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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 increase risk-adjusted return, but risks remain.
25 NOVEMBER 2012

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 33281008 Kristina Styf +46 8 50623048 Jakob Lage Hansen
+45 33281469 Johan Lundgren

+46 8 50623246

KEY CONCLUSIONS: EXPANDING THE UNIVERSE
TRADITIONAL ASSETS - LONG-TERM TRACK RECORD WITH FLAWS Traditional assets appeal to investors due to their long track records, transparency and their intuitive roles in the economic system. However, both bonds and equities have extended periods of real losses and are not good at diversifying macro risks: equities only perform well in 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 to include commodity futures, hedge funds and alternative betas. They have less historical backing and risk-adjusted returns are similar to traditional assets, but they offer powerful diversification effects. Commodities hedge inflation risks, 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 for portfolio construction, we get a high optimal allocation to non-traditional assets for all risk levels. In a 15% Value- atRisk long-term portfolio, the optimal weight is above 50%. Alternative assets displace fixed income assets, but allow an 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 not enough to eliminate periods of sub-trend returns of a cyclical nature. Using the SEB Waves cyclical framework, we find that while alternative returns are less correlated to macro risks, the expanded portfolio still suffers systematic episodes of sub-par performance during cyclical setbacks on all horizons.

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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 capitalist development and fulfil a clear and crucial role in the economic system. They are also very good long-term investments with 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 real returns, and they struggle to diversify systematic macro risks: equities need a favourable growth environment, bonds need low and stable inflation. These facts are largely forgotten during long secular bull markets, but equities have now delivered poor results for more than 10 years, and with zero rates and bond yields at all-time lows, investors have strong reasons to look for a new investment approach.
Chart 1. Real return and risk, 1927-2011
7% 6% 5% Real return 4% 3% 2% 1% 0% 0% 5% 10% Standard deviation
Note: The combined "Alternative betas" has been constructed as an equal weighted basket Source: GFD, Ecowin, Fama & French and SEB X-asset

Chart 2. 12M correlations with macro factors, 1961-2011
0.80 US CPI
Equities

0.60 0.40 Commodities
FX carry Small/Large cap CTA

FX carry

Credit
Macro

Value/Growth

Commodities
CTA Small/Large cap High/Low dividend

Defensive sectors/market

0.20 Alternative betas Value/Growth 0.00 -0.20

OECD LEI

Hedge funds combo Alternative betas
Market neutrals Credit premium

High/Low dividend Gvt.bonds curvature

Hedge funds combo
Macro Market

Gvt.bonds
Defensive sectors/market

Equities

T-bills

Gvt.bonds curvature

-0.40 Gvt.bonds -0.60
15% 20%

T-bills

Credit premium

Credit

-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00
Note: The combined "Alternative betas" has been constructed as an equal weighted basket Source: GFD, Ecowin, Fama & French and SEB X-asset

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 all the different asset classes on the same basis as we look at traditional assets. These assets lack the transparency and track record of traditional assets, but they turn out to be less susceptible to the risks that hurt traditional assets. Nontraditional assets are thus not attractive because of their high returns, but because they offer a range of uncorrelated sources of return – the holy grail of asset allocation. Commodities stand out as the only asset class providing inflation protection. Hedge funds as a group do not offer true diversification, but our exposure is comprised of strategies with proven diversifying effects, and the seven alternative betas we have identified complement each other as well as the traditional assets on all horizons.
Chart 3. Optimal portfolio traditional assets, 15% VaR
10% 26%

Chart 4. Optimal portfolio extended universe, 15% VaR
0% 2% 12%

31%

T-bills Gvt.bonds Credit Equities

44%

32%

T-bills Gvt.bonds Credit Equities Commodties Hedge funds Alternative betas

33%

5%

5%
Source: GFD, Ecowin, Fama & French and SEB X-asset

Source: GFD, Ecowin and SEB X-asset

The stronger diversification achieved by including non-traditional assets increases the risk-adjusted return of a balanced portfolio, with significant exposure to alternative beta at all risk levels. Based on our forward-looking estimates, we 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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X-asset themes

