Multi-asset income investing

The need for a long term, active approach

White Paper April 2017

Authored by:

Joseph Little, Global Chief Strategist

Jane Davies, Senior Portfolio Manager

Any views expressed were held at the time of preparation,

reflected our understanding of the regulatory environment; and

are subject to change without notice. The value of investments

and any income from them can go down as well as up and

investors may not get back the amount originally invested.

For professional clients only

2

Income investingThe need for a long-term view

Demographics and pensions uncertainty are changing clients’ needs 4

Not as good as they seem: current solutions have clear weaknesses 6

Total return with an income orientation: a credible option 9

Conclusion 11

Introduction

Multi-asset income is a popular strategy today.* The

demand stems from the low yield available on

traditional safety assets and conventional retirement

products like annuities.

Standard liquid return-seeking asset classes have

not provided the return stability investors were

seeking. Since 2000, equity investors have endured

two large bear markets, significant volatility, and

relatively low total returns.**

Against a backdrop of heightened political and

economic uncertainty, a desire for stability and

income seems like a natural response1.

However, we believe it is a mistake to invest

indiscriminately in income strategies. Many popular

income “solutions” artificially boost the regular income

they provide at the expense of longer term returns.

In an environment where life expectancy and

longevity are increasing long term capital appreciation

should not be sacrificed to maximise short term

distribution yield.

Investors need a sustainable income stream to fund

their retirement. But they also need income sources

that will grow over time. In this paper we discuss how

they can achieve this in the current environment.

* Multi-asset income funds are in the top 5 sectors in terms of net sales and assets in both 2015 and the latest 2016 Fund Radar Second Sight reports

** Total returns on the US S&P500 have been 5% nominal since 2000

We acknowledge the research support of Kim Kooner (Global Investment Strategy) in writing this paper.

3

Executive summary

The risk of greater longevity

Across advanced economies, life expectancy is

increasing. Forecasts may still underestimate

longevity; in the future, retirements could last

upwards of 30 years.

But at the same time, lower birth rates, shrinking

working age populations and weak productivity

diminish potential GDP growth rates. Linked to this,

an environment of historically-low bond yields implies

that the sustainable investment return across a range

of asset classes is compressed versus the returns

that investors have enjoyed in the past.

Moreover, there is no longer a set and rigid

retirement path. Investors need retirement solutions

that can be flexible and that can provide the income

needed for a longer retirement.

Limitations of current solutions

This perspective highlights the limitations of many,

currently popular, multi-asset retirement solutions.

For example, so-called “glide-path” strategies (or

Target Date Funds) structurally favour traditional

safety assets, such as Gilts, at retirement. But

historically low bond yields imply that investors are

being required to significantly over-pay for perceived

safety. And the recent sell-off in global government

bonds starting in Q4 2016 reminds us that over-

paying for any asset class embeds a risk of (short

term) capital loss in our portfolio.

Other popular strategies which aim to enhance short

term income (such as capital distribution or covered

calls) come with a significant cost. They compromise

long term savings objectives and may undermine

investors’ ability to support a long retirement.

The benefits of a total return approach

To meet the challenge, investors need a solution

which provides an income source that will grow over

time.

We believe that a total return approach, combined

with a sustainable income goal, is the right

investment strategy. Even at retirement, today’s

retirees are effectively “long-horizon investors”. Our

approach ensures we provide an attractive current

level of income, makes an efficient use of the

portfolio risk budget, and seeks to provide adequate

capital growth and income into the medium term.

A key part of this approach is to widen our

investment universe. A number of less mainstream

sources of income can bring stable yield to a

portfolio.

We also need to recognise that standard definitions

of safety do not incorporate current market pricing.

Our long-term view and active approach to asset

allocation means that we design portfolios to be tilted

toward attractively-valued asset classes, where

returns are more secure.

We can further support the income properties of our

portfolios by thinking hard about how we fulfil our

desired asset class “beta” exposures.

4

In fact, these projections may even be understating

the scale of the longevity challenge.

Exhibit 3 shows how projections of the UK population

aged 65 and older have been revised substantially

over time. For example, in 1981 it was estimated that

the number of over 65s in the UK by 2050 would be

11 million. In fact, today, the OECD places this

estimate at nearly 19 million!

Separately European academics2, have suggested

that official measures of longevity are systematic

underestimates. Quite possibly, this tendency to

under-estimate may be symptomatic of other

developed countries too. In other words, the balance

of risks lies to still greater longevity.

