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Adaptation to low-yield environments

June 2015

Case studies in cross asset quant

Quantitative Strategies Global Markets Research

Tony Morris

Adapting to the investment challenges in a low-yield world

1. Extracting returns from G10 FX in a low carry environment FX carry has declined along with rate differentials – what can be done to generate returns from FX?

2. The search for defensive assets in a low-yield world Bonds have been a good defensive asset to protect against downturns – but at low yields, will they continue to help?

3. Earning returns from equities in a deleveraging environment Equity risk premium declines in a deleveraging environment – is there a replacement for long-only equities?

4. Making commodities work in turbulent times Long-only commodities have not performed – how can we make commodities work?

1

Extracting returns from G10 FX in a low-carry world

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

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G10 FX carry (lhs)

"Carry" of the G10 carry trade (%, rhs)

G10 FX carry is looking less attractive than before

Source: Bloomberg, Nomura Research. Carry of the G10 carry trade: average interest rate of the top 3 high yielding currencies in G10 minus average interest rate of the bottom 3 low yielding currencies. Sharpe ratios have been calculated using monthly data. Sample period: May 2000 to March 2015. The G10 FX carry strategy has a target volatility of 8% p.a.

FX carry trades were popular in Japan, but carry has underperformed with compression of rate differentials

3

The risk-adjusted performance of the carry trade has fallen sharply as G10 interest rate differentials have narrowed

2000-08

Average carry in G10 : 4.6% p.a.

Sharpe ratio of G10 FX carry: 0.96

2009-15

Average carry in G10 : 2.7% p.a.

Sharpe ratio of G10 FX carry: 0.35

4 Source: Nomura Research. Strategies scaled to 3% annual volatility. EM FX momentum on 10 liquid crosses. All strategies net of transaction costs.

G10 Momentum has not performed since 2004

But G10 Momentum looks bad too

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G10 FX Momentum

EM FX Momentum

Performance of Momentum + Value when Carry returns are in the bottom x%

Rotating between Carry and other investment styles

Source: Bloomberg, Nomura Research. Sample period: May 2000 to March 2015. The carry, momentum and value strategies have a target volatility of 8% p.a.

Other styles like momentum and value can provide positive returns even when carry is underperforming

5

Momentum: Trend-following in G10 FX Value: Reversion to fair-value (based on PPP)

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bottom 50% bottom 33% bottom 25% bottom 10%Aver

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Regime of FX carry returns

Carry Momentum +Value

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

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Dynamic G10 FX styles portfolio

G10 FX carry

What seems to work...

Source: Bloomberg, Nomura Research (March 2015). All statistics have been calculated on monthly data. The individual styles (carry, momentum and value) have a target volatility of 8% p.a.

A diversified, dynamic styles portfolio has outperformed FX carry

6

Full sample (2000-15) Post GFC (2009-15)

Styles portfolio FX carry Styles portfolio FX carry

Returns (%, p.a.) 7.8 6.1 5.1 3.0

Volatility (%, p.a) 6.6 8.7 5.8 8.6

Sharpe ratio 1.18 0.71 0.88 0.35

Max drawdown 9.3 25.0 7.4 17.1

Calmar ratio 0.84 0.25 0.69 0.18

The search for defensive assets in a low-yield world

1: Bear market overlap is defined as the probability that the asset class is in a bear market if equities are in a bear market. A bear market is defined as a drawdown of greater than 1 standard deviation Source: Bloomberg, Nomura Research (Feb 2014). All statistics are calculated on monthly data. All returns are excess returns i.e. returns over cash rate . DM Equities : MSCI Daily TR Gross World USD ( GDDUWI Index). Commodities: S&P GSCI excess return index (SPGSCIP Index).US credit: North America IG 5Y Unfunded return index (NMCINAIG before March 2007, ERIXCDIG Index after that) Hedge funds: HFRX Global Hedge Fund Index (HFRXGL Index), Listed private equity: LPX50 Listed Private Equity Index USD TR (LPX50TU Index, Global real estate: S&P Global REIT USD TR (SREITTGL Index). Cash rate: Fed funds effective rate (FEDL01 Index). 10yt UST returns have been calculated as the returns of holding and rolling the TY1 futures contract.

