Target Date Fund’s popularity set to Grow

Target Date Funds are popular, particularly amongst Millennials, and this growth is expected to continue.

This is a key insight from a WealthManagement.com survey of 530 retirement plan advisors in the US. The survey was conducted in February 2019. (TDF Survey Feb 2019)

 

Target Date Funds (TDF), also referred to as Glide Path Funds or Life Cycle Funds, automatically reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

In previous posts I have highlighted it is important to understand the shortcomings of TDF given their growing dominance international. According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.

Encouragingly, the shortcomings of TDF can largely be overcome.

 

The WealthManagement.com survey highlighted that almost half of those surveyed expect to increase their use of TDF in the next two years.

From this perspective, the following insights are provided from the survey:

  • TDF are an important tool in many retirement plans: 61% of Advisors surveyed currently have clients invested in target date funds.
  • TDF also typically represent an important component of their retirement plan when used.
  • Many plan advisors expect the reliance on TDFs to increase in the coming years.

 

Risk Management and Glide Paths

Of the Advisors surveyed longevity and volatility where the top two risks.

“The popularity of TDF was partly attributed to their ability to help retirement plan advisors address two of the biggest risks to successful retirement: longevity and volatility risk.”

“These two risks line up well with the strengths of the glide path concept. In particular, the gradual reduction in equity exposure over time seeks to minimize volatility in retirement, while the exposure to the growth potential of equities beyond retirement hedges against longevity risk.”

 

It is also noted that Glide paths help manage other risks, such as behavioural risks – to guard against investors adjusting their investment allocations based on emotions.

 

Interestingly: Nearly two-thirds of plan advisors (63%) report favouring a “through” glide path for clients, over a “to” glide path (37%); the latter achieves and maintains a conservative allocation at the target date, while the former reduces its equity allocation gradually throughout retirement.

“Given that retirement can last for 30 years or more, and that more plan advisors prioritize longevity risk over volatility risk, a “through” glide path is logically the more attractive feature.”

 

Customisation

The report observes that one of the major appeals TDF is the ability to contribute money to an investment account that automatically shifts its asset allocation over time according to a pre-determined schedule.

Therefore, in evaluating TDF Advisors tend to focus on the mix of assets and allocation in the glide path and the glide path itself.

Although Fees are a consideration, it is worth emphasising the above two aspects are considered the most important by Advisors in determining which TDF to recommend to Clients.

 

Therefore, it is not too surprising that a greater degree of customisation would be attractive to Advisors so as to better meet Client’s investment objectives:

  • Most advisors surveyed (59%) believe that more customization versus off-the-shelf options would help make TDFs more useful and more attractive to clients.
  • In fact, the most commonly cited reason advisors say they don’t use TDFs in the plans they advise is the lack of customizability (33%).

 

Goals-based Investing

Further to the above customisation observations, the report notes that the popularity of TDF among retirement plan advisors may be linked to advisors’ tendency to take a goals-based investment approach:

  • Just over half of the plan advisors surveyed (51%) identified most strongly with a goals-based label, as compared to targeting outperformance against a benchmark (41%)

“It’s perhaps not surprising that a group that favors the use of TDFs would also favor an investment strategy built around a specific target or outcome. This trend suggests that if goals-based investing is in fact gaining broader popularity, TDFs may benefit from increased usage as well.”

 

Shortcomings of Target Date Funds

I have posted previously on the shortcomings of TDF.

Essentially, Target Date Funds have two main shortcomings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, current level of income to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2.  Additionally, the glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

    • Delays in pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme risk environments

 

I have advocated the customisation of the fixed income allocation within TDF would be a significant step toward addressing the shortcomings of many TDF. The inclusion of Alternative assets and the active management of the glide path would be further enhancements.

These shortcomings are consistent with the desire for a greater level of customisation from Advisors.  Although not explicitly addressing the shortcomings outlined above, the following commentary from the report is interesting:

“A comment from one retirement plan advisor with more than 25 years of experience in the industry hits on multiple suitability issues at once. “TDFs look only at age and not where we are in the interest rate cycle,” he says. “Retirement date is not a terminus date, and many clients still need growth well after their retirement date.”

While most TDFs do not explicitly factor the interest rate cycle into their glide paths, many do address the need to maintain exposure to growth beyond the target retirement date—particularly through the choice of a “through” glidepath, although perhaps not at the level advisors would like to see. “

 

This is a great insight and consistent with my previous posts where it has been highlighted that maintaining high levels of cash at time of retirement is scandalous. This is addressed by having an equity allocation at the time of retirement (through glide path) and a more customised fixed income allocation within the TDF.

 

Measuring success

Great to see:

“In keeping with the general tendency toward a goals-based approach identified earlier, however, it is noteworthy that advisors most commonly evaluate TDF performance relative to peer groups (40%) and not based on outperformance of a benchmark, whether an industry index (21%) or a custom benchmark (16%).”