Traditional assets – long-term track record with flaws
Traditional assets like government bonds, corporate bonds and equities were introduced early in the industrial development and still play a clear and crucial economic role. They thus offer an unparalelled long-term track record with two centuries of risk premiums ranging from 1-3% for Treasuries and credit to 4-6% for equities. They cover a wide range of risks and thus allow investors to combine them for almost any risk level. But from an asset allocation perspective, they also have important drawbacks: they all suffer from long periods of low or negative real returns and they are only suited for a narrow range of macro climates on both long and short time horizons.

T-BILLS: RISK-FREE RATE WITH REAL RISK
T-bills are a (nominally) risk-free benchmark and anchor for risky assets offering superior liquidity. Nominal losses are extremely rare as rates almost never fall below zero, and real returns are for a majority of developed countries positive over the very long-term. However, returns are very vulnerable to both long- and short-term inflation.
Chart 5. Real T-bill risk and return, 1900-2011
3%
Denmark

Chart 6. Real T-bill return, 1835-2011

2% 1% Real return 0% -1% -2% -3% -4%

Sweden Canada South Africa Norway UK USA/World/World ex USA Switzerland NetherlandsAustraliaIreland Spain New Zealand Belgium Finland

Japan Germany France Italy

0%

5%

10% Standard deviation

15%

20%

Source: Global Investment Returns Yearbook 2012

Real US t-bill returns have averaged 1.6% since 1835, but it has not been stable. In the 1800s it was above 3%, but after a trend break in early 20th century, in connection with the collapse of the Gold Standard, real returns have averaged 0.5% with several periods of major losses. For a global comparison we use numbers from Global Investment Returns Yearbook (CS 2012) covering data for 19 countries 1900-2011. Their real T-bill returns range from -3.5 to 2%, with volatility between 4% and 14%. T-bills can thus suffer irrecoverable losses from extreme inflation/currency shocks, but global exposure can mitigate concentration risk. Our long-term estimate for the real T-bill return is 0.75%.

GOVERNMENT BONDS – STABLE RETURNS WITH DEEP INFLATION RISK
Government bonds offer a safe nominal return, but inflation can lead to real return drawdowns that outlast even the most patient investor. Short-term government bonds are a low risk investment: governments are assumed not to default (although they sometimes do), so the main risk is inflation which normally moves at a slow speed. However, long bonds have a duration that expose them to slow, but persistent changes in inflation. Historically, both return and risk have increased with duration with the risk adjusted return rising fastest at the front end of the curve.
Chart 7. Real 10Y US Treasury return, 1820-2012 Chart 8. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
OECD LEI CPI

Source: GFD, Ecowin and SEB X-asset

Since 1820 10-year US government bonds have had a real annual return of 3%, with a trend change around 1910 after which the return dropped from 4% to 2%, in our view caused by the collapse in the gold standard that also triggered a sharp decline in real T-bill returns. Bond returns have had an unstable relationship with growth, but they have invariably been negatively correlated to inflation. Higher and more variable inflation in the 20th century has thus reduced the level of real bond returns, even though the risk premium tripled from 0.3% to 0.9% after 1910.

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X-asset themes

Chart 9. Real bond market risk and return, 1900-2011
4% 3% 2% Real return 1% 0% -1%
Italy Denmark Sweden Switzerland Canada New Zealand USA South Africa World Norway Australia UK Netherlands World ex US Spain Ireland France Finland

Chart 10. US 10Y Treasury risk premium, 1835-2012

Belgium

Japan Germany

-2% 0% 5% 10% 15% Standard deviation

20%

25%

Source: Global Investment Returns Yearbook 2011

Bonds have limited short-term risk – the largest 12M real loss is around 20% – but the past 100 years have seen two long periods of sustained, inflation driven losses for US bond-holders, with negative returns in one case extending over more than 40 years. Meanwhile, 6 of 19 countries in GIRY experienced outright losses over the full period since 1900, the same six countries that showed a negative real t-bill return. However, even in these countries the losses were smaller than those for T-bills, so all 19 countries in GIRY have had positive government bond risk premiums between 0 and 2.5%. Our forward-looking estimate is for a long-term risk premium of 1.25% and a real return of 2%.

