FEBRUARY 2019 THE COMPARATIVE PERFORMANCE OF …

FEBRUARY 2019

THE COMPARATIVE PERFORMANCE OF DIFFERENT INVESTMENT STRATEGIES ON FOREIGN FINANCIAL INSTRUMENTS PIERRE-EMMANUEL DARPEIX NATACHA MOSSON

Risks & Trends

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Abstract The performance of different investment strategies in the main French financial assets was investigated in an in-depth study published in February 2018 (Darpeix and Mosson (2018)). The analysis has been extended by considering other countries, in order to test whether the results obtained in the French case could be generalised to other jurisdictions. Germany, the United States and Japan were therefore examined. The results obtained in the latter case seem more original and instructive since Japan's past trajectory could open up avenues for thought on what could be the trajectory of a negative scenario for the Euro Area. We consider the case of a French saver who invests in France on counterfactual stock and bond indices, the real returns of which correspond to those that have been observed in Japan since 1987. This approach enables us to examine specifically the optimal savings strategies for a French individual who would anticipate a Japanese scenario for the coming years. The analysis show that Japanese equities did not fulfil the promises conventionally associated with investments in securities. However, even in this atypical macro-financial environment, the results confirm, for a saver investing in a diversified portfolio, the benefits of annual portfolio rebalancing, which was one of the major conclusions of the study already published. Moreover, the extension to international markets confirms the benefits of analysing a regular savings effort and a one-off investment separately, because otherwise households would not have appropriate information to make their savings decisions.

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INTRODUCTION

The performance of different investment strategies in the main French financial assets was analysed in an in-depth study published in February 2018 (Darpeix and Mosson (2018)). This research has been extended to foreign countries in order to assess whether the results remained valid in other jurisdictions. Germany, the United States and Japan were therefore examined. The results obtained are very similar in the first two cases, and we chose only to display synthetic graphs in Appendix. The Japanese situation seems more original and instructive: partly because of the very atypical behaviour of the equity indices over the period

1, and partly

because Japan's recent economic and financial history, with a combination of very low interest rates, massive central bank intervention, excessive public debt and deflationary pressures, makes this country a textbook case (Japan's past trajectory could open up avenues for thought on what could be the trajectory of a negative scenario for the euro area). The following study therefore focuses on the Japanese case. You will find in Appendix summary graphs for the United States and German cases, which show a very great similarity with the results obtained for France, and to which we will not refer again. For this analysis, we consider the case of a French saver who invests in France on counterfactual stock and bond indices the real returns of which correspond to those that have been observed in Japan since 1987. This approach enables us to examine specifically the optimal savings strategies for a French individual who would anticipate a Japanese scenario for the coming years. Nevertheless, this studies deals in no way with the situation of a Japanese saver investing on his domestic market, nor does it describe the case of a French saver willing to diversify his portfolio with Japanese assets. Japanese equities did not fulfil the promises conventionally associated with investments in securities. In addition to the burst of the dot-com bubble and the subprime crisis, which hit all the advanced economies very hard, Japan had previously undergone the effects of the Plaza Agreement with the United States and the Asian crisis of 1997. Between these multiple shocks, the Topix Index of the Japanese stock market saw no significant expansion phases, so that between January 1992 and January 2018 (i.e. 26 years), the Japanese total return index grew by only 50 % compared with 350 % for the CAC 40 and 500 % for the S&P 500. The very low returns coupled with the high volatility of Japanese equities tend to significantly distort the risk/return curves. However, even in this atypical macro-financial environment, the results confirm, for a saver investing in a diversified portfolio, the benefits of annual portfolio rebalancing, which was one of the major conclusions of the study already published. Moreover, the extension to international markets confirms the benefits of analysing a regular savings effort and a one-off investment separately, because otherwise households do not have appropriate information to make their savings decisions. The first section will present the returns obtained by a Japanese saver investing in the domestic market using various strategies. The strategies and assumptions adopted are exactly the same as those that were adopted for French assets. Section 2 will endeavour to explain the atypical behaviour of Japanese financial assets through an analysis of the macro-financial environment.

1 By comparison, German and US returns are highly correlated to returns in the French market.

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1. PERFORMANCE OF DIFFERENT INVESTMENT STRATEGIES IN JAPANESE ASSETS

The analysis now covers the series relating to the return on Japanese assets. The performance of the equity instrument is represented by the Topix Index, while the bond instrument tracks the synthetic index of 10-year constant-maturity Japanese government bonds. Lastly, for the risk-free interest rate, we consider the rate of remuneration of bank deposits

2.

