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SEB report: Expanding the universe

SEB report: Expanding the universe

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Published by SEB Group
Based on forward-looking estimates, SEB’s experts find an optimal allocation to non-traditional assets of around 54% for a 15% Value- at-Risk long-term portfolio. Alternatives only displace fixed income assets, but allow an increase in the equity allocation that leads to an expected extra annual return of around 0.6%. However, while the long-term risk-adjusted return improves, including non-traditional assets in a balanced portfolio does not eliminate losses in episodes of market distress.
Based on forward-looking estimates, SEB’s experts find an optimal allocation to non-traditional assets of around 54% for a 15% Value- at-Risk long-term portfolio. Alternatives only displace fixed income assets, but allow an increase in the equity allocation that leads to an expected extra annual return of around 0.6%. However, while the long-term risk-adjusted return improves, including non-traditional assets in a balanced portfolio does not eliminate losses in episodes of market distress.

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Published by: SEB Group on Dec 14, 2012
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X-asset themes
#8, 2012: Expanding the universe
Traditional assets work in the long run,but they don’t diversify macro risks well.Expanding the universe can increaserisk-adjusted return, but risks remain.
25 NOVEMBER 2012
 
 2
 
X-asset themes
CONTENTS
Summary: Expanding the universe..........................................................................................................................................................3
 
Traditional assets – long-term track record with flaws........................................................................................................................4
 
Expanding the universe with non-traditional assets............................................................................................................................7
 
Constructing long-tem portfolios using the full tool-box....................................................................................................................9
 
Cyclical risk in a balanced, expanded portfolio...................................................................................................................................10
 
Lead analyst on this study: Kristina Styf
THE SEB X-ASSET TEAM
Thomas Thygesen +45 33281008Kristina Styf +46 8 50623048Jakob Lage Hansen
 +45 33281469Johan Lundgren
+46 8 50623246
KEY CONCLUSIONS: EXPANDING THE UNIVERSE
TRADITIONAL ASSETS - LONG-TERM TRACK RECORD WITH FLAWS
Traditional assets appeal to investors due totheir long track records, transparency and their intuitive roles in the economic system. However, both bonds andequities have extended periods of real losses and are not good at diversifying macro risks: equities only perform wellin a favourable growth environment and bonds need low and stable inflation.
EXPANDING THE UNIVERSE WITH NON-TRADITIONAL ASSETS
In this study we expand the investment universe toinclude commodity futures, hedge funds and alternative betas. They have less historical backing and risk-adjustedreturns are similar to traditional assets, but they offer powerful diversification effects. Commodities hedge inflationrisks, while diversifying hedge fund strategies and alternative betas have acyclical, uncorrelated returns
CONSTRUCTING LONG-TERM PORTFOLIOS USING THE FULL TOOL BOX
Using the expanded universe as basis forportfolio construction, we get a high optimal allocation to non-traditional assets for all risk levels. In a 15% Value- at-Risk long-term portfolio, the optimal weight is above 50%. Alternative assets displace fixed income assets, but allowan increase in the equity allocation that leads to an expected extra annual return of around 0.6%.
CYCLICAL RISK IN AN EXPANDED PORTFOLIO
Alternative assets improve long-term portfolio returns, but notenough to eliminate periods of sub-trend returns of a cyclical nature. Using the SEB Waves cyclical framework, wefind that while alternative returns are less correlated to macro risks, the expanded portfolio still suffers systematicepisodes of sub-par performance during cyclical setbacks on all horizons.
 
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X-asset themes
Summary: Expanding the universe
 
THE CASE FOR A DEEPER ALLOCATION FRAMEWORK WITH MORE ASSET CLASSES
Asset allocation models have traditionally focused on a limited set of traditional asset classes: bonds and equities.This is partly for historical economic reasons, as these capital markets were developed early in the capitalistdevelopment and fulfil a clear and crucial role in the economic system. They are also very good long-term investmentswith a history of positive risk premiums extending over more than a century.The long track records, transparency and relatively intuitive explanations behind traditional assets appeal to investors.Nonetheless, both bonds and equities have, with regular intervals, seen very long periods with flat or negative realreturns, and they struggle to diversify systematic macro risks: equities need a favourable growth environment, bondsneed low and stable inflation. These facts are largely forgotten during long secular bull markets, but equities havenow delivered poor results for more than 10 years, and with zero rates and bond yields at all-time lows, investors havestrong reasons to look for a new investment approach.
Chart 1. Real return and risk, 1927-2011 Chart 2. 12M correlations with macro factors, 1961-2011
In this note, we expand the investment universe to include commodity futures, hedge funds and alternative betas.This work builds on earlier in-depth studies of historical returns, but here we tie all the strains together, analysing allthe different asset classes on the same basis as we look at traditional assets. These assets lack the transparency andtrack record of traditional assets, but they turn out to be less susceptible to the risks that hurt traditional assets. Non-traditional assets are thus not attractive because of their high returns, but because they offer a range of uncorrelatedsources of return – the holy grail of asset allocation. Commodities stand out as the only asset class providing inflationprotection. Hedge funds as a group do not offer true diversification, but our exposure is comprised of strategies withproven diversifying effects, and the seven alternative betas we have identified complement each other as well as thetraditional assets on all horizons.
Chart 3. Optimal portfolio traditional assets, 15% VaR Chart 4. Optimal portfolio extended universe, 15% VaR
10%31%33%26%T-billsGvt.bondsCreditEquities
Source:GFD, Ecowin and SEBX-asset 
 
The stronger diversification achieved by including non-traditional assets increases the risk-adjusted return of abalanced portfolio, with significant exposure to alternative beta at all risk levels. Based on our forward-lookingestimates, we find an optimal allocation to non-traditional assets of around 54% for a 15% Value- at-Risk long-termportfolio. Alternatives only displace fixed income assets, but allow an increase in the equity allocation that leads to anexpected extra annual return of around 0.6%. However, while the long-term risk-adjusted return improves, includingnon-traditional assets in a balanced portfolio does not eliminate losses in episodes of market distress.
0%1%2%3%4%5%6%7%0% 5% 10% 15% 20%Standard deviation
   R   e   a    l   r   e   t   u   r   n
Source:GFD,Ecowin,Fama & French and SEBX-asset 
T-billsGvt.bondsCreditEquitiesHedge funds combo
Market neutralsMacroCTAGvt.bonds curvatureCredit premiumDefensive sectors/marketHigh/Low dividendSmall/Large capFX carryValue/Growth
Alternative betasCommodities
Note: The combined "Alternative betas" hasbeen constructed asan equalweighted basket 
-0.80-0.60-0.40-0.200.000.200.400.600.80-0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00OECD LEIUS CPI
Source:GFD,Ecowin, Fama &French and SEB X-asset 
T-billsGvt.bondsCreditEquitiesCommoditiesHedge funds comboAlternative betas
Defensive sectors/marketGvt.bonds curvatureHigh/Low dividendValue/GrowthFX carrySmall/Large capCredit premiumMarketMacroCTA
Note: The combined "Alternative betas" has been constructed asan equalweighted basket 
 
32%44%2%0%5% 5%12%T-billsGvt.bondsCreditEquitiesCommodtiesHedge fundsAlternative betas
Source:GFD,Ecowin,Fama & French and SEBX-asset 

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