EQUITIES – OUTPACING THE ECONOMY - WHEN IT GROWS
Equities have an unparalleled long-term return history, but returns are highly variable over all operational horizons. Equity returns consist of a direct return from dividends and volatile changes in the stock price. Over long horizons stock prices track earnings, so returns come mainly from the dividend yield and earnings growth. Since 1875 each has contributed around half of the S&P 500’s total return, but the contributions have not been stable: price increases have picked up with nominal growth in the 20th century, but this has been off-set by a decline in the dividend yield.
Chart 11. S&P 500 real total return, 1820-2012 Chart 12. 10Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
OECD LEI CPI

Source: GFD, Ecowin and SEB X-asset

Real total S&P 500 return has thus been remarkably stable at around 6% over the past 200 years, but as Chart 11 shows the return has been extremely volatile. 12-month losses have exceeded 40% more than once, and there are regular periods of negative returns lasting as long as 20 years. Real equity returns have had a variable correlation to inflation, with the correlation turning positive when inflation is low, but they have always been negatively correlated to growth. Indeed, our cyclical analysis shows equity losses are clustered in economic downturns on all time horizons.
Chart 13. Real equity market risk and return, 1900-2011
9% 8% 7% 6% Real return 5% 4% 3% 2% 1% 0% 10% 15% 20% 25% Standard deviation
Source: Global Investment Returns Yearbook 2012

Chart 14. S&P 500 risk premium, 1835-2012

Australia

South Africa

Canada World

USA Sweden New Zealand Finland Norway Ireland Spain France Belgium Japan Germany Italy

UK Denmark Netherlands World ex US

Switzerland

30%

35%

40%

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As was the case for bonds, the higher variability of real returns in the 20th century has been accompanied by an increase in the risk premium. The excess S&P 500 return over T-bills rose from 3% between 1835 and 1910 to more than 5% after 1910, even though the real return for equities didn’t budge. The rise of paper money and inflation has clearly reduced long-term returns for fixed income assets, but does not appear to have a similar effect on equities. Over the very long term, equity returns are actually less risky than bond returns: the real returns since 1900 have been positive for all the 19 countries in the GIRY sample – even those that had negative long-term bond returns – and risk premiums are in a range from 2.5-6.5%. Our forward-looking long-term estimate for real equity return is 5.75%, consistent with a 5% risk premium over T-bills.

CREDIT – COMBINING BOND AND EQUITY CHARACTERISTICS
Private sector bonds share characteristics from both the bond and equity market: they include the fixed nominal payments of government bonds, but add a yield spread to cover default risk. Corporate bond returns can thus be divided into a relatively stable return of a similar duration government bond and a more volatile excess return driven by changes in preceived default risk as well as by actual defaults and rating changes.
Chart 15. Accumulated real credit return, 1915-2012 Chart 16. 5Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
OECD LEI CPI

Source: GFD, Ecowin and SEB X-asset

Even after factoring in defaults, the long-term excess return is positive, but the total real return has nonetheless suffered during both short and long periods of government bond losses. The biggest 12-month real losses of around 25% have thus coincided with extreme losses for government bonds. The excess return is correlated with equity beta, as equity capital is a buffer for credit losses, and credit risk can rise in a non-linear way relative to the risk of similar government bonds in periods with very low equity prices and high volatility, limiting the ability to hedge against extreme equity losses. Credit has underperformed government bonds by more than 15% during equity crashes. Due to the conflicting forces combined in the two parts of corporate bond returns, credit’s link to macro factors is unstable: the correlation to growth indicators ranges from almost perfect positive correlation to almost perfect negative correlation, while the correlation to inflation is dominated by the negative effect from duration risk.
Chart 17. Credit vs Treasury return, 1915-2011 Chart 18. Excess return and S&P 500 return, 1915-2012

