How Do You Measure Risk

1/19

How do you measure risk?by Sandy McIntyre Co-Chief Executive Officer

March 2014

After five years of recovery from the global financial crisis of 2008/09, ‘risk’ is being targeted by regulators globally. By definition, when you control the attributes of risk, you limit the attributes of your return. What’s the definition of risk? According to Wikipedia...

Risk is the potential of losing something of value, weighed against the potential to gain something

of value. Values (such as physical health, social status, emotional well being or financial wealth) can

be gained or lost when taking risk resulting from a given action, activity and/or inaction, foreseen or

unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Risk perception

is the subjective judgment people make about the severity of a risk, and may vary person to person.

Any human endeavor carries some risk, but some are much riskier than others.

What I like about this definition is the sentence concerning the perception of risk. In investment terms, the most common perception of risk is linked to mark-to-market volatility of an investment’s ‘value.’ This single attribute – volatility of price of an investment – is used by investors to measure the risk of an investment.1 In my view, volatility alone is an inadequate measure of risk. Volatility may be used to justify inaction or inadequate capital allocation, and prevent an investor from accessing opportunities that are suitable for his or her actual, but unrecognized, investment requirements.

There are some elements of our response to the risks we take that are skewed by our love for positive volatility and utter surprise when exposed to negative volatility. What we experience in recent periods is what we tend to project forward as the most likely outcome. One of my Sentry colleagues refers to this as “persistence of perception.” Our current fixation on perceived risk in equity markets is based on volatility experienced through a global financial crisis and a generational low in equity markets. Our current fixation on perceived safety in fixed-income markets is based on a generational bull market in bonds supported by a fall in the 10-year government bond yield from over 15% in the U.S. and 17% in Canada (September 1981) to below 2% (mid 2012).

1 Volatility is a measure of the difference in actual returns from their central tendency (mean or average return) and incorporates returns in excess of the mean (positive volatility) and below the mean (negative volatility).

2/19

I have written at length about bear markets and causal reasons. Cyclical bear markets follow the ebb and flow of the business cycle. Secular bear markets in assets occur when the broad population and their agents are over-invested in an asset class, and become disappointed in the performance of that asset class. The liquidation of the position drives valuations down to a level that then attracts new holders at great values and the cycle begins again. A primary uptrend by its very nature requires positive volatility to exceed negative volatility.

The following chart provides some context for this statement. In the modern era, there have been three generational lows: 1942, 1974 and 2009. The market declines started with a global financial shock: World War II, Arab oil embargo and a global banking crisis. The “persistence of perception” in each case was for a continuation of negative volatility. The outcome was positive volatility for many years: a new secular bull market.

ChaRt 1:

GeneRational lows have histoRiCally been followed by new seCulaR bull maRkets

Source: Robert Shiller; Bloomberg L.P.; Sentry Investments As at March 12, 2014

1

10

100

1,000

10,000

SPX Index + - 1 STDEV Trendline 7.09% + - 2 STDEV

1942CPI 11.3%, LB 2.5%P/E 8x; Div Yld 8.7%

1973 Oil EmbargoCPI 3.4%, LB 6.4%

P/E 21X; Div Yld 2.7%

1974 LowCPI 12%, LB 8.0%

P/E 10x; Div Yld 4.2%

1987 CrashCPI 4.3%, LB 9.4%Pre: 23x Post: 15x

Div Yld 2.7%, 3.7%

Tech BubbleCPI 3.5%, LB 5.8%

P/E: 38x; Div Yld 1.1%

1932CPI -10.1%, LB 3.7%P/E 4X; Div Yld 13.8%

March 9/09 S&P 676.53CPI 0.2%, LB 2.9%, P/E: 9x; Div Yld 3.6%

1970 Vietnam LowCPI 4.4%, LB 8.2%


1982 LowCPI 6%, LB 13.6%


Subsequent Returns when you bought @ the quarterlyaverage price when 2 Standard Deviations below Trendline:

Yr5 Yr 3 Yr 1 Returns over: Q 2 1932 +61% +75% +197%Q 2 1942 +47% +83% +82%Q 4 1974 +28% +36% +52%Q 3 1982 +45% +66% +181%

+136%Q 1 2009 +39% +71%

1968 Nifty FiftyCPI 5.5%, LB 8.6%


1949CPI 24.0%, LB 2.3%


1938CPI -3.4%, LB 2.5%


Earnings used in calculations: 5 Year average of Recurring Earnings,Post 1956 Sentry Investments, Bloomberg & S&P, Pre 1956 Robert Shiller Irrational Exhuberence Data - nominal not inflation adjusted

1957 to 2012 avg P/E of 5 Yr Avg Earnings = 19.3xs

Secular Bear Markets are valuation drivenand move down across trend from high P/E to

low P/E. Secluar Bull markets are also valuation driven moving up trend from low P/E to high P/E.Cyclical market moves are contained within 1 std

deviation of trend. Trend is generated using: Excel, Data Analysis, Regression. Trend follows nominal GDP & earnings growth of approx 6.5%.

1929CPI -0.6%, LB 3.6%


2003 LowCPI 3.0%, LB 3.8%,

P/E:18x, Div Yld 1.8%1957CPI 3.7%, LB 3.9%


Oct 2007CPI 3.6%, LB 4.7%

P/E: 23x; Div Yld 1.8%

The 1974 and 2009 shocks followed excess allocation to equities at high valuations; U.S. private pension equity exposure in the first quarter (Q1) of 1972 was 61.4% of assets with a price-to-earnings ratio (PE) of over 21; U.S. defined benefit equity exposure in Q1 2006 was 62.9% of assets with a PE of over 23. There is no data for 1942. The excess exposure occurred during periods of high valuation and was liquidated into periods of low valuation: 1974 10 times earnings and 2009 9 times earnings.2 Once the asset mix shift was in place, equity exposure remained relatively stable for the next 20 years (after 1974) and has been relatively stable since 2009. (Source for data: Federal Reserve Statistical Package Z1; L.118)

2The earnings used in these calculations are the five-year average of reported earnings; an average is used to smooth volatility of business cycles.

3/19

I entered the investment industry with National Trust in the aftermath of the 1974 financial crisis. At the time, trust companies were the dominant asset managers. They managed estates and private accounts for the wealthy, as well as family trusts and foundations, and dominated the pension industry. While it barely shows on the preceding chart, a minor bear market in 1976 shook the confidence of trust company clients. Many began to question the suitability of equity investments and sought safety in the bond market. They had come to fear equity volatility.

At the time, National did a study on the volatility characteristics of the equities held for estates, trusts and agency accounts. A similar study today would arrive at the same outcome: metals, oils, information technology and health care are volatile sectors. The volatility cut-off was at a level that allowed for the inclusion of financial stocks. The study concluded that major components of our ‘benchmark’ were unsuitable for investment by a conservative investor. A similar study today would arrive at the same verdict.

Re-examining risk disclosure in the mutual fund industry

In Canada, we are in the process of reviewing risk disclosure in the mutual fund industry. Canadian Securities Administrators (CSA) Notice 81-324 has proposed refining and broadening risk classifications based on 10-year annualized standard deviation of return. The following table contrasts the existing and proposed risk classifications.

Current Proposed

Low <=6% 0% to 2%

Low to medium 6% to 11% 2% to 6%

Medium 11% to 16% 6% to 12%

Medium to high 16% to 20% 12% to 18%

High >20% 18% to 28%

Very high >=28%

If a fund does not have 10-year performance history, the volatility of the fund’s benchmark will be used as a proxy for the missing data to determine the risk disclosure.

