SEB report: The role of alternative betas in a long-term portfolio

7/30/2019 SEB report: The role of alternative betas in a long-term portfolio

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X-asset themes#7, 2012: the role of alternative betas in long-term portfolios

Can alternative betas increase the risk-adjusted return of balanced portfolios?

We analyze 7 premiums over 85+ yearsand find strong diversification effects

25 NOVEMBER 2012


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X-asset themes

CONTENTS

Summary: the role of alternative betas in a long-term portfolio ........................................................................................................3The curvature premium............................................................................................................................................................................4The credit premium.............. ................ ................ ................ ................. ................ ................ ................ ................ ................ ................ .... 5The FX carry premium...............................................................................................................................................................................6The defensive sectors premium .............................................................................................................................................................. 7The value premium ...................................................................................................................................................................................8The dividend premium..............................................................................................................................................................................9The size premium .............. ................. ................ ................ ................ ................ ................ ................ ................ ................ ................. .... 10Alternative betas in a portfolio context.................................................................................................................................................11

Lead analyst on this study: Johan Lundgren

THE SEB X-ASSET TEAMThomas Thygesen+45 33281008

Kristina Styf+46 8 50623048

Jakob Lage Hansen+45 33281469

Johan Lundgren

+46 8 50623246

KEY CONCLUSIONS: THE ROLE OF ALTERNATIVE BETAS IN A LONG-TERM PORTFOLIO

REASONS FOR A NEW APPROACH Poor equity returns since the turn of the century and record-low interest ratesand bond yields have given investors a renewed interest in the benefits of diversification. Alternative betas, or riskpremiums that are not fully captured by the traditional asset classes, can deliver diversification at a low cost.

TRADITIONAL ASSETS CANT DIVERSIFY KEY MACRO RISKS Traditional assets do not diversify macro risks verywell. Alternative betas are less susceptible to these risks and thus promise uncorrelated returns. However, in order toqualify for inclusion in a long-term portfolio, they must lift the same burden of proof as traditional assets.

THREE CRITERIAS NEED TO BE FULFILLED FOR INCLUSION In order to avoid statistical noise, we impose 3criterions on the alternative betas: they must have demonstrated performance over many decades, an intuitive

explanation for why the risk premium exists and broad backing from academic studies in order to be included.

LONG-TERM ANALYSIS COVERING 85+ YEARS The alternative betas we analyze are well known but whatdistinguishes this study is the consistent analysis covering many decades. Seven different alternative betas, from

fixed income, FX and equity markets have been analyzed on a fully funded basis just like traditional assets.

ALTERNATIVE BETAS IN A PORTFOLIO CONTEXT Alternative betas enter into an optimal portfolio of traditionalassets with a high weight at all risk levels, even though most risk-adjusted return estimates are lower. Thediversification allows a higher allocation to equities, leading to a 50 bps higher long term expectation return.

A list of research papers referenced in this study can be provided on request


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X-asset themes

Summary: the role of alternative betas in a long-term portfolio

Stocks and bonds are good long-term investments, but they regularly have long periods of low or negative returns.This fact is mostly forgotten when both asset classes are doing well as they were in the 1980s and 1990s, but the poorreturn of equities since the turn of the century and the record-low interest rates and bond yields have given investors

a renewed interest in the benefits of true diversification.Traditional assets can not diversify key macro risks but need growth and low and stable inflation in order to performwell. Alternative betas, or risk premiums that are not fully captured by the traditional asset classes, promise to deliveruncorrelated returns at a relatively low cost, and there is substantial academic evidence supporting this claim for anumber of risk premiums. However, in order to qualify for inclusion in a long-term investment framework, they mustlift the same burden of proof as traditional assets. The risk premiums analyzed here are thus well known, but whatdistinguishes this study is the consistent analysis of the whole group in a consistent context with traditional assetportfolios, based on empirical data covering many decades.

