#44 | Global Hindsight Bias
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One of the long-running debates in Indexed UL is whether the 5 Year Global Hindsight strategy is superior to vanilla one year point-to-point S&P 500 options. The issue is far from resolved and ING threw more fuel on the fire a couple of weeks ago when it announced a 5% increase in the participation rates on its Global accounts. I’ve generally avoided discussing the Global option specifically because, frankly, I don’t think it’s particularly relevant. The vast majority of IUL premium still goes to vanilla indexed accounts. But illustrated rates on Global strategies have hit stratospheric levels and interest has started to pick up. So I decided to throw in my two cents, for whatever it’s worth.
Are Historical Lookbacks valid?
The validity of using historical lookbacks for illustrated rates hinges on the assumption that the cap or participation rate available today would have remain unchanged over the historical period used for the lookback. How good is that assumption? Pretty terrible, actually, and there’s no better evidence than the actual track record of participation rates in Global strategies. ING will no doubt promote their new 80% participation rate as evidence that the Global strategy is attractive. Actually, the opposite is true. ING can now afford an 80% cap rate because the option has gotten cheaper. Given that the price of an option is equal to its weighted payoff, a cheaper option essentially means that the expected payout of the strategy has declined. Using an 80% participation rate, ING historical lookback calculator produces an illustrated rate of 12%. So on the one hand, the option has become less expensive because the expected return has dropped but the illustrated rate has increased. What gives?
This is a perfect indication of why the historical lookback method is such a sham. Options prices for Global strategies are highly correlated to volatility. Volatility obviously changes over time and is pretty low at the moment. The rigid historical lookback methodology essentially assumes that the past would have enjoyed the benefits of volatility without rising options costs. In other words, the historical lookback assumption allows for a structural arbitrage that could not have existed and, in fact, never has. AIG’s Elite Global was released in 2006 with a 55% participation rate. Why? Because options were more expensive. Are historical lookbacks based on 55% any less valid than those based on 80%? No one has even the slightest clue. All we know is that the participation rate will change with many of the same factors that impact market performance. Consequently, historical lookbacks are woefully inadequate for gauging absolute returns or making relative comparisons.
So, about the Hang Seng…
But for the sake of argument, let’s assume that the historical lookback methodology is accurate. The remaining question in that case is whether or not the historical data used in the lookback is a meaningful indicator of future returns. Based on ING’s literature, the Hang Seng accounted for 51% of first place finishes and 71% of total returns that would have been credited under the Global strategy from 1980 to 2013. The outsized performance of the Hang Seng clearly accounts for the vast majority of the Global strategy’s edge over vanilla account options. In other words, if you’re going to choose Global over a vanilla S&P 500 option, you’d better believe that the Hang Seng is going to blow the S&P 500 out of the water.
So what exactly is in the Hang Seng? I never thought to ask that question until I started doing a bit of research for this article and what I found was, well, shocking. The Hang Seng is comprised of 50 stocks segmented into four major sub-indices – Finance, Utilities, Property and Industry. The industry category is a hodgepodge of firms in shipping/logistics, oil and gas, consumer goods and electronics. The shocking part is that 21 of the 50 stocks in the Hang Seng are Chinese state-owned enterprises. Furthermore, the Hang Seng is heavily exposed to what is commonly known to be the most corrupt and leveraged parts of the Chinese economy – banking, property and oil. I don’t think it’s a stretch to argue that the Hang Seng is currently more tied to state-owned enterprises run by Communist technocrats than the consumptive powers of China’s exploding middle class.
Furthermore, the presence of Chinese state-owned firms in the Hang Seng is a relatively new phenomenon. Prior to the beginning of Chinese control in 1997, the index was dominated by Hong Kong utilities and private firms. The mix was still strongly focused in Hong Kong until 2007 when Chinese in the mainland were allowed to invest in Hong Kong listed shares. The fantastic growth in the Hang Seng from 1980-1996 that drives the majority of the returns in ING’s historical lookback occurs in the regime of a British controlled Hong Kong and a Hang Seng chock full of private enterprises. The returns since then have been less than exciting. The Hang Seng from 1980-1996 accounted for 57% of the total lookback return and only 14% thereafter. So is it reasonable to believe that the Hang Seng will have a repeat performance in this new regime? It may be, but the historical data absolutely can’t be used as evidence.
But isn’t Global structurally superior?
Ah, if only things were so simple. Proponents usually posit two reasons for the superiority of the Global strategy – its longer duration (5 years) and the benefits of diversification. Both of these reasons appeal to traditional investment logic for their justification. Long duration things usually pay a higher yield and the Global strategy has three indexes, therefore it offers a diversification of returns. But Global isn’t an investment. It’s an options strategy governed by options pricing. Options with intrinsically higher returns have higher prices. Long duration options have “cheaper” options because they’re discounted by the opportunity cost of capital over a longer period, but that’s not a real savings because the buyer is the one giving up the earnings. Returns over longer durations actually tend to be less volatile on an annualized basis than short durations. Think about the enormous annualized returns of daily shifts in the stock market versus the annualized return of rolling 20 years of historical data. Obviously, the former is exponentially larger than the latter. More volatility means higher options prices and, therefore, 5 year option prices tend to be cheaper. But, of course, that also means that their expected yields are lower.
Options and the hindsight strategy also eliminate the diversification angle. Diversification works because it allows non-correlated asset classes to offset each other in the short-term while still participating in long-term return drift. The only way it works is by making fixed investments. Global hindsight is a proportional investment that captures 75% of the best performing and 25% of the 2nd best. It’s the best of both worlds, right? Yes, of course. This is exactly why the participation rates are below 100% and are directly correlated with volatility. In other words, the options get more expensive at exactly the moment when the lookback strategy is most valuable. The options act as the filter on the returns for the strategy. So while the Global strategy as multiple indexes, it’s not diversified. It’s a single purchase of a single option.
Some of ING’s marketing materials start with blithe statements such as “Hindsight is 20/20” to position the Global story. Hindsight is 20/20 because we universally suffer from hindsight bias – retrofitting a story to the facts under the guise of “knowing it all along.” This, in essence, is the problem with the Global strategy. The Global strategy’s posited superiority is contingent on retrofitted assumptions that fall apart outside of the world of the hindsight bias. The historical lookback methodology hinges on the false assumption of a static participation rate. The Hang Seng is fundamentally different now than it was when it generated the returns that drive high illustrated rates in the Global strategy. Long durations actually lead to less volatile returns and the benefits of diversification are filtered out by the options strategy. The biggest danger about the hindsight bias isn’t that we use it to explain past events – it’s that we use our fabricated narratives to try to predict future events. And, unfortunately, that’s exactly the way the Global strategy is sold.
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