4/19

In looking at this, I was immediately struck by the fact that there is going to be a reclassification of funds out of lower-risk categories into higher-risk categories. This prompted me to take a look at the distribution of assets in mutual funds using the 10-year standard deviation of the benchmark for each of the mutual fund categories. The data for the assets comes from the Investment Funds Institute of Canada (IFIC) and Investor Economics as at November 30, 2013. The benchmarks and standard deviation of the benchmarks are sourced from IFIC’s “Voluntary Guidelines for Fund Managers regarding Fund Volatility Risk Classification” updated to December 31, 2012. The assets by category are as follows:

5/19

The distribution of assets by risk ranking is very illuminating. Over 54% of mutual fund assets are in cash, and fixed-income and balanced mandates, with benchmark volatility that supports either ‘low’ or ‘low to medium’ risk disclosure. In aggregate, 94% of the assets would support ‘medium’ risk or lower. This implies that Canadians, in aggregate, are risk averse as a result of the financial panic. It also implies that investors are prepared to accept most managed equity portfolios as involving moderate risk.

ChaRt 2:

94% of Canadian mutual fund assets aRe Rated ‘medium’ Risk oR loweR

The distribution of assets by risk ranking is very illuminating. Over 54% of mutual fund assets are in cash, and fixed-‐income and balanced mandates, with benchmark volatility that supports either ‘low’ or ‘low to medium’ risk disclosure. In aggregate, 94% of the assets would support ‘medium’ risk or lower. This implies that Canadians, in aggregate, are risk averse as a result of the financial panic. It also implies that investors are prepared to accept most managed equity portfolios as involving moderate risk.

Chart 2: 94% of Canadian mutual fund assets are rated ‘medium’ risk or lower

6/19

The distribution of assets under CSA 81-324 is sharply different and represents a major reclassification of risk in long-established asset classes.

ChaRt 3:

distRibution of assets undeR Csa 81-324 is shaRply diffeRent

The distribution of assets under CSA 81-‐324 is sharply different and represents a major reclassification of risk in long-‐established asset classes.

Chart 3: Distribution of assets under CSA 81-‐324 is sharply different

True low-‐volatility, low-‐risk investments decline from 23.2% to 7.5%. The 15.7% of ‘low’ risk that is re-‐categorized as ‘low to medium’ completely replaces the 29.8% of funds that had been in this category and are now classified as ‘medium’ risk.’ Some fixed-‐income and most balanced funds will be categorized as ‘medium’ risk. In the equity categories, most funds will move to ‘medium to high’ in terms of risk disclosure. The major exceptions would be global with a standard deviation of 11.7% and U.S. equity with a standard deviation of 11.4%. This reclassification of risk goes against the industry’s long-‐standing understanding that most balanced portfolios have a ‘low to medium’ risk level and that most well-‐managed equity portfolios have a ‘medium’ risk profile.

One of the major consequences of this reclassification of risk will be a re-‐examination of risk tolerance at the client level. While each dealer’s compliance department will screen differently, alarms will go off when there is migration of assets into higher-‐risk categories within accounts that have a stated risk tolerance under which they had previously qualified. There is no change in how the underlying assets

True low-volatility, low-risk investments decline from 23.2% to 7.5%. The 15.7% of ‘low’ risk that is re-categorized as ‘low to medium’ completely replaces the 29.8% of funds that had been in this category and are now classified as ‘medium’ risk. Some fixed-income and most balanced funds will be categorized as ‘medium’ risk. In the equity categories, most funds will move to ‘medium to high’ in terms of risk disclosure. The major exceptions would be global, with a standard deviation of 11.7% and U.S. equity, with a standard deviation of 11.4%. This reclassification of risk goes against the industry’s long-standing understanding that most balanced portfolios have a ‘low to medium’ risk level and that most well-managed equity portfolios have a ‘medium’ risk profile.

One of the major consequences of this reclassification of risk will be a re-examination of risk tolerance at the client level. While each dealer’s compliance department will screen differently, alarms will go off when there is migration of assets into higher-risk categories within accounts that have a stated risk tolerance under which they had previously qualified. There is no change in how the underlying assets are managed by the manager. A potential unintended consequence of this will be a forced migration of investors to lower-risk strategies that may create a mismatch with their longer-term investment needs.