Chart 1. Real total return and risk, USD, 1927-2011 Chart 2. 12M correlations, real total return, 1961-2011

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High/Low dividend*Small/Large cap*

FX carry*

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*Trading costs of 75bps hasb een 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

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Value/GrowthFX carry

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Credit premium

Note: The combined "Alternative betas" has been constructed as an equal weighted basket In order to avoid patterns that are essentially statistical noise, it is imperative that there is a qualitative explanation forthe premiums, but also that we can document them historically and understand how they work in various macroeconomic climates. Historical returns vary for all asset classes, and any 10-20 year period can thus give seriouslymisleading information about the true nature of long-term returns and their interaction with other investments. Wethink 80 year is the minimum data sample required to cover all types of investment climate and give a relativelyconfident estimate of the long-term return and risk.

In this study, we start by identifying risk premiums that meet the basic criterions before we turn to the role of a basketof such assets in a broader portfolio. We impose three criterions on the alternative betas in order to include them inthe analysis: a) they must have demonstrated empirical performance over many decades, i.e. showing a positive riskpremium during various macroeconomic climates b) they have to have an intuitive explanation for why the riskpremium exists and c) there needs to be broad backing from academic studies covering different time periods and

markets to support consistency of the risk premium.

By applying these criterions, we end up with relatively few risk premiums, but are able to cover all macro economic

scenarios. We analyze seven risk premiums that fit the bill, from fixed income, FX and equity markets on a stand-alonebasis using 85+ years of data. All alternative beta vehicles are based on a long and short position (the risk premium),fully funded with US T- bills and includes estimated costs. These should be seen as generic constructions, interpretedas guidelines that in practice might be implemented differently. The historical excess returns have been highest forthe FX and equity related vehicles, while the fixed income premiums are more marginal (at least without leverage).

Individually, they all have experienced long periods of real losses; hence it is important to include a basket ofalternative betas for internal diversification. As an equal weighted basket, they have historically had a lower risk thangovernment bonds and at the same time slightly higher return, including estimated costs. The basket also deliveredpositive return in all parts of our strategic and tactical cycles, varying from 2.5% to 5% in real terms, uncorrelated to

government bonds and equities as well as macro factors like the OECD leading indicators and US inflation.

Due to the truly uncorrelated nature of the returns, the alternative beta basket ends up with a high allocation in a

portfolio with traditional assets for all risk levels. They should however not be seen as a substitute to the traditionalassets but a complement. Equities will start being very profitable investments again, maybe in 5-10 years time; themain roles of alternatives is to allow to maintain the exposure order not to miss out on the next secular bull market.


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X-asset themes

The curvature premium

Historically the U.S. yield curve has had a positive slope but has clearly had a steeper slope at the front end of thecurve, as can be seen in chart 3. This implies that the shape of the yield curve has on average been concave, hence

short term bonds have had a higher risk adjusted return that then declines as the duration increases.

The explanation: There are several possible explanations for this; savers may be less willing to forego consumptionin the immediate future and thus demand a higher compensation per unit of time at the short end of the curve. Thismeans that they are not time invariant but put a higher value on time close to present compared to further into thefuture. At the other end, pension companies and other institutional investors may, because of regulations andguarantees, be forced or willing to buy long-dated bonds, hence pushing prices up and yields down at the long endof the curve. Short-dated bonds will therefore be systematically undervalued in relation to long-dated bonds. Theconvexity bias, which means that losses when yields increase are smaller than the gains of declining yields, alsoaffects the long end. The convex relationship between the yield and price increases with duration and hence works asa hedge against volatility of the yield. Because of this bias, the risk premium for longer maturities will be reduced.

Chart 3. The average U.S. yield curve, 1976-2012 Chart 4. Curvature vehicle real return, USD, 1927-2011

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T- bills Gv t.bo nds Equ ities Gvt .bon ds curvatureSource: GFD, Ecowin and SEB X-asset

The premium: The curvature premium is constructed as going long one part of the 2Y government bond whileshorting one half of the 5Y bond and the Treasury bills, hence taking advantage of the concave shape of the yieldcurve. Our analysis indicates that this construction, with the steep first 1-2 years of the curve offered a premium of0.15% at very low risk over the past 85 years. This barbell strategy showed an uncorrelated relationship togovernment bonds and equities as well as key macro risks such as OECD leading indicator and US CPI.

