BlackRock Investment InstItute

RIsk anD ResIlIence Patterns in equity returns

sePtember 2013

[ 2 ] R I s k a n D R e s I l I e n c e

the opinions expressed are as of september 2013 and may change as subsequent conditions vary.

Edward FishwickCo-Head of BlackRock’s Risk and Quantitative Analysis Group

What is insideFirst Words and summary ......................................................................3

VoLatiLe traits ................................................................................................... 4–6

return driVers............................................................................................... 7–10 Inflation and Interest Rates ........................................................................................7 economic Growth ..........................................................................................................8 Dividends and earnings ................................................................................................9

currencies and capital structure .............................................................................10

ComPLiCation: CorreLations ....................................................11–12 correlations and Returns ..........................................................................................11 Portfolio allocation .....................................................................................................12

the Curious Case oF LoW beta ..............................................13–15 volatility and Bondification ............................................................................... 13–14 low-volatility Paradox ................................................................................................15

}high correlations do not always mean similar returns—or low dispersion of returns.

}Low volatility has outperformed— but is vulnerable to rising rates.

}index averages mask huge disparities between countries, sectors and companies.

}Currencies have a big impact on equity returns—especially in the short run.

Sub tlE tiES

equItIes

}equities have generated strong returns over the long run (in most countries).

}Patient equity investors are usually rewarded.

}equities are much more resilient to inflation than bonds—but not bulletproof.

}Company fundamentals are prime drivers of returns in the medium term.

PROS CONS VS

Ewen Cameron WattChief Investment Strategist, BlackRock Investment Institute

Russ KoesterichBlackRock’s Global Chief Investment Strategist

}Losses of 30% or more occur once a decade on average in us equities.

}most equity markets have lagged us returns.

}equities are volatile compared with company fundamentals and the business cycle.

}Prices can take a long time to catch up with corporate performance.

P at t e R n s I n e q u I t y R e t u R n s [ 3 ]

the new millennium has not been kind to equity investors. two market crashes soured many on the equity markets. some cut their allocations to equities, and others deserted the stock market altogether.

a global rally from the depths of early 2009 has made up for the losses on paper—but it has not felt like a bull market to many investors. bonds became the kings of the new millennium. they generated higher returns than equities—with a lot less volatility.

history suggests it is premature to throw in the towel.

First Words and summary

stocks have always been volatile. Losses of 30% or more have occurred roughly once a decade in us equity markets—and more in some other countries.

yet patient investors are usually rewarded for staying the course—provided they are able and willing to stick around long enough for prices to catch up with improving corporate earnings and balance sheets. Warning: it can be a long wait.

What are the rules of this waiting game? We highlight the inherent risks of stocks, detail drivers of equity returns and flag complexities such as correlations and the paradoxical outperformance of low-volatility strategies.

We do not discuss whether it is a good time to buy equities—read our investment outlooks for those insights. nor do we propose a grand theory on equity markets. instead, we provide pieces of a dynamic puzzle that investors will want to solve themselves:

} Inflation: equities tend to do well when inflation is in the sweet spot of 2%–3% or lower. if inflation accelerates (especially over 4%), real returns dive—but equities still outperform bonds. bonds rule in (severe) deflation.

} Real interest rates: high real interest rates usually herald high equity returns and vice versa. one explanation: the higher the real rate, the higher the premium equities must offer to entice investors.

} Reinvested dividends: they account for the majority of equity returns in the (very) long run. yet corporate earnings trends and financial conditions drive returns in shorter timeframes, overshadowing dividends.

} currencies: Foreign exchange swings can make all the difference in the short term—especially in emerging markets. Currency volatility tends to affect real returns less over longer time periods.

} success bias: most equity analyses are skewed toward us data. Long-term investors did not fare nearly as well in most other countries.

} Growth (1): the level of economic growth matters little for equity returns in the long run.

3 E

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inflation, interest rates, growth, currencies, correlations and volatility can affect returns in surprising ways.

investors willing to hold equities for 10 years or more have a high chance of earning a positive real return.

equities are volatile—and have been throughout history. Get used to it.

1 equities are risKy 2 PatienCe

Pays oFF 3 diG beneath the surFaCe

} Growth (2): Growth direction and inflation levels can affect short-term returns in eye-opening ways.

} Inside the index: equity market averages mask huge disparities in performance across different countries, industries (who could forget the global tech bubble of the late 1990s?) and sizes and types of companies.

} capital structure: equity holders are last in line when it comes to corporate payouts. this means changes in the capital structure (and the cost and duration of companies’ debt) can affect equity returns.

} correlations: asset prices tend to move in lockstep during crises. this does not mean diversification is dead: assets with high correlations can deliver very different returns over time. and high correlations do not necessarily mean returns are bunched closely together.

} Free lunch?: adding a dose of equities to a bond portfolio can enhance real returns without increasing risk much.

} low-beta paradox: Low-volatility stocks have benefited from the bull run in bonds and (more recently) the “bondification” of the equity market. they may struggle when interest rates rise.

[ 4 ] R I s k a n D R e s I l I e n c e[ 4 ] R I s k a n D R e s I l I e n c e

Sources: BlackRock Investment Institute and Robert Shiller, July 31, 2013.Notes: Chart shows drawdowns in nominal terms from the high in the previous five years. With contributions by Steve Satchell of Trinity College Cambridge.