Box 1: Choice of the Topix rather than the Nikkei

Like the various Nikkei indices, the Topix indices (short for the Tokyo Stock Price Index) are capitalisation indices for the

Tokyo Stock Exchange (TSE). While the Nikkei has been calculated by the Nihon Keizai Shinbun newspaper since 1950, the

Topix Index has been produced directly by the TSE since 1969. On the other hand, the total return series (with dividends

reinvested) are only available on Datastream within a far more restricted time frame: since January 1973 for the Topix, and

since January 2002 for the Nikkei. The very short history of the Nikkei Total Return Index led us to reject this series and focus

on the Topix3.

1.1. PERFORMANCE OF THE JAPANESE INDICES

The returns on an equity index and a bond index (government bonds, 10-year constant-maturity) for various countries, including Japan, show the specific nature of the Japanese case (see Graph 1).

4

Graph 1: Real aggregate returns on equity and bond indices in the United States, Japan and France

Source: Datastream, AMF calculations

2 The deposit rate adopted is the average rate offered by banks on deposits of maturities ranging between 3 and 6 months for an amount

ranging between 3 million yen (about €23,556) and 10 million yen (about €78,520). In the Darpeix and Mosson study (2018) of the strictly French case, this risk-free rate corresponded to returns on the Livret A passbook savings account (completely tax-exempt). 3 Note, however, that over the period when the two series are available simultaneously (2002-2018), the correlation is very high (the R² of

the econometric regression in levels is 94.5 %). Considering two different sub-periods (before and after January 2009), we even achieve R² values of more than 99 % (99.1 % and 99.6 % respectively), because it would seem that there is a slight break of slope at that time. 4 All the indices are calculated with reinvested dividends or coupons in order to take into account not only capital gains or losses but also the

dividends or interest received, since it is assumed that the latter are fully reinvested throughout the investment period. Finally, all the indices are adjusted for corresponding domestic inflation (in order to consider only real returns) without taking into account the exchange rate, charges or taxes. To simplify, the aggregate returns assume an investment of one unit at the start of the period.

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The Japanese bond index shows aggregate returns similar to those of the US bond index. This is because the period of low interest rates prevailing in Japan from the mid-1990s supported returns on bonds. On the other hand, the aggregate returns obtained by investing on the Topix (+50 % in just over 30 years, i.e. an annualised return of 1.3 %) are far lower than the returns offered by the S&P 500 (the index value was multiplied by more than 6) or the CAC 40 (index value multiplied by 4.5). The remainder of this section considers the case of a French investor (French stylised charges and taxes) investing in France on counterfactual equity and bond indices for which the real returns correspond to those which have been seen in Japan since 1987 (the nominal Japanese indices are therefore adjusted for Japanese inflation, and will be compared with the real return on the deposit rate in Japanese banks). Likewise, the amounts invested are adjusted for Japanese inflation

5. This approach makes it possible, inter alia, to examine the best saving strategies

for a French investor anticipating a Japanese-style scenario (inflation remaining low, persistently expansionary monetary policy, etc.). If we had wanted to study the case of a Japanese investor, we would simply have used charge and tax assumptions applicable to Japan. For the remainder of the study, we make a stylised assessment of charges and taxes so as to best represent the situation of a French saver wanting to invest in financial markets. We consider an equity fund replicating the performance of the Topix total return and a sovereign bond fund replicating the performance of 10-year Japanese government bonds, with reinvested coupons. The charge assumptions adopted for each of the financial instruments are as follows:

Equity funds Bond funds Deposit

Subscription fee 2 % 1 % 0 %

Ongoing charges 1.5 % per annum 1 % per annum 0 % Redemption fee 0 % 0 % 0 %

These assumptions are therefore exactly the same as those which were adopted for French assets. For the sake of simplicity, ongoing charges are assumed to be monthly and are applied every month on the fund’s current outstanding. In reality, charges are debited whenever the fund's net asset value is calculated, usually every day. The taxes in question correspond to a flat tax of 30 % (including social security contributions), applied to the income generated by all the instruments except bank deposits (which are considered to be fully exempted).

1.2. ANNUALISED REAL RETURNS

The annualised real returns on the Japanese equity and bond index for a one-off investment over investment horizons of 1, 5, 8 and 10 years were analysed first. As a reminder, we considered real indices (i.e. deflated by the Japanese consumer price index) which served as a counterfactual performance trajectory for funds bought in France by a French consumer. For greater clarity, in the remainder of this article, we will speak of the "Japanese case" as opposed to the "French case" dealt with in the original article on the history of French index performances.

5 We consider that inflation and the index series reflect the country's macroeconomic environment and form a whole: inflation has an impact

on asset valuations and on household purchasing power.

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Real returns on Japanese bonds and equities and bank deposits (after charges and taxes, as a %)

Graph 2: Annual returns


Graph 3: Returns annualised over 5 years






NB: The dates on the x-axis correspond to the redemption dates (end of the investment window).

