Changing the Conversation on Management Fees

Bloomberg report:

“BlackRock Inc. is tired of the conversation about costs. The world’s largest asset manager, which runs some of the cheapest investment products available, plans to place a greater focus on the quality of the engineering, construction and management of its funds going forward, …… “

“There’s too much emphasis purely on cost,” said Senra, ……….. “We don’t talk enough about quality. That’s not to say we’re not going to be competitive — we have to be competitive, this is a competitive industry — but I would move away from just a low-cost conversation.”

 

I agree, “too much emphasis purely on cost”, investment management fees, there should be a “greater focus on the quality of engineering, construction, and management”, and “we don’t talk enough about quality”.

 

Now don’t get me wrong, I think investment management fees are important.  I also think we should have a mature discussion about fees.  

The cheapest solution may not be the best, a race to bottom is not helpful.  And I’d say, not necessarily in the best interest of investors.

 

There are many reasons why you might consider paying more for something.  In an investing context this could be for greater levels of true portfolio diversification to manage portfolio volatility and return outcomes, for example the model followed by US Endowment Funds which has been very successful.

 

I appreciate BlackRock is making comment in relation to gaining access to certain areas of the market that they believe will deliver greater return outcomes overtime. 

 

I think this is an interesting issue when framed in the context of Responsible Investing.  Particularly in relation to quality of data, portfolio construction, and portfolio management.   From a more broader perspective, it also  helps highlight issues beyond just a headline investment management fee.

 

The evidence is compelling, Environmental, Governance and Social (ESG) investing can be a clear win for companies.  It can also be a clear winner for investors, yet it is not easy to capture this value.

For a start the ESG data is not consistent across providers.  At the company level this creates a diversity of opinion amongst providers.  Several studies have highlighted the contrasting conclusions of ESG data providers. (See this article on ESG Scoring, sourced over LinkedIn and published by RBC GAM.) 

Studies highlight the low level of correlation between ESG data.  This can result from different weighting systems that generate an ESG score and that there is a level of subjectivity in determining the materiality of ESG input.

 

Let’s consider this from a New Zealand perspective.

As the recent RIAA Benchmark Report  highlights:

“When primary and secondary RI strategies are taken into account, the dominant responsible investment strategy is negative screening, which represents 44% of AUM. Where ESG integration was nominated as the primary strategy, it was usually paired with either corporate engagement and shareholder action, or negative screening, as secondary strategies.”

Negative Screening is the dominant Sustainable Investing approach in New Zealand, to move beyond this will take an increasing level of resources and time.

There is a lot more to RI than negative screening.  The implementation of negative screening is not straight forward i.e. coming up with the investment philosophy, approach, and framework takes time and consideration, trading on the exclusion list is relatively straight forward.

 

As the RIAA Report covers, there are seven broad RI strategies as detailed by the Global Sustainable Investment Alliance (GSIA) and applied in the Global Sustainable Investment Review 2018, which maps the growth and size of the global responsible investment market.

The Broad RI strategies are:

  1. ESG integration
  2. Corporate engagement and shareholder action
  3. Negative/exclusionary screening
  4. Norms-based screening
  5. Positive/best-in-class screening
  6. Sustainability-themed investing
  7.  Impact investing and community investing

 

Best practice RI involves the full spectrum of these strategies, negative screening, ESG integration, Best-in-class and impact investing, at the very least.  This includes corporate governance and shareholder action.

 

So how do New Zealand’s leading investment managers compare to best practice.  The RIAA report makes the following comment in relation to New Zealand managers:

“There’s a growing number of investment managers applying leading practice ESG integration, but the overall number remains small. Of the 25 investment managers assessed, just eight (32%) are applying a leading approach to ESG integration (score >80%). That said, the number of leading ESG integration practitioners has risen from four last year, with some employing other responsible investment strategies as their primary strategy.”

 

It is great to see ongoing progress.

To implement leading ESG integration practices, let alone capture the full value of the ESG factors, takes time and resources.  Those managers making this commitment are to be commended.  It takes a lot of hard work.

The market leading managers are applying a wide range of sustainable investing approaches and resources.  This comes at a cost.