DRaWDoWns all tHe tImes&P 500 Drawdowns From Five-year Highs, 1871–2013

0%

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1871 1891 1911 1931 1951 1971 1991 2013

Dot.comBust

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1970sstagflation

WWI aftermath

Financialcrisis

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Sourcebook 2013.Note: Returns are net of US Treasury bill rates.

tHe GooD, tHe BaD anD tHe uGlyexcess Returns of us equities, 1900–2012

-50 -40 -30 -20 -10 0 10 20 30 40 50 60%

1931 19331935

19581954

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200319751945193619281915

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200919971995199119851980197619671961195519501944194319381927192519241922

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20112007200519931992198619821978196819591956194819471939193419261921191619121911

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19941987198419771970196019531946194019321923

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2001200019901981196919661962195719471929191419131910

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200219731920

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19001901190519091918191919421949195119521963196419651971197219791983198819891996199819992004200620102012

RETURN

Volatile traitsbear markets and big losses have been around for as long as bourses. drawdowns of 30% or more are common in the us equity market, occurring around once a decade on average since the 1870s. see the chart on the right. in extreme cases, the losses can be catastrophic. investors who bought at the market’s peak in 1929 had lost more than 80% of their (nominal) wealth by 1932. stock markets elsewhere show even greater volatility.

despite harrowing drawdowns, the past century has been (mostly) kind to us equity investors. us stocks have delivered annualized total returns (nominal) of 9.4% since 1900, according to London business school (Lbs) research. in slightly more than two-thirds of years, returns were positive. annual excess returns (returns above the “risk-free” rate on us treasury bills) of 10%–20% have been the most frequent pattern. see the chart below.

these averages, however, mask huge variations within any year and from one year to the next. returns ranged from a 44% loss in 1931 to a 57% gain in 1933. and these extremes were tame compared with the experience of some equity investors elsewhere. Japanese and German stocks, for example, were pummeled during World War ii and its aftermath, with losses of 96% and 88%, respectively, between 1939 and 1948 (after accounting for inflation).

MANiAS AND PANiCS What causes the bumpy ride? equities are much more volatile than bonds because their future cash flows are much more uncertain (most bonds pay fixed coupons). shareholders are last in line to be paid when a company goes bankrupt—but capture most of the gains when businesses (and their cash flows) are growing. individual stock prices are ultimately determined by fundamentals such as cash flows, earnings and sales (see page 9).

in the short term, however, prices can swing wildly. reasons:

} small changes in expectations of future earnings growth (especially for high-flying growth equities) can translate into big moves in share prices.

} discount rates matter, especially for interest-rate- sensitive sectors such as utilities (see page 15).

} stock markets have been prone to manias and panics for centuries (isaac newton lost a fortune during the south sea bubble of the 18th century). Prices deviate from fundamentals as investor sentiment swings between fear and greed.

the last point is key. equities are up to 13 times more volatile than is justified by changes in fundamentals alone, research by robert shiller shows. shiller’s work triggered a flood of papers arguing against or for the findings. What is clear: equities are inherently volatile.

P at t e R n s I n e q u I t y R e t u R n s [ 5 ]

Source: BlackRock Investment Institute, June 30, 2013.Notes: The analysis uses Robert Shiller data. All returns are forward returns over the holding period indicated. Returns are from the start of the year and the midpoint. Teal indicates a positive real return while orange indicates real losses. Magnitudes of positive and negative returns are indicated by color shading, as in the legend above. The index used is S&P 500 Total Return, adjusted for US inflation as represented by the Consumer Price Index. With contributions by Steve Satchell of Trinity College Cambridge.

steaDy WIns tHe RaceForward Real Returns of us equities, 1890–2013

click for interactive data

t Real losses Real GaIns u

-72% -25% -15% -10% -5% 0% 15% 30% 70% 170% 1,072%

1890s 1900s 1910s 1920s 1930s 1940–1951

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1952–1959 1960s 1970s 1980s 1990s 2000s 2010–13

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StAyiNG tHE COuRSE bear markets do not last forever. us equities have delivered positive real returns (returns after adjusting for inflation) in almost any 20-year period since 1890—a century that included two World Wars, the Great depression and the 1970s stagflation period. see the chart above. there was one exception: the hapless investor who bought us equities in mid-1901 was down 4% in real terms two decades later.

investing in equities is an imprecise science over periods of a year or less. Fundamentals are often swamped by swings in market sentiment. investors in us stocks have made money two-thirds of the time in any given year, with an average annual return of 19% since 1890. but they lost an average of 14% a year the remainder of the time.

the risk of losses declines as investors extend their holding periods. investors suffered losses in 23% of five-year periods and 14% of 10-year periods. a small probability, perhaps, but potentially an expensive one.

Consider a retiree who invested in us equities in mid-1972. a decade later, the real value of the portfolio would have declined by 32% after inflation, which peaked at double-digit rates during that decade. if the retiree had the financial means and physical health to wait an additional decade, the loss would have turned into a real gain of 155%.

timing is (almost) everything in investing. those who buy equities near peaks in the market’s valuation (or ahead of big spikes in inflation and other calamities) have to wait a long time before seeing the value of their investments recover—especially after accounting for the impact of inflation.