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Improve investment decisions – Behavioural Finance

Behavioural finance is the branch of behavioural economics that focuses on finance and investment. It encompasses elements of psychology, economics, and sociology.

Behavioural finance has gained increased prominence since Daniel Kahneman was awarded the Nobel Prize for economics in 2002. (Kahneman was recently involved in analysis of the regret-proof Portfolio.)

Kahneman is best known for identifying a range of cognitive biases in his work with the late Amos Tversky. These biases, and heuristic (which are mental shortcuts we take to solve problems and make judgments quickly), are consistent deviations away from rational behaviour (as assumed by classical economics).

Richard Thaler, also awarded a Nobel Prize, has made a large contribution to Behavioural Economics, his work has had a lasting and positive impact within Wealth Management.

There is a continued drive to better understand how our behaviour affects the decisions we make.

From an investing perspective, failing to understand our behaviour can come with a cost.  By way of example, the cost could be the difference between the returns on an underlying investment and the returns received by the investor.

 

In short, we have behavioural biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioural biases. Behavioural Finance can help us make better investment decisions.

There are lots of good sources on Behavioural Finance, none other than from Joe Wiggins, whose blog, Behavioural Investment, provides clear and practical access to the concepts of Behavioural Finance.

 

By way of example, Joe has recently published “A Behavioural Finance Toolkit”. This is well worth reading (Behavioural Finance Toolkit).

The Toolkit helps us understand what Behavioural Finance is and then identifies the major impediments to making effective investment decisions.

These impediments are captured in the “MIRRORS” checklist outlined below:

As the Toolkit outlines: “An understanding of our own behaviour should be at the forefront of every decision we make. We exhibit a number of biases in our decision making. While we cannot remove these biases, we can seek to better understand them. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.

Investors should focus on those biases that are most likely to impact their investment decisions – and those supported by robust evidence. We have developed a checklist to reduce errors from the key behaviours that affect our investment decisions – ‘MIRRORS’.”

 

M Myopic Loss Aversion We are more sensitive to losses than gains, and overly influenced by short-term considerations.
I Integration We seek to conform to group behaviour and prevailing norms.
R Recency We overweight the importance of recent events.
R Risk Perception We are poor at assessing risks and gauging probabilities.
O Overconfidence We over-estimate our own abilities.
R Results We focus on outcomes – the results of our decisions – when assessing their quality.
S Stories We are often persuaded by captivating stories.

The Toolkit provides detail on each of these impediments.

 

Risk Perception is the big one for me, particularly the ability to gauge probabilities and to effectively probability weight risks.

This is vitally important for investors and for those that sit on Investment committees.

Identifying risks is relatively easy, we tend to focus on what could go wrong.

As this The Motley Fool article highlights, being pessimistic appears to sound smart, and being optimistic as naïve. As quoted in the article: John Steward Mill wrote 150 years ago “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”

 

Albeit, in truth, assigning a probability to a risk, the likelihood of an event occurring, but also its impact, is a lot more difficult than merely stating a “potential” risk.

Remember, “more things can happen than will happen” – attributed to Elroy Dimson who also said “So you manage risks by comparing them to potential returns, and through diversification. Remember, just because more things can happen than will happen doesn’t mean bad things will happen.”

 

The Toolkit highlights that Noise affects our decision making.

“Our decisions are affected by noise; random fluctuations in irrelevant factors. This leads to inconsistent judgement. Investors can reduce the effects of noise and bias through the consistent application of simple rules.”

 As quoted “Where there is judgement, there is noise, and usually more of it than you think” – Kahneman

 

Accordingly, the Toolkit offers six simple steps to improve our decision making; three dos and three don’ts.

  • Do have a long-term investment plan.
  • Do automate your saving.
  • Do rebalance your portfolio.
  • Don’t check your portfolio too frequently.
  • Don’t make emotional decisions.
  • Don’t trade! Make doing nothing the default.

The central point: “These six steps seem simple but are not easy. We cannot remove our biases, or ignore the noise. Instead, we must build an investment process that helps us overcome them.”

There is a lot of common sense in the six steps outlined above.

 

Finally the Toolkit outlines four books that have changed the way we think about thinking!

I’d like to suggest a couple of books that I value highly, which are on topic, and with a risk focus angle as well:

  1. The Undoing Project, A Friendship That Changed Our Mind, Michael Lewis, this book outlines the relationship between Kahneman and Tversky, and the collaboration they had in developing their theories, including highlighting the different experiments they undertook. In doing so, Lewis provides practical insights into the types of biases we have in making decisions.
  2. Against the Gods, The Remarkable Story of Risk, Peter L. Bernstein. True to its label this book provides a history of the perception of risk and its management over time, right up to modern times, emphasising: more things can happen than will happen!

 

Both books provide fascinating accounts of history.

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

 

Impact Investing – a large and growing market

A recent Report by the Global Impact Investing Network (GIIN) estimated the size of the Global Impact Investing universe to be $502 billion (see: Sizing the Global Impact Investing Market).