The stylised fact that the return on equities is far more volatile than that on bonds is shown clearly in the above graphs (Graph 2 – Graph 5). In the case of equities, the annual returns range between −49 % and +40 %, and the annualised 10-year returns range between −10 % and +3 %. The returns on Japanese bond indices are far smoother than returns on equities (between −15 % and +10 % annually, and between +1 % and +5 % annualised over ten years). As in the French case, an increase in the length of the holding period can smooth out performance. The density functions for equity and bond instruments confirm this finding (see Graph 6 and Graph 7).

Graph 6: Distribution of annualised real returns on Japanese equities by investment horizon

Graph 7: Distribution of annualised real returns on Japanese bonds by investment horizon



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Bond Fund

Equity Fund

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-.6 -.4 -.2 0 .2 .4Annualised return (%)

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-.2 -.1 0 .1Annualised return (%)

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bond JP

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Table 1 also confirms that the annualised return on equities is far more volatile than the annualised return on bonds and bank deposits, irrespective of the investment horizon considered. The standard deviation of the return is a decreasing function of the investment horizon for all the instruments considered.

Table 1: Mean returns, median returns and standard deviations of investments in French equities, French bonds and deposits

Mean return (as %) Median return (as %) Standard deviation of return

Bonds Equities Deposit Bonds Equities Deposit Bonds Equities Deposit

H = 12 months 0.68 % −3.99 % 0.39 % 0.76 % −3.22 % 0.47 % 4.19 18.70 1.06

H = 60 months 2.06 % −2.87 % 0.46 % 1.69 % −4.15 % 0.51 % 1.62 7.39 0.47

H = 96 months 2.14 % −2.91 % 0.46 % 1.47 % −3.19 % 0.49 % 1.40 3.90 0.20

H = 120 months 2.11 % −2.92 % 0.44 % 1.48 % −2.99 % 0.48 % 1.22 3.05 0.17


The higher volatility of equities relative to bonds is again found clearly in the Japanese case, although the traditional advantage of equities over bonds in terms of return is largely called into question on these series (see Graph 5). For a ten-year investment horizon, Japanese equities only very seldom made it possible to recover (in real terms) the capital invested (only for redemptions in 2007, and then between 2013 and 2015). As a reminder, for a 10-year investment in the French case, the unfavourable periods for redemption (negative annualised real return) were 2009 to 2012 and then 2015 and 2016. As could be seen from the graph of Japanese aggregate returns, the performance of Japanese equities was extremely mediocre over the past thirty years. Ultimately, the real return on Japanese equities was almost always negative for long-term investments. Conversely, for a 10-year investment horizon, Japanese bonds never posted a negative annualised return over the period examined (Graph 5).

Graph 8: Comparison of the distributions of returns after charges and taxes in the French and Japanese cases





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-.5 0 .5Annual return (Year-on-year, %)

JP-bond FR-bond

JP-stock FR-stock

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-.1 -.05 0 .05 .1 .15Annualised return (%)

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JP-stock FR-stock

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The comparison of the distributions of returns confirms, on the one hand, that the return on Japanese bonds is generally higher than the return on Japanese equities, and on the other hand that French instruments on the whole posted better performances than Japanese instruments (the blue curves are generally to the right of the red curves). Table 1 confirms that, whatever the investment horizon, the mean and median returns on equities are negative. On a mean and median basis, bonds outperformed equities and bank deposits, regardless of the investment horizon. In Japan as in France, interest rates went through a long phase of decline, even reaching the level of 0 % (certain short-term interest rates even became negative). If a forward-looking approach is adopted, it should be emphasised that a further fall in interest rates into sharply negative territory is impossible: the recent environment, so favourable to bond funds, is therefore not about to be repeated, in either France or Japan. Either interest rates will remain in the vicinity of zero (meaning a low return and limited potential for capital gains), or they will rise again (meaning an increased return on new issues, but capital losses booked on the stock). To sum up, Japanese equities were more volatile than bonds over the period in question, without necessarily delivering a better performance, or even a positive mean performance.

1.3. COMPARISON OF PERFORMANCE FOR MONTHLY SAVING OF A CONSTANT NOMINAL AMOUNT

We now examine the performance of regular monthly saving of a constant nominal amount (adjusted for inflation) over a given period (we adopt the same investment horizons as before). To avoid calculating the implied return on the savings, we reason in terms of outperformance relative to bank deposits: we will therefore consider the ratio between the final amount produced by the instrument (equity or bond) and the final amount produced by a deposit investment (which is therefore normalised to 1) depending on the investor's situation (regular saving or one-off investment).

