

UK Retail Sales Telephone 01491 417600 Email [email protected]

UK Institutional Sales Telephone 020 7543 541 www.invescoperpetual.co.uk/investinginideas

Telephone calls may be recorded.

Important information

This document is for Professional Clients in the UK only and is not for consumer use.

Where Georgina Taylor has expressed 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.

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

The Invesco Perpetual Global Targeted Returns Fund makes significant use of financial derivatives (complex instruments) which will result in the fund being leveraged and may result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.

The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss. This counterparty risk is reduced by the Manager, through the use of collateral management.

The securities that the fund invests in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity, may mean that it is not easy to buy or sell securities. These risks increase where the fund invests in high yield or lower credit quality bonds and where we use derivatives.

For more information on our funds, please refer to the most up to date relevant fund and share class-specific Key Investor Information Documents and the Supplementary Information Document, the ICVC ISA Key Features and Terms & Conditions and the latest Prospectus. This information is available using the contact details shown. The first Interim Short Report will be available from the end of August 2014 and the first Annual Short Report will be available from the end of February 2015.

Invesco Perpetual is a business name of Invesco Fund Managers Limited and Invesco Limited. Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.

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