 

Therefore, some thought must be given to quality of RI outcomes being delivered and are they in line with best practice and is there continuous improvement in place.  Do they meet customers expectations?

 

Accordingly, I agree, let’s change the conversation about investment management fees, there are a lot of issues to consider other than investment management fees alone.

There is a lot to consider in delivering robust outcomes to investors.

Happy investing.

 Please see my Disclosure Statement

 

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

Unscrambling the Sustainable Investing Return Puzzle

“The evidence is compelling: Sustainable investing can be a clear win for investors and for companies. However, many SRI fund managers, who have tended to use exclusionary screens, have historically struggled to capture this. We believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value. ESG best-in-class focussed funds should be able to capture superior risk-adjusted return if well executed.”

This is the key finding of a Deutsche Bank Group (DB) report published in 2012, Sustainable Investing, Establishing Long-Term Value and Performance

The DB report looked at more than 100 academic studies of sustainable investing around the world, and then closely examined and categorized 56 research papers, as well as 2 literature reviews and 4 meta studies.

To the point, they comment “… most importantly, “Environmental, Social and Governance” (ESG) factors are correlated with superior risk-adjusted returns at the securities level…..”

DB were surprised by the clarity of results. Which are as follows:

  • 100% of academic studies agree that companies with high ratings for Corporate Social Responsibility (CSR) and most importantly ESG factors have a lower cost of capital, for debt and equity. The market recognises them as having lower levels of risk.
  • 80% of studies show that companies with high ESG ratings exhibit market-based outperformance. The market is showing correlation between financial performance and what is perceived as the advantages of ESG strategies.
  • The single most important factor is Governance, Environment is next, closely followed by Social.

 

The study shows quite clearly that ESG factors matter at the security level, with consistent evidence of better financial performance.

The key for investors and fund managers is the ability to identify and capture these factors. This is a key issue as it comes down to the ESG scoring approach (whether active or index based) implemented, level and definition of portfolio exclusions.

It comes down to how ESG is integrated into the investment process.

 

Unscrambling Fund performance

A common perception is that Sustainable Investing is hard to define and provides mixed results – there is no really clear evidence it leads to a superior risk-adjusted return.

A key conclusion from DB is that “Sustainable investing has been too closely associated for too long with the performance of SRI Funds. These funds are not only an extremely broad category (i.e. in terms of investment mandate), but historically were based more exclusionary (or negative) – as opposed to positive best-in-class-screening.”

DB note that the Academic studies have not been aggregated and classified into appropriate categories, but have been mixed together, thus providing mixed results.

DB: “ By “unscrambling” them – as we do in this paper – a clearer picture emerges.”

 

“Socially Responsible Investing (SRI) in the academic literature have tended to rely on exclusionary screens – show SRI adds little upside, although it does not underperform either. Exclusion, in many senses, is essentially a value-based or ethical consideration for investors.”

With regards to the SRI Funds, the results are mixed, largely support they do not underperform, and there is no significant difference in performance.   Neutral to mixed results.

These results are limited to the review of SRI Funds only, they did not look at categories of ESG Funds.

 

DB found that ESG factors are correlated to superior performance at the security level, as highlighted above.

The real issue is how Managers are attempting to capture the superior performance from ESG factors at the security level in their portfolios.

Therefore, implementation and the approach taken to integrate ESG into the investment process is key in capturing the excess returns available from Sustainable investing as identified by the DB.

 

Increasingly, positive ESG investing, commonly referred to best-in-class, approach is being employed.

Best-in-class is an investment approach that focuses on companies that have historically performed better than their peers within a particular industry or sector on measures of environmental, social, and corporate governance issues. This typically involves positive or negative screening or portfolio tilting.

Best-in-class compares to exclusion, also called negative screening, where companies involved in certain “controversial” activities, such as tobacco or weapons are removed or excluded from an investor’s portfolio.

Best practice includes exclusions, ESG integration with a focus on best-in-class, and Impact investing, the full array of Sustainable Investing.

Crucially it requires an understanding of how to integrate ESG criteria in to the investment process, so as to capture the full value of the ESG factors.

 

Summary

DB note that the analysis on SRI performance goes a long way towards explaining why the concept of sustainable investing has taken so long to gain acceptance, it has been too closely associated for too long with the SRI fund manager results, which is a very broad category and has historically been based on exclusions, as opposed to a best-in-class screening.