[ 6 ] R I s k a n D R e s I l I e n c e[ 6 ] R I s k a n D R e s I l I e n c e

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Sourcebook 2013.

tIme Doesn’t Heal all WounDslongest Periods of negative Real Returns, 1900–2012

YEARS

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Finland

0 20 40 60 80 100

CanadaAustralia

USS. Africa

N. ZealandUK

SwitzerlandIreland

NetherlandsSweden

NorwayJapan

GermanySpain

FranceItaly

BelgiumAustria

Average Longest Period Of Losses

tHE luCKy (uS) CENtuRy the past century has been relatively kind to us investors. the united states has been the world’s largest political, military and economic force for most of the period. a stable political and legal system was fertile ground for strong equity returns. this introduces a “success bias” into the (many) studies of equity returns that rely on us data only.

equity investors in most other countries have not been so lucky. in France, italy, belgium and austria, there have been periods of 60 years or more when equity returns failed to keep pace with inflation. see the chart on the right.

the longest period of losses averaged 40 years across 20 countries, based on reliable stock market data going back to 1900. most investors cannot wait that long (especially retirees). both shareholders and bondholders were wiped out in the russian and Chinese revolutions.

this illustrates a key point. equities are usually a sound investment over the long run—but only in countries with stable political and legal frameworks. all bets are off in cases of war, revolution or government expropriation of assets.

diversification can help smooth the ride. the volatility of a basket of global equities tends to be lower than that of any individual market. Why? the global basket is exposed to a much more diversified set of economic risks than any one country. in addition, stock concentration in local markets is much higher. the 10 largest stocks comprise 60% or more of total market capitalization in australia, Germany and switzerland, and more than 80% in russia—versus only about 10% of total value in the global equity market, our research shows.

PEEK uNDER tHE HOOD

another caveat: studies of equity returns are based on broad market indices and, therefore, mask huge variations in sector performance. this is especially true in shorter time periods, when bubbles or panics can drive valuations in certain sectors far from broader market averages.

the technology segment of the russell 1000 index soared by 117% in 16 months during the late 1990s dot.com bubble. see the chart on the left. yet the broad index rose just 27% over the same period. the subsequent technology crash was similarly dramatic. investors who had been willing to pay top dollar for tech stocks marked them down to almost zero. (this type of re-rating is an important driver of equity returns, as we discuss in the next chapter.) in the five years after the tech bubble, the contraction of earnings multiples explained 54% of global stock performance. Valuation says little about the short term—but everything about the long term.

Cisco systems is illustrative. the stock peaked at almost $80 per share in march 2000. these days, its trailing 12-month earnings per share are almost four times as high as they were back then. yet Cisco’s share price has collapsed to around $23. What changed? the earnings multiple. investors happily paid more than 200 times earnings for the stock back in 2000, whereas they are willing to pay only 13 times these days.

the lesson? disparities between countries, sectors and companies are huge. as a result, different exposures can translate into radically different returns.

Sources: BlackRock Investment Institute and Bloomberg.

WHat BuBBle?us equity Performance, 1999–2001

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P at t e R n s I n e q u I t y R e t u R n s [ 7 ]

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Yearbook 2012.Notes: Study includes 19 countries and 2,128 country-year observations. Inflation levels are minimums and in percentiles of the range over the period. The top and bottom 5% occurrences are at the extremes while the remainder is grouped in percentiles of 15%.

InFlatIon HuRtsReal Returns and Inflation, 1900–2011

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8

1.94.5

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Yearbook 2013.Notes: Returns are annualized over the subsequent five years. Study includes 19 countries and 2,160 country-year observations. Real interest rates are minimums and in percentiles of the range over the period. The top and bottom 5% occurrences are at the extremes while the remainder is grouped in percentiles of 15%.

loW Rates = loW RetuRnsReal Returns and Real Rates, 1900–2012

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return drivershigh or sharply rising inflation is the enemy of equity (and bond) markets. equities have averaged a real annual loss of 12% since 1900 whenever inflation averaged 18% or more. see the chart below.

bonds are hit even harder by inflation (with the exception of bonds whose principal or yield is tied to inflation). this is because bond coupons and principal are fixed and do not adjust to compensate investors for any losses in purchasing power. equities have comfortably outperformed bonds in all inflationary environments over the past century—and even in periods of mild deflation.

Corporate profit margins often expand in inflationary periods. When inflation is rising, companies usually pass on higher input costs to consumers by raising prices (and their nominal debt loads are inflated away). Corporate revenues tend to rise at a faster clip than expenses because most companies do not like to raise wages. this is bad news for employees but good news for equity holders—up to a point. as inflation takes off, investors usually become less willing to pay up for future earnings (price-to-earnings multiples contract). hard assets such as real estate perform better in these environments, and equities suffer losses. the sweet spot for equity returns? inflation of 2%–3% or lower.

equities have averaged real returns of more than 10% in deflationary periods, the bottom chart shows. one caution: most of these instances took place in the prewar period and were extreme. For example, nominal returns on uK equities were flat in 1921. yet investors ended up with a 35% real gain due to severe deflation, Lbs data show.

recent history shows some very different results. take Japan. the nikkei 225 index is still 65% below its 1989 peak in nominal terms and Japanese policymakers have been battling bouts of deflation since the late 1990s. Caution is needed in interpreting these results, too. Japan’s equity market has descended from sky-high bubble era valuations (showing the importance of both valuations and the right entry point).

interest rates are another key to equity returns. equities tend to post strong returns in the five years after high real interest rates. see the chart above. one reason: equities are much more risky than government bonds. this means they have to offer a premium over the inflation-adjusted “risk-free” rate to entice investors. (they have to offer compelling value.) the higher the risk-free rate, the higher the hurdle for equities (and vice versa). Periods of low real interest rates, by contrast, often coincide with high inflation (but not always, as we have seen in recent years).