7/19

A more normal distribution of risk can be achieved by adding a ‘very low’ category to the Notice 81-324 ranges while eliminating the ‘very high’ range which covers very few funds and assets. Using the volatility break points under the existing Fund Facts risk disclosure would moderate movement between categories and sharply reduce the administrative burden that will result for the mutual fund dealers. This proposal would recognize the ‘very low’ risk of assets with a standard deviation less than or equal to 2%. It would also recognize as ‘high risk’ the very limited assets with a standard deviation greater than 20%.

ChaRt 4:

moRe noRmal distRibution of Risk Could be aChieved by addinG ‘veRy low’ CateGoRy and

eliminatinG ‘veRy hiGh’

are managed by the manager. A potential unintended consequence of this will be a forced migration of investors to lower-‐risk strategies that may create a mismatch with their longer-‐term investment needs.

A more normal distribution of risk can be achieved by adding a ‘very low’ category to the Notice 81-‐324 ranges while eliminating the ‘very high’ range which covers very few funds and assets. Using the volatility break points under the existing Fund Facts risk disclosure would moderate movement between categories and sharply reduce the administrative burden that will result for the mutual fund dealers. This proposal would recognize the ‘very low’ risk of assets with a standard deviation less than or equal to 2%. It would also recognize as ‘high risk’ the very limited assets with a standard deviation greater than 20%.

Chart 4: More normal distribution of risk achieved by adding ‘very low’ category and eliminating ‘very high’

8/19

Closer look at the various types of risk

Focusing on one attribute of risk – volatility – while ignoring other attributes of investment risk is myopic. What risks should be considered? While no list of risks is going to be all encompassing, an investor might want to consider some of the following in addition to mark-to-market volatility.

What is the time frame until the investor needs access to the capital? This should govern the duration risk that the investor’s portfolio can be exposed to. A 40 year old saving for eventual retirement in 25 years actually has an investment time horizon that is as long as 50 years. He should consider exposure to longer-duration assets that may well have higher price volatility. A 70 year old who is harvesting the portfolio should be considering another duration issue; will the portfolio have sufficient longevity to match her life expectancy?

liquidity is another key risk and the perceived need for liquidity can result in misallocation of capital. The 70 year old might consider staged liquidity to deal with actual cash-flow needs over a specific period, with the liquidity being rebuilt over time from a long-term total return portfolio. The 40 year old might want to consider holding sufficient cash or low-volatility investments to deal with an interruption in employment and concentrate the majority of his assets in a growth portfolio. He has time to ride out investment cycles.

transaction risk is also a key element to consider. To be blunt, retail investors trade too much and, as a result, create a chain of decisions that hinders their portfolios’ long-term growth. The introduction of low-cost exchange-traded products – think ETFs – that can be traded frequently does not help matters. The financial industry can manage assets on behalf of investors in a manner that combines integrity and a standard of care that could be deemed to be fiduciary and at a fair cost to the investor. But will investors have the self discipline to stay the course? A study of holding-period returns indicates they will not. The next chart is from Ned Davis Research and shows 10-year-holding-period returns for equities and fixed income.

9/19

Mutual fund flow data is unavailable for the entire period of this chart and Canadian holding period data is not available to me. It should be noted that maximum inflows into U.S. equity funds coincided with the peak of 10-year returns in 2000 and at maximum valuations (average PE ratio of reported earnings 28 times). Maximum U.S. outflows coincided with the trough of 10-year returns in the first quarter of 2009 and at an average PE of 12 times reported earnings. The timing of purchase and sale materially affects future returns.

ChaRt 5:

Real annualized 10-yeaR holdinG peRiod RetuRns foR stoCks and bonds

Mutual fund flow data is unavailable for the entire period of this chart and Canadian data is not available to me. It should be noted that maximum inflows into equity funds coincided with the peak of 10-‐year returns in 2000 and at maximum valuations (average PE ratio of reported earnings 28xs). Maximum outflows coincided with the trough of 10-‐year returns in the first quarter of 2009 and at an average PE of 12xs reported earnings. The timing of purchase and sale materially affects future returns.