They note that ESG investing, by contrast takes a best-in-class approach. DB have analysed the various categories within the universe of sustainable investing, they confidently say that the ESG approach, at an analytical level, works for investors and companies (in terms of lower cost of capital).

“It is now a question of ESG best-in-class funds capturing the available returns.” This is a key point.

So while Sustainable investing is the term use to refer to all form of investment, DB believe using ESG factors in a best-in-class approach is emerging as the key investment methodology. It is worth noting this was forecast in 2012 and is coming into fruition now.

DB note: “Investors should seek out investment managers who understand the ESG advantages and can leverage the information arbitrage that exists in the studies we examined. Sustainable Investing can pay dividends, but it requires managers who have internalised this information into their investment process and can also create appropriate strategies to help capture the upside that undoubtedly exists in this approach.”

Or put another way: “In effect, the conclusion is that there are superior risk-adjusted returns for investors, but managers need to take the right approach toward sustainable investing in order to capture these. For corporations, these are important results but the implication of lower cost of debt and equity capital must surely make this a key issue for any CFO, not just the CEO and Sustainability Officer.”

As an aside, this has implications in relation to the fee debate and manager selection. This will be covered in a future Post.

 

Another Comprehensive Study

A more recent study, ESG and financial Performance: aggregated evidence from more than 200 empirical studies, published in 2015 came up with similar conclusions.

They too found clear evidence in support of ESG investing. Their central conclusions was: “the orientation toward long term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors……..”

As  mentioned, implementation is key. Therefore, when selecting an index provider or/and active manager, their integration of ESG factors into the investment process and strategy is very important, as also highlighted by the DB study.

The full conclusion of the 2015 study:

“Through a second-level review of 60 review studies – including both, vote-count studies and meta-analyses – on the ESG–CFP relation, we are able to combine more than 3700 study results from more than 2200 unique primary studies. Based on this sample, we clearly find evidence for the business case for ESG investing. This finding contrasts with the common perception among investors. The contrary perception of investors may be biased due to findings of portfolio studies, which exhibit, on average, a neutral/mixed ESG–CFP performance relation. It is important to be aware that the results of these (to date about 150 studies) are overlaid by various systematic and idiosyncratic risks in portfolios and, in the case of mutual funds, by implementation costs. Still more than 2100 other – in particular company-focused – empiric studies suggest a positive ESG relation. ESG outperformance opportunities exist in many areas of the market. In particular, we find that this holds true for North America, Emerging Markets, and in non-equity asset classes. Our results propose that capital markets so far demonstrate no consistent learning effects regarding the ESG–CFP relation: Since the mid-1990s, the positive correlation patterns in primary studies have been stable over time.

 Based on this exhaustive review effort, our main conclusion is: the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors. A key area for future research is to better understand the interaction of different ESG criteria in portfolios and the relevance of specific ESG sub-criteria for CFP. These insights will shed further light on the ESG determinants for long-term positive performance impacts.”

 

Happy investing.

 

Please see my Disclosure Statement

 

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

 

Not Investing Responsibly

The United Nation’s responsible investing body, Principles for Responsible Investment (PRI), could delist up to 50 groups next year, as reported by the FT.

Seemingly, almost a third of the PRI signatories placed on a watchlist by the PRI are at risk of being booted out of the body next year.

Last year the PRI put 180 of its signatories on notice after an annual audit suggested they had not demonstrated a minimum standard of responsible investment activity.

 

Signatories to the PRI, which include asset owners and managers, commit to six principles (See below) designed to embed environmental, social and governance (ESG) considerations into mainstream investing and holding companies they invest in to account on ESG failures.

Signatories must file an annual report to the PRI detailing their progress. And continuing to make progress is key. An organisation has to do more each year. You are either in or you are out!

 

According to the FT article, the PRI last year gave those on the list two years too lift their game. The responsible investment body said 88 on the watchlist made improvements and met the minimum requirements this year. It is also working with 42 signatories who are on track to do so by 2020.

However 50 groups with $1tn in assets have failed to engage with efforts to get them to shape up and are at risk of being delisted. The PRI refused to name names.