It is important to note this is a separate measure “to estimates of the size of related markets (such as ESG or socially responsible investing). Neither, of course, are accurate or complete indicators of the current impact investing market size.”

 

The GINN report defines “impact investing as investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments are made in both emerging and developed markets as well as across all asset classes, including private and public markets.”

 

They also note that impact investing has gained significant momentum over the last decade “as both an investment strategy and an approach to addressing pressing social and environmental challenges. Through impact investments, investors seek to generate both a financial return and positive, measurable social and environmental impact.”

 

The Article provides a detailed explanation of their approach and types of organisations included in the analysis. There is also a section on how to interpret the results.

The database captures many types of organizations. Over 60% are asset managers. About one in five are foundations, and the rest include banks, development finance institutions, family offices, and institutional asset owners.

The database also includes a global group of investors. The majority are based in developed markets, including the U.S. and Canada (58%) and Western, Northern & Southern Europe (21%). It also includes investors based in regions like Sub-Saharan Africa, Latin America & the Caribbean, the Asia-Pacific, and the Middle East & North Africa.

 

 

Market Size

GIIN estimates the overall global impact investing industry AUM is USD 502 billion, as of the end of 2018.

They estimate that there is over 1,340 active impact investing organizations across the world.

They also estimate the median investor AUM is USD 29 million, the average is USD 452 million, indicating that while most organizations are relatively small, several investors manage very large impact investing portfolios.

Overall, asset managers account for about 50% of estimated AUM who typically channel capital via specialized managers.

Investments are across the board, including venture capital, private equity, fixed income, real assets, and public equities.

This is an important study, previously, as they noted in their article, a well-defined estimate of the size of the impacting market did not exist. This provides a benchmark to measure future industry growth.

 

Conclusions

The GIIN Report concludes as follows:

“Since the term ‘impact investing’ was formally coined in 2007, the industry has grown in leaps and bounds. With a growing recognition of the power of investment capital to address pressing social and environmental challenges, impact investing has attracted the attention of an increasing number of investors of all types and from all over the world. Indeed, over 50% of active impact investing organizations made their first investment in the past decade.

This research shows that there are over 1,340 active impact investing organizations across the world who collectively manage USD 502 billion in investments intended to bring about positive change. These figures are a snapshot as of the end of 2018, yet the market is quickly growing and will continue to do so. Indeed, it must: trillions of dollars are needed to effectively address the critical social and environmental challenges that face the world today, such as those outlined in the Sustainable Development Goals.

In order to meet global need, much more capital will need to be unlocked for impact investing — but there is good reason to be optimistic. One in four dollars of professionally managed assets (amounting to USD 13 trillion) now consider sustainability principles. There is great potential for these investors, who have already aligned their capital with their values, to more intentionally use their investments to fuel progress through impact investments. The growing consideration of social and environmental factors in investing is also a signal of a larger shift in the global financial markets — an increasing number of people are recognizing that their money should do more than just make more money. Their investments can — and should — also seek to fuel meaningful, sustainable social and environmental impact.”

 

 

This is a very interesting study and provides a benchmark to measure future growth of impact investing. Globally it is a large market and it is sure to grow further.

Likewise, impact investing is gaining a growing presence in New Zealand. Based on international evidence, there is a strong demand from investors for investments that generate positive, measurable social and environmental impact alongside financial returns.

Fort those wanting more background on Impact Investing this report posted by the Ākina Foundation maybe of interest (Ākina Foundation Impact Investing Sept 2017).

 

Happy investing.

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

 

 

 

 

Financial Climate Change – And the Risks are with You!

The impending global pension crisis is well known, the numbers are staggering, and will worsen dramatically from here unless something is done.

Nevertheless, the well-known demographic problem is only one third of the story.

Increasingly the risks of the pension shortfall are residing squarely with the individual, who typically lack the time and expertise required to make such complex financial decisions. Furthermore, there is a lack of appropriate investment products to meet post-retirement challenges.

Addressing the retirement savings gap requires several responses. For the individual, more sophisticated and robust investment solutions and greater tailoring of the investment advice is required.

New Zealand is not immune from these global trends. Appropriately, the lack of post-retirement investment solutions in New Zealand has been identified and has had increased coverage recently.

To my mind, not just in New Zealand but globally, Goals Based Investment solutions with a focus on delivering a more stable level of income in retirement are a fundamental part of the retirement solution. Importantly, the investment knowledge and capabilities are available now to meet the challenges ahead.

 

The global savings gap is highlighted in the infographic from Raconteur, which illuminates a growing problem attached to an aging population.

As this article by Visual Capital highlights, the World Economic Forum (WEF) estimates that the combined retirement savings gap, for the following eight major countries: Canada, Australia, Netherlands, Japan, India, China, the United Kingdom, and the United States, is growing at $28 billion every 24 hours!

“The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050…..”