In practice, the total return from a credit investment will depend on a range of factors with the average credit rating and the duration of the bonds in front. Our analysis, based on long-term US investment grade bonds, shows a real return from US credit of 3.3% since 1915, 1.3% more than government bonds, and a risk premium over T-bills of around 3%. Our forward-looking long-term estimate is a risk premium of 2.5% and a real return of 3.25%.

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X-asset themes

Expanding the universe with non-traditional assets
The common thread from the analysis of the traditional assets is clear: they all have long track records and are transparent, liquid and credible markets. Nonetheless, they have all seen very long periods with flat or negative real returns, and they struggle to diversify systematic macro risk – in particular, balanced portfolios tend to do well only when growth is strong and inflation is neither too high nor too low. These conditions have not been in place for more than a decade, and this naturally increases the interest in finding more robust alternatives. In this section we introduce alternative “asset classes”: commodity futures, hedge funds and alternative betas. They do not offer higher long-term risk-adjusted returns, but have other advantages in a portfolio context.

COMMODITIES FUTURES – MAINLY FOR INFLATION PROTECTION
Unlike traditional assets, investing in commodity futures does not provide capital for corporates– they are essentially bets on the future price of commodity spot prices. Long-term, commodity futures offer a positive risk premium if futures prices are set lower than the expected future spot price, and this has historically been the case because commodity producers are willing or forced to pay for downside price protection. Short-term commodity returns are mainly driven by unexpected spot price changes and hence have a strong correlation with actual price developments. As a result, commodities stand out among all assets as the only one to show a clear, positive correlation to inflation.
Chart 19. Historical real risk and return, 1915-2012
12%
Energy

Chart 20. 12M correlations with macro factors, 1970-2012
0.80 0.60
Energy US CPI

10% 8% Real return 6% Credit 4% 2% T-bills 0% 0% 5% 10% 15% 20%
Agriculture

0.40
Agriculture

Commodities Precious metals

0.20

Commodities Equities

0.00
Precious metals Industrial metals

Industrial metals

OECD LEI

-0.20
T-bills

Equities

Gvt.bonds

-0.40
Gvt.bonds

-0.60 -0.80

Credit

25%

30%

35%

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

Standard deviation
Source: GFD, Ecowin, SEB X-asset

Source: GFD, Ecowin and SEB X-asset

Our commodity index is calculated from three sources: 1915-1950 data is based on reconstructed futures contracts from GFD, 1951-1969 results from a study by Gorton & Rouwenhorst (2005), and starting 1970 it is an equal weighted total return index based on four GSCI commodity sub-groups – precious metals, industrial metals, agriculture and energy. Academic studies show a risk premium from commodities of around 5-7% over the last 50 years, but this was a favorable period for commodity returns. Using long-term data, we estimate the historical risk premium to have been 3% since 1915, at a risk level a bit below equities, and this is also our long-term forward-looking estimate.
Chart 21. Distribution of 12 months real returns, 1915-2011
50% 40% 30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 5%-0% 10%-5% 15%-10% 20%-15% 25%-20% 30%-25% 35%-30% 40%-35% > 40%

Chart 22. 5Y rolling correlation to CPI & OECD LEI, 1970-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
OECD LEI CPI

Equities

Commodities
Source: GFD, Ecowin and SEB X-asset

Source: GFD, Ecowin and SEB X-asset

The distribution of commodity returns clearly deviates from the normal distribution and follow that of equity returns rather well with a similar 12 month average. Both have rather fat tails with maximum 12-month losses well above 30%, but equities have more extreme observations on both the upside and downside. Correlations with macro risks are very different from the traditional assets: real commodity futures returns are almost invariably positively correlated with inflation, while the correlation to growth indicators is more variable. Although commodities have a rather low return per unit of risk compared with equities, a small, diversified exposure is thus a valuable addition to traditional assets in a balanced portfolio thanks to the diversification benefits.

