CIO Report


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Addvantages of investing in equities

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CIO Report

  1. 1. 11th September 2013 CIO Report: Advantages of Investing in Equities Summary  Equities have several major advantages that can be used to help mitigate their main disadvantage: significant downside risk  Controlling risk in a liquid asset class such as equities is easier and cheaper than in more illiquid ones  Using risk control strategies in equities is not because we expect equities will not deliver attractive returns, but rather that their other positive characteristics enable downside risk to be managed more easily than other asset classes  The liquidity and diversity of equities enables a wide range of potential strategies within the asset class as well as at the asset class level Equities have many advantages: 1. High expected returns relative to most other asset classes 2. Liquid markets at both the index and individual stock level 3. Reliable and transparent pricing 4. Liquid option markets 5. Low management fees for passive exposure 6. Geographical and sector diversity 7. Familiar asset class 8. Asset allocation already in place But a few disadvantages: 1. Volatile prices 2. Significant drawdowns often lasting many years 3. No “pull to par” effect over the long term 4. Bottom of the capital structure However the advantages of equities can be used to help mitigate the disadvantages. For example: • The existence of liquid market indices available in unfunded formats (such as futures and total return swaps on stock indices) means that running a dynamic asset allocation such as volatility control is much easier and cheaper in equities than in almost any other asset class. • Liquidity, for example in equity futures, has also continued during market downturns unlike some other asset classes such as credit. CIO Report: Advantages of Investing in Equities 1 11th September 2013 Philip Rose, CIO – Risk & Strategy
  2. 2. 11th September 2013 CIO Report: Advantages of Investing in Equities • The existence of liquid derivative markets means that a pension fund which wishes to invest in a volatility controlled equity strategy has a choice of both direct fund investment or total return swaps at relatively low cost. • Transparency of pricing means that historical analysis of risks and returns is relatively easy and of strategies that are the same or closely mimic those which can actually be executed. • The existence of a large and liquid options market in equities means that downside risk can also be managed using option strategies. A client who wants a potential return similar to equities but with a lower potential downside can target a given risk level (in terms of volatility) and then buy a relatively cheap put option on the resulting low volatility portfolio. Using volatility control is not because of a bearish view on equities; rather it is trying to maintain the attractions of equities with a constrained risk budget. Another advantage of investing in equities is the ability to take advantage of the liquidity and return dispersion of individual stocks to implement strategies based on style risk premia such as: Value: Buying undervalued stocks and selling overvalued ones based on a set of fundamental measures of some kind Momentum: Persistence of individual stocks to continue to outperform or underperform Defensive: Low volatility stocks tend to outperform high volatility stocks for a given level of risk Many of these strategies can also be implemented in a non-systematic way via manager alpha. For long only stock funds many of these risk premia may get drowned out by overall market volatility. Controlling equity market volatility with volatility control and a put enables a greater known amount of available risk budget to be allocated to: • Systematic strategies such as style risk premia • Manager skill in an equity long/short hedge fund Controlling equity risk does not mean that a client has to give up the benefits from taking advantage of style risk premia or manager skill; rather it enables them to choose the size of their exposure. Contact If you would like further information on this report, please do get in touch. Philip Rose CIO – Risk & Strategy 2 1
  3. 3. 11th September 2013 CIO Report: Advantages of Investing in Equities Disclaimer In preparing this document we may have relied upon information supplied by third parties. Whilst reasonable care has been taken to gauge the reliability of this information, this document carries no guarantee of accuracy or completeness and Redington Limited cannot be held accountable for the misrepresentation of any information by third parties involved. This document is for investment professionals only and is for discussion purposes only. This document is based on data/information available to Redington Limited at the date of the document and takes no account of subsequent developments after that date. It may not be copied modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipients to any other party without Redington Limited’s prior written permission except as may be required by law. Redington Limited accepts no responsibility for any consequences arising from you or any third party relying on this document or the opinions we have expressed. This document is not intended by Redington Limited to form a basis of any decision by you or a third party to do or omit to do anything. “7 Steps to Full Funding” is a trade mark of Redington Limited. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Conduct Authority and registered in England and Wales. © Redington Limited 2013. All rights reserved. 3