Most traditional “alternatives” offer the same pro-cyclical risk as equities; bonds have been different

Bonds have been the only defense

8

-20%

0%

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60%

80%

100%

Commodities(1970-2014)

US credit(1990-2014)

HFRX global(1998-2013)

Listed privateequity

(1994-2014)

Global real estate(1995-2013)

US 10yTreasuries

(1982-2014)

Correlation with DM equities

Bear market overlap with DM equities

67% probability that commodities suffer a large drawdown at the same time as equities

Can bonds play defense in the future?

Source: Bloomberg, Nomura Research. All returns in this slide are excess returns i.e. returns over risk-free rate, All statistics have been calculated on monthly data Bond returns have been calculated as the returns of holding and rolling the corresponding 10yr futures contract (TY and JB), DM Equities : MSCI Daily TR Gross World USD ( GDDUWI Index).

No: low yield levels can significantly hamper the defensive nature of government bonds

9

Even in a crisis, bonds cannot rally much Bonds and equities can move together

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Change in 10yr yields post Lehman shock (Sept 08 to Dec 08)

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May-13 Jun-13 Jul-13 Aug-13

S&P 500 excess returns (lhs)

UST 10yr returns (rhs)

JGBs have become short put carry trades

Source: Bloomberg, Nomura Research Feb 2014). Skew is calculated on monthly data.. All returns are excess returns i.e. returns over cash rate . DM Equities : MSCI Daily TR Gross World USD ( GDDUWI Index). Commodities: S&P GSCI excess return index (SPGSCIP Index).US credit: North America IG 5Y Unfunded return index (NMCINAIG before March 2007, ERIXCDIG Index after that) Hedge funds: HFRX Global Hedge Fund Index (HFRXGL Index), Listed private equity: LPX50 Listed Private Equity Index USD TR (LPX50TU Index, Global real estate: S&P Global REIT USD TR (SREITTGL Index). Cash rate: Fed funds effective rate (FEDL01 Index/FDTR index) 10yr USTS refer to the returns of holding and rolling the TY futures contract Barclay CTA Index: BARCCTA Index . Equity VRP: skew is average of skews of Nomura eVRP strategy odd and even months.

Unlike most traditional assets and “alternatives”, momentum has a positive skew

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Moving on: Time-series momentum

1 Fung, William, and David Hsieh ‘The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers’, The Review of Financial Studies, Vol. 14, No. 2. (Summer. 2001), pp. 313-341. Source: Bloomberg, Nomura Research. Excess returns refer to return over cash. Cash rate: fed funds rate. MSCI world equities : GDDUWI Index. Index of CTAs: Barclay CTA Index (BARCCTA) Index. Excess returns of the CTA index have been scaled to have the same volatility as equities over this sample period, for ease of comparison. (May 2013).

Trend following can help provide downside protection

11

Momentum is expected to outperform during extreme returns This results of a straddle-like behavior in practice

Valu

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stra

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Value of the underlying

Loss if market is range-bound

Gains from extreme moves

Gains from extreme moves

Lowest equity return months

Highest equity return months

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Regimes of equity returns

MSCI World equities

Index of momentum funds (CTAs)

Momentum is well-established across markets and assets

Source: Bloomberg, Nomura. All statistics are based on daily data until end of Feb 2015. 1. Sample period for different momentum strategies: Equities – 07/2004 to 02/2015; Rates – 02/1990 to 02/2015; Commodities – 01/1970 to 02/2015; FX: 02/1996 to 02/2015. FX momentum results are only for EM FX momentum

Momentum is consistent with financial theory after the 1970s and has strong empirical support

12

A long history of academic research into Momentum

Evidence from across markets and asset classes1

1960s and early 70s

Efficient Markets equals Random Walk

Fama (1964), Samuelson(1965), Burton Malkiel (1973)