Falling birth rates

At the same time, birth rates have fallen in developed

economies. As shown in Exhibit 4, the “dependency

ratio”, which measures the number of young and

elderly dependents relative to the size of the working

population, is expected to increase dramatically over

the coming decades.

9

11

13

15

17

19

21

2010 2020 2030 2040 2050 2060

2015

2004

2000

1996

1992

1989

1985

1981

Population 65+

(millions)

Demographics and pensions uncertainty are changing clients’ needs

Meeting investment objectives in an environment of

changing demographics and pension reforms

requires a strategy that aims to deliver income over

the long term.

The risk of greater longevity

Exhibits 1 and 2 show life expectancy trends in

OECD countries. From birth, life expectancy has

been increasing by almost 2.5 years every decade

since the 1950s.* At age 65, life expectancy has

been increasing by around 1 year per decade. This

rising longevity across the OECD reflects

technological, medical and nutritional advances. It is

unambiguously good news, but poses challenges in

terms of how we might fund longer retirements.

Moreover, projections show this trend of rising

longevity continuing well into the future. Forecast

data suggests that by 2060, average OECD life

expectancy at age 65 will be 25.8 years**, and as

much as 29.7 years for Japan.

* OECD (2014), Pensions Outlook 2014

** OECD (2014), Pensions at a glance

Exhibit 1: Life expectancy at birth for OECD countries

Source: Human mortality database, December 2014

Exhibit 2: Life expectancy at 65 for OECD countries

Exhibit 3: Official projection of population aged 65+ by year

of publication

Source: OECD Pensions at a Glance (2011) & OECD Stat 2015

55

60

65

70

75

80

85

1950 1960 1970 1980 1990 2000 2010

France JapanSpain United KingdomUnited States SwedenNetherlands

Life expectancy at birth

(increase = 2.4 yrs per decade)

10

12

14

16

18

20

22

24

1950 1960 1970 1980 1990 2000 2010

Life expectancy at 65

(increase = 1.1 yrs per decade)

Source: Human mortality database, December 2014

5

An analysis of long-term growth dynamics suggests

that growth trends in developed markets and many

emerging markets will be damaged by falling

working-age population numbers.3 Estimates on the

breadth of the impact and the prognosis for secular

growth vary but shrinking labour forces create a clear

structural headwind for growth.4

Consequently, research from the OECD forecasts

medium-term, inflation-adjusted growth rates in

advanced economies of only 1.8% (and as low as

1.2% for economies like Japan. Meanwhile, with still

greater pessimism, US economist Robert Gordon

projects US growth rates of around half the OECD

forecast.5

The work of Prof Gordon is not universally accepted

among academic and market economists. But the

OECD growth scenario and the downside risk raised

by Gordon’s analysis brings into acute focus the

question of how individuals can prepare for a

situation where life expectancy will be 95 years (with

the additional costs it induces such as care and

medical bills), while the economy lingers in a weak

growth equilibrium.

Economics Nobel Laureate Prof Robert Merton has

put the choice for today’s investors even more

bluntly, “…there are only three things they can do:

save more, work longer, or take more risk”.6

Merton’s first two points are intuitive. But taking more

investment risk is not always beneficial. The “efficient

markets” school of thought implies that risk is always

rewarded. But, in reality, we know that the price of

risk varies significantly over time and is something

that investors must be aware of.

Retirement is changing

For pension providers, the difficulty lies in offering

their members solutions which are able to deliver

income over the long term.

In parallel, pensions reform or uncertainty in many

countries around the world (in the UK or Greece)

mean that investors need both guidance and access

to the right products. Typically, low engagement

levels and pronounced risk-aversion in the

accumulation phase have reinforced the problem and

heightened this need.

Moreover – and crucially – retirement is changing;

there is no longer a set path or a given retirement

date but, on the contrary, increasing numbers

continue to work part-time or become self-employed

after their official retirement date. This calls for

solutions to be managed throughout the retirement

lifecycle.

The key consequence of increasing life expectancy,

a shrinking working population, and uncertainty

around pensions policies is that it is not in clients’

best interests to take a short-term view of

investments at retirement:

Conventional wisdom in the industry still seems

geared towards offering short-term focused

solutions when aiming to achieve an income

objective. Investors close to, or at the point of

retiring, are in fact likely to enjoy a long

retirement, of perhaps 30 years, and will need to

see their income continue to grow over time to

protect from the effects of inflation.

