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Equity Perspectives

In August 2018, we used scenario analysis to quantify the potential market impact of an escalation in the Italian political crisis.

 

In Brief:

  • Portfolio managers regularly need to determine how different stocks will perform in various market environments; scenario analysis can help.
  • Projected returns are not predictions that a scenario will play out exactly as modeled.  The return estimates are meant to offer a sense of magnitude of the risks that a portfolio faces.
  • One potential advantage of using custom-built models like Lord Abbett’s is that these models can generate nuanced scenarios that third-party models cannot accommodate.

 

Portfolio managers regularly need to determine how different stocks will perform in various market environments. For example, most investors agree that “bond proxies,” such as utility stocks, are likely to underperform if interest rates rise. The magnitude of these stocks’ underperformance and the implication of their returns for a given portfolio, however, are an open question. At Lord Abbett, we use a variety of techniques to help investment managers understand the risk profiles of their portfolios. One of these techniques is scenario analysis.

Scenario analysis involves making forecasts about stocks’ performance in different states of the world.  These states of the world can be characterized by macroeconomic conditions, assumptions about factor behavior, or specific narratives.

 

Scenario analysis involves making forecasts about stocks’ performance in different states of the world.

 

Depending on the scenario, we use different statistical techniques to project stocks’ returns.  For example, if one is interested in a scenario in which value stocks outperform growth stocks, then it is natural to rely on an equity factor model to generate the forecasts.1  Table I offers examples of Russell 1000 stocks’ projected returns for two scenarios: a Better Economy and a Growth Shock.

 

Table 1: Lord Abbett’s Model Projected the Impact of Two Scenarios on Russell 1000® Index Returns
Projected Russell 1000 Index returns by scenario, as of August 31, 2018

Source: The Russell 1000 Index and Lord Abbett.
Projections are based on Lord Abbett’s internal models.  Other models may generate very different projected returns. The return figures shown are meant to offer examples of scenario analysis calculations and are not forecasts of future returns.

 

The “Better Economy” macroeconomic scenario is characterized by greater risk appetite. Thus, it makes intuitive sense that financials outperform while utilities underperform. The “Growth Shock” factor-based scenario is designed so that value outperforms growth. Unsurprisingly, slow-growth telecom stocks generate higher returns than fast-growth information technology stocks.

 

The return estimates are meant to offer a sense of magnitude of the risks that a portfolio faces.

 

Projected returns like those in Table I are not predictions that a scenario will play out exactly as modeled.  The return estimates are meant to offer a sense of magnitude of the risks that a portfolio faces.  For example, a 10% overweight to financials funded by a -10% underweight to consumer discretionary stocks would generate an excess return of 0.6% in the Better Economy scenario [= 10% × (financials return – consumer discretionary return)]. A portfolio manager can combine his or her views on individual stocks, projected returns from various scenarios, and other risk metrics to build a portfolio that has a desired risk and performance profile.

Example: Scenario Analysis Applied to Italian Political Risk
Lord Abbett’s scenario analysis machinery is very flexible, and we regularly use it to identify new, stylized risks. One potential advantage of using custom-built models like Lord Abbett’s is that these models can generate nuanced scenarios that third-party models cannot accommodate.

For example, toward the end of August 2018, we examined stocks’ exposure to the Italian political crisis at that time.  This exercise was motivated by the instability of the Italian ruling coalition and uncertainty about Italy’s continued membership in the European Union. Table 2 presents shock estimates for MSCI ACWI ex US stocks in two Italy-related scenarios: Political Panic and Risk-Relief.

 

Table 2. Lord Abbett’s Model Examined Stocks’ Exposure to Italian Political Risk
Projected MSCI ACWI ex. U.S. Stocks' returns by scenario, as of August 31, 2018

Source: The MSCI ACWI (All Country World Index) ex-U.S. Index and Lord Abbett.
Projections are based on Lord Abbett’s internal models. Other models may generate very different projected returns. The return figures shown are meant to offer examples of scenario analysis calculations and are not forecasts of future returns.

 

The “Political Panic” scenario is meant to capture the market impact of an escalation in the Italian political crisis.  Italian stocks, particularly banks, underperform in this scenario since these names are most exposed to domestic political turmoil. The “Risk Relief” scenario assumes that investors perceive less of a threat from Italian politics. The MSCI ACWI ex US rises 4.7% in this scenario and Italian stocks outperform. Table 2 shows that UK stocks only rise 0.5% in the Risk Relief scenario, presumably because  less Italian political risk need not imply less uncertainty stemming from Brexit.

Other Scenarios
In the recent past, we also have examined the potential market impact of higher inflation, increased trade tensions, and crude oil supply-related shocks. We have found that bespoke quantitative analytics are useful for making actionable recommendations to portfolio managers, analysts, and other stakeholders.

 

By construction, low-probability scenarios imply that some stocks will generate large returns.

 

Concentrated Strategies
We typically design scenarios to correspond to probabilities of less than 5% over a quarter. By construction, low-probability scenarios imply that some stocks will generate large returns. Small probabilities of large losses are of particular concern to investors in concentrated strategies. A large loss on an individual stock may have a material impact on the long-term performance of a concentrated strategy.  Thus, a portfolio manager may want to reduce holdings in such a stock if he or she believes that a given scenario, or some similar state of the world, is more likely than the data suggest.

At Lord Abbett, scenario analysis is one of the many tools that we use to quantify portfolios’ risk profiles.  We believe that having a variety of perspectives on a portfolio’s historical behavior and future prospects offers a robust way to manage risk and improve performance.

 

1 Read more details about Lord Abbett’s use of factor models here

 

Glossary of Terms

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The MSCI ACWI (All Country World Index) ex-U.S. Index is a subset of the MSCI ACWI Index.  The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.

Source: MSCI.  MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein.  The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products.  This report is not approved, reviewed or produced by MSCI.

According to the Oxford Handbook of Quantitative Asset Management, the use of equity factor models is increasing significantly within the institutional asset management community. They are routinely used to estimate the potential benchmark relative returns of equity securities and portfolios. Equity factor models offer numerous advantages over simple historical observation in providing understandable linkages between security characteristics and subsequent returns, and filtering out much of the random noise affecting returns. Most importantly such models help clarify the distinction between return generating processes that impact a particular security, and processes which are in common across many firms.

The information provided here is for general informational purposes only. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual re turns or results will not be materially different from those described here.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Small and midcap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid cap companies typically experience a higher risk of failure than large cap companies.  Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.  Investing involves risk, including possible loss of principal. Diversification does not guarantee a profit or protect against loss in declining markets. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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