The vehicle: The risk premium translates into a real return of 0.75% for the curvature vehicle. The return is low butthe same can be said about the standard deviation. This could work well as a substitute to Treasury bills with a 25%higher long term return, at a slightly higher level of risk. However, it might not work well in the current economicclimate due to the extremely low interest rates wiping out most of the premium, and the low rate regime will probablybe for some years. Also, since this vehicle is relatively small when fully funded, it is very sensitive to costs. We havedecided not to use leverage in this study but there is a possibility of using leverage, leading to better results.

Chart 5. Distribution of 12M real returns, USD, 1927-2011 Chart 6. 10Y rolling correlation to CPI & OECD LEI, 1961-2011

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Equit ies Gvt.bonds curvatureSource: GFD,Ecowin and SEB X-asset

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Source: GFD,Ecowin and SEB X-asset As can be seen in the distribution chart, the returns of the vehicle are relatively low and show a relatively stable

pattern. This can also be seen in our cyclical analysis where we note that the curvature vehicle has a return patternclose to Treasury bills while outperforming in early recession and late downturn. Chart 6 shows that the correlationsof the vehicle are relatively variable through time while the average is located close to the centre of the chart.

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Source: GFD, Ecowin and SEB X-assetNote: The yield levels are the average monthlyyield at annual rates


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X-asset themes

The credit premium

Merton in his 1973 research paper claimed it was possible to replicate the return of a corporate bond with equities andgovernment bonds. This is what has been done in this analysis, where a combination of 5Y and 10Y governmentbonds as well as equities has been used to form a payoff structure similar to the real credit bond index. We find thataggregate returns do in fact largely reflect Treasury and stock markets, but there is a pure credit premium on top.

The explanation: The main explanations for this credit premium are liquidity and default risks. Credit bond marketsare less liquid than both government bond and equity markets and investors demand compensation with higherreturn. Another explanation of higher importance has to do with credit defaults (and rating risks) which tend to clusterin extremely distressed periods. Credit suffers capital losses when all equity is lost, so when stock prices are very lowthe risk of losses increases in a non-linear way and credit becomes more equity-like. This elevated default risk is notcaptured by traditional betas and it is something investors demand compensation for, hence in combination with the

liquidity risk creating what we call the pure credit risk premium.

Chart 7. 12M rolling real return, USD, 1915-2012 Chart 8. Credit premium vehicle real return, USD, 1927-2011

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T-bills Gvt.bonds Equities Credit premiumSource: GFD, Ecowin and SEB X-asset

For example, as can be seen in chart 7, the US corporate bond TR index performed worse than the replication duringthe early 30s, the early 80s and most recently in 2008 when the economy suffered during deep recessions. The chartalso shows that the corporate bond index has its lowest 12 month return at around -25% while the lowest return forthe credit premium during the same period has been around -15%, i.e. roughly 40% lower losses.

The premium: Usually the credit premium is calculated as the credit bond minus the government bond return but inthis analysis we have stripped out not only government bond beta but also equity beta. This is done by taking a longposition in a corporate bond index and a short position of 75% in government bonds (20% 5Y and 55% 10Y) and12.5% each in equities and treasury bills. Historically over the last 85 years this strategy yielded a risk premium of1.1%, uncorrelated to stocks and bonds while correlated to credit. The construction, just as all alternative betascovered in the analysis, is just a generic example; weights may vary depending on market, durations and other factors.


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Source: GFD,Ecowin and SEB X-asset The vehicle: The real return during the 85 year period has been 1.3% with a cost of 40 bps. The distribution ofreturns for the credit premium vehicle is concentrated with moderate returns or losses. The premium shows a semi-cyclicality which is apparent when looking at the rolling correlations, where it is both positively and negatively

correlated towards leading indicators through time. The credit premium also tends to have its lowest returns duringmarket declines, when most of the defaults occur. Returns have however on average always been kept above zeroduring these times.