The need to deliver income over the long term

means that pension funds, like individuals, need

to consider sustainable solutions

Exhibit 4: Projected old-age dependency ratio

(Over 65s as % of 15-64s)

Source: Eurostat

2015 2020 2040 2060 2080

EU (28) 28.8 31.8 45.9 50.2 51.0

France 29.2 32.6 44.0 42.9 46.4

Germany 31.9 35.8 55.6 59.2 59.9

Italy 33.6 34.9 49.9 53.1 56.8

UK 27.4 29.5 39.1 42.7 44.7

6

Conventional approaches face a range of problems

1. A glide path without a valuation discipline

So-called “glide path” strategies typically reduce the

allocation to equities and favour developed market

bonds for investors nearing retirement.* This is a

problem: (i) the key asset allocation decision is made

without a valuation framework and (ii), risk is

dangerously simplified to being a fixed concept –

equities are “risky” and bonds are “safe”.

Core government bonds currently trade at historically-

low yields, even when we examine data going back to

the 18th century – or even earlier**. In other words, in

order to access the conventionally-assumed “safety

asset class” in their retirement, investors will have to

substantially over-pay for this privilege (see exhibit 5).

And having now overpaid, the recent rise in yields

reminds us that this strategy remains vulnerable to

short term capital losses. It is far from a “safe”

investment.

2. Different investors, different preferences?

Another school of thought is that income investors

have a different set of preferences to long-term

investors. For example, many income strategies

come with a range of settings which might imply

maximising for yield. However, there are no free

lunches and such a strategy comes at a cost. Do

income investors really place more value on current

income than on gains tomorrow? Are they willing to

pay higher taxes in order to achieve a stable

income? Are they willing to suffer high levels of risk

(i.e. volatility of the underlying asset) as long as

portfolio yields remains relatively high and constant?

None of these cases seem particularly plausible to

us.

Such approaches (glide paths into long bonds and

maximising for yield) suffer from the pitfalls of a

short-term perspective of income. As explained

above, it seems likely to us that investors who are

retired or approaching retirement will still be focused

on long-term returns – at least for a portion of their

asset allocation – while also being preoccupied with

generating a sustainable income stream to match

this longer investment horizon.

3. Using capital distributions to enhance yield is

not a true income strategy

Another temptation is to use capital to support (or

“guarantee”) a yield on a given portfolio. If investors

have been emotionally scarred by past investments

in equity markets, their likely aversion to volatility

would make such an offering attractive. It also seems

like an easy way for pensions to meet their short-

term obligations.

However, technically speaking, capital-distribution

strategies fail the classic definition of “income” set

out in the 1930s by economist Sir John Hicks.

Consequently, we doubt whether they should be

regarded as legitimate income strategies at all.

"The purpose of income calculations in practical

affairs is to give people an indication of the amount

which they can consume without impoverishing

themselves. Following out this idea, it would seem

that we ought to define a man's income as the

maximum value which he can consume during a

week, and still expect to be as well off at the end of

the week as he was at the beginning"

John Hicks 1939, Value and Capital

Exhibit 5: Long run government bond yields

(US Treasuries and UK Consols)

Source: Global Financial Data, March 2017

* This is the asset allocation formula for a target-date fund strategy based on the number of years left to the target date.

** For example, we have studied data on the Venice loan market (Venice Prestiti yields) between 1285 and 1502. The lowest yield was 4.88%, with an average of 6.8%.

0

2

4

6

8

10

12

14

16

18

1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

US 10Y Government Bond Yield

0

4

8

12

16

20

1729 1759 1789 1819 1849 1879 1909 1940 1970 2000

UK Consol Government Bond Yield

7

Indeed, the main problem with this approach comes

from the prospect of substantially higher-than-

expected longevity; you can’t divest indefinitely, or

even for the long run.

Moreover, if we are right that retirees should still

consider themselves as “long horizon investors”, then

there is a significant opportunity cost from divesting

to boost short-term income. We can illustrate this

with a simple example.

We assume an investor has £100 to invest and

returns on the stock market are 6% annually for the

foreseeable future. This return includes a dividend

yield of 2.5%. Using a ‘total return’ approach means

we will keep the 2.5% dividend as income for

spending, but leave the rest of the capital (i.e. the

initial capital plus the 3.5% return) invested in the

market.