The size of the global retirement savings gap is very well presented in the Raconteur infographic

As we know, we are all living longer, “life expectancy has risen by three years per decade since the 1940s”……. “The population of retirees globally is expected to grow from 1.5 billion to 2.1 billion between 2017-2050, while the number of workers for each retiree is expected to halve from eight to four over the same timeframe.”

As noted in the article, the WEF has made clear that the situation is not trivial, likening the scenario to “financial climate change”

 

In short, this is a major issue that needs to be addressed, and with a high degree of urgency, otherwise the effects are likely to be overwhelming.

This is not just a global issue, but also here in New Zealand.

The range of initiatives include raising the retirement age and likely cuts to benefits.

Specially for the individual, more sophisticated and tailored investment solutions are required. Goals Based investment solutions to be specific.

 

But wait, there is more!

Research by EDHEC Risk Institute builds on the view provided above. As they note, the three pillars of the retirement savings system are under duress.

The first pillar is the State/Government pension, as noted above. Nevertheless, this is only a third of the story.

The Second and Third Pillars are as follows.

The Second Pillar is the shift globally from Defined Benefit (DB) schemes to Defined Contribution (DC) e.g. Super Funds, Retirement Accounts, KiwiSaver. This shift takes the risk of delivering retirement income from the employer to the employee. Under a DC scheme the investment decision has been squarely placed with the individual. A default option is often provided if no investment decision has been made.

The Third Pillar is the growth of private savings, given the erosion of the above two Pillars. This is for those that can make additional savings and for those in retirement. Quite obviously the investment decision(s) rest with the individual, who typically lack the time and expertise required to make such complex financial decisions.

The key point with the Third Pillar is the lack of investment solutions globally to appropriately provide a secure and sustainable level of replacement income in retirement.

As EDHEC highlight:

Insurance companies, asset managers and investment banks offer a variety of so-called retirement products such as annuities and target date funds, but they hardly provide a satisfactory answer to the need for retirement investment solutions. Annuities lack flexibility and have no upside potential, and target date funds have no focus on securing minimum levels of replacement income.

 

The Solution

Luckily, there are appropriate investment solutions to help address the growing retirement shortfall.

Goals Based Investment solutions can help address the shortcomings of both Pillar Two and Three.

This Blog is filled with Posts on Goals Based Investing and the short comings of many Target Date Funds. For New Zealand readers I have outlined what a Goals Based investment solution would look like as a Default Fund option within Kiwisaver.

To recap, the modern day investment solution requires “flexicurity”. This is an investment solution that provides greater flexibility than an annuity and increased security in generating appropriate levels replacement income in retirement than many modern day investment products.  #EDHEC

The focus on generating replacement income in retirement should be considered during the accumulation phase.

The concept of Goals Based Investment solution is not radical, the investment frameworks, techniques, and approaches are currently available. The implementation of which can be easily handled by any credible fixed interest team.

Goals Based Investment solutions have been shown to increase the likelihood of reaching retirement income objectives. They also achieve this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested into growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Lastly, Goals-Based Investment strategies provides a better framework in which to access the risk of not meeting your retirement goals.

 

Happy investing.

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, a robust portfolio is broadly diversified across different risks and returns.

Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative, and hedge fund risk premia. And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above. There has been a disaggregation of investment returns.

Not all of these risk exposures can be accessed cheaply.

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

 

Growing importance of ESG within the Alternatives sector

The growing importance of ESG within the Alternatives sector is one of the key themes from the JP Morgan Alts Survey March 2019.  This survey provides some fascinating detail on the state of the Global Alternatives industry, including Private Equity, Real Estate, Infrastructure and Hedge Funds.

Some of the other highlights from the survey include:

  • Diversified benefits – correlation matrix
  • Strategy and manager selection is vitally important – dispersion of manager returns
  • Detailed analysis of the varying Alternative categories e.g. hedge funds and real estate, including drivers of returns

 

As noted in previous Posts, Kiwisaver Funds are underweight Alternatives relative to the rest of the world, an alternatives allocation would be beneficial for Target Date Funds, and US Endowment have provided superior long term returns after fees due their successful allocations to Alternatives.

 

The benefits of Alternatives have been well documented and they are set to continue to become a larger part of Client portfolios over time as outlined by the recently published Prequin Global Alternatives Report.

 

Therefore, not surprisingly, according to JP Morgan, “Institutional investors are flocking to hedge funds this year, even after a turbulent 2018 marked by poor performance and market volatility.”

The demand for hedged funds is driven by the search for market-beating returns and diversification.

They found that about a third of respondents plan to boost allocations, up from 15 percent in 2018. Just 13 percent expect a decrease while 55 percent said they plan to maintain current allocations.

As a recent Bloomberg article highlighted, the hedge fund industry took its biggest annual loss last year since 2011, declining 4.8 percent on a fund-weighted basis, according to Hedge Fund Research Inc. Managers were hurt by volatility that trampled markets, and hedge funds saw $33.5 billion in outflows.