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X-asset themes

The FX carry premium

The explanation: The existence of a FX carry premium has been known for decades and is supported by manystudies, e.g. Hansen and Hodrick (1980, 1983) and Fama (1984). Several explanations have been suggested.According to Menkhoff et al. (2011) the carry premium is a compensation for cyclical risk and liquidity risk: currencieswith high interest rates tend to weaken during volatility shocks while low yielding currencies have positive return,hence both legs of a FX carry position yields negative return. Another explanation is that markets compensate forinflation uncertainty by overpaying for expected depreciation. Countries with a high interest rate usually have weakfundamentals with external and internal imbalances and they also often have a history of high and uncertain inflation.Currencies with high inflation tend to have a more volatile inflation, as can be seen in chart 11, so the price level is less

predictable and this is reflected in higher interest rates as compensation.

Chart 11. Average and volatility of inflation, 1971-2011 Chart 12. FX carry vehicle real return, USD, 1927-2011

The premium: The FX carry premium, based on US cross currency rates, has been constructed as going long themoney market rate with the highest return the previous month and shorting the money market rate with the lowestreturn, while gaining the corresponding spot rate returns. A dynamic number of currencies from industrialisedcountries have been used, starting in 1927 with CHF, SEK and USD and with time adding up to a total of tencurrencies, Academic studies based on data from the post-Bretton Woods era show a historical premium of around

7%. Our longer study going back to 1927 finds a risk premium of 4.1%, rising after 1970 when the fixed exchange rateregimes were abandoned.

The vehicle: The real return for the FX carry vehicle has been 4.2% for the same period, when deducting a cost of 50bps. Interesting to note regarding this risk premium is that over the period 1927-2011 correlations to the traditionalassets as well as all other alternative betas has on average been around zero. Even when looking at the period 1970-2011, i.e. excluding the period with fixed exchange rates, the risk premium has been uncorrelated to all assets.


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Source: GFD,Ecowin and SEB X-asset However, since the beginning of the financial crisis, correlations to equities and leading indicators have picked up agreat deal. An explanation to this would be the severity of the last recession leading to a flight of capital from volatilecurrencies, primarily to the USD, CHF and JPY, to a much larger extent compared to previous recessions. This has leadto losses for the FX carry strategy during the financial crisis, while our cyclical analysis shows that the vehicle has had

positive return in all other recessions since 1970. Even though it is a lot more cyclical now, we see this strategy asinteresting in the current climate because of the global imbalances of large debtor nations with zero interest ratepolicies and currencies expected to depreciate during the coming decade. I.e. we think it will hold going forward.

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X-asset themes

The defensive sectors premium

It has long been known that low-risk equities have high risk-adjusted returns. This is known as the low volatilityanomaly, and in this section we will analyze it through sectors, building on the fact that the consumer staples, energy

and health care sectors have historically had significantly higher returns than the market average, but at lower risk.

The explanation: The most prominent explanation for the anomaly is that investors tend to seek high returns but areunwilling or unable to use leverage and therefore will be more prone to invest in riskier sectors in order to increaseoverall return. As a result, defensive sectors have been systematically undervalued and delivered higher risk-adjusted

returns compared to the market or the more volatile sectors.

Chart 15. Return and risk, equity sectors, USD, 1926-2011 Chart 16. Defensive sectors vehicle real return, USD, 27-11

A complementary explanation is that investors may engage in herd-like behavior, overweighting sectors that lead themarket during normal times, while analysts also extrapolate cyclical earnings growth. Only in recessions and short-term corrections do earnings expectations and valuation adjust to more realistic levels; this is consistent with thestrong tendency of the long-term premium to be concentrated in periods of poor overall return.

The reason why this pattern does not extend to the two other low-risk sectors, telecom and utilities, could be moreintense political regulation surrounding these sectors. Both are natural monopolies, thus the earnings they extract

tend to be capped through policy makers capping prices. These two sectors, compared to the three other defensivesectors, have had higher dividend yields but far lower earnings growth, leading to lower returns.

The premium: This strategy, the most defensive of the four equity related risk premiums, has been constructed asinvesting in an equal-weighted basket of the three defensive sectors while taking a short position in the total market.During the period 1927-2011, this strategy delivered a premium of 1.3%. Other papers covering the low volatilityanomaly have found a risk premium around 1-2% on a yearly basis. The analysis has been based on the Fama andFrench data of sectors, reconstructed to match the ten Global Industry Classification Standard (GICS) sectors.