An investor seeking a 5% yield can supplement the

2.5% dividend income by drawing down an additional

2.5% from the total invested capital each year.

Exhibit 6 shows the impact on the portfolio’s value

after 5 years and 25 years.

After 5 years, the total wealth under both approaches

is fairly similar. However, over a longer timeframe,

the lack of capital invested in the market causes an

investor’s overall wealth to shrink relative to the total

return approach. Cash distributions are lower under

this “total return” approach (note the height of the

grey bars), but overall wealth is 24% higher. In fact,

after 30 years of investment, the total cash amount

paid out each year from this approach is actually

greater than under the capital distribution strategy.

This is in spite of the higher percentage distribution

rule. These effects become even more pronounced

when market returns are stronger than 6%, or if a

large disbursement occurs early on.

Using capital to fund a yield today therefore seems

incompatible with the prevailing demographic forces.

Because investors nearing pension age will require

income sources that grow over time, a more durable

solution is required.

A true income strategy should be able to provide a

good running yield without “impoverishing” our future

selves.

4. Covered calls do not guarantee investment

income

Many income strategies use covered call writing as a

key structural feature. The historic performance of

covered call writing has been very strong. We

calculate that the historic (ex post) Sharpe ratio of

so-called “buy-write” strategies is 0.54 and compares

favourably with long-only US equities (S&P500

Sharpe ratio is 0.45, data since 1990). On the basis

of impressive historic performance, it could be

argued that asset managers should embed covered

call writing as a strategic part of their multi-asset

income process.7

In principle, covered call strategies (that is to say,

writing call options on an underlying equity position)

offer the opportunity to increase the portfolio yield.

We gain a premium from selling call contracts but

give up the capital upside from a naked equity

position.

For purely income-focused investors, this could be a

reasonable trade-off. Indeed, it is a technique used

by many well-known asset managers for income

enhancement.

Yet historic returns are not a reliable indicator of

future performance. A recent academic study8 has

demonstrated that, like other asset classes, the

expected return of a covered call strategy is not

static. Rather, it is determined by a combination of

the risk-free rate, the equity risk premium and the

implied-to-realised volatility spread. The author

concludes his article:

“In order for investors to find the CC (covered

call) strategy attractive, they must be convinced

that, going forward, implied volatility will be

higher, on average, than the corresponding

realised volatility. In addition, this volatility spread

needs to be high enough to counteract the negative

influence that the equity risk premium has on the CC

strategy relative to the stock index.”

Exhibit 6: The Impacts of Capital Drawdown

Source: HSBC Global Asset Management, March 2017

0

100

200

300

400

Strategy withCapital

Distributions

Total ReturnApproach

Strategy withCapital

Distributions

Total ReturnApproach

total capital invested sum of cash payments

5 Years

25 Years

To

tal

Wealt

h

8

This is very interesting and useful because it gives us

a clear framework to assess the prospective

attractiveness of the covered call strategy, rather

than merely relying on historical experience.

A covered call strategy makes sense if we expect

implied volatility to be greater than future realised

volatility (IV > RV) and we identify an inadequate

equity risk premium.

As exhibit 7 shows, implied volatility on the equity

market is variable over time. It tends to cluster and

then mean-revert, but it is not classically stable like a

sine wave. This is intuitive as perceptions of risk shift

around a lot over the market cycle.

To us, this implies that, like other aspects of our

asset allocation strategy, we need to constantly

review the attractiveness of covered calls. If investors

tend to form their assessment of asset class risk in a

backward-looking fashion9 then, following a volatility

spike, implied volatility will be higher than future

realised volatility. But this will not always be the case

and being active is key.

Moreover, since a covered call strategy caps the

upside, investors are losing the right-hand tail of the

future return distribution. The remaining exposure is

significantly concentrated in downside risk. This is

only somewhat mitigated by the revenue associated

with call writing, dispelling the view that covered calls

provide downside protection.10 Another way to see

this is that downside correlations of covered call

strategies are nearly perfect with a long equities

strategy. A better diversifying option, therefore, would

be to express a volatility view through a variance

swap (which removes the equity directional element).