As the article highlights “The move comes at a time of greater scrutiny of whether investors are practising what they preach when it comes to responsible investment. “We still have some where they haven’t met with us,” said Fiona Reynolds, chief executive of the PRI, who said it was hard to know why they have not done so. “The aim was always to get people moving, not to delist people.” The PRI also requires that at least half a fund manager’s assets be covered by a responsible investing policy and for there to be explicit commitment to the issue by senior managers.”

 

Raising the Bar on free riders

This comes after the PRI signalled last year they were raising the bar by introducing new minimum hurdles. PRI is also pushing its 1900-plus members to be more active on issues like climate change, human rights and corruption. The SMH reported that collectively this group has US$70 trillion in assets under management.

As outlined by the SMH “The PRI put in place minimum requirements, a move it hopes will strip out free-riders in its ranks while bolstering its relevance, more than 10 years after the PRI’s launch by then-United Nations secretary general Kofi Annan and a group of major institutions……….. “And it wants its members to be more active in holding companies to account on so-called ESG – environmental, social and governance – issues, with climate change risks, fracking, corruption, water rights, modern slavery and child labour among its current areas of focus.”

 

As noted in the SMH article many PRI signatories proudly tout their membership, sustainability reports and marketing materials, but about 10 per cent would not currently meet the proposed new hurdles.

 

Responsible investing is more than establishing portfolio exclusions.

Being a PRI signatory takes a real commitment. Increasingly the PRI is asking signatories to be more active. This includes investors wield their proxy votes against company management when more gentle forms of engagement – like letters to boards and meetings – fail to get results.

Collaborating with the industry is also a key component of being a signatory, e.g. PRI members have collectively pushed for more disclosure on issues like water quality, air emissions, and community consultation and consent by fracking companies, and for improved labour practices in agricultural supply chains.

Also, late last year, the PRI backed the Climate Action 100+ campaign, launched by 200 institutional investors with US$26 trillion in assets under management, which aims to push 100 high-emitting companies including BHP, Rio Tinto and Wesfarmers to curb emissions and boost climate risk disclosure.

 

As outlined in a previous post, increasingly best practice involves incorporating ESG Integration, Exclusions, and Impact Investing into the investment process and implementing across a variety of asset classes i.e. not just equities.

Furthermore, while exclusions adopt a negative approach, increasingly the ESG research is being applied in a positive way i.e. investing in companies with the best ESG practices rather than just avoiding those with the worst practices.

 

Signatory Requirements

PRI signatories are required to report once a year on their activities, pay their fees and declare their intention to invest responsibly via the six voluntary and aspirational principles.

They also have to:

  • have a responsible investment policy that covers at least 50 per cent of their assets under management,
  • name a person within the organisation that is responsible for carrying it out, and
  • spell out who in their group’s senior ranks is accountable for it.

 

As the SMH records they are not particularly high hurdles.

It is not that onerous and it is amazing what can be achieved with steady incremental improvements.

 

How to avoid being on the PRI Black List?

A recent UBS Survey highlighted that a lack of internal resources was one of the most important barriers to ESG related thinking. Unclear terminology was another, along with a fear it will hurt financial performance (I hope to blog on this barrier later).

A lack of internal ESG implementation knowledge, particularly on Boards and Trustees can not only be a barrier to taking the first steps toward being a Responsible Investor, it is also a barrier for the advancement and continuous improvement of the Responsible Investing approach the PRI is looking for.

Terminology is a barrier but can be easily overcome.

Furthermore, from this perspective, the first step an organisation should take when adopting ESG and a Responsible Investing approach is to formulate a Policy. This signals a genuine intent to start integrating ESG. The Policy should be Board approved.

Therefore, very surprisingly, the USB Survey found that only a minority of ESG adopters (7%) had established a Policy. This is staggering. 40% of the survey respondents said no – but would like to do this! wow. 30% just said no.

The UBS ESG Survey, Do you or don’t you? Received 613 responses from asset owners, across 46 countries representing EUR19 Trillion in assets.  Not all the respondents were PRI Signatories.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

PRI Principles

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Could Buffett be wrong?

