Advantages of investing in equities - 11 sep 2013

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. 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
CIO@redington.co.uk
2
1

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