In the 1990's, target annual returns for a market portfolio of stocks and bonds was over 9% and was easily achieved with the equity markets returning over 20% per year and bond yields much higher than today’s yields. With equity returns now being much lower investors have few options to achieve those same target returns. One is to increase the allocation to equities, but this increases volatility with very low benefit. According to Goldman Sachs, public equities make up 59% of large institutional portfolios and account for 96% of their total volatility. Another option is to reduce the target return, but this requires greater corporate funding of the pension liability.
A third alternative is to replace market risk with active risk. Active risk provides excess returns (alpha) over market returns and contributes very little additional risk to the overall portfolio since market risk is already included. Therefore active risk provides a more efficient method of achieving market risk, but active risk isn't available to everyone because it requires finding active managers with above average skills. Such managers have usually uncovered and taken advantage of an inefficient anomaly in an otherwise efficient market.
There are four sources of active equity risk:
Traditional long-only managers provide a more conservative and transparent approach than the other three, but with the market for U.S. large cap stocks being the most efficient, few opportunities exist in this segment. That is what makes Beacon Street Capital so unique.
Beacon Street Capital offers investors a highly disciplined process of active management in the form of a long-only strategy that selects stocks from the Standard & Poor's 500-Stock Index. This process has generated an average alpha over 4% per year, net of fees, over the past six years with a standard deviation nearly half the benchmark index. Allocating this process to a market portfolio of stocks and bonds can bring substantial benefits without having to relax constraints that may increase risk. The following examples illustrate the benefits.
Asset allocation in a market portfolio is a function of the target return, the volatility of each asset class, and the expected excess return of that asset class over the risk free rate of return. The risk free return is based on the 10year US Treasury Note and is currently approximately 4.5%. The expected excess return for stocks is the return premium, over the risk free return, which the equity market should pay for the additional risk the equity investor must absorb. According to Goldman Sachs, over many market cycles the excess return for US large cap stocks is estimated to be 3.5% to 4% per year, with a volatility of 18% and a correlation of 80%. This means US large cap stocks should be expected to return 8-8.5% over the long-term. For US fixed income securities the expected excess return over the risk free rate of return is 0.2% with a volatility of 4.4%.
As Table I shows, a market portfolio of 50% large cap stocks and 50% bonds would generate an expected excess return of 1.9% and an expected total return of 6.4% (1.9% plus the 4.5% risk free rate) which is much less than the 9% targeted return of the average institutional pension fund. The expected excess return would have volatility of 9.2% and a Sharpe Ratio of 0.21. The Sharpe Ratio is an excellent way to compare returns of different strategies and is calculated by dividing the return of the asset class by its volatility. A larger Sharpe Ratio implies a higher return for a given level of risk.
| Class | Market Weight | Expected Excess Return | Volatility (Std. Dev.) | Sharpe Ratio |
|---|---|---|---|---|
| Market Risk-US Large Cap | 50% | 3.5% | 17.5 | 0.20 |
| Interest Rate Risk-US Bonds | 50% | 0.2% | 4.4 | 0.05 |
| 100.0% | 1.9% | 9.2 | 0.21 | |
| Expected Total Return | 6.4% | |||
Source: Goldman Sachs
One way to increase the market portfolio return is to add more stock market risk. As Table II shows adding 25% more stock market exposure only provides 80 basis points of additional return, but with 26% more volatility since the increase in the new risk is correlated with the old risk. A very low benefit that increases expected total return to 7.2%, still short of the 9% target by 180 basis points.
| Class | Market Weight | Expected Excess Return | Volatility (Std. Dev.) | Sharpe Ratio |
|---|---|---|---|---|
| Market Risk-US Large Cap | 75% | 3.5% | 17.5 | 0.20 |
| Interest Rate Risk-US Bonds | 25% | 0.2% | 4.4 | 0.05 |
| 100.0% | 2.7% | 11.6 | 0.23 | |
| Expected Total Return | 7.2% | |||
Source: Goldman Sachs
Increasing the market portfolio exposure to 100% stocks only makes things worse. While the additional risk creates an expected total return of 8% (3.5% expected excess return plus 4.5% risk free return), the volatility of the expected excess return would increase to 17.5%, with a Sharpe Ratio of 0.20 and this is not realistic. High volatility diminishes the compounding effect on rates of return, which is the primary source of building wealth. Therefore, the only viable options that remain are (1) to lower the targeted return or (2) to add alpha by trading market risk for active risk.
Active risk is the potential to use active management to add considerable value to a market portfolio over and above the market risk. This can be accomplished without altering the traditional portfolio allocation by simply trading market risk for active risk. This is a different way of thinking about portfolio construction using an extension of the basic principal of modern portfolio theory. The result is an expected excess return equal to (1) the actual excess return added by the active manager over the benchmark index, plus (2) the expected excess return of the asset class. With active risk including the market risk component, active risk can add to the expected excess return without increasing volatility. In some cases it actually reduces volatility creating a more efficient method of capturing market risk.
The most successful active managers have the skill to identify an inefficient anomaly in an otherwise efficient market. As shown in Table III, exchanging the market risk US large cap component for our S&P500/Select active risk strategy increases the expected excess return for that allocation to 7.1% from 3.5%, while reducing its overall volatility by nearly half. The result is a total market portfolio return of 8.2% compared to 7.2% from the example in Table II, and a Sharpe Ratio of .76, over three times that in Table II, indicating greater efficiency in capturing stock market risk.
| Class | Market Weight | Expected Excess Return | Volatility (Std. Dev.) | Sharpe Ratio |
|---|---|---|---|---|
| Active Risk-S&P500/Select | 50% | 7.1% | 7.6 | 0.93 |
| Interest Rate Risk-US Bonds | 50% | 0.2% | 4.4 | 0.05 |
| 100.0% | 3.7% | 4.9 | 0.76 | |
| Expected Total Return | 8.2% | |||
As previously discussed, long-term expected returns for U.S. large cap stocks should average 8.0% - 8.5% per year, but annual stock returns tend to move to extremes on either side of this long-term expected average. During the latter part of the 1990's the S&P 500 Stock Index returned 12.2% per year, but since 2001 the index has returned 2.9% per year. In contrast, our unique strategy has not only achieved substantial excess returns compared to the market index, but these excess returns have been captured with much less volatility than the index itself which boosts their compounding affect.
| 1998-2000 | Std. Dev. | 2001-2006 | Std. Dev. | |
|---|---|---|---|---|
| S&P500/Select | 30.2% | 15.39 | 4.9% | 7.73 |
| S&P500 Stock Index | 12.2% | 17.67 | 2.9% | 13.87 |
| Avg. Annual Excess Return | 18.0% | 2.0% |
Although past performance is no indication of future performance, the evidence does suggest that our philosophy, objective and strategy will continue to help our clients achieve their long-term investment goals with greater efficiency and with less overall portfolio risk.