Lastly, and related to the above, a covered call

strategy exhibits negative skew and high kurtosis

(i.e. heightened drawdown risk and fat tails). It is

somewhat similar to a carry strategy in currencies

which itself is likened to “picking up pennies in front

of a steamroller”. It has been met with forceful

criticism from finance philosopher Nassim Taleb11:

“For a mutual fund manager, doing such “covered

writing” against his portfolio increases the

probability of beating the index in the short run,

but subjects him to long-term underperformance

as he will give back such outperformance during

large rallies.”

Taleb’s point is profound. Even at retirement,

investors need to be long run focused.

In summary, although option selling generates a

positive cash flow, it is incorrect to conclude a

covered call strategy guarantees investment income.

In order for there to be investment income, the

option must be sold at a favourable price. This

strategy generates income only to the extent that

any other strategy generates income – by buying or

selling mispriced securities or securities with an

embedded risk premium.12

Exhibit 7: US implied equity volatility

0

10

20

30

40

50

60

70

80

1990 1995 2000 2005 2010 2015

CBOEVIX

Source: Bloomberg, March 2017

9

As explained in the previous sections, the changing

demographics and retirement landscape mean that,

even at retirement, investors should still be long run

focused.

Imposing an income target is a heavy-handed

solution

By imposing an income constraint on the strategy,

the mathematical reality is that our ability to achieve

the “Maximum Sharpe Ratio” portfolio13 is

compromised.

Exhibit 8 illustrates the problem. Adding binding and

heavy-handed constraints drag us away from making

the best use of our risk budget. It leads to a sub-

optimal portfolio. For a given level of risk, we will

achieve lower returns than we otherwise could.

As a consequence, whilst the clearest way to achieve

an income target is to simply impose an income

constraint, it comes at a cost. In order to avoid a

highly-inefficient use of the risk budget, some careful

calibration of this income constraint is required. The

portfolio must balance the need for capital growth

with a heightened preference for income return.

In our view, the solution is to set the income target at

a sustainable level, not too far from the “natural yield”

of an efficient total return-focused portfolio.*

A credible solutionTotal return with an income orientation

Exhibit 8: Constraints impair our ability to achieve the MSR

Source: HSBC Global Asset Management, March 2017

* For example, we currently believe that a high dividend equity strategy without a deleterious reduction in quality can sustainably yield 3.5%

Active Asset Allocation

Asset allocation is the key determinant of portfolio

success and we believe that it should not be

neglected by investors. The typical “set-and-forget”

approach to establishing strategic asset mixes is

inappropriate for an investment environment where

the return profile (risk premium) to an asset class

varies dramatically over time. Asset allocation needs

to be a dynamic decision and be regularly revisited.13

Our approach to multi-asset investing is grounded in

asset valuation and economic analysis. Academic

studies have confirmed that asset returns are

predictable (in the medium term) based on starting

valuations.14 There is an “excess volatility” across

bonds, credits, equities and alternative asset classes.

What’s more, a valuation perspective provides a

disciplined and structured framework for us to build

multi-asset portfolios. It forces us to pay attention to

how “the odds” implied by the market are moving.14

This philosophy underpins our entire approach to

portfolio management. From thinking about

benchmark construction, strategic asset allocation

and portfolio rebalancing; to actively managing

tactical asset allocation overlays; to selecting

fulfilment vehicles and portfolio assembly.

Widen the investment universe

The historically-low level of global government bond

yields and compressed risk premium in global credits

and, to a degree, in global equities creates a

challenging environment for investors today.

Sustainable returns across core asset classes are

low, especially when compared with the kind of

excess returns that investors have enjoyed over the

last 30 years.

An obvious opportunity is to widen the typical

investment universe to include, for example, a more

significant allocation to emerging market asset

classes and also to liquid alternatives (including

factor exposures).

Our point from above is that the perceived safety of

Gilts or Treasuries is challenged by the high price we

are required to pay to access this safety today. This

means that the sustainable return on developed

True Efficient

Portfolio (MSR)

Return

Risk free

rate

Risk

Global Min

Variance

Portfolio

Unconstrained

Frontier

Constrained

Frontier

10

As can be seen below, these stocks often go on to

decline significantly in price and deliver lower levels

of total return.

Instead, we believe three attributes are key to

achieving sustainable equity income whilst also

considering valuations: (i) high dividend yield, (ii)

cash flow yield and (iii) return on investment capital.

The first directly pursues stocks with an attractive

level of current income. The second and third

incorporate an element of quality into stock selection,

ensuring the sustainability of income and the potential

for capital appreciation.