Performance of equity and bond instruments relative to bank deposits (Japanese indices) for a one-off investment and for regular saving

Graph 9: For a one-year horizon


Graph 10: For a 5-year horizon


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Regular savings in equity

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Graph 11: For an 8-year horizon




The bond investment which seemed to give a higher performance in the case of a one-off investment yields less in the case of regular saving. In an environment of constant decline in Central Bank policy rates and bond yields since 1992 in Japan, the oldest investments have offered a higher return than more recent ones, and this has favoured one-off investment over regular saving. For a 10-year investment, the bond instrument appeared to give a higher performance than deposits in a one-off investment, although this result is not always found in the case of regular saving. Whereas, it is far more difficult to draw conclusions for equities, because their performance varies so much depending on the type of investment (one-off investment or regular saving), the investment horizon and the period. These graphs confirm the major finding obtained with the French asset series: the relative ranking of the investment instruments may be altered depending on whether it is a one-off investment or regular saving spread over time that is considered. In the case of an investment on an 8-year horizon, for redemption between 2013 and 2016, equities significantly underperform bonds in the case of a one-off investment, but significantly outperform them in the case of regular saving. A similar situation can be found for a ten-year investment, for redemptions between 2005 and 2007.

1.4. PORTFOLIO REBALANCING IN THE CASE OF A ONE-OFF INVESTMENT

We now consider the possibility for investors to build a mixed portfolio, consisting of 50 % equities and 50 % bonds. These investors can choose to let their portfolio composition fluctuate throughout the investment period depending on market performances, or else rebalance their portfolio regularly in order to restore the original allocation, i.e. 50 % equities and 50 % bonds. Here we examine the cases of monthly rebalancing and annual rebalancing, but many other frequencies are possible. The assumption here is that the investment is made in a vehicle offering access to several instruments, including an equity fund and a bond fund. The subscription and switch transaction fees are therefore identical for both instruments, with only the ongoing fees differing. Fees are assumed as follows:

Equity funds Bond funds

Subscription fee 2 %

Ongoing charges 1.5 % per annum 1 % per annum

Switch transaction fee 0.4 %

Redemption fee 0 %

As in the case of a single instrument, discussed above, the ongoing charges are applied every month on the fund’s current outstanding. There is no change in taxation, with a uniform rate of 30 % applied to the difference between the final amount and the invested amount, less subscription fees.

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Annualised real returns (net of charges and taxes) for different strategies

Graph 13: 1-year investment horizon


Graph 14: 5-year investment horizon


Graph 15: 8-year horizon


Graph 16: 10-year horizon


For a twelve-month investment horizon, the passive strategy seems to slightly outperform monthly rebalancing. Over longer-term horizons, comparison of the three strategies is more complex. In general, annual rebalancing seems to outperform monthly rebalancing (the purple curve is generally above the grey curve). However, while the rebalancing strategies outperform the passive strategy towards the end of the study period, the passive strategy seems to give better results at the start of the period. This is especially visible on Graph 17 for redemption dates prior to 2003, when the yellow and red curves are located below the x-axis, whereas, from 2003, the curves are found above this axis almost all the time.

Graph 17: Annualised return differential (in bp) for an investment on a 10-year horizon


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Passive strategy

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These graphical results are confirmed by Table 2 below. For a one-year investment, the passive strategy is, on average, preferable to the monthly rebalancing strategy. For an investment horizon of at least five years, the return on the annual rebalancing strategy is higher, on average, than the return on the passive strategy, which is itself higher than the return on the monthly rebalancing strategy. However, note that the relation linking length of holding period and frequency of outperformance of annual rebalancing over the passive strategy is not linear: the frequency of outperformance of the annual rebalancing strategy relative to the passive strategy is higher for an 8-year investment than for a 10-year investment.

Table 2: Mean return and outperformance of different strategies

Mean return Frequency of outperformance

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horizon

Passive

strategy

Monthly

rebalancing

Annual

rebalancing

Monthly

rebalancing

vs passive

strategy

Annual

rebalancing vs

passive strategy

1 year −1.74 % −2.01 % NA 47.13 % NA

5 years 2.34 % 1.22 % 2.59 % 37.00 % 57.00 %

8 years 2.99 % 2.01 % 4.21 % 57.58 % 72.35 %

10 years 3.27 % 1.96 % 4.83 % 54.58 % 66.67 %

Source: Datastream, AMF calculations Ultimately, though it is less pronounced than in the French case, we again find annual rebalancing outperforming the passive strategy. However, monthly rebalancing generally proves to be lower-performing than the passive strategy, whereas, on average, it outperformed the passive strategy in the French case.

1.5. PORTFOLIO REBALANCING COMBINED WITH MONTHLY SAVING OF A CONSTANT NOMINAL AMOUNT

Lastly, we consider the case of a mixed portfolio built by regular monthly saving. Once again, we will reason in terms of outperformance of different strategies relative to bank deposits: we compare the final amount obtained by the mixed portfolio with the final amount obtained through an investment in bank deposits.