JPMorgan polled 227 investors with about $706 billion in hedge fund assets for its annual Institutional Investor Survey.

 

For those new to Alternatives, a recent Investment News article provides some wonderful insights into the benefits of Alternatives and implementation challenges with clients.

With regards to the benefits of Alternatives, comments by Dick Pfister, founder and president of AlphaCore Capital, a firm that allocates between 15% and 30% of client assets to alternative investments, are worth highlighting.

“We look at some alternatives as diversifiers,” he said. “But we will also look at other alternatives as ways to capture chunks of up markets.”

The article notes the “message that investors, advisers and allocators like Mr. Pfister understand is that the big picture perspective rarely looks good for alternative investments, which is why those who dwell on broad category averages often get stopped at the gate.”

The article continues “Making the case for alternatives, which are generally designed to neutralize market beta and enhance alternative alpha, is never easy when market beta is robust in the form of a bullish stock market.”

“That is the reality of allocating to alternative investments. To benefit from the diversifying factors, investors and advisers must appreciate that losing less than the market can often mean gaining less than the market.”

“There’s always something to complain about when you have a diversified portfolio,” said Hans-Christian Winkler, a financial planner at Claraphi Advisory Network, where client portfolios have between 20% and 30% allocated to alternatives.

“A diversified portfolio will never outperform the market, but in times like the last quarter of 2018, when we saw the market down 20% from the high, our portfolios with alternatives were down 5%,” he added. “By using alternatives, you are spreading out your risk and making your investment portfolio a lot less bond-market- and stock-market-dependent.”

 

These are key points, they highlight the benefits but also the challenges when it comes to positioning Alternatives with clients and stakeholders e.g. Trustees, Investment Committees.

Alternatives “underperform” on a relative basis when equity and bond markets perform strongly.  This can have some challenges with Clients, the article is well worth reading from this perspective, as it provides insights into how a number of Advisors are positioning Alternatives with their Clients.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Pioneering work on yield-curve inversions and risk of economic recession

There is no doubt that global economic growth has slowed over the last six months. The Reserve Bank of New Zealand (RBNZ) highlighted rising global economic risks in its recent Policy statement. The RBNZ noted that economic growth has slowed in our major trading partners of Australia, China, and Europe.

Economic growth has also slowed in the US. Although US financial conditions have eased in recent months, they did tightened over the course of 2018.

The risk of a US recession has risen in recent months. Albeit calls of a US recession have been around for some time.

A recent article by Gary Shilling in Think Advisor captures the type of the analysis undertaken on the US economy over the last 18 months.

Leading economic indicators for the US have weakened. Nevertheless, they are not consistent with forecasting a looming recession, except perhaps one, an inverted yield curve which is discussed below.

Overall the US economy is in good health, with record low unemployment, growing incomes, high saving rates, strong household balance sheets, business investment is set to increase, as is Government spending.

 

As Shilling notes in his article, the US economy could go several ways e.g. economic growth rebounds over 2019, the US experiences a period of prolonged moderate economic growth without a recession, or the US experiences a classic economic cycle and tips into a recession at a later date due to the US Federal Reserve raising interest rates.

By Shilling’s count, there have been 12 occasions since World War 2 that the Fed raising interest rates has resulted in a recession. Presently, this would appear some time away  given the Fed has indicated it is unlikely to undertake further interest rate increases in 2019.

The later scenario is most consistent with the consensus view – it is a little early to call a US recession, yet the risks of a recession within the next 2-3 years are growing. For the time being the US continues to expand and will enter its longest period of economic expansion in modern history in July 2019. Recession will eventually be triggered by the Fed increasing interest rates resulting in a more “garden variety” recession.

 

And this leads to a key point in Shilling’s article, the word recession invokes images of a Global Financial Crisis (GFC) type outcome – not surprising given this was our last experience.

His expectations are that the next US recession will not be as severe as the GFC.

He has a similar view with respect to the next US “Bear” market (i.e. fall in value of greater than 20%).

I’ll leave it to him to explain:

“Recession” conjures up specters of 2007-2009, the most severe business downturn since the 1930s in which the S&P 500 Index plunged 57 percent from its peak to its trough. The Fed raised its target rate from 1 percent in June 2004 to 5.25 percent in June 2006, but the main event was the financial crisis spawned by the collapse in the vastly-inflated subprime mortgage market.

 Similarly, the central bank increased its policy rate from 4.75 percent in June 1999 to 6.5 percent in May 2000.  Still, the mild 2001 recession that followed was principally driven by the collapse in the late 1990s dot-com bubble that pushed the tech-laden Nasdaq Composite Index down by a whopping 78 percent.

The 1973-1975 recession, the second deepest since the 1930s, resulted from the collapse in the early 1970s inflation hedge buying of excess inventories. That deflated the S&P 500 by 48.2 percent. The federal funds rate hike from 9 percent in February 1974 to 13 percent in July of that year was a minor contributor.