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X-asset themes

HEDGE FUNDS – ACTIVE DIVERSIFYING STRATEGIES WITH ALPHA POTENTIAL
Hedge funds add value through skill and access to deep risk premiums. Many hedge funds also have the possibility to use leverage which is not always accessible for individual investors. The hedge fund universe return is dominated by equity beta and has not delivered the promised uncorrelated returns. This means selection is key – hedge funds can add diversification in a portfolio, but it is essential to identify hedge funds with targeted characteristics. Our hedge fund exposure is comprised of three strategies, based upon a X-asset study (Hedge funds – avoiding a simplistic approach, Hansen 2012): equity market neutral, macro and CTA funds. Each strategy has been a better macro hedge historically and a combination of them has attractive diversification characteristics– unlike hedge funds on average.
Chart 23. Real total return and risk, 1915-2012
7% 6% 5% Real return 4% 3% 2% 1% T-bills 0% 0% 5% 10% Standard deviation
Source: GFD, Ecowin, Fama & French and SEB X-asset

Chart 24. 12M correlations with macro factors, 1961-2012
0.80 US CPI 0.60 0.40 0.20

Equities

Macro

Credit Hedge funds universe
CTA

0.00 -0.20 -0.40 Gvt.bonds -0.60 -0.80

Hedge funds combo
CTA Macro Market neutrals

OECD LEI Hedge funds universe Equities

Hedge funds combo Gvt.bonds
Market neutrals

T-bills Credit

15%

20%

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

Source: GFD, Ecowin, Fama & French and SEB X-asset

Due to limited history of around 20 years of realized returns, our analysis uses risk factor replication of the beta return of hedge funds by several risk factors. The three strategies complement each other in balanced portfolios of most risk levels and would be included even with a conservative forward-looking estimate without alpha assumptions due to their attractive diversification characteristics. We find that a basket of the strategies would have had a real return of 2.5% and a risk premium of 2.1% since 1915 close to uncorrelated with macro risks. Our estimate for the forwardlooking risk premium of a balanced portfolio of diversifying hedge funds is 2% at a risk between Treasuries and credit.
Chart 25. Distribution of 12 months real returns, 1915-2011
50% 40% 30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 5%-0% 10%-5% 15%-10% 20%-15% 25%-20% 30%-25% 35%-30% 40%-35% > 40%

Chart 26. 5Y rolling correlation to CPI & OECD LEI, 1961-2011
1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
OECD LEI CPI

Equities

Hedge funds combo
Source: GFD, Ecowin and SEB X-asset

Source: GFD, Ecowin and SEB X-asset

The distribution of returns from our hedge fund basket is more concentrated than that of equities, with much smaller tails. Real 12-month losses peak around 20%, similar to government bonds. But unlike government bonds, the hedge fund basket is not negatively correlated to inflation. Correlations with macro risk factors are less volatile than those for traditional assets and average correlation is very close to the center of Chart 26, highlighting the attractive diversification characteristics.

ALTERNATIVE BETAS – PASSIVE DIVERSIFYING STRATEGIES
Alternative betas are risk premiums embedded within capital markets that are not fully captured by traditional asset betas. Alternative betas have raised hopes of uncorrelated returns, but they must lift the same burden of proof as other assets. In order to put them on a level playing field with other assets, we have required that they must have proven performance over many decades, an intuitive explanation and backing from academic studies. In this analysis’ companion study, “The role of Alternative Betas in long-term portfolios”, we identify seven risk premiums satisfying these requirements: Government bonds curvature, Credit premium, FX carry, Defensive sectors, Value premium, Dividend premium and Small cap premium. They have all been analysed on a stand-alone, unleveraged basis using >85 years of data and are calculated as long/short baskets with collateral interest. Costs have been included, between 40-75 bps depending on underlying assets, for all alternative betas except curvature.