With our measure of sustainable dividend yield, we

simply seek to build highly diversified portfolios which

exhibit a broad tilt to this factor. We maximise

exposure to the income factor while minimising other

systematic risks (like sectors, countries and other

factors). This process aims to maximise exposure to

the most attractive income stocks whilst managing

risk and creating well-diversified portfolios.

With robust quantitative research, smart beta equity

income strategies can find the right balance to

achieve efficient income “beta capture” without

compromising dividend sustainability or embedding

unintended systematic risks.

A credible solutionTotal return with an income orientation

market bonds is low and the distribution of return

outcomes is skewed to the downside (i.e. there is

scope for capital loss). Notions of safety, in other

words, cannot be viewed independent of valuation.

This means that asset classes that we would

conventionally regard as “risky” can actually be

sources of safety, depending on how the market is

pricing them. For example, at the start of 2016, Brazil

local-currency bonds were unloved and under-owned

and trading on a yield of 16%. Investors perceived

this asset class as highly risky. But the reality was,

even when confronted with further bad news about

the economic and political outlook, the asset class

was able to rally strongly. By the middle of 2016,

investor total returns in USD terms were c.50%. The

pricing of the asset class at the start of 2016 already

embedded a large margin of safety and, from a

valuation perspective, it already looked low-risk.

Liquid alternatives are a potentially important part of

the opportunity set too. Once again, a valuation

discipline is critical. We have to make sure that we

are not caught up in fashions and fads. And we must

ensure that we do not over-pay for the asset class.

But given a need for income and a desire to build a

portfolio with effective diversification, the ability to

allocate to a range of liquid alternatives must make

sense.

Yield-orientated fulfilment

A further and important consideration is the use of

fulfilment vehicles. Across our multi-asset platform we

make extensive use of low-cost passive and

enhanced passive (smart beta) fulfilment vehicles, as

well as active funds.

Designing an appropriate and cost-efficient “beta

capture” is a regular part of our multi-asset process.

Why should multi-asset income strategies be any

different?

As such, we can make use of fulfilment tools such as

high dividend strategies, among others, to support the

income objective.

The power of smart beta income equity fulfilment

Cost-efficient “beta capture” in an equity-only context

can enable investors to achieve equity income in a

sustainable yet affordable manner.

There is, however, an upper limit to sustainable

dividend yield. Simply buying companies with the very

highest yield will entail holding high income

generators without the cash flow to sustain it.

3%

5%

7%

9%

11%

Low Yield 2 3 4 High Yield

CA

GR

Dividend Yield Quintile

Exhibit 9: CAGR of Equal Weight Portfolios Grouped by

Divided Yield Quintile

Source: HSBC Global Asset Management, March 2017

11

Conclusion

Rising longevity means that today’s retirees have to

focus on capital growth alongside income. They need

to find income sources that will grow over time.

Our analysis suggests that a number of popular

strategies in the market (such as providing income

from capital distributions) are inappropriate. They

achieve the income objective in the short term, but at

a significant cost to the investor.

Today’s retirees are set to enjoy retirements of 30

years or more. They need to think like long run

investors. Our solution is to adapt a total return based

approach to portfolio management.

Imposing an unrealistic income objective imposes

inefficiencies on the portfolio construction process.

We need to think carefully about the type of yield that

is sustainable.

Traditional notions of safety ignore price. Many

retirement solutions emphasise developed market

bonds as the core safety asset class. But the low

current market yields mean that we are being asked

to pay a high price to access this safety.

We take a structured, disciplined and coherent

approach to multi-asset investing based around

valuation and economic analysis.

An important step is to widen and broaden the

investment universe as much as possible. Many

income strategies still focus on traditional asset

classes, but extending the opportunity set to include

more emerging markets and strategies like liquid

alternatives must make sense.

Finally, it is important to think hard about fulfilment

strategies (including smart beta). Yield-focused

vehicles can be income and return enhancers.

12

Authors

Joseph Little

Global Chief Strategist

HSBC Global Asset Management

Jane Davies

Senior Portfolio Manager

HSBC Global Asset Management

Joseph joined HSBC's Asset Management business in

2007. He is currently Chief Global Strategist,

responsible for leading our work on macroeconomic

and multi-asset research, and for developing the house

investment strategy view. He was previously Chief

Strategist for Strategic Asset Allocation and a Fund

Manager on HSBC's absolute return Global Macro

fund, working on Tactical Asset Allocation. Prior to

joining HSBC, he worked as a Global Economist for JP

Morgan Cazenove.