The remaining eight post-World War II recessions were not the result of major financial or economic excesses, but just the normal late economic cycle business and investor overconfidence. The average drop in the S&P 500 was 21.2 percent.

 

In short, history shows that US sharemarkets drop by about 21% when the economy falls into recession, remembering the S&P 500 fell almost 20% during the last three months of 2018.

 

Inverted Yield Curve

As you will know, the slower economic growth has resulted in several Central Banks, with the RBNZ the latest, to turn more cautious on the outlook for economic growth and inflation. This list includes the US Federal Reserve, European Central Bank, and Reserve Bank of Australia.

This sudden change in direction of interest rate policy (Monetary Policy) has witnessed a flattening of yield curves (when longer-dated interest rates are at similar level to shorter-term interest rates).

In the US, the yield curve has become inverted, where longer-term interest rates are lower than shorter-term interest rates.

The inversion has primarily been due to the significant reduction in longer-term interest rates rather than the increase in shorter-term interest rates (inversions normally occur when short term interest rates are increased rapidly by Central Banks).

The significance of this is that prior to the last 7 US recessions the yield curve has inverted each time.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

As you can imagine a lot has been written in recent weeks on the implications of a negative yield curve, I would like to highlight the following three articles, which pretty much sums up the current debate:

  1. A very recent interview with the person who undertook in 1986 the pioneering work on yield-curve inversions and their foreshadowing of economic downturns (RA-Conversations)
  2. Mohamed A. El Erain’s article of “Beware of Misreading Inverting Yield Curve “
  3. BCA LinkedIn Post, Yield Curve Inversions and S&P 500 Peaks, don’t get bogged down in the noise.

 

It would appear, that when it comes to the current inversion of the US yield curve, we have “Nothing to fear but fear itself” (Franklin D. Roosevelt). This is certainly the view of Mohamed A. El Erain.

 

I have blogged previously on the history of inverted yield curves and their predictive ability. Similar there is also a previous post on the anatomy of equity Bear markets.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Balance Funds are not on Target for Default KiwiSaver Investors

Personally I am not convinced with the suggestion of moving KiwiSaver Default Fund Investors into a Balance Fund is the right solution, as was recently promoted in a Stuff article.

It is certainly a bit of a stretch to claim it is a radical idea. Nor is it really something materially different, it is a variation on a current theme – what equity allocation should be targeted.

 

The Balance Fund solution would result in a higher equity allocation, which in theory, and observed in practice over the longer term, will “likely” result in higher savings account balances. This is not guaranteed of course.

On this basis, a higher allocation is more likely to be appropriate for some Default Fund investors but not all. Conceivably it may be more appropriate for more than is currently the case.

Albeit, it is far from an ideal solution.

As noted in the article, it would not be appropriate for those saving for a house deposit, a high equity allocation is not appropriate in this situation. Therefore, there is still a need to provide advice as suggested. Unfortunately, whether it is a Conservative or Balance Fund a level of advice will be required.

A higher equity allocation may not necessarily result in a better outcome for KiwiSaver investors, what happens if an investor switches out of the higher equity weighted fund just after a major market correction as they cannot tolerate the higher level of market volatility. It may take years to get back to their starting position. Over the longer term, they may have been better off sticking with a more Conservative Fund. This is a real risk given a lack of advice around KiwiSaver.

This is also a real risk currently given both the New Zealand and US sharemarket have not had a major correction in over 10 years and both are currently on one of their best performance periods in history.

A higher level of volatility may result in pressure on the Government to switch back to a more conservative portfolio at a later date. A variation on the above individual situation which would likely occur at exactly the wrong time to make such a change in an equity allocation.

 

A more robust investment solution is required.

 

A possible Solution?

Perhaps the solution, and some may argue a more radical and materially different approach, is to introduce Target Date Funds as the Default Fund KiwiSaver solution.

Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement. Administratively it is more complex for the Providers, as many different Funds are required, as is a higher level of oversight.

Target Date Funds adjust the equity allocation on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through salary and wages. These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy. This is a generalisation and does not take into consideration the individual circumstances of the investor nor market conditions.

Target Date Funds are becoming increasingly popular overseas e.g. the US and Australia. Particularly in situations where the Investor does not want or cannot afford investment advice. The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice is provided.

 

All good in theory, nevertheless, these products have some limitations in their design which is increasingly being highlighted.

Essentially, Target Date Funds have two main short comings:

  1. They are not customised to an individual’s circumstances e.g. they do not take into consideration future income requirements, likely endowments, level of income generated up to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2. Additionally, the equity allocation glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion i.e. asset returns eventually return back toward the mean or average return
    • Therefore, linear glide paths, as employed by most Target Date Funds, do not exploit mean reversion in assets prices which may require:
      • Delays in pace of transitioning from risky assets (equities) to safer assets (cash and fixed income);
      • Stepping off the glide path given extreme market risk environments

The failure to not make revisions to asset allocations due to market conditions is inconsistent with academic prescriptions and common sense, both suggest that the optimal strategy should display an element of dependence on the current state of the economy.