1970s and 80s

Markets are efficient but not random, existence of

autocorrelation

Leroy(1973), Lucas (1978), Lo and Mackinlay (1988)

1990s

Evidence of momentum in US stocks, alternative

explanations

Jegadeesh and Titman (1993), Conrad and Kaul (1998), Green and Naik (1999), Hong and Stein (1999), Hirschleifer et. al (1998)

2000s

Momentum is universal and straddle-like, better

understanding of drivers

Fung and Hsieh (2001, Griffin and Martin (2005),Gorton et. al (2008), Asness et. al (2009), Moskowitz, Ooi and Pedersen (2011)

Equities TS Momentum

Rates TS Momentum

Commodities TS Momentum

EM FX TS Momentum2

Average returns 1.9% 9.1% 7.8% 12.6%

Volatility 4.7% 7.5% 9.3% 8.7%

Sharpe ratio 0.40 1.21 0.84 1.44

Max drawdown -14.7% -12.5% -17.8% -15.8%

% Positive months 55% 62% 54% 67%

The strategic value of TS momentum in asset portfolios

Source: Bloomberg, Nomura Research. All returns shown are excess returns i.e. returns over cash rare. Cash rate: fed funds rate. MSCI world equities : GDDUWI Index. Index of CTAs: Barclay CTA Index (BARCCTA) Index. The cross-asset momentum returns are already excess returns since it is an unfunded index

TS Momentum does well during sell-offs, especially during extended bear markets

13

Negative correlation with equities during bear markets Performance during specific crises

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Correlation of momentum returns with equities in months when equity returns are in bottom x% (1990-2015)

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Mar-12 to May-12 (3 months)

Apr-98 to Sep-98 (6 months)

Apr-10 to Jun-10 (3 months)

Apr-11 to Sep-11 (6 months)

Dec-99 to Mar-03 (40 months)

Oct-07 to Feb-09 (17 months)

Cumulative excess returns over the sample Equities long-onlyIndex of momentum funds (CTAs) (scaled to same volatility as equities)Cross-asset momentum (scaled to same volatility as equities)

14 Source: Nomura Research. Results of regressing a typical pension fund portfolio against cross-asset timeseries factors.

Typical hedge-fund or real-money portfolios are negatively exposed to the time-series momentum factor

Why most investors need this

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Earning returns from equities in a deleveraging environment

Volatility risk premia went mainstream in Japan

Source: Bloomberg, Nomura Research. Neil Sheppard and Vincent Li presentation ‘The Japan Uridashi Market, Jan 2013’. Nikkei returns are the returns of holding and rolling the first equity futures contract. VRP: returns on a selling a 1m variance swap with 0.25 vega notional

Japanese investors became big buyers of auto-callable knock-outs

Big market in equity index-linked Uridashi (~USD15 bn p.a.) Buying what works—VRP outperforms equities

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While the Uridashi structure can’t be fully replicated with simple options, it is most akin to the:

investor selling the bank a down & in put owning a series of digital options with an upside knock-out

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VRP: Volatility Risk Premium

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The picture in Europe is similar

Source: Bloomberg, Nomura research. Eurostoxxi returns are the returns of holding and rolling the first equity futures contract. VRP: returns on a selling a 1m variance swap with 0.25 vega notional

Volatility risk premium vs long-only equities in Europe

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S&P 500 VRP returns vs. S&P 500 returns (1990-2013)

VRP can perform even when equities do not

Source: Bloomberg, Nomura research. All returns have been scaled to 6% volatility. 6% is also close to the realized volatility of the VRP on S&P 500 in this sample. Equities: returns of holding and rolling the first equity futures contract. VRP: returns on a selling a 1m variance swap with 0.25 vega notional. 18

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S&P 500 return regimes

S&P 500S&P 500 VRP

Lowest equity returns Highest equity returns

VRP is similar to equities, not an “alternative” Equity crashes are also bad periods for VRP

However VRP can add significant value in markets which are range-bound or slowly

trending down

Low implied volatility is usually good for VRP

Source: Nomura Research. For charts on the left, analysis based on data daily data from 1994-2014. For the chart on the right, we look at daily data between 2001 and 2014 and divide the sample period in to three equally sized buckets based on the level of VIX. We then report the returns of the S&P 500 VRP strategy in each of these buckets. The full sample volatility of the VRP strategy is 6%.