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X-asset themes

Chart 27. Real total return and risk, 1927-2012
7% 6% 5% Real return
FX carry*

Chart 28. 12M correlations with macro factors, 1961-2011
0.80 US CPI

Equities

0.60 0.40 0.20

4% 3%

Credit

Value/Growth*

Defensive sectors/market

Value/Growth

FX carry Small/Large cap

0.00 -0.20 -0.40 -0.60

OECD LEI

Alternative betas
High/Low dividend

2% 1% 0% 0%

Alternative betas

Gvt.bonds

Small/Large cap* High/Low dividend*

Gvt.bonds curvature

Equities
Credit premium

Credit premium* Defensive sectors/market* Gvt.bonds curvature*

T-bills

Gvt.bonds

Credit

T-bills 5% 10% Standard deviation
Source: GFD, Ecowin, Fama & French and SEB X-asset

15%

20%

-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80
Note: The combined "Alternative betas" has been constructed as an equal weighted basket Source: GFD, Ecowin, Fama & French and SEB X-asset

*Trading costs of 75 bps has been included for equity related premiums, 40 bps for the credit premium and 50 bps for FX carry Note: the combined "Alternative betas" has been constructed as an equal weighted basket

As with commodity futures, a majority of the individual alternative betas have rather low historical risk-adjusted return but attractive correlation benefits. All but one of the seven strategies have historically been below the riskreturn trend line of traditional assets. Like equities the performance from individual alternative betas vary over time. Some strategies have delivered flat or even negative returns over periods as long as 10-20 years. On the upside the alternative betas are close to uncorrelated with inflation with a tilt towards negative correlation to leading indicators. They are also internally independent, so an en equal weighted basket has historically had a real return of 2.2% with a risk around 5% like government bonds. Our forward-looking risk premium estimate is 1.6%.
Chart 29. Distribution of 12 months real returns, 1927-2011
50% 40%
0.6

Chart 30. 12M correlations with macro factors, 1961-2011
1.0 0.8 US CPI

30% 20% 10% 0%
< -20% -20% - (-15%) -15% - (-10%) -10% - (-5%) -5%-0% 0%-5% 5%-10% 10%-15% 15%-20% 20%-25% 25%-30% 30%-35% 35%-40% > 40%

0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0
Source: GFD, Ecowin, Fama & French and SEB X-asset

OECD LEI

Equities
Note: The combined "Alternative betas" has been constructed as an equal weighted basket

Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset

12 month alternative beta returns are clustered around zero with relatively small tails and mainly on the upside. Over 40% of the observations are within the 0-5% return bucket and more than 90% of the observations are covered within -5% to +10% return. 12-month real losses peak below 15%, somewhat lower than for government bonds. Correlations with macro factors for the equal weighted alternative beta basket has been variable, but 10-year observations are generally scattered evenly around the centre, with the average being very close to uncorrelated to both inflation and leading indicators – as well as to the traditional asset class returns.

Constructing long-tem portfolios using the full tool-box
Based on these forward looking risk and return estimates and historical correlations since 1927 we optimise a longterm passive portfolio including both traditional assets and our expanded universe. As a group, the new assets offer similar risk-adjusted returns to traditional assets, but we can now populate a larger part of the correlation chart.
Chart 31. Forward-looking real return and risk
6% 5% 4% Real return Credit 3% 2% 1% 0% 0% 5% 10% Standard deviation
Source: GFD, Ecowin, Fama & French and SEB X-asset

Chart 32. 12M correlation with macro factors, 1961-2011
0.80 US CPI 0.60 0.40 Commodities

Equities

Commodities Hedge funds combo Alternative betas Gvt.bonds

0.20 0.00 Alternative betas -0.20 -0.40 Gvt.bonds T-bills Credit OECD LEI Hedge funds combo Equities