The optimal Target Date Fund asset allocation should be goal based and multi-period:

    • It requires customisation by goals, of human capital, and risk preferences
    • Some mechanism to exploit the possibility of mean reversion within markets

 

To achieve this the Investment Solution requires a more Liability Driven Investment approach: Goals Based Investing.

Furthermore, central to improving investment outcomes, particularly most current Target Date Funds and eliminating the need for an annuity in the earlier years of retirement, is designing a more suitable investment solution in relation to the conservative allocation (e.g. cash and fixed income) within a Target Date Fund.

From this perspective, the conservative allocations within a Target Date Fund are risky when it comes to generating a secure and stable level of replacement income in retirement. These risks are not widely understood nor managed appropriately.

The conservative allocations within most Target Date Funds can be improved by matching future cashflow and income requirements. While also focusing on reducing the risk of inflation eroding the purchasing power of future income.

This requires moving away from current market based shorter term investment portfolios and implementing a more customised investment solution.

The investment approach to do this is readily available now and is based on the concept of Liability Driven Investing applied by Insurance companies, called Goal Based Investing for investment retirement solutions. #Goalbasedinvesting

 

Many of the overseas Target Date Funds address the shortcomings outlined above, including the management of the equities allocation over the life cycle subject to market conditions.

This is relevant to improving the likely outcome for many in retirement. This knowledge is helping make finance more useful again, in providing very real welfare benefits to society. #MakeFinanceUsefulAgain

 

As we know, holding high Cash holdings at retirement is risky, if not scandalous.

We need to be weary of rules of thumb, such as the level of equity allocation based on age and the 4% rule (which has been found to be insufficient in most markets globally).

We also need to be weary of what we wish for and instead should actively seek more robust investment solutions that focus on meeting Clients investment objectives.

 

This requires a Goals Based Investment approach and an investment solution that displays “flexicurity”. This is an investment solution that provides greater flexibility than an annuity and increased security in generating appropriate levels replacement income in retirement than many modern day investment products.

This is not a radical concept, as discussed above the investment frameworks, techniques, and approaches are currently available to achieve better investment outcomes for Default KiwiSaver investors.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Further growth expected for an Alternative future – Prequin

The outlook for Alternative investments continues to look bright according to the recent Prequin Global Alternatives Report.

Prequin note investor’s motivations for investing in alternatives are quite distinctive:

Private equity and venture capital, motives = high absolute and risk-adjusted returns

Infrastructure and real estate, motives = an inflation hedge and reliable income stream

Private debt, motives = high risk-adjusted returns and an income stream

Hedge Funds, motives = diversification and low correlation with other asset classes

Natural Resources, motives = diversification and low correlation with other asset classes

Prequin comment “Set against these objectives, it becomes clear why investors have not only consistently increased their allocations to alternative assets over the past decade, but also why they are planning to continue to do so in the years ahead (not to mention the growing number of investors that come into alternatives each year – i.e. growing ‘participation’).”

Interestingly, investors are expressing an increasing allocation not only to those alternatives that have exceeded expectations recently (Private equity and venture capital, private debt, infrastructure, real estate), but are also looking to increase allocations to areas where recent performance has disappointed – notably hedge funds and natural resources. As they note “the diversification and low correlation offered by these assets may be especially attractive in a challenging returns environment.”

 

Importantly, the Prequin survey is set against a backdrop where investors “see a challenging environment ahead for returns.”

They also note that continued growth is expected despite alternative assets having enjoyed a “tremendous decade of growth” and “becoming ever more vital in investors’ portfolios worldwide;”

 

With regards to expected growth, “Preqin is sticking with its forecast for further growth of alternative assets to 2023: from $8.8tn in assets under management in 2017 to $14.0tn in 2023.”

 

The full Prequin report is available and covers each of the Alternative strategies outlined above.

The Preqin-Alternatives-in-2019-Report, for example, provides some interesting facts and figures on Hedge Funds:

  • 59% of Surveyed investors believe we are the top of the equity cycle, 40% intend to position their portfolios defensively
  • 79% of surveyed investors intent to maintain or increase their level of allocation to hedge funds over the next 12 months

 

For further articles on Alternatives by Kiwi Investor Blog:

  1. An Alternative Future for Kiwisaver Funds
  2. Alternatives Investments will improve the investment outcomes of Target-Date Funds
  3. Future’s Hedge Funds
  4. Investment Fees and Investing like an Endowment – Part 2
  5. Perspective of the Hedge Fund Industry
  6. Adding Alternatives to and Investment Portfolio – Part 3 – Investing Like an Endowment Fund
  7. Adding Alternatives to and Investment Portfolio – Part 2
  8. Adding Alternatives to and Investment Portfolio

 

 

Happy investing.