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Source:GFD,Ecowin,Fama & French and SEBX-asset The vehicle: The defensive sectors vehicle has delivered a real return of 1.2% over the same period, with a cost of 75bps. The returns have been evenly distributed and the vehicle has had a lot lower tail risks compared to equities. Thiswith on average negative correlation to the stock market (-0.41) and to OECD leading indicator (-0.42, measured over

the period 1961-2011) while being uncorrelated to US CPI. The 10Y rolling correlations to leading indicators has variedquite a bit but been mostly on the defensive side of the chart, while experienced both slightly negative as well aspositive correlation to inflation.

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Defensive sectors

Market

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Industrials Technology

FinancialsMaterials

UtilitiesTelecom

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T-bil ls Gvt .bonds Equit ies Defensive sectors/marketSource: GFD, Ecowin,Fama & French and SEBX-asset


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X-asset themes

The value premium

The explanation: The higher long-term return for stocks with lower valuations has been known for many decades,but there is no clear consensus on why it exists. Also, there is no clear consensus on how to define value. In thisanalysis value has been based on the book-to-market ratio, with high book-to-market being classified as value stocksand low book-to-market as growth stocks. Other definitions, such as dividend yield, earnings/price and cashflow/price could also be used. Several explanations for the value premium have been suggested. Fama and French(1992) argue that the higher return on value stocks is a compensation for risk not captured by the capital asset pricingmodel. A higher level of risk is however only one part of the explanation. Chart 19 shows the real return and risk forstocks split on book-to-market. High book-to-market ratio stocks have higher standard deviation and at the same

time overcompensate with return resulting in a Sharpe ratio higher than the low book-to-market ratio stocks.

Chart 19. Stocks split on B-t-M, 30-40-30, USD, 1926-2011 Chart 20. Value premium vehicle real return, USD, 1927-2011

Chan and Lakonishok (2002) base their argument on market psychology; the value premium would arise due toinvestors exaggerating the problems of the distressed value companies and the future earnings growth of apparentlysuccessful companies. We note that growth stocks suffer more during recessions, which is when optimistic earnings

expectations tend to adjust to more realistic levels.

The premium: This risk factor is based on the Fama and French factors value and growth and is constructed by goinglong stocks with the 30% highest book-to-market ratio while shorting stocks with the 30% lowest ratio. The totalmarket is split in two parts based on size and the book-to-market portfolios are constructed by equal weighting thebook-to-market portfolios from the small and large size sample. This is done in order to be sure that the valuepremium is not capturing a hidden size premium. The value versus growth strategy has yielded a risk premium of3.8% during the last 85 years, while other studies have shown a premium of between 2% and 7%.


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Source:GFD,Ecowin,Fama & French and SEBX-asset The vehicle: The corresponding real return for the value vehicle has been 3.7% for the same period of time, with acost of 75 bps. Historically, the value versus growth vehicle has had its highest return in market declines whereequities suffer losses, which shows that this strategy is of a defensive nature as well. The real return of the valueversus growth strategy has on average been positive all through the strategic and tactical cycles, supporting the factthat it has been close to uncorrelated to leading indicators, varying only slightly. Even though the correlation to

equities has been slightly positive over the 85 year period, the risk premium has shown to have defensivecharacteristics. Also, the distribution of 12 month real returns shows a more concentrated return pattern compared toequities, with lower tail risks.

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T-bills Gvt.bonds Equities Value/GrowthSource: GFD,Ecowin, Fama & French and SEB X-asset

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Real ret urn 6. 0% 8 .4% 1 0.0 %

Standard deviation 22.1% 21.8% 26.5%

Sharpe ratio 0.24 0.36 0.35

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Real ret urn 6. 0% 8 .4% 1 0.0 %

Standard deviation 22.1% 21.8% 26.5%

Sharpe ratio 0.24 0.36 0.35


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X-asset themes

The dividend premium

The explanation: Numerous studies show that historically there has been a risk premium for high dividend stocks.Like for the value premium, it seems to be related to exaggerated earnings growth hopes for stocks with highervaluations. The main difference to the value premium would be that high dividend yield stocks are normally not indistress, they are actually often the opposite, since high dividend payouts are signs of good quality of earnings, in thecase that they have been sustainable. The premium is also less correlated with the equity market. The valuation ofhigh dividend yield stocks is less dependent on future earnings growth and thus likely to suffer less if expectations are

not met. The returns are hence yield supported which means that losses during market declines will be reduced.