Performance (net of charges and taxes) of different investment strategies against bank deposits

Graph 18: For a one-year horizon




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- 12 -

Graph 20: For an 8-year horizon




Graph 22: Ultimate performance differential for regular saving on a 10-year horizon


Table 3: Outperformance of different strategies

Mean outperformance relative to bank deposits Frequency of outperformance

Investment

horizon

Passive

strategy

Monthly

rebalancing

Annual

rebalancing

Monthly

rebalancing

vs passive

strategy

Annual

rebalancing vs

passive

strategy

1 year −2.14 % −2.25 % NA 47.41 % NA 5 years −0.05 % −0.59 % −0.03 % 34.33 % 50.33 % 8 years 0.74 % 0.26 % 1.24 % 39.39 % 67.42 % 10 years 0.60 % 0.08 % 1.41 % 57.08 % 77.50 %


For a one-year investment horizon, the mixed portfolio underperforms bank deposits on average. Conversely, for a holding period of more than five years, the mixed portfolio outperforms bank deposits on average. The monthly rebalancing strategy is outperformed on average by the passive strategy and the annual rebalancing strategy irrespective of the investment horizon. The annual rebalancing strategy outperforms the passive strategy on average. Moreover, as the holding period becomes longer, the frequency of outperformance of the annual rebalancing strategy increases. This therefore confirms the benefits of annual rebalancing.

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- 13 -

1.6. BEYOND A 50-50 EQUITY/BOND ALLOCATION

So far, the study has exclusively covered the performance of a portfolio consisting half of equities and half of bonds, but many alternative allocations are possible. We now analyse this possibility by calculating the portfolio's risk/return profile for each allocation, strategy and investment horizon. We decided that for both regular savings and a one-off investment we would use pseudo-returns, i.e. the final amount compared with the amount obtained using an equivalent strategy invested in bank deposits, minus 1.6

6 A pseudo-return of 0 means that on

average the investment performed as well as the bank deposit. In the following graphs, each allocation structure is represented by a single point that links the average pseudo-return across all available windows in the period under review with the standard deviation for that same pseudo-return (its risk). For each curve, the far left (at the top) corresponds to a 100 % bond allocation, while the far right (at the bottom) corresponds to a 100 % equity allocation. These extremes therefore correspond to “single-instrument” portfolios, which by definition do not require rebalancing. They are common to the various strategies.

Graph 23: Pseudo-risk/return profile for a mixed portfolio on a 1-year horizon (with or without charges and taxes)

Source: Datastream, AMF calculations NB: The solid-line curves show results excluding taxes and charges, while the dotted-line curves show results including taxes and charges.

6 These pseudo-returns are not annualised.

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- 14 -

Graphs obtained when suppressing the sub-optimal section of the risk/return plot


As seen earlier, the passive strategy is preferable to the monthly rebalancing strategy, whatever the chosen allocation and the type of investment (one-off or regular). When charges and taxes are taken into account, the investment in financial markets gives a lower performance than the investment in bank deposits (the curves are in negative territory). The general shape of the plots is very different from thos corresponding to the cases of France, Germany and the US (see Appendix). Generally, a better return is associated with a higher risk. In the present case, the highest mean return is obtained for a lower level of risk: Japanese equities experienced high volatility without generating significant long-run capital gains or returns, while the bonds’ value increased at a stable and sustained pace. Bonds outperformance relative to equity distorts the relationship between risk and return: the former is no longer rewarded. Indeed, it appears that a significant portion of the curves is actually inefficient, as the increase in risk-taking gets associated with a lowering of the expected return. No investor would be interested in selecting those asset allocations. For a 5-year investment, the annual rebalancing strategy outperforms the other two strategies. However, in the case of regular saving, the return differential between the annual rebalancing strategy and the passive strategy decreases and the curves almost merge. After taking into account charges and taxes, the investment in financial assets is more profitable than bank deposits only if the portfolio consists of at least 50 % bonds in the case of annual rebalancing, due to the good performance of Japanese bonds for around the past 30 years. Like for a one-year investment horizon, risk is not rewarded and is not linked to a higher return. The efficient portion of the plot is very limited.

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- 15 -

Graph 24: Pseudo-risk/return profile for a mixed portfolio on a 5-year horizon (with or without taxes)




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- 16 -

Graph 25: Pseudo-risk/return profile for a mixed portfolio on an 8-year horizon (with or without taxes)




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- 17 -

Graph 26: Pseudo-risk/return profile for a mixed portfolio on a 10-year horizon (with or without taxes)




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- 18 -

The longer the investment horizon, the more the curves steepen, while getting more concave. Accordingly, two allocations and therefore two different returns correspond to a given risk and strategy. Whereas in the conventional case (such as, for example, that which the French case study had highlighted), the risk/return graphs show a maximum return for a moderate risk, the Japanese case is characterised by a minimum risk for an intermediate return, and thus a large inefficient portion. Despite this difference of form, the outperformance of the annual rebalancing strategy relative to the passive strategy (which had been observed in the French case) is again perceptible here. For a given risk level, the annual rebalancing strategy generates a higher return than the passive strategy on average (the green curve is above the blue curve). As with a 5-year investment horizon, a mixed portfolio cannot always outperform bank deposits, especially when charges and taxes are allowed for.