Chart 5: Real annualized 10-‐year holding period returns for stocks and bonds

10/19

You might also conclude from this chart that from 1947 to 1981, long-term treasuries were not a safe investment. They generally provided negative annual real returns to investors. The modern era peak inflows into fixed income in both the U.S. and Canada occurred in the aftermath of the financial crisis and coincided with generally low interest rates. You cannot replicate a 10-year-holding-period return of 6%, which coincided with peak fixed-income flows, when you start with a bond yield of 3%. The flow chart is as follows:

ChaRt 6:

modeRn eRa peak inflows into fixed inCome CoinCided with low inteRest Rates

You might also conclude from this chart that from 1947 to 1981, long-‐term treasuries were not a safe investment. They generally provided negative annual real returns to investors. The modern era peak inflows into fixed income occurred in the aftermath of the financial crisis and coincided with generally low interest rates. You cannot replicate a 10-‐year-‐holding-‐period return of 6% when you start with a bond yield of 3%. The flow chart is as follows:

Chart 6: Modern era peak inflows into fixed income coincided with low interest rates

A fixation on the volatility of price also ignores the impact that inflation will have on the purchasing power of an investor’s capital. The harvest investor should examine the security of his income stream and determine if there is an element of growth in that income stream. It may force the investor to recognize that by avoiding the risk that is volatility, a new risk is introduced: lack of capital or lack of income earned by that capital. Once he realizes the personal risks being taken with his capital allocation, he can move on to the actual investment risk that he exposes his capital to. It is beyond the scope of this piece to go into detail on the investment risks.

A fixation on the volatility of price also ignores the impact that inflation will have on the purchasing power of an investor’s capital. Harvest investors should examine the security of their income stream and determine if there is an element of growth in that income stream. It may force them to recognize that by avoiding the risk that is volatility, a new risk is introduced: lack of capital or lack of income earned by that capital. Once they realize the personal risks being taken with their capital allocation, they can move on to the actual investment risk that they expose their capital to. It is beyond the scope of this piece to go into detail on the investment risks.

11/19

demographic trendsThere has been a lot of focus on demographics and the aging of the baby boomers. It has been suggested that this alone is responsible for the emphasis of the market on income-seeking investment solutions and conservative investing. When I look into the demographics, I sense some unusual cross currents. The following chart is of the population pyramid as of 1971 and 2012. It is clearly evident that the population is getting older. It is also clearly evident that the bulk of the population is not old.

ChaRt 7: an aGinG, but not old, Canadian population

These investors should consider

total-return solutions;

their accumulation time line is more than 10 years. Most are too conservative.

Source: Statistics Canada CANSIM

12/19

When you look at this, keep a couple of things in mind:

• The largest cohort in 1971 was aged 10 to 14 years and born from 1957 to 1961.

• The largest cohort in 2012 was aged 50 to 54 and born from 1958 to 1962. They are the same cohort and have another 10 to 15 years to accumulate assets before they retire.

The population can also be sorted by ‘capital users’ – children and early career adults, 0 to 39 years – and ‘capital providers’ – mature adults and retired, over 40. When you look at the data in this way, you find that in 1971, the ratio of consumers to providers was 2:1. In 2012, the ratio was 1:1. This ratio affects the price of low-risk investments; when capital is plentiful the cost of capital declines.

In the last chart, I highlighted those aged 25 to 54 inside a blue box. In 2012, there were 14.9 million Canadians in those age ranges, representing 42.8% of the population. This group has almost doubled in size over the 41 years. In contrast, the population of 55 and older is 9.7 million, representing 27.7% of the population – up from 15.8% in 1971. The population of harvest investors is clearly growing rapidly, but they represent a minority of all investors. Reclassifying risk levels and moving portions of their capital to low-risk investments will result in reduced current and potential income and growth in that income.

13/19

how are retail investors allocating capital?