[ 8 ] R I s k a n D R e s I l I e n c e[ 8 ] R I s k a n D R e s I l I e n c e

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Yearbook 2010.Note: Countries are divided into quintiles by trailing five-year GDP growth rates.

HIGHeR GRoWtH, loWeR RetuRnsequity Returns by GDP Growth quintile, 1900–2009

83 Countries1972–2009

19 Countries1900–2009

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sHoRt-teRm suRPRIsesmonthly asset Returns in various Growth and Inflation scenarios, 1988–2013

Source: BlackRock Investment Institute, June 2013. Notes: Rising or falling inflation is defined by a trailing three-month average change in the US Consumer Price Index. Expanding or contracting growth is defined by the monthly level of the JP Morgan Global PMI Manufacturing Index. Data through May 2013. Returns based on indices from MSCI, Ibbotson, Merrill Lynch, Standard & Poor’s and Bloomberg.

Growth

Inflation

occurrences

Developed equity

emerging equity

us Gov. Bonds

us IG Bonds

us High yield

us mBs

energy

Gold

us cash

expanding rising 112 -0.07% 0.52% 0.94% 0.66% 0.28% 0.6% 2.49% 0.69% 0.34%

expanding Falling 101 1.57% 1.56% 0.43% 0.62% 1.25% 0.43% 1.09% 0.33% 0.28%

Contracting rising 38 -0.66% -0.80% 1.16% 0.74% 0.55% 0.76% -1.97% -0.46% 0.41%

Contracting Falling 54 0.62% 2.25% 0.70% 1.14% 0.93% 0.65% -0.53% 0.78% 0.31%

global economic expansion and declining us inflation in the past 25 years. For emerging market stocks, falling inflation has been the key driver. see the table below.

the interaction of growth, inflation and other macroeconomic factors on asset prices can have surprising results—especially in the short run. us government bonds, for example, have tended to perform well in months of rising inflation since 1988. one reason: us inflation was subdued throughout the period. in addition, global quantitative easing by central banks in recent years has kept bonds well bid.

bottom line: Growth is good for equities—but is often priced in fast. Growth can affect equity returns, depending on the time horizon, the type of growth signal and the interplay with related factors such as inflation.

OF tORtOiSES AND HARES so how can investors decide in which countries to invest? Let us start with one (discredited) strategy: buy equities of the fastest growing economies. intuition tells us faster growth should equal higher returns on equities. history tells a different story.

since 1900, the countries with the slowest trailing GdP growth have delivered the same returns as the ones that grew at the fastest clip. see the chart on the right. this counterintuitive trend has been even stronger since 1972. nominal annual returns averaged 25% a year in the slowest- growing economies, compared with 18% in the fastest. stocks in middle-of-the-road economies fared the worst.

Why? the equities of the slowest-growing countries are often shunned—just like out-of-favor value stocks that tend to subsequently outperform. by contrast, investors are often willing to pay a premium for (expected) growth. similar to growth stocks that are “priced for perfection,” equities of fast-growing countries can get overheated. betting on growth alone often does not work because markets have already factored in economic performance. only surprise growth will likely affect returns.

Fast-growing emerging economies are capital hungry. their bond markets are immature, so new (and existing) companies must issue shares to raise capital. this dilutes existing shareholders and tends to lower returns.

Globalization means bellwethers in slow-growing economies (think toyota) can boost earnings even while their domestic economy is sluggish. similarly, companies in some country indices represent only a small portion of the economy (think emerging markets).

the level of economic growth may have little impact on equity returns in the long run, but its direction (expansion versus contraction) matters in the short term—especially in combination with inflation. the sweet spot for (monthly) developed equity performance has been a combination of

P at t e R n s I n e q u I t y R e t u R n s [ 9 ]

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DIvIDenDs DomInate—In tHe lonG Runcomposition of annualized equity Returns, 1900–2012

Sources: Elroy Dimson, Paul Marsh and Mike Staunton, London Business School and Credit Suisse Global Investment Returns Sourcebook 2013.Notes: Multiple expansion measures the change in the price-to-dividend ratio.