- 19 -

2. ORIGINS OF THE BEHAVIOUR OF JAPANESE EQUITIES AND BONDS OVER THE STUDY PERIOD

In September 1985 Japan signed the Plaza Agreement, agreeing, inter alia, to intervene in the foreign exchange market in order to weaken the US dollar. The yen therefore appreciated massively (+60 % in less than one year), and this inevitably affected Japanese exporting firms and reduced GDP and inflation (Graph 27).

Graph 27: Yen/Dollar exchange rate, and Japanese GDP and inflation

Sources: US Fed, OECD, Ministry of Internal Affairs and Communications, Thomson Reuters Datastream

To offset its harmful impact on Japanese businesses and the Japanese macroeconomic environment, the Central Bank policy rate was rapidly reduced from 5 % in January 1986 to 2.5 % in April 1987. Households and businesses took advantage of this interest rate cut to borrow money and invest in domestic financial and real estate markets. As a consequence, the Nikkei, one of the two most significant Tokyo stock exchange indices, soared, as did real estate prices (Graph 28). Faced with the rise in both headline and core inflation resulting from the interest rate cuts (Graph 29), the authorities decided to raise the Central Bank policy rate as of May 1989, leading to a dramatic drop in the Nikkei in 1990 and a downturn in the real estate market in 1991.

Graph 28: Central-bank policy rate, Nikkei 225 and real estate prices

Sources: OECD, Nikkei, Bank of Japan

Graph 29: Central-bank policy rate and inflation

Sources : Bank of Japan, Ministry of Internal Affairs and Communications

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- 20 -

Since the investment in financial and real estate markets was largely financed by bank borrowing, the banks then started to accumulate a growing number of doubtful debts. The Japanese authorities therefore decided to cut the Central Bank policy rate once more and at the same time put in place an expansionary fiscal policy which contributed to a surge in public debt (Graph 30) but which was able to limit the negative impact of the crisis on GDP (Graph 31).

Graph 30: Japan's public debt (as a % of GDP)

Source: DG ECFIN AMECO

However, nothing was done to consolidate the banks' balance sheets, since the banks partly concealed their undercapitalisation and non-performing loans. Despite all this, signs of an improvement in the economy appeared from the mid-1990s (Graph 31), and this led the Japanese government to adopt a less accommodating fiscal policy, notably by increasing the VAT rate (from 3 % to 5 %) in April 1997.

Graph 31: Real GDP and industrial production

Sources: Cabinet Office, Ministry of Economy, Trade and Industry (*) Manufacturing and mining production.

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- 21 -

The Asian crisis which occurred in the summer of 1997 hurt the Japanese economy by reducing foreign demand at a time when the VAT hike was depressing domestic demand. The financial system was already very vulnerable and found itself in great difficulty. The combination of the Asian crisis, a more restrictive fiscal policy and the problems of the financial system pushed Japan into recession in 1998. Banks, real estate loan companies, consumer lending companies and securities trading firms went bankrupt. To prevent a systemic crisis, the Bank of Japan gradually reduced its policy rate to zero and provided the banks with liquidity, notably in its capacity as lender of last resort. Wanting to deleverage, Japanese firms endeavoured to cut wage costs through wage moderation from the end of 1997 and employment adjustment, which contributed to a rise in unemployment (Graph 32). Fiscal policy was also relaxed, and this enabled Japan to return to positive growth from 2000.

Graph 32: Participation rate, unemployment rate and wages

Sources: Ministry of Health, Labour and Welfare and Ministry of Internal Affairs and Communications

The bursting of the dot-com bubble in March 2000 hit the Japanese economy again. The banks' problems and lacklustre economic activity led to a fall in loans to households and exacerbated the decline in lending to non-financial corporations (NFC – Graph 33).

Graph 33: Lending to the private sector (in thousand billion yen)

Source: Bank for International Settlements

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- 22 -

The banks, meanwhile, had to cope with a growing amount of non-performing loans (Graph 34).

Graph 34: Non-performing loans for the banking sector as a whole (in billion yen)

Source: Financial Services Agency

The consolidation of the banking sector took place only in the early 2000s, notably using public funds. This necessary restructuring reduced the supply of bank loans, thereby causing a contraction in corporate investment. From then on, companies accumulated substantial excess savings (Graph 35).