There is however a relatively strong relationship between the value and dividend premiums, with a correlation ofaround 0.60 over the 85 year period. This means that there is some overlapping of the two strategies, but the returnpatterns are not exactly the same and correlations to OECD leading indicators and equities are a bit lower for thedividend premium. The defensive sectors premium on the other hand is uncorrelated both to the value and dividendpremiums; hence the defensive characteristics represented by that premium are something completely different.

Chart 23. Stocks split on dividend, 30-40-30, USD, 27-11 Chart 24. Dividend premium vehicle real return, USD, 27-11

One should note that in the very highest segment of the market, there are lots of firms that have had, under a shortperiod of time very lucrative earnings or a collapse in the stock price, and by that being able to increase the dividendyield substantially. This has however not been sustainable through time and therefore the high dividend payouts havenot been able to continue, leading to migration to lower dividend groups. Therefore, it is an advantage if sustainabledividend payment is a selection criterion when investing in high dividend yield stocks.

The premium: This particular risk factor has been constructed as investing in the 30 percent of the market with thehighest dividend yield while going short the 30 percent with the lowest yield. Studies estimate a risk premium in the

range of 1.5% to 5% while our analysis shows a premium of 2.2% since 1927, with no correlation to the stock market.


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Source:GFD,Ecowin,Fama & French and SEBX-asset The vehicle: When constructing an investable vehicle of the dividend premium and deducting a cost of 75 bps, thehistorical real return has been 2.1%. Supporting the explanations, stocks with a high dividend yield havesystematically had smaller losses than the total market during periods of cyclical weakness, which means that thisequity related vehicle also has defensive characteristics. The correlation to growth indicators is mostly negative, and

the correlation to inflation is variable, allowing this like the three other equity related risk premiums to deliver above-trend returns during both high-inflation and low-inflation secular bear markets.

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Standard deviation

Realreturn

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

Low

Neutral

High

Low Neutral High

Real re turn 5. 6% 7.0% 7.9%Standard deviation 19.9% 18.2% 20.4%

Sh arpe ratio 0.2 5 0.35 0 .36


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10

X-asset themes

The size premium

The size premium is well known but there has recently been disagreement regarding the existence. Banz (1981) andFama & French (1992) conclude that there is a size premium, but more recent studies show that it was gone duringthe 80s and 90s. However, the premium is still evident over longer time periods and it has been shown that it hasbeen delivering positive returns during the last decade.

The explanation: The higher return of small cap stocks can be explained by a higher level of risk in terms of standarddeviation, but also a much higher level of tail risk. The higher standard deviation and mortality risk for small firmsneeds to be compensated by a higher level of return. Another explanation is that institutional investors and othersprefer large cap stocks to a much larger extent, hence small cap stocks will be under priced in relation to large capstocks, leading to higher long-term returns. One reason for this could be the insufficient information available forsmall cap firms because of a bias towards large cap stocks from equity analysts. Liquidity is also an argument for the

small cap premium, since there is a lower liquidity for firms in that segment of the market, compared to large cap.

Chart 27. Return and risk for size quintiles, USD, 1926-2011 Chart 28. Size premium vehicle real return, USD, 1927-2011

The premium: The risk factor has been constructed as going long the second quintile of the market while going shortthe fifth quintile, where the quintiles are based on market cap with quintile one including the smallest firms. Thereason for not using quintile one is because it captures micro cap firms. Academic studies covering the size premiumshow a premium of around 0%-6% while our analysis over the 85 year period has shown a risk premium of 2.4%,

The vehicle: The real return for the size vehicle during the same period of time has been 2.3%, when charging a costof 75 bps. This alternative beta, contrary to the three other equity market based strategies, does not possessdefensive characteristics but have positive correlation to both equities and leading indicators, making it morefavorable when equity markets perform well. It has shown to be tactically cyclical, while not being cyclical during thelonger time horizons of the strategic cycle. Chart 30 shows the 10 year rolling correlation to US CPI and OECD leadingindicators and confirms the cyclicality of this vehicle, showing basically only positive correlation to leading indicators.