When you look at the changes in asset allocation over time, you find that retail investors have been selling equity funds and buying a blend of fixed-income and balanced funds in response to the negative volatility experienced during the unwinding of the technology bubble and subsequently the financial crisis. The income-seeking/low-volatility characteristics of the broad population’s mutual fund purchases are a mismatch with the duration, or time horizon, the investment should be exposed to.

ChaRt 8: funds flows shiftinG away fRom equity funds

How are retail investors allocating capital?

When you look at the changes in asset allocation over time, you find that retail investors have been selling equity funds and buying a blend of fixed-‐income and balanced funds in response to the volatility experienced during the financial crisis. The income-‐seeking/low-‐volatility characteristics of the broad population’s mutual fund purchases are a mismatch with the duration or time horizon the investment should be exposed to.

Chart 8: Funds flows shifting away from equity funds

Source: Investment Funds Institute; Credo Consulting; Sentry Investments

14/19

If you look through the balanced funds and allocate capital according to their benchmark’s asset mix, you find the overall exposure to equities has not fallen as much as implied by the fund flows. Within equities, the allocation to conservative equities held in most balanced and dividend funds has driven their valuations to levels that are similar to valuations accorded to growth stocks in the past. The asset class rotation was from short-term investments into fixed income as rates fell.

ChaRt 9:

oveRall equity exposuRe Remains stRonG when you faCtoR in equity alloCation within

balanCed funds

If you look through the balanced funds and allocate capital according to their benchmark’s asset mix, you find the overall exposure to equities has not fallen as much as implied by the fund flows. Within equities, the allocation to conservative equities has driven their valuations to levels that are similar to valuations accorded to growth stocks in the past. The asset class rotation was from short-‐term investments into fixed income as rates fell.

Chart 9: Overall equity exposure remains strong when you factor in equity allocation within balanced funds

15/19

The exposure to fixed income has grown through a period of ‘financial repression.’ Central banks’ manipulation of term structure for fixed income has suppressed longer-term interest rates and reduced the volatility of the asset class. A proxy for volatility in the bond market is Bank of America Merrill Lynch’s MOVE Index. It is the weighted average of volatilities for the current two-, five-, 10- and 30-year treasuries. At current levels, this volatility index is 35% below its long-term average. Investors who have bought fixed-income funds for their low-volatility characteristics may well be surprised if fixed-income volatility returns to more normal levels.

ChaRt 10: volatility in bond maRket is siGnifiCantly below the lonG-teRm aveRaGe

The exposure to fixed income has grown through a period of ‘financial repression.’ Central banks’ manipulation of term structure for fixed income has suppressed longer-‐term interest rates and reduced the volatility of the asset class. A proxy for volatility in the bond market is Bank of America Merrill Lynch’s MOVE Index. It is the weighted average of volatilities for the current two-‐, five-‐, 10-‐ and 30-‐year treasuries. At current levels, this volatility index is 35% below its long-‐term average. Investors who have bought fixed-‐income funds for their low-‐volatility characteristics may well be surprised if fixed-‐income volatility returns to more normal levels.

Chart 10: Volatility in bond market is significantly below the long-‐term average

Abnormally low interest rates coincident with abnormally low volatility do not represent a low-‐risk investment. While fixed-‐income volatility will likely remain lower than equity volatility, the potential for negative volatility in fixed income is higher than in the past three decades of falling interest rates. Retail investors respond to negative volatility. More importantly, very low real interest rates and targeted inflation of 2% will devalue capital and income received on that capital by approximately 20% each decade. Avoidance of volatility ensures capital loss over time.

Abnormally low interest rates coincident with abnormally low volatility do not represent a low-risk investment. While fixed-income volatility will likely remain lower than equity volatility, the potential for negative volatility in fixed income is higher than in the past three decades of falling interest rates. In these circumstances, hugging a benchmark will not reward investors. Active management of duration and credit are critical to achieving acceptable fixed-income returns. Retail investors respond to negative volatility. More importantly, very low real interest rates and targeted inflation of 2% will devalue capital and income received on that capital by approximately 20% each decade. Avoidance of volatility ensures capital loss over time.

