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Historical Returns and Rearview Mirrors
Historical returns are a common way to assess risk in portfolios for wealth clients. Wealth managers and advisors often rely on historical returns because the act of producing analyses based on current exposures at scale can be a resource-intensive task.
But historical returns have several major drawbacks, chief among them that they build in the impact of historical positions, rather than using the current make up and risk profile of a portfolio as it exists today. (See footnote for additional challenges.*)
This is akin to relying solely on the rearview mirror when driving. The road behind you won't necessarily inform the path forward.
Returns-based analyses only look at past returns. They don’t differentiate between the portfolio positions that generated those returns in the past from the holdings you may own today. Imagine the companies and their weights in the S&P 500® in 1990. Would you prefer to do an analysis using those historical weights or an analysis that better captures your current portfolio exposures?
We can look to the example set by institutional investors and asset managers, who predominantly use more forward-looking risk measures in how they manage and construct portfolios.
Look Through the Windshield
Advisors who can show clients the impact of how their portfolios are positioned today will help them better understand and make investment decisions for the future. Capturing the most recent exposures and applying those when simulating past events can change the direction of advisors’ decision making. It can be a better, more informed approach.
Look at the 2007-2008 credit crisis for example. From July 2007 to August 2008, the S&P 500 dropped 15%, enough to shake most clients’ confidence. What do you think would happen to the S&P today in a similar event?
Using a historical portfolio returns-based analysis, your answer would skew towards -15%, influenced by 1) the impact of companies like Lehman Brothers and Bear Stearns that no longer exist in the index, 2) ignoring the shifts in constituent weights for companies like Amazon and Exxon, and 3) ignoring the impact of additions like Facebook and Twitter. Advisors in this case might recommend their clients take more defensive positions, giving up the growth potential of stocks for more conservative allocations.
Source: BlackRock Solutions. Data as at 9/21/2020. Scenario time range from 7/1/2007 to 8/1/2008. Example for illustrative purposes only.
As shown on the right in the example above, when we model the constituent companies within the S&P 500 today and simulate the credit crisis period with updated weights, we only see a loss of 1%. That is a huge difference from the purely historical analysis – one that could help advisors keep their clients better positioned in equities for the long-term. This answer is perhaps not what advisors or clients might have expected, giving advisors an opportunity to use more robust analyses to showcase the value they can bring to help clients stay on track for their goals.
Aladdin® Wealth Helps You Steer for the Road Ahead
Aladdin technology models portfolios using current holdings, capturing the most recent exposures for advisors to view. This provides more specific insights, making advisors more knowledgeable drivers for the road ahead. Advisors who use Aladdin Wealth tools in their own oversight process can establish a deep understanding of clients’ situations and more finely tune outcome expectations to drive the overall value of their relationships.
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*Footnote: additional challenges with historical returns. Firms and advisors may wish to consider other issues with historical returns. First, not all securities have enough time series to make historical returns effective. Examples in this category include IPOs, new issues, alternatives and privates. Second, risk changes over time, while historical returns do not. For example, a 10-year treasury bond would have a much different risk profile 10 years ago than it would have today (which would be effectively zero). And third, since a historical return number is just that – one number – there is no way to dissect it and explain where risk may be coming from." bold and combine into one section.
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