In the February edition of the Open Access Blog we present our investment returns compared to the benchmark returns for periods ending December 31, 2017. On reviewing the results you will note that over most time frames our returns have exceeded the benchmark return. This leads into a discussion regarding the composition of the benchmark and how risk adjusted returns are calculated. We then turn to current American monetary policy, the end of Quantitative Easing, and the effect it has had on asset values globally. Finally, there is a description of the tools used to measure valuation levels of common stocks and why now may be a time to be cautious about common stock prices.
The prime objective of our investment team is to consistently produce investment returns that exceed that of a benchmark which is created from common stock and fixed income indices in similar proportions to the asset mix of the OAL CAP portfolio in question. The second objective is to assume an equal or less amount of investment risk than that of the benchmark as measured by the standard deviation of the quarterly returns.
Click here to view our December 2017 returns
Managing Investment Risk
The standard deviation of quarterly returns is a commonly used measure of investment risk in the industry, and while not perfect it does serve a purpose by enabling the industry to compare “risk-adjusted” investment returns. For example our CAP portfolio #6 has an equity band of a minimum of 50% and a maximum of 70% in common stocks. The amount invested in common stocks is divided between Canadian, American, and non-North American equities based on valuation levels in each of the geographic areas, and to mitigate investment risk through diversification. As a result the common stock portion of the benchmark is 60%, which represents the mid-point between the minimum and maximum common stock commitment, and is divided between three indices; the S&P/TSX Composite Index covering Canadian common stocks, the S&P 500 Index covering US common stocks, and the MSCI EAFE Index covering common stocks in Australia, Europe and the Far East.
The fixed income portion of CAP portfolio #6 has a minimum of 30% and a maximum of 50% in cash and bonds, and therefore the fixed income portion of the benchmark is 40%, which represents the mid-point between the minimum and maximum fixed income commitment and consists of the following three indices; the DEX 91 day T-Bill Index, the DEX Short Term Bond Index, and the DEX Universe Bond Index.
Calculating Risk Adjusted Returns
This benchmark enables our investment team to measure how they are doing and to compare risk adjusted returns with other funds using the 3 or 5 year Sharpe Ratio. The Sharpe Ratio is a formula that produces a risk adjusted return and is calculated as follows: The Sharpe Ratio for a fund is the total compound annual rate of return minus the compound annual rate of return for 91 day T-Bills, with the resulting return divided by the standard deviation of the monthly returns for the fund. For example:
At first glance it would appear that the Benchmark out-performed the Fund (7.6% to 7.5%) over the 3 year period, however after taking investment risk into consideration, the Sharpe Ratio indicates the Fund out-performed the Benchmark (1.02% to 0.94%) on a risk-adjusted basis.
Quantitative Easing and the Effect on Asset Valuations
Turning to the financial markets it appears to us that the Quantitative Easing (“QE”) undertaken by the US Federal Reserve to avoid a serious economic correction in 2008 has created a number of distortions that will need to be worked out of the system gradually over an extended period. This policy of purchasing bonds in the marketplace started in late 2008 and lasted until 2014 during which period the Federal Reserve acquired over $3 trillion of fixed income securities expanding their holdings from less than $1 trillion to over $4 trillion. This is a massive injection of liquidity into the economy and has likely created distortions in asset valuations. Distortions, such as common stock prices, home values and commodity values all of which are up substantially over the last 10 years. Vividly showing investors what can happen when asset values are surging within a bubble. Frightening sidelights to the Fed’s QE issues are; the inflationary outlook and a possible spike in consumer prices, the prospect of higher interest rates as the Federal Reserve "right-sizes" its balance sheet and a reduction in the policy initiatives available to the Fed should inflation surge because of their need to sell bonds.
How Common Stock Valuations are Compared
When we look at common stock prices we do so through a historical lens, comparing today’s valuations with where valuations have been over the past 5 or 10 years. The data is then presented relative to the past median valuation levels and referred to as a Z-Score. The following chart shows the Z-Score for a number of common valuation measures for the Canadian, American and EAFE markets.
To conceptualize this comparison, picture a normalized bell curve consisting of the monthly P/E ratio of a market index for the last 10 years, in other words 120 data points. On the left is the lowest P/E ratio, on the right is the highest P/E ratio and somewhere close to the middle is the mean P/E ratio. On either side of the mean is a vertical line representing + or – 1 standard deviation. By definition 68.2% of the P/Es fall between these two vertical lines. Now picture two more vertical lines representing + or – 2 standard deviations, and again by definition 95.4% of the P/Es fall between these two outer vertical lines. Therefore if the current P/E ratio fall outside of the second vertical line on the right, it is in an area that has only occurred 2.76 times out of 120 occurrences over the last 10 years.
These numbers indicate that the S&P 500 is quite expensive by historical standards, trading at a price/earnings ratio (“P/E”) of 22.5 or close to 2 standard deviations above it historical mean, while the EAFE market is fairly priced based on a P/E that is equal to the historical mean, and S&P/TSX is moderately expensive with a P/E about 1 standard deviation above the mean. The other valuation measures tell a similar story in every case, with the exception of the Canadian price/cash flow measure that is trading below the historical mean.
When common stock valuations push into the stratosphere it doesn’t necessarily mean that they are going to collapse, an alternative is that sales, earnings and cash flows rebound and these valuation measures drop back to normal levels. However now is a time to be cautious and perhaps even a little risk averse. That is the reason why we have reduced the common stock exposure in each of the nine CAP portfolios.
Warren is the founder of Open Access, a company whose prime objective is to ensure plan members not only retire, but retire “well”.