T-bills

-0.60

15%

20%

-0.80 -0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80
Note: The combined "Alternatives" has been constructed by equal weighting the alternative betas Source: GFD, Ecowin, Fama & French and SEB X-asset

*Trading costs of 75 bps has been included for equity related premiums, 25 bps for the credit premium and 50 bps for FX carry

Note: The combined "Alternatives" has been constructed by equal weighting the alternative betas

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X-asset themes

We use resampled mean variance optimisation which, as the name suggests, uses resampling in order to avoid some of the well know problems with traditional Markowitz optimisation. Portfolios are optimised with a 12 month time horizon and a 98% confidence level. The three hedge fund strategies and the seven alternative betas enter the optimisation as individual strategies. No cost assumptions are included for traditional assets and commodities. For hedge funds and alternative betas costs are taken into consideration depending on the underlying asset class.
Chart 33. Allocation along the efficient frontier
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 5.0% 7.5% 10.0% 12.5% 15.0% 17.5% Value-at-Risk 20.0% 22.5% 25.0%

Chart 34. Optimal portfolio extended universe, 15% VaR
0% 2% 12%

44%

32%

T-bills Gvt.bonds Credit Equities Commodties Hedge funds Alternative betas

5%

5%
Source: GFD, Ecowin, Fama & French and SEB X-asset

T-bills

Gvt.bonds

Credit

Equities

Commodties

Hedge funds

Alternative betas

Note: The alternative betas and the hedge fund strategies have been included individually Value-at-Risk based on 98% confidence level and a 12 month time horizon

Source: GFD, Ecowin, Fama & French and SEB X-asset

Taken as a group, alternative betas have a 25-70% allocation along the risk spectrum thanks to their attractive diversification characteristics. Hedge funds have a rather stable allocation along the efficient frontier at all but the highest risk levels, while the commodity exposure increases with risk level. In a portfolio at 15% Value-at-Risk nontraditional assets make up 54% of an unconstrained portfolio. They push out fixed income assets - the exposure to tbills and government bonds is reduced to close to zero and credits to less than half of that in a traditional assets only portfolio. Due to the uncorrelated nature of the independent alternative returns sources, we think it’s fair to call the expanded portfolio less concentrated, with increased diversification allowing a 6%-point increase in equity allocation which creates an additional annual return of 60 bps compared to a traditional portfolio at the same level of risk.

Cyclical risk in a balanced, expanded portfolio
Including non traditional assets in a balanced portfolio is not likely to eliminate losses in episodes of market distress. While alternative returns are less correlated to macro risks and can even hedge away some inflation risk, they still leave a limited capacity to hedge risks from low growth and high inflation.
Chart 35. Real portfolio return by decade, 1930-2009
10% 8% 6% Real return

Chart 36. 12-months rolling real return, USD, 1927-2011
75% 60% 45% 30%

4% 2% 0% -2% 0% 5% 10% 15% 20% 25% 30% 35%

15% 0% -15% -30% -45% 1928
Source: GFD, Ecowin, Fama & French and SEB X-asset

Value-at-Risk

1938

1948 1958 1968 Traditional portfolio

1978 1988 1998 Expanded portfolio

2008

Source: GFD, Ecowin, Fama & French and SEB X-asset

Chart 35 shows portfolio return and risk by decade, and even in this limited sample the portfolio has experienced one decade with no return and one decade with twice the expected risk. Short-term risk has only been marginally reduced, particularly in the high-inflation 1970s, but tail risk remains and real 12-month losses still break the 15% limit during periods of extreme market stress – such as the early 1930s and 2008 – more often than they are supposed to. Adding alternative assets thus improves long-term risk-adjusted returns, but not enough to eliminate recurring periods of sub-trend returns over several horizons. In order to get a better understanding of the nature of this risk, we use the SEB Waves cyclical allocation framework, our systematic macro-based cyclical risk analysis based on three macro cycles across three different time horizons. Each cycle is broken down into four phases using historical macro indicators and we then analyse phase-dependent investment returns to identify macro-based clusters of risk. The underlying idea is that investors should be willing to pay more for risk that is not clustered in the same periods as other assets, and in particular for losses that are not clustered together with losses for the most risky assets.