Source: BlackRock Investment Institute, June 2013.Note: Measures contributions of growth in earnings per share, change in the price-to-earnings ratio and dividend yield to returns over rolling five-year periods. With contributions by Steve Satchell of Trinity College Cambridge.

exPlanatoRy PoWeRcontribution to Rolling 5-year mscI World Returns, 1996–2012

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DiviDEND AND RulE? the power of dividends has been drilled into investors’ minds. reinvested dividends make all the difference in equity returns over the (very) long run, many studies show.

returns on equities can be split into three components: dividend yield, divided growth (after inflation) and multiple expansion (the increase in the price investors are willing to pay for earnings or dividends). dividends usually increase over time, in line with corporate earnings and cash flows. outcomes across countries vary significantly, but overall dividends have accounted for four-fifths of equity returns since 1900. see the chart below.

yet there is a rub: equities are volatile. market swings can swamp the impact of dividends in any single year—many times over. many investors don’t have the luxury or patience to wait decades for their dividends to compound. in addition, companies reinvest their capital to boost growth (some more successfully than others). Google has increased its share price around tenfold since it went public in 2004—without paying a cent in dividends.

take a simple example of a portfolio of two $100 stocks. one pays no dividend and rises 10%. the other has a 5% payout but drops 10%. the total return on this $200 portfolio is 2.5%—with the dividend yield equaling 100% of the return. yet which stock would you rather have owned?

EARNiNGS REAlly RulEFundamentals—metrics that gauge corporate performance—usually win in the medium term. Changes in corporate earnings explain around two-thirds of relative stock performance in the msCi World index since 1996 measured over five-year periods, our research shows. dividends explain just a small sliver. see the chart above.

equity valuation is not all about earnings. it is also about how much investors are willing to pay for those earnings. When investors are feeling exuberant, they are often willing to pay more for stocks (and vice versa). the multiple expansion (or contraction) explains half of the msCi World’s performance in some five-year periods.

this makes life a bit more complicated for equity investors. it is hard enough to correctly forecast a company’s earnings. it is near impossible to predict the mood of investors and how much they will be willing to pay for a company’s earnings in the future. multiples can contract across the board in periods of risk aversion. even companies with strong fundamentals are punished then—at least temporarily.

yet even when investors awarded many companies rich valuations in the late 1990s, changes in earnings still accounted for the majority of returns over five-year periods. the recent bull market has been underpinned by a steady rise in earnings, as the chart shows.

Conclusion: dividends account for just a fraction of equity returns over (relatively short) periods of five years. earnings trends and shifts in market sentiment are the real movers.

[ 1 0 ] R I s k a n D R e s I l I e n c e[ 1 0 ] R I s k a n D R e s I l I e n c e

FluMMOXED by FX Foreign exchange swings can make all the difference in equity returns—especially in the short to medium term. the currency impact takes place on two levels:

1. When investors hold foreign assets, currency fluctuations will affect returns in their base currency. uK equities, for example, have gained 41% over the past five years. yet the return was just 19% for us dollar investors as the british pound steadily fell over the period.

2. Currencies also directly influence asset prices. a strong us dollar, for example, tends to hurt emerging market assets, as detailed in What’s Developing in april 2013. Currency movements can also affect corporate earnings and valuations. a strong yen, for example, has historically hurt Japanese equities.

the impact of exchange rate swings appears to subside in the long run as currencies adjust to relative inflation rates. annualized local equity returns have not differed markedly from us dollar returns in real terms since 1900, Lbs data show. the reason: real exchange rates averaged a change of less than 1% a year versus the us dollar in the period.

australian equities, for example, generated annualized real returns of 7.3% from 1900 to 2012, Lbs data show. the australian dollar gained an annual 0.12% against the us dollar over the same period, so the total return to a us investor would have been 7.42%. yet over shorter time periods, the currency impact can be crucial. Consider the aussie moved 45% in nominal terms from peak to trough against the us dollar in the past five years.

to hedge or not to hedge? there is no clear-cut answer. Considerations include:

} the investment horizon is key. Currency exposure appears less risky in the long run than in the short term.

} Currency risk can be greatest in the medium term, if recent history is any guide. Currency fluctuations contributed an average of 14%-16% to equity risk across 27 countries in rolling periods of up to 2 years since 2001, our research shows. yet over five- and 10-year rolling windows, they averaged 27% and 21%, respectively. Caution: the benefits of hedging on average disappear after 8 years when using longer data series (40 years or more), Lbs research shows.

} there is a cost to hedging—which adds up over time. hedging where you need it most (in emerging or illiquid markets) is often expensive.

} hedging is not not always the most effective way to reduce currency risk. diversification through holding assets in multiple currencies can reduce volatility.

caPItal stRuctuRess&P 500 metrics and Global credit maturity, 2003–2013

Sources: BlackRock Investment Institute and Bloomberg, August 2013. Notes: The S&P 500 metrics are per share as of the end of June each year. The average corporate bond maturity is represented by the corporate credit component of the Barclays Global Aggregate Index.

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s&P 500 metric 2003 2008 2013

Free cash Flow $45 $68 $112

eBItDa $134 $211 $203

Book value $341 $530 $680

net Debt $642 $977 $383

P/e Ratio 20 17 16

RiSiNG FROM tHE bOttOM Changes in corporate debt levels and servicing costs can also influence equity returns. equity holders are at the very bottom of the capital structure, giving them a claim on corporate cash flows only after all creditors have been paid off. the value of the equity claim rises if the company reduces obligations to debt holders.

how does this work in practice? Consider some recent history. Companies have been strengthening their balance sheets and reducing leverage since the 2008 financial crisis. the net debt of s&P 500 companies, for example, has fallen 61% in the period. see the table below.