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

 

High cash holdings a scandalous investment for someone in retirement

Arguably a primary goal of retirement planning is to provide a stable and secure stream of replacement income in retirement. Such income should be sufficient to support a desired standard of living in retirement.

Therefore a key risk is uncertainty about how much spending (consumption) can be sustained in retirement.

Fundamental to this approach is measuring risk relative to the spending/consumption goals. As a result, the focus should not be on the size of the account value (Super pot). Nor is volatility of capital and returns a true measure of risk.

The size of the super pot, Kiwisaver account balance, does not tell someone the level of income that can be generated to support a desired standard of living in retirement.

As a result, strategies that focus on capital preservation, such as holding high levels of cash and short-term fixed income strategies, are more risky and volatile relative to the investment goal of generating a stable and secure stream of replacement income in retirement.

Therefore, holding high levels of cash at the time of retirement could potentially be a very poor investment decision, as is proposed by a number of Target Date / Life Stages investment products.

 

The Analysis

Dimensional Funds Advisors (DFA) undertook analysis comparing two investment strategies relative to the goal of generating a stable and secure level of income in retirement:

  1. Goals based strategy that looks to generate sufficient income in retirement to match expected spending (consumption). This is called a liability-driven investment strategy or “LDI”.
  2. Capital preservation strategy that is invested in Cash as a means to manage the volatility of the account balance.

 

The following conclusions can be drawn from the DFA analysis:

  • The LDI strategy provides a stable stream of replacement income in retirement
  • The LDI strategy provides greater clarity and confidence to plan for retirement
  • The Cash strategy results in a high level of volatility relative to the goal of generating a stable level of income

 

The DFA analysis highlight that, relative to the Income goal, the LDI’s estimated volatility relative to this goal was 2.9%, compared to 20.7% for Cash strategy.

As far as range of outcomes, DFA compared the LDI and Cash strategy over a number of 10-year periods between 1962 and 2015, 44 overlapping 10-year periods.

“The pattern was clear. In all 10-year periods, the LDI strategy is relatively stable”. Meanwhile the Cash strategy “is a rollercoaster”.

If we assume the Investment goal was to deliver $1 of income every year, the analysis showed that annual income from the LDI strategy ranged between $0.97 and $1.09.

Conversely, the Cash strategy generated retirement income outcomes from $0.35 to $2.09. The median outcome was $0.67, this is well below $1 desired and the $1.01 LDI median.

 

Why?

In simple terms, the LDI strategy is a long-term bond portfolio that matches the expected retirement spending/consumption goal. Effectively, the LDI strategy generates cashflows to match future expected spending. This reduces volatility relative to the retirement spending goals. This is exactly the same approach insurance company’s implement to pay out future expected liabilities (insurance claims).

DFA conclude that “any strategy that attempts to reduce volatility using short- to intermediate-term fixed income, when the goal is a long-term liability like retirement consumption, will not be as effective as the LDI strategy.”

Although cash is perceived as low risk, it is not low risk when it comes to generating a steady and secure stream of replacement income in retirement. Short term fixed income securities, while appropriate for capital preservation, are risky if the goal is meet future spending/consumption.

 

This is not a fantasy, the portfolio construction techniques are available today to implement LDI strategies, which should not be beyond the capability of any credible fixed interest team to implement.

 

Goals Based (LDI) Strategy Benefits

  1. More stable level of income in retirement
  2. More efficient use of capital – potentially need less retirement savings
  3. Better framework to make trade-off between allocation to equities and LDI fixed income portfolio in improving the likelihood of reaching desired standard of living in retirement.

 

If an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will need additional precautionary savings to meet their retirement income requirements.

 

Therefore, an LDI strategy increases the likelihood of reaching the retirement income objectives. It also achieves this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

 

Lastly, the LDI strategy provides a better framework in which to access the risk of not meeting your retirement income goals.

 

Holding a large allocation to Cash does not tell you if you are able to generate a sufficient level of income to support a desired standard of living in retirement.

 

The approach outlined here is consistent with EDHEC Retirement Income Framework. Furthermore, such an approach applied to the Income assets of the Target Date Fund would greatly improve the efficiency and effectiveness of such products.

 

Dimensional conclude”

“If one of the primary goals of retirement savings is to provide for consumption in retirement, the investment approach should be aligned with the investment goals. This means that it is important to manage the risks that are relevant to the goal. In the case of retirement income, two primary risks are inflation and interest rate risk, both of which can be addressed with an LDI approach to risk management. Not having the right risk management in place leads to unnecessary uncertainty about how much income one can afford. Additionally, investors may sacrifice returns unnecessarily. As investors shift away from growth assets, they tradeoff some expected return to gain risk reduction. So, it’s imperative that the investments reduce the risks that matter to make this a good tradeoff. We show that a blended LDI and equity solution may be able to achieve a better balance of growth vs. risk reduction—…………………”

 

Happy investing.

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.