Graph 35: Gross savings of Japanese non-financial corporations (in billion yen)

Source: OECD

At the same time, rising unemployment combined with stable or falling wages depressed household consumption, even after the economic recovery. The rise in the yen between 1998 and 2012 also exacerbated deflationary pressures. To these cyclical causes should also be added structural factors such as population ageing, which exerts downward pressure on potential growth and prices. Lastly, Japan was not spared by exogenous shocks: the 2008 crisis and then the natural disasters of 2011. The combination of these factors pushed Japan into a prolonged period of disinflation or even deflation. Since 1997, therefore, Japan has seen only a few brief periods of positive core inflation.

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- 23 -

The economic policies adopted by Prime Minister Shinzo Abe ("Abenomics") in 2012 aimed to finally bring Japan out of this period of deflation using three tools, the "three arrows" of fiscal stimulus, monetary easing and structural reform. However, so far Abenomics has only partially fulfilled its objective.

7

7 Japan faced with deflation: What are the results of Abenomics?, Trésor-Éco No. 184, November 2016.

- 24 -

3. THE INTEREST OF THE JAPANESE CASE FOR A FRENCH INVESTOR

France's situation since 2008 is in certain respects similar to that experienced by Japan. The subprime crisis initially led to a fall in share prices and real estate prices (Graph 36).

Graph 36: Real estate prices and CAC 40

Sources: INSEE, Euronext Paris

The European Central Bank (ECB) initially reacted by reducing its policy rate and providing liquidity for the banks. However, some observers consider that the ECB's cut in its policy rate was too gradual and belated, and the ECB even introduced several rate hikes during the crisis (July 2008, April 2011 and July 2011 – Graph 37).

Graph 37: Policy rate of the European Central Bank (as a %)

Source: European Central Bank

Likewise, the implementation of quantitative easing by the ECB (in January 2015) could be considered belated. This was also the case in Japan, where quantitative easing was implemented only in March 2001. These policies meant that central banks substantially increased their balance sheets (Graph 38). Going hand-in-hand with an accommodating monetary policy, fiscal policy was eased, leading to a significant increase in public debt (Graph 39).

- 25 -

Graph 38: Balance sheets of the European and Japanese

central banks (01/01/2007 = 100)

Graph 39: Public debt (as a % of GDP)

Sources : Bank of Japan, BCE Source : DG ECFIN AMECO

Since the crisis, headline inflation has remained a long way from its target (although it moved closer to it sporadically in 2017 and 2018) and core inflation is low despite the European Central Bank's very expansionary monetary policy (Graph 40). There is therefore a legitimate fear that the euro area might experience a situation similar to that of Japan. The advantage of the euro area compared with Japan lies in weaker deflationary pressures, because the crisis took the form of a rise in the unemployment rate rather than a fall in wages (Graph 41).

Graph 40: Central Bank policy rate and inflation in

France

(*) Core inflation excludes prices subject to State intervention (electricity, gas, tobacco, etc.) and products whose prices are volatile (oil products, fresh produce, dairy produce, meat, flowers and plants, etc.). Sources: European Central Bank, INSEE

Graph 41: Unemployment rate and wage level

in the euro area

Source : INSEE, DARES

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- 26 -

CONCLUSION:

In order to adopt a more forward-looking viewpoint, we have analysed the hypothetical behaviour of the principal financial assets if the euro area were to experience a "Japanese-style scenario". In such a situation, the one-off investment appears far more favourable to bonds than to equities. When investors are looking to build a mixed portfolio, consisting of half equities and half bonds, the annual rebalancing strategy is a winning strategy whether for a one-off investment or regular saving. This result was already found for French financial assets. Finally, the risk/return profiles for different allocations of a mixed portfolio appear atypical, especially for longer investment horizons (8 and 10 years). Accordingly, there are two allocations and therefore two different returns that correspond to a given risk and strategy: there is actually a large group of allocations that are inefficient as other portfolios would yield the same return at a lower risk.

- 27 -

BIBLIOGRAPHY

Adda, J. (2008). Les leçons de la déflation japonaise [The lessons of Japanese deflation], Alternatives économiques No. 275. https://www.alternatives-economiques.fr/lecons-de-deflation-japonaise/00037969 Alimi, M. (2014). L’Europe en voie de japonisation : feuille de route [Europe on the way to Japanisation: a road map]. Globalix. http://globalix.fr/content/leurope-en-voie-de-japonisation-feuille-de-route Artus, P. (2018). La BCE dans le piège de la Banque du Japon [The ECB in the Bank of Japan ‘s trapp], Flash Economie, 14 décembre 2018 – n°1434. Ciornohuz, V. (2016). Le Japon face à la déflation : quel bilan des Abenomics [Japan faced with deflation: What are the results of Abenomics?], Trésor-Éco No. 184. Darpeix, P.-E. & Mosson, N. (2018). The comparative performance of different savings strategies that use French instruments. Risks and Trends Papers Series of the Autorité des marchés financiers, Feb. 2018, 49p. https://www.amf-

france.org/en_US/Publications/Lettres-et-cahiers/Risques-et-tendances/Archives?docId=workspace%3A%2F%2FSpacesStore%2Feb48e4ce-4793-42ee-bd7c-