With less debt on their books (and interest rates at historically low levels), companies are spending less on debt service—and have more left over to pay shareholders in the form of share buybacks and dividends. Companies have also been refinancing much of their debt (cheaply), pushing maturities further into the future. see the chart above. this has the potential to enhance shareholder value.

similarly, companies (and equity returns) have to be viewed in conjunction with the economy. if governments spend freely (as many have done since 2008), corporate cash flows and margins can get a boost. this virtuous circle may reverse when governments tighten their belts.

P at t e R n s I n e q u I t y R e t u R n s [ 1 1 ]

Complication: Correlations

coRRelatIon DIsconnecteuropean equities: correlations and cumulative Returns, 2011–2012

Sources: BlackRock Investment Institute and Bloomberg.Notes: Country returns are in euros and based on respective MSCI indexes for each country. Correlations are based on weekly returns and measured over the period July 1, 2011, to July 6, 2012.

0%

-80

-60

-40

-20

Greece

Portugal

Italy

spain

Ireland

tOtA

l R

Etu

RN

Jul 2011 Jan 2012 Jul 2012

Ireland Italy spain Greece Portugal

Ireland100% 90% 86% 50% 71%

Italy90% 100% 95% 55% 81%

spain86% 95% 100% 51% 82%

Greece50% 55% 51% 100% 55%

Portugal71% 81% 82% 55% 100%

diversification—across different sectors, companies and asset classes—can lessen volatility. the problem: When investors need diversification most (during financial crises), correlations tend to rise sharply.

asset prices moved in lock-step, often in violent “risk-off/risk-on” swings during and in the aftermath of the global financial crisis. this pattern dominated global markets until signs of a shift emerged this year, as detailed in Exit, Entry and Overshoot in June 2013.

When equities, credit markets, commodities and currencies collapse at once (as they did in 2008), even diversified portfolios will likely stomach losses. the financial crisis showed real diversification is tough to come by.

another simple, but often overlooked point: high correlations between two sectors or asset classes do not necessarily mean similar returns. highly correlated assets can rise and fall pretty much in tandem—but the result of these moves can be very different over time. Correlation is not causation.

the equities of Greece and other european peripheral markets are a good example. investors deserted these markets in droves in 2011 on worries these nations could not refinance their huge debt loads.

Correlations spiked. irish and italian equities traded with a weekly correlation of 90% in the one-year period. see the table below.

yet their performance was vastly different. irish stocks declined just 3.3%, while italian stocks collapsed 37.5%. see the line chart below. neighbors Portugal and spain had a lower correlation of 82% over the same period, but their equity markets posted almost identical returns.

the conclusion: Correlations can be misleading in predicting returns. they show direction, not magnitude.

it’S COMPliCAtEDCorrelations can also change dramatically over time. Correlations between us large cap equities have ranged from less than 10% to more than 50% over the past three decades. they hit the lowest levels since 2007 this year. see the left chart on the following page. the trend was even more pronounced in global markets: Correlations on the msCi World recorded 7%, also a six-year low.

surely this must be a great time for stock pickers? Fundamentals such as corporate earnings reign supreme when equities are not moving in lockstep—and positive earnings are usually rewarded with higher share prices. Know your companies, and you will outperform, the theory goes.

the reality is a little more complicated. Low correlations do not necessarily translate into a wider dispersion of returns than in other periods, our research shows. and high correlations do not herald a bunching up of returns. the reason? Periods of market stress (and high correlations) are usually characterized by outsized returns.

[ 1 2 ] R I s k a n D R e s I l I e n c e[ 1 2 ] R I s k a n D R e s I l I e n c e

a FRee luncH? Return-to-Risk Ratio for uk equity/Bond Portfolios, 1899–2012

When correlations of russell 1000 stocks were highest in the past 25 years, dispersion (in the interquartile range—the middle 50%) was actually at its widest. see the right chart above. this means active investors cannot blame high correlations for poor (relative) performance.

Sources: BlackRock Investment Institute and Barclays Capital, August 2013. Notes: The chart shows the annualized risk-return ratio for various blended gilt/equity portfolios over five-year periods. The ratio is derived by dividing the portfolio’s annualized return by the annualized volatility.

stock PIckeRs Welcome correlations and Return Dispersions of us large caps, 1989–2013

Sources: BlackRock Investment Institute, Russell Investments, IDC and Thomson Reuters, August 2013.Notes: Chart shows the average correlation of pairs of stocks in the Russell 1000 over a 12-month window. Data are monthly through July 2013 and equal weighted. The bars on the right chart represent the interquartile range, or middle 50%, of 12-month Russell 1000 stock returns in each correlation decile over the 1989 –2013 period.

0

50%

40

30

20

10

CORR

ELAT

ION

1989 1995 2001 2007 201340%200-20

DISPERSION OF 12-MONTH RETURNS

LOW

HIG

HC

OR

RE

LATI

ON

Median Return

.13

.33

.23

RE

TUR

N-T

O-R

ISK

RAT

IO

ALL BONDS ALL EQUITIES50/50

Literature about asset allocation could fill the (classical) alexandria library. We limit ourselves to one simple point: even conservative investors can benefit from adding some equities to their portfolios. take a uK investor with a portfolio invested 100% in gilts. allocating a moderate portion to equities would have increased returns without adding much volatility over the past century. see the chart on the left.

the reason? equities and bonds tend to move in opposite directions. this helps smooth the ride for investors. a caveat: Correlations between asset classes are not static. if bonds and equities start moving in lockstep (as they did from the late 1960s through the early 1990s), the portfolio suddenly looks a lot more risky. the benefits of diversification also fade as the equity portion rises: risk-adjusted returns hit a ceiling once equities made up more than half of the portfolio.