0%

10%

20%

30%

40%

50%

60%

40%

Equities Small/Lar ge capSource: GFD,Ecowin, Fama & French and SEBX-asset

-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

US CPI

Source:GFD,Ecowin,Fama &French and SEBX-asset This is also the most risky of the seven alternative betas, with an average standard deviation of 14% over the 85 yearperiod. There are also a couple of very long drawdowns, for example during the 80s and 90s as noted earlier. Onepossible explanation for the missing premium during that period could be that investors were overpaying for IPOs

during the dot-com mania, leading to overvalued firms in the small cap segment.

4%

5%

6%

7%

8%

9%

10%

15% 20% 25% 30% 35%

Standard deviation

Realreturn

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

Qnt 1Qnt 2Qnt 3

Qnt 4

Qnt 5

Note: Qnt2 has been used as small cap and Qnt 5 as large cap

Qnt 1 Qnt 2 Qnt 3 Qnt 4 Qnt 5

R ea l r et ur n 8 .4 % 8. 7% 8 .4 % 7. 8% 6 .1 %

Standard deviation 31.8% 26.9% 24.4% 21.9% 18.1%

S har pe r at io 0. 24 0 .3 0 0 . 32 0. 33 0. 30

4%

5%

6%

7%

8%

9%

10%

15% 20% 25% 30% 35%

Standard deviation

Realreturn


Qnt 1Qnt 2Qnt 3

Qnt 4

Qnt 5

Note: Qnt2 has been used as small cap and Qnt 5 as large cap

Qnt 1 Qnt 2 Qnt 3 Qnt 4 Qnt 5

R ea l r et ur n 8 .4 % 8. 7% 8 .4 % 7. 8% 6 .1 %

Standard deviation 31.8% 26.9% 24.4% 21.9% 18.1%

S har pe r at io 0. 24 0 .3 0 0 . 32 0. 33 0. 30

0

1

10

100

1000

1927 1937 1947 1957 1967 1977 1987 1997 2007

July1927=1

T-bills Gvt.bonds Equities Small/Large capSource: GFD, Ecowin,Fama & French and SEB X-asset


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11

X-asset themes

Alternative betas in a portfolio context

In this section we look at how the alternative betas add to a balanced portfolio of traditional assets in the long termscenario. For the alternative betas, the forward looking real return estimates for the truly long term case are based onhistorical performance adjusted for our slightly higher Treasury bill forward estimate compared to the historicalreturn. The credit premium is based on the return estimates for t-bills, government bonds, credit and equities. Thehistorical standard deviations during the last 85 years have been used as forward-looking risk estimates. FX carrystandard deviation has however been adjusted upwards since the first part of the analysis with fixed exchange rates

came with relatively low volatility. Costs have been included for all vehicles except for the curvature premium.

Chart 31. Forward-looking real return and risk estimates Table 1. Real return, risk and correlations, USD, 1927-2011

0%

1%

2%

3%

4%

5%

6%

0% 5% 10% 15% 20%

Standard deviation

Realreturn


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

High/Low dividend*Small/Large cap*

FX carry*

Value/Growth*

T-bills

Gvt.bonds

Credit

Equities

*Trading costsof 75 bps has been included for equity related premiums,

40bps for the credit premium and 50bps forFX carry

Note:the combined "Alternative betas" has been constructed asan equal weighted basket

Alternative betas

Even though most of the alternative betas individually are below the risk-return trend line for the traditional assets,they make it into a portfolio with close to 50% weight at a risk level of 15% Value-at-Risk. This is due to favourablecorrelation characteristics, making them able to perform in a broader range of macro climates than stocks and fixedincome. They are thus included in balanced portfolios even at relatively modest risk-adjusted returns. Fixed incomeassets are displaced when including alternative betas in a portfolio, while equity allocation is actually increased due to

diversification added by the alternative betas, which in turn increases the long term return of the portfolio.