12c4daab4c5a&langSwitch=true Hoshi, T., & Kashyap, A. K. (2004). Japan's financial crisis and economic stagnation. Journal of Economic perspectives, 18(1), 3-26. Marini, P. (2009). Le Japon face à la crise [Japan faced with the crisis]. Briefing No. 294 (2008-2009) produced on behalf of the "Commission des finances". https://www.senat.fr/rap/r08-294/r08-294_mono.html Tokuoka, K., Syed, M. M. H., & Kang, M. K. (2009). “Lost Decade” in Translation: What Japan’s Crisis could Portend about Recovery from the Great Recession (No. 9-282). International Monetary Fund.

http://www.alternatives-economiques.fr/lecons-de-deflation-japonaise/00037969

http://globalix.fr/content/leurope-en-voie-de-japonisation-feuille-de-route

https://www.amf-france.org/en_US/Publications/Lettres-et-cahiers/Risques-et-tendances/Archives?docId=workspace%3A%2F%2FSpacesStore%2Feb48e4ce-4793-42ee-bd7c-12c4daab4c5a&langSwitch=true



http://www.senat.fr/rap/r08-294/r08-294_mono.html

- 28 -

Appendix : Pseudo-risk/return graphs for three economies

The various economies do not necessarily offer their private savers a guaranteed product paying a risk-free rate (equivalent to the Livret A passbook account in France or the rate of remuneration of deposits in Japan). To allow comparability, the following pseudo risk/return graphs are obtained by comparing the final real amounts with the real amounts invested (rather than with the real amounts obtained in the risk-free investment). The nominal indices are adjusted for the specific domestic inflation of each country. The solid lines show results excluding taxes and charges, while the dotted lines show results including taxes and charges. NB: The simplifying assumptions for charges and taxes are common (they correspond to the French case).

- 29 -

UNITED STATES OF AMERICA

(SP 500 index / government bond index, 10-year constant-maturity / US inflation / FR charges)

Source : datastream, calculs AMF


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.1.1

5.2

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 30 -



0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

.65

.7

Yie

ld

0 .1 .2 .3 .4 .5 .6 .7 .8Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 31 -

FRANCE (without reference to the "risk-free" instrument)

(CAC 40 index / government bond index, 10-year constant-maturity / FR inflation / FR charges)



0

.02

.04

.06

.08

.1

Yie

ld

0 .05 .1 .15 .2 .25Risk

Passive strategy

Monthly rebalancing


0

.02

.04

Yie

ld

0 .05 .1 .15Risk

Passive strategy

Monthly rebalancing


0

.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 32 -



0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

.65

.7

Yie

ld

0 .1 .2 .3 .4 .5 .6 .7 .8Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 33 -

GERMANY

(DAX 30 index / government bond index, 10-year constant-maturity / DE inflation / FR charges)



0

.02

.04

.06

.08

.1

Yie

ld

0 .05 .1 .15 .2 .25Risk

Passive strategy

Monthly rebalancing


-.02

0

.02

.04

.06

Yie

ld

0 .05 .1 .15Risk

Passive strategy

Monthly rebalancing


0

.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 34 -



0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

.65

.7

Yie

ld

0 .1 .2 .3 .4 .5 .6 .7 .8Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 35 -

JAPAN (without reference to the "risk-free" instrument)

(TOPIX index / government bond index, 10-year constant-maturity / JP inflation / FR charges)



-.04

-.02

0

.02

.04

Yie

ld

0 .05 .1 .15 .2 .25Risk

Passive strategy

Monthly rebalancing


-.03

-.02

-.01

0

.01

.02

Yie

ld

0 .05 .1 .15Risk

Passive strategy

Monthly rebalancing


0

.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 36 -



0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

Yie

ld

0 .1 .2 .3 .4 .5 .6Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3

Yie

ld

0 .1 .2 .3 .4Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


0

.05

.1.1

5.2

.25

.3.3

5.4

.45

.5.5

5.6

.65

.7

Yie

ld

0 .1 .2 .3 .4 .5 .6 .7 .8Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


.05

.1.1

5.2

.25

.3.3

5

Yie

ld

0 .1 .2 .3 .4 .5Risk

Passive strategy

Monthly rebalancing

Annual rebalancing


- 37 -

This report has been coordinated by the Research, Financial Stability and Risks Directorate of the AMF. It is based on sources considered reliable, but whose exhaustiveness and reliability cannot be guaranteed. The views expressed in "Risk and Trends" are those of the authors; they do not necessarily reflect the position of the AMF. Copying, distributing or reproducing this report, in full or in part, is subject to prior express written authorisation from the AMF.

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