ADDiNG RiSK … but StAyiNG SAFE

more correlation food for thought: the dispersion of returns is pretty stable regardless of the level of correlations between different companies. in other words, good stock pickers should be able to outperform regardless of the market environment—in theory, at least.

P at t e R n s I n e q u I t y R e t u R n s [ 1 3 ]

the Curious Case of Low beta

Source: BlackRock Investment Institute and Bloomberg, July 31, 2013.Notes: Nominal returns. Based on benchmark indexes from MSCI, Barclays, Citigroup and JP Morgan.

tHe volatIle mIllennIum annual Returns and volatility, 2000–2013

AN

NU

AL

RET

UR

N

ANNUAL VOLATILITY

10%

8

6

4

220%0 5 10 15

Emerging Market Debt

Emerging Market Equity

Developed Market Equity

US Cash

Developed Government Debt

Global Investment Grade Bonds

US High Yield

Inflation-Linked Debt

Sources: BlackRock Investment Institue and Investment Company Institute (ICI), July 31, 2013.Notes: Combines cumulative flows into actively managed US funds (ICI data) and into US-listed exchange traded products (BlackRock data).

BonDs Rule(D)cumulative money Flows Into us Funds, 2005–2013

$1,500

bil

liO

NS

money market

Fixed Income

equity

1,000

500

0

2005 2007 2009 2011 2013

When stocks rise, investors forget just how volatile equities can be. they are rudely awakened every once in a while (usually when the consensus says equities are a sure thing).

the new millennium dealt investor psychology not one, but two blows: two market crashes with peak-to-trough losses of more than 40% (the collapse of the tech bubble and the global financial crisis).

many investors ran for the (apparent) safety of bonds. Cumulative money flows into us fixed income funds and exchange-traded products have exceeded flows into us equities by a factor of 2.4 since 2005. see the chart below.

the real story has been a $1.3 trillion outflow from us money market funds since risk assets hit bottom in early 2009 and rates headed mostly lower, as detailed in Forget Rotation: Think Risk Mitigation in February 2013.

us bond funds attracted $1.2 trillion over this period whereas equities drew a measly $234 billion. this is why the current equity market rally—which saw the s&P 500 more than double from its 2009 lows—does not feel like a bull market: many investors missed the boat.

A lOSt DECADE? Who can blame disillusioned equity investors? developed market equities have delivered paltry annual returns of just 3.5% since 2000—barely enough to keep pace with inflation. see the chart above. equities underperformed every major bond market over the same period.

even worse: equities were far more volatile. developed market stocks, for example, notched average volatility of 17% a year. only emerging market stocks were more volatile, but only by less than one percentage point.

by comparison, the riskiest bond market sector (emerging market debt) delivered annual returns of 10%, with just half the volatility of developed equities. us high yield bonds delivered double the annual return of developed stocks at less than a third of the volatility. the result: many investors lost faith in equities.

shift the time period, and the case for equities looks much stronger. equities had comfortably outperformed 10-year government bonds in both the united states and the uK over periods of 1, 3, 5, 10, 20 and 30 years by the end of august 2013. us equities beat treasuries by 37 percentage points in the last decade, while uK stocks outperformed gilts by 53%.

how is that for a lost decade in stocks?

it underscores the importance of the right entry point—as well as the dangers of focusing on standard return periods (or track records).

[ 1 4 ] R I s k a n D R e s I l I e n c e[ 1 4 ] R I s k a n D R e s I l I e n c e

Sources: BlackRock Investment Institute, Kenneth French and Federal Reserve Bank of St. Louis.Notes: Total returns in five-year rolling Sharpe ratios. Returns are annualized and minus the yield on three-month US Treasury bills. Bonds are represented by 10-year US Treasuries. Equities are represented by the Fama/French model. Data through June 30, 2013.

RetuRns tHat Really matteRRisk-adjusted Returns of us equities and Bonds, 1959–2013

SHA

RPE

RAT

IO

0

-0.5

-1

1.5

1

0.5

US Equities

US Bonds

20131959 1970 1980 1990 2000 2010

Sources: BlackRock Investment Institute and MSCI Barra.Notes: The chart shows the difference in cumulative return between the top 10 and bottom 10 beta industries in the MSCI Barra US Equity Model over the period. Industries without full histories are excluded. The gold and oil services industries are excluded from the low-beta basket because their volatility exceeds the broad market’s. Monthly data through May 31, 2013.

loW Beta WIns—FoR noWcumulative excess Return of low-Beta us equities, 1973–2013

0

20

40

-10

60%

CUM

ULA

TIVE

RET

UR

N

1973 1983 1993 2003 2013

vOlAtility bluES Volatility is rarely enjoyable. markets tend to climb slowly and steadily—but fall with a thud.

equities have always been more volatile than bonds, but have generated enough returns to compensate investors for the anxiety. risk-adjusted us equity returns (excess returns divided by volatility) consistently beat those of bonds from 1960 to 2000. see the chart below. this was especially true in the 1970s, when bonds were slammed by double-digit inflation.

the trend reversed in the new millennium, with bonds recording superior risk-adjusted returns. investors took notice. Low returns are bad. Low returns with high volatility are worse. new regulations also encouraged financial institutions to minimize asset volatility, making it harder to maintain large equity allocations.