Joseph holds an MSc in Economics from Warwick

University and is a CFA charterholder.

Jane is a Senior Portfolio Manager and has been

managing the World Selection Portfolios and Global

Strategy Portfolios since launch. Her previous roles

include Head of Global Investment Solutions, Head of

Multimanager for the UK and Middle East, and working

within the Tactical Investment Unit of HSBC Global

Asset Management. Prior to this, Jane was a tutor in

Statistical Research Methods with the Institute of

Public Administration and Management MBA

programme.

Jane is a qualified Chartered Financial Analyst (CFA),

holds the Investment Management Certificate (FSA,

UK), is a Member of the Society of Technical Analysts

(MSTA), and holds a First Class BSc (Hons.) degree in

Psychology and Philosophy (University of Leeds).

13

1. Indeed, this is well understood in the psychology literature. See Kahneman and Tversky (1979), “Prospect

theory: an analysis of decision under risk”, Econometrica & Kahneman (2011), “Thinking Fast and Slow” –

chapter 29

2. Ediev (2011), “Life expectancy in developed countries is higher than conventionally estimated. Implications

from improved measurement of human longevity”, Population Ageing

3. OECD (2015) Economic Outlook & IMF (2015) World Economic Outlook. Ball (2014), “Long term damage

from the Great Recession in OECD countries”, JHU Working Paper & Hall (2014), “Quantifying the harm to the

US economy from the financial crisis”, NBER Working Paper

4. Solow (1956), “A contribution to the theory of economic growth”, QJE

5. Gordon (2012), “Is US economic growth over? Faltering innovation confronts six headwinds”, NBER working

paper, and Gordon (2014), “The demise of US economic growth: restatement, rebuttal and reflections”, NBER

working paper

6. Merton (2014), “The crisis in retirement planning”, Harvard Business Review

7. Ilmanen “Expected Returns”, 2010 – see chapter 15 on covered call writing

8. Figelman (2008), “Expected Return and Risk of Covered Call Strategies”, Journal of Portfolio Management

9. Ang et al (2014), “Asset Allocation and Bad Habits”, Rotman International Journal of Pension Management

10. Israelov and Nielsen (2014), “Covered call strategies: One fact and eight myths”, Financial Analysts Journal

11. Taleb (2004), “Bleed or Blowup? Why do we prefer asymmetric payoffs?”, Journal of Behavioural Finance.

Taleb argues that much of the literature points to a utility-based explanation for covered calls. Investors

psychologically benefit from capping further upside since the marginal utility of gains decreases as asset prices

rise

12. Israelov and Nielsen (2014), “Covered call strategies: One fact and eight myths”, Financial Analysts Journal

13. Formally, the Sharpe Ratio reads as follows:

And we can define the MSR portfolio, in the absence of weight constraints as follows:

14. "Long‐horizon investors have an edge. They can ride out short‐term fluctuations in risk premiums, profit

from periods of elevated risk aversions and short‐term mispricing” – Ang and Kjaer (2011), “Investing for the

long run”

15. For a broad and deep review see Cochrane (2007), “Portfolio Theory” or Cochrane (2009), “Portfolio

Formation in the new Financial World”. The same portfolio construction methodologies apply in a more dynamic

setting – see Cochrane (2014), “A mean-variance benchmark for inter-temporal portfolio theory”, Journal of

Finance

References

𝑺𝑹𝒑 =𝝁𝒑 − 𝒓𝒇

𝝈𝒑=

𝒊=𝟏𝒏 𝒘𝒊𝝁𝒊 − 𝒓𝒇

𝒊,𝒋=𝟏𝒏 𝒘𝒊𝒘𝒋 𝝈𝒊𝝈𝒋𝝆𝒊,𝒋

=𝝈𝒊,𝒋

=𝒘′(𝝁 − 𝒓𝒇𝟏)

(𝒘′𝚺𝐰)𝟏/𝟐

𝒘𝑴𝑺𝑹∗ = 𝒇 𝝁𝒊, 𝝈𝒊, 𝝆𝒊,𝒋 =

𝚺−𝟏(𝛍 − 𝒓𝒇 𝟏)

𝟏′𝚺−𝟏(𝛍 − 𝒓𝒇 𝟏)

14

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