No relationship between implied volatility level and returns Performance is stronger when implied volatility is lower

Strong relationship between returns and implied - realised

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VRP returns depend on the difference between implied and realized volatility

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Implementation is key

Source: Nomura, Bloomberg. Data from 21 /10/2011 to 31/12/2014. Past performance is no indication of future performance. This chart is based on the Swap format of the product. The Nomura Volatility Risk Premium combined portfolio (“VRP Combined”) is an example portfolio for illustrative purposes only. On each expiry day of the Nomura Volatility Odd (resp. Even) month Risk Premium USD ER Index, the notional exposure to the Nomura Volatility Odd (resp. Even) month Risk Premium USD ER Index for the period until the next odd (resp. even) monthly expiry is determined by the combined portfolio level as of the immediately preceding business day. S&P500 Vol Scaled ER means a volatility-scaled version of S&P 500 Excess Return. Vol Scaled HFRX Global HF Index is a volatility-scaled version of HFRX Global Hedge Fund Index.

Strikes

Vega profile

Liquidity

20

Live performance of Nomura Volatility Risk Premium Implementation can mitigate risks

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2600Nomura Volatility Risk Premium combined portfolio ("VRP Combined")

S&P500 Vol Scaled ER

Vol Scaled HFRX Global HF Index

2011-14 VRP Combined Vol Scaled S&P500 ER Vol Scaled HFRX Global Hedge Fund Index

Annualised Return 33.46% 21.07% 12.73%

Volatility 13.94% 13.92% 13.91%

Sharpe ratio 2.40 1.51 0.92

Making commodities work

Long-only commodities have not worked

22

The underperformance is even more severe recently given concerns on slowdown in demand and declining inflation

Long-only commodity returns are negative ignoring the one-time gain at the end of the Bretton Woods peg

Source: Bloomberg, IMF, Nomura Research. Long-only commodities: S&P GSCI Excess return Index. Global Inflation: IMF World CPI % change

Where is the risk premia in long-only commodities?

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Long-only commodities

Post Bretton Woods peak

Commodities are also macro—like equities, rates or FX

Source: Bloomberg, World Bank, Nomura Research. Top left chart shows excess returns of S&P GSCI. Shaded areas are when real world GDP growth was in the bottom quartile. S&P GSCI returns up to December 2014. World real GDP growth to December 2013. In the top right chart, carry refers to the difference between the index total returns and the index spot returnsFor PCA analysis, calculations are based on data from 1997 to 2009.

Component % of the total variance explained

Crude oil curve over 5 years USD swap curve over 30 years

Parallel shift/level 93.3% 91.0%

Twist/Slope 5.2% 6.7%

Bend/Convexity 0.8% 1.1%

Commodities are quite similar to other asset classes, contrary to common thinking

23

Commodities are also pro-cyclical, like equities

Commodities also have dynamic curves, just like interest rates

Carry matters for commodities, just like in FX

Principal component analysis shows that dynamic patterns are similar

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S&P GSCI BCOM

Treating commodities like FX works

24 Source: Bloomberg, Nomura Research. MaCS: NMX3MC7U Index, Commodity hedge funds: HFRXCOM Index, S&P GSCI: SPGSCIP Index BCOM: BCOM Index. All returns are excess returns ie, returns over cash rate. For hedge funds, cash rate has been assumed to be the 1-month USD Libor. All statistics have been calculated on monthly data. In the chart all indices have been scaled to the same volatility as BCOM for ease of comparison.