Pension funds have shuffled more money into bonds over the past decade. european pension funds have reduced their equity allocations to below 40%—the lowest level in at least 10 years, according to consulting firm mercer. bonds provide greater certainty of future cash flows, making them ideal for matching long-term liabilities.

but it is not a one-way street for bonds. With interest rates near record lows, bond yields had only one way to go: up (and prices down). equities looked poised to start offering better risk-adjusted returns.

bONDiFiCAtiON

equity market volatility not only sent many investors scurrying for the safety of bonds; it led some to reshuffle their equity allocations as well. investors flocked to dividend stocks, defensives and “quality” equities with steady earnings and low volatility.

Low-volatility, or “low-beta” strategies outperformed more volatile equities. excess returns from the first group accelerated in the new millennium. see the chart above.

this “bondification” of parts of the equity market led to stark performance differences. the minimum-volatility counterparts of equity indices outperformed their plain- vanilla peers—with much lower volatility. see the chart on the left of the next page.

the new mantra of equity investing became: Low risk = high return.

this poses a conundrum for standard investment thinking. theory says the expected return of an equity should be proportional to its risk over time. riskier (or “higher-beta”) equities should offer investors greater returns over time to compensate for their higher volatility (and vice versa).

yet the investor experience has been different—at least in recent times.

P at t e R n s I n e q u I t y R e t u R n s [ 1 5 ]

Sources: BlackRock Investment Institute, MSCI and Standard & Poor’s.Notes: Data from June 28, 2003, to June 28, 2013. Total returns and volatility are annualized and in US dollars.

WHen RIsk Doesn’t Payminimum volatility Indices, 2003–2013

AN

NU

ALI

ZED

PER

FOR

MA

NCE

ANNUALIZED VOLATILITY

20%

15

10

525%10 15 20

MSCIEmerging Markets

MSCIWorld

MSCIEurope

S&P 500

MSCI EM Minimum Volatility

MSCI WorldMinimum Volatility

S&P 500 Minimum Volatility

MSCI Europe Minimum Volatility

PoWeReD By Ratesus utilities Price-to-Book vs. s&P 500, 1997–2013

Sources: BlackRock Investment Institute and Bloomberg, August 2013.Notes: The relative price-to-book (P/B) ratio is the P/B of US utilities divided by the P/B of the S&P 500 Index. Real rates are represented by the yield on 10-year Treasury Inflation-Protected Securities (TIPS). Monthly data through July 31, 2013.

REL

ATIV

E PR

ICE-

TO-B

OO

K R

ATIO

10-YEAR TIPS YIELD

90%

80

Jun 30, 2008

Dec 31, 1999

Jul 31, 2013

70

60

50

40

305%0-1 1 2 3 4

EXPlAiNiNG tHE uNEXPlAiNAblE Why has taking risk not paid off? the bondification of the equity market is part of the answer. in periods of large interest rate changes, relative repricing of low- and high-volatility strategies may drive performance. We can think of this as a kind of “equity duration.”

Consider two hypothetical companies: an oil explorer and an electric utility. the oil explorer offers a risk premium (after inflation) of 10%, compared with 2% for the utility. the explorer has a big potential payoff if it strikes oil—but this is a big “if.” the regulated utility offers more predictable cash flows, but much lower returns.

Source: BlackRock Investment Institute, August 2, 2013. Notes: Hypothetical utility with a real risk premium of 2% and oil explorer with a real risk premium of 10%. For illustrative purposes only.

tHe Real multIPlIeR eFFectHypothetical stock Performance as Rates Decline

$400utIlIty

real risk Premium=2%

real risk Premium=10%oIl exPloReR

300

200

100

PRiC

E O

F SE

CuR

ity

6 5 4 3 2 1 0%

Real RIsk-FRee Rate DeclIne

When interest rates decline (making it harder to earn attractive income from bonds), the utility’s stable cash flows become more valuable. investors bid up the utility’s shares in a grab for yield. see the chart on the top right.

this is not just theory. the valuation of us utilities (represented by the price-to-book ratio) has moved in the opposite direction of real interest rates since 1997. see the chart on the bottom right.

a shift in the risk-free rate is an afterthought for the oil explorer. the most important driver of this company’s stock is whether or not it strikes oil. (unless the explorer carries a huge debt load: debt becomes cheaper to finance and easier to roll over when risk-free rates drop.)

What happens when interest rates rise?

Low-beta plays could become a lot tougher—and less rewarding. Volatile assets could once again start compensating investors for the additional risk (and anxiety) they take on.

Not FDiC insured • May lose value • No bank Guarantee

exeCutiVe direCtorLee Kempler

ChieF strateGist ewen Cameron Watt

exeCutiVe editorJack reerink

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