10

X-asset themes

Our structural wave reflects a technology cycle of secular bull and bear markets, where each phase on average lasts 10-15 years. Traditional assets have their main drawbacks during “crises”, while non-traditional assets have stable and positive return in all phases but “Golden age boom” where returns are positive but lower. The expanded portfolio posts a positive real return in all phases, but in the high inflation capacity shortage phase the real return has been less than 1% while the low-inflation overcapacity crisis phase risk has significantly exceeded the long-term average.
Chart 37. Total real return in structural phases, 1927-2011
20%
10%

Chart 38. Portfolio performance, structural phases, 1927-2011
12%

15%
8%

New era boom

10% 5% 0%

Real return

6% 4%
Golden age boom Full sample Overcapacity crisis Capacity shortage crisis

2%

-5% Capacity shortage New era boom Overcapacity crisis Golden age boom crisis Gvt.bonds Credit Equities Commodities Hedge funds Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset

0% 0% 5% Standard deviation
Source: GFD, Ecowin, Fama & French and SEB X-asset

10%

15%

T-bills

The strategic wave is based on the output gap cycle: growth above trend or below trend and easing or tightening credit conditions determine four phases of the cycle with duration of 1-3 years. Traditional portfolio losses are concentrated in the first part of a recession. Alternative betas are basically a-cyclical with positive and stable return in all strategic phases, while both commodities and hedge funds have losses in early recession. Improved diversification is not enough to prevent the expanded portfolio from systematically posting average real losses and elevated risk in the early recession, mainly due to the significant losses from equities.
Chart 39. Total real return in strategic phases, 1970-2011
Note: Weights for optimised versions are 69% defensive sectors, 31% value and 45% cyclical sectors, 55% large cap

Chart 40. Portfolio performance, strategic phases, 1970-2011
12% 10% 8% Real return 6% 4% 2% 0% -2% -4% Early recession Early expansion Full sample Late recession Late expansion

30% 25% 20% 15% 10% 5% 0% -5%

-10% -15% -20%
T-bills

Early recession Late recession Early expansion Late expansion Gvt.bonds Credit Equities Commodities Hedge funds Alternative betas
Source: GFD, Ecowin, Fama & French and SEB X-asset

0%

5% Standard deviation

10%

15%

Source: GFD, Ecowin, Fama & French and SEB X-asset

The tactical wave is based on the manufacturing inventory cycle, with leading indicators defining 3-6 month phases. Tactical asset class behaviour and portfolio performance is similar to strategic cycle: the sequence of relative returns is similar, it just happens faster. The most critical phase is early downturn where equities have sharp losses and all non-traditional assets hold up well. Again, the expanded portfolio has systematic losses at elevated risk in this phase.
Chart 41. Total real return in tactical phases, 1970-2011
Note: Weights for optimised versions are 69% defensive sectors, 31% value and 45% cyclical sectors, 55% large cap

Chart 42. Portfolio performance, tactical phases, 1970-2011
20%

30% 25% 20% 15%

15%

Real return

10% 5% 0% -5% -10% -15% -20% T-bills Early downturn Late downturn Early upswing Gvt.bonds Credit Equities Commodities Hedge funds Late upswing Alternative betas

10%

Early upswing Late downturn

5%

Late upswing

Full sample

0%

Early downturn

-5% 0% 5% Standard deviation 10% 15%

Source: GFD, Ecowin, Fama & French and SEB X-asset

Source: GFD, Ecowin, Fama & French and SEB X-asset

Active asset allocation, including the expanded universe, is the subject of a coming study. The study will include a deeper analysis of systematic variations of especially non-traditional assets, the implications on portfolio performance and how phase dependent overlays can dampen portfolio drawdowns and reduce short-term risks.

11

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