Macro Commodity Strategy (MaCS) has delivered positive returns despite turbulent times

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MaCSCommodity hedge fundsBCOM

Live period performance of MaCS (Nov 09 – Dec 14)

MaCS Commodity HFs BCOM Index

Returns (%, p.a.) 5.4 -4.1 -4.1

Volatility (%, p.a) 6.1 5.3 15.5

Sharpe ratio 0.87 -0.78 -0.26

Max drawdown 6.4 19.6 40.5

Calmar ratio 0.83 -0.21 -0.10

Learning from Japan

Out of equities, into carry. Out of bonds, into trend following.

25

Old New

Equities Bonds

Commodities (long/short)FX CarryVRPCreditBondsTrend following

Appendix A-1

Analyst Certification I, Srivaths Balakrishnan, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Important Disclosures Online availability of research and conflict-of-interest disclosures Nomura research is available on www.nomuranow.com/research, Bloomberg, Capital IQ, Factset, MarkitHub, Reuters and ThomsonOne. Important disclosures may be read at http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx or requested from Nomura Securities International, Inc., on 1-877-865-5752. If you have any difficulties with the website, please email grpsupport@nomura.com for help. The analysts responsible for preparing this report have received compensation based upon various factors including the firm's total revenues, a portion of which is generated by Investment Banking activities. Unless otherwise noted, the non-US analysts listed at the front of this report are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of NSI, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account. Nomura Global Financial Products Inc. (“NGFP”) Nomura Derivative Products Inc. (“NDPI”) and Nomura International plc. (“NIplc”) are registered with the Commodities Futures Trading Commission and the National Futures Association (NFA) as swap dealers. NGFP, NDPI, and NIplc are generally engaged in the trading of swaps and other derivative products, any of which may be the subject of this report. ADDITIONAL DISCLOSURES REQUIRED IN THE U.S. Principal Trading: Nomura Securities International, Inc and its affiliates will usually trade as principal in the fixed income securities (or in related derivatives) that are the subject of this research report. Analyst Interactions with other Nomura Securities International, Inc. Personnel: The fixed income research analysts of Nomura Securities International, Inc and its affiliates regularly interact with sales and trading desk personnel in connection with obtaining liquidity and pricing information for their respective coverage universe. Valuation methodology - Fixed Income Nomura’s Fixed Income Strategists express views on the price of securities and financial markets by providing trade recommendations. These can be relative value recommendations, directional trade recommendations, asset allocation recommendations, or a mixture of all three. The analysis which is embedded in a trade recommendation would include, but not be limited to: • Fundamental analysis regarding whether a security’s price deviates from its underlying macro- or micro-economic fundamentals. • Quantitative analysis of price variations. • Technical factors such as regulatory changes, changes to risk appetite in the market, unexpected rating actions, primary market activity and supply/ demand considerations. The timeframe for a trade recommendation is variable. Tactical ideas have a short timeframe, typically less than three months. Strategic trade ideas have a longer timeframe of typically more than three months. Disclaimers This document contains material that has been prepared by the Nomura entity identified on page 1 and/or with the sole or joint contributions of one or more Nomura entities whose employees and their respective affiliations are also specified on page 1 or identified elsewhere in the document. The term "Nomura Group" used herein refers to Nomura Holdings, Inc. or any of its affiliates or subsidiaries and may refer to one or more Nomura Group companies including: Nomura Securities Co., Ltd. ('NSC') Tokyo, Japan; Nomura International plc ('NIplc'), UK; Nomura Securities International, Inc. ('NSI'), New York, US; Nomura International (Hong Kong) Ltd. (‘NIHK’), Hong Kong; Nomura Financial Investment (Korea) Co., Ltd. (‘NFIK’), Korea (Information on Nomura analysts registered with the Korea Financial Investment Association ('KOFIA') can be found on the KOFIA Intranet at http://dis.kofia.or.kr); Nomura Singapore Ltd. (‘NSL’), Singapore (Registration number 197201440E, regulated by the Monetary Authority of Singapore); Nomura Australia Ltd. (‘NAL’), Australia (ABN 48 003 032 513), regulated by the Australian Securities and Investment Commission ('ASIC') and holder of an Australian financial services licence number 246412; P.T. Nomura Indonesia (‘PTNI’), Indonesia; Nomura Securities

26

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