Altogether, alternatives displace around 30-70% of the traditional asset portfolio depending on the level of risk. Thecredit, value, defensive sector-based and FX carry premiums have the highest weight in a portfolio at 15% Value-at-Risk. The strategies also complement each other since they work well in different parts of the risk spectrum. In thetruly long term case, the curvature and to some extent the credit premium has its highest allocation at low risk, whiledefensive sectors works well at low to medium risk and the value premium and FX carry at medium to high risk.

Chart 32. Optimal portfolio at a 15% Value-at-Risk level Chart 33. Alternative beta allocation along the frontier

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

5.0% 7.5% 10.0% 12.5% 15.0% 17.5% 20.0% 22.5% 25.0%

Value-at-Risk

G vt. bo nd s curva tu re Credi t p re mi um V al ue /G ro wt h

Defensive sectors/market High/Low dividend Small/Large cap

FX carrySource: GFD, Ecowin, Fama & French and SEB X-assetNote: Value-at-Risk based on 98% confidence level and a 12 month time horizon

With our forward-looking estimates and the historical correlations, a expanding the portfolio with alternative betaswould increase return with roughly 50 bps per year, at a 15% Value-at-Risk level. This might not be a lot, butaccumulates over time. Another value with the approach of alternative betas is the part of active allocation, since wehave found strategies that have their peaks in return during declining markets while at the same time show a longterm premium. It seems likely that this approach has a positive role in the hedging of cyclical risks and that it leads toa more clear-cut diversification effect. Hence by increasing allocation to alternative beta during distressed periods,

losses will dampen or even result in positive returns, in times when equities perform negatively. This is particularlyinteresting in the current climate when a portfolio of equities and fixed income is expected to perform with low andvolatile returns. This is something that will be covered in an upcoming analysis of our cyclical allocation framework.

11%

15%

34%

14%

0%

16%

4%

1%

2%

0% 3%

T-bills

Gvt.bonds

Credit

Equities

Gvt.bonds curvature

Credit premium

Value/Growth

Defensive sectors/market

High/Low dividend

Small/Large cap

FX carry

Source:GFD, Ecowin,Fama & French and SEBX-asset

Expanded universe

Source:GFD, Ecowin,Fama & French and SEBX-asset

33%

26%

10%

31%

Note:The alternativebetasa nd thehedge fund strategieshave been included individually.

Value-at-Risk based on 98%confidencelevel and a 12 month timehorizon

Traditional portfolio

Return Risk Sharpe ratio T-bills Gvt.bonds Credit Equities

T-bills 0.6% 1.8% 0.37 0.28 0.07

Gvt.bonds 2.1% 5.8% 0.26 0.37 0.63 0.08

Credit 3.7% 6.5% 0.47 0 .28 0.63 0.43

Equities 6.0% 18.8% 0.29 0.07 0.08 0.43

Gvt.bonds curvature 0.7% 2.1% 0.07 0.86 0.24 0.22 0.08

Credit premium 1.3% 4.7% 0.15 0.34 -0.05 0.61 0.04

Value/Growth 3.7% 12.3% 0.25 0.05 0.03 0.29 0.28

Defensiv e sectors/mar ket 1.2% 7.2% 0.08 0.27 0.15 -0.11 -0. 41

High/Low dividend 2.1% 12.8% 0.11 0.11 0.15 0.20 -0.03

Small/Large cap 2.3% 14.0% 0.12 0.09 -0.01 0.31 0.39

FX carry 4.2% 10.5% 0.34 0.07 -0.05 0.04 0.02

Alternative betas 2.7% 5.5% 0.39 0.22 0.07 0.19 -0.01

Note: the "Alternative betas" is constructed b y the weights from a normalised portfolio at 15% Value-at-Risk


12/12

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SEB report: The role of alternative betas in a long-term portfolio

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