Source: Bloomberg L.P.; Bank of America Merrill Lynch; Sentry Investments

16/19

A similar look at equity volatility finds the recent experience overstates volatility relative to past experience. The equity equivalent to the MOVE Index is the CBOE’s VIX Index which measures the market’s ‘estimate’ of future volatility. It is ‘expectations based’ rather than a measure of actual volatility. A better measure, which looks at actual experience, is to use standard deviation. Bloomberg has an index which calculates the 30-day volatility of the S&P 500 Index. According to Bloomberg: “The 30-day price volatility equals the annualized standard deviation of the relative price change for the 30 most recent trading days closing price expressed as a percentage.” The data goes back to 1952 and shows that the recent past is anomalous for its volatility.

If you were to take the 10-year average standard deviation of return using this metric, the last 10 years’ volatility is 26% higher than normal, while the current volatility is approaching the 62-year average. The “persistence of perception” is likely overstating the size of future volatility. The two peak volatility experiences are the fourth quarters of 1987, our first flash crash and of 2008 subsequent to the failure of Lehman Brothers. Coincidentally, the two largest reductions in margin debt outstanding as a percentage are October 1987 at -13.4% and October 2008 at -22.2%. Each of the peaks in volatility coincides with margin events. Liquidity matters.

ChaRt 11: CuRRent equity maRket volatility is appRoaChinG the lonG-teRm aveRaGe

A similar look at equity volatility finds the recent experience overstates volatility relative to past experience. The equity equivalent to the MOVE Index is the CBOE’s VIX Index which measures the market’s ‘estimate’ of future volatility. It is ‘expectations based’ rather than a measure of actual volatility. A better measure, which looks at actual experience, is to use standard deviation. Bloomberg has an index which calculates the 30-‐day volatility of the S&P 500 Index. According to Bloomberg: “The 30-‐day price volatility equals the annualized standard deviation of the relative price change for the 30 most recent trading days closing price expressed as a percentage.” The data goes back to 1952 and shows that the recent past is anomalous for its volatility.

If you were to take the 10-‐year average standard deviation of return using this metric, the last 10 years’ volatility is 26% higher than normal while the current volatility is approaching the 62-‐year average. The ‘persistence of perception’ is likely overstating the size of future volatility. The two peak volatility experiences are the fourth quarters of 1987, our first flash crash and of 2008 subsequent to the failure of Lehman Brothers. Coincidentally, the two largest reductions in margin debt outstanding as a percentage are October 1987 at -‐13.4% and October 2008 at -‐22.2%. Each of the peaks in volatility coincides with margin events. Liquidity matters.

Chart 11: Current equity market volatility is approaching the long-‐term average

17/19

The two hypothetical investors referenced earlier (the 40 year old and the 70 year old) require very different approaches to their capital. The 40 year old, with 25 years till potential retirement, might want to consider the following analysis from Ned Davis Research. Real annualized 20-year-holding-period returns for equities have been positive for each period since 1945. The current approximately 6.5% 20-year-holding-period return is at the lower end of returns during secular bull markets.

While more volatile than fixed income during this period, equities were a safer investment; they protected the purchasing power of capital during periods of high and low inflation. Fixed-income returns from 1981 till present peaked in 2000; the long treasury fell in yield from 15.75% to 6.0% during this period, prompting material capital gains on long-term bonds. Returns moderated from 2000 on as long rates fell from 6.0% to 4.0%. Improving on the current 4.4% 20-year-holding-period return on long-term treasury bonds will be difficult given the current interest-rate structure. The 40-year-old investor should consider choosing growth and have the intestinal fortitude to ignore volatility.

ChaRt 12:

Real annualized 20-yeaR-holdinG-peRiod RetuRns foR equities have been positive

foR eaCh peRiod sinCe 1945

The two hypothetical investors referenced earlier (the 40 year old and the 70 year old) require very different approaches to their capital. The 40 year old, with 25 years till potential retirement, might want to consider the following analysis from Ned Davis Research. Real annualized 20-‐year-‐holding-‐period returns for equities have been positive for each period since 1945. The approximately 6.5% annual gain in capital is at the lower end of returns.

While more volatile than fixed income during this period, equities were a safer investment; they protected the purchasing power of capital during periods of high and low inflation. Fixed-‐income returns from 1981 till present peaked in 2000; the long treasury fell in yield from 15.75% to 6.0%. Returns moderated from 2000 on as long rates fell from 6.0% to 4.0%. Improving on the 4.4% current holding period return will be difficult given the current rate structure. The 40-‐year-‐old investor should consider choosing growth and have the intestinal fortitude to ignore volatility.

Chart 12: Real annualized 20-‐year-‐holding-‐period returns for equities have been positive for each period since 1945

18/19

The 70 year old can expect to have a retirement of 20 to 30 years; gender and genetics will factor in. Conventional wisdom suggests that investors should subtract their age from 100 to determine equity exposure. Based on the 70-year-old investor, 30% percent of her capital exposed to growth in capital and income makes for some interesting math. While there may be some improvement in yield from the fixed-income portfolio over time, the majority of income growth will have to be provided by the equity portion of the portfolio. We know the Bank of Canada is targeting 2% inflation. If the investor expects to maintain a stable standard of living, then 30% of her portfolio will need to provide 100% of the income growth that she needs. The equity portfolio has to deliver income growth of 6.67% annually to allow the total portfolio to grow income at 2%. Historical data suggests that this is an achievable outcome, but with little room for error. Dividend growth on the S&P/TSX Composite Index over the past 57 years has averaged 5.7% while over the same period, S&P 500 dividends grew by 8.6% annually.

When you look at the composite asset mix of the Pension Investment Association of Canada, you find that its exposure is reversed: 30.7% net cash and fixed income, and 69.4% equities. The mandate or the majority of pension funds is to provide long-term income streams with growth. By avoiding volatility, they cannot achieve their investment objectives. They use fixed income to moderate equity volatility and provide current cash flow for benefit payments.

The 70 year old can expect to have a retirement of 20 to 30 years; gender and genetics will factor in. Conventional wisdom suggests that investors should subtract their age from 100 to determine equity exposure. Based on the 70-‐year-‐old investor, 30% percent of her capital exposed to growth in capital and income makes for some interesting math. We know the Bank of Canada is targeting 2% inflation. If the investor expects to maintain a stable standard of living, then 30% of her portfolio will need to provide 100% of the income growth that she needs. The equity portfolio has to deliver income growth of 6.67% annually to allow the total portfolio to grow income at 2%. Historical data suggests that this is an achievable outcome, but with little room for error. Dividend growth on the S&P/TSX Composite Index over the past 57 years has averaged 5.7% while over the same period, S&P 500 dividends grew by 8.6% annually.

When you look at the composite asset mix of the Pension Investment Association of Canada, you find that its exposure is reversed: 30.7% net cash and fixed income, and 69.7% equities. The mandate for the majority of pension funds is to provide long-‐term income streams with growth. By avoiding volatility, they cannot achieve their investment objectives. They use fixed income to moderate equity volatility and provide current cash flow for benefit payments.

19/19

my conclusions

Volatility is not the only measure of risk. The most important risk an investor can examine is: “Will my current capital allocation enable my portfolio to maintain my purchasing power through the inevitable business cycles of life?”

The aggregate pension portfolio is well structured to provide duration in the income stream together with sufficient growth in income to build capital and deal with benefits increases over time. The aggregate retail portfolio is very similarly placed when you look at the asset mix with balanced funds allocated to their underlying components. Mutual fund flows over the past five years indicate that the broad population is investing new capital in a very conservative manner.

I hate to say this but I suspect a lot of 30, 40 and 50 year olds are investing as if they were already running a retirement portfolio. The fear of volatility is preventing appropriate risk taking at a point when investors have ample time for capital to accumulate over multiple cycles.

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Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what Sentry Investments and the portfolio manager believe to be reasonable assumptions, neither Sentry Investments nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

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How Do You Measure Risk

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