As has been widely reported Warren Buffett frequently comments on the benefits of investing in low-cost index funds.

He’s reportedly instructed the trustee of his estate to invest in index funds. “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund,” he noted in the Berkshire Hathaway’s 2013 annual letter to shareholders.

 

Not that I want to disagree with Buffett, I have enormous respect for him, incorporate many of his investment insights and philosophies into my own investment approaches. Albeit, I think he might be wrong on this account.

And this is not to say Index Funds do not have a part to play in a portfolio, nor that investment fees are not important. They are. I do think more portfolios should be invested along the lines of Endowments. Broad diversification is the key.

 

Following Buffett could be the right advice for a young person starting out with many years until retirement.  Such an investor would need to weather the volatility of being largely invested in equities, which is no mean achievement when equity markets can suffer falls of over 40%. A high equity strategy can become horribly undone.

Nevertheless, as one gets closer to retirement and is in retirement Buffett’s strategy is unsuitable.

Similarly Buffett’s strategy is not appropriate for a Pension Fund or Endowment. These Funds are in a similar position to those in retirement. Meanwhile, the equity allocation should be reduced as one gets closer to retirement.

The short comings of a higher equity allocation was highlighted in a recent article  by Charles E.F. Millard, who is a consultant to AQR Capital Management, LLC.

 

Once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.

The key point that Millard makes is that Pension Funds and Endowments are required to make periodic payment obligations. So do those in retirement, they either draw capital or income from the portfolio to sustain a desired standard of living.

 

Ultimately, it the drawing of an income or the payments by Endowments that consume most of the investment returns. “This is why assets don’t just mushroom over time.”

As Millard explains, “each year endowments usually pay out at least 5% of their holdings, and the institutions they support tend to count on those funds. That changes the situation an awful lot.”

Let’s look at the math. Millard explains”

and assume that each year the endowment pays out 5% of its assets. In that case, starting at $1 million, the endowment would not have the $5.3 billion Buffett imagines. Rather, after having paid out almost $145 million along the way, the endowment would have less than $150 million remaining”

Still a great result, but far from the billions assumed by Buffett.

It is also worth noting that a Pension’s obligation (liability) can continue to grow as employees retire and live longer. The Pension Fund has no ability to reduce its payouts and must manage this risk.

 

This is where market volatility comes into play, particularly drawdowns – a large fall in the value of the market.

“In a prolonged stock market drawdown, those growing benefit payments will consume a larger share of the shrunken plan assets.  So, they can’t take too much solace in long-run optimism when in the intermediate run they’re already paying out much of their capital.”

 

This is a key point. You can’t take comfort in the long-term returns from equities when you are running out of money!

Equity markets do fall in value and this is why institutions with meaningful annual pay-out obligations are not invested only in equities.

 

No argument that equities will not outperform over the longer term, this is highly likely. Yet this observation fails to recognise the volatility inherent in equities.

Millard:

“Over Buffett’s 77 years investing, the endowment CIO would see fund assets decline in 23 out of 77 years (when equity returns didn’t cover the 5% distribution), and in the average bad year, the fund would shrink by -12%. But at least an endowment may be able to reduce its spending; a pension fund can’t, so in a bad year, the fraction of pension assets that must be paid out increases substantially. This is why most institutional investors subscribe to a concept that Buffett seems to hate – diversification. He’s said it’s “a protection against ignorance.” We think it is more a protection against hubris.”

Diversification is key.

“It is worth noting that Institutions do not seek to maximize potential long-term returns, without regard to risks. They often seek to maximize the likelihood that they can meet their payout obligations. They seek to be reliable payers of those obligations. And in the case of pensions, they also seek to make it possible for the employer to have somewhat predictable and affordable contribution obligations. A portfolio of stocks alone doesn’t do that. That’s why asset class diversification is a bedrock principle of modern investing.

 

In short, institutional investors have different goals and obligations to Buffett.

For those in retirement, their goals and obligations are more closely aligned with the Pension Fund and Endowment, than Buffett and Berkshire Hathaway. Those closer to retirement need to make sure that market volatility does not impact them and their ability to sustain the standard of level they wish to maintain in retirement.

 

Happy investing.

Please see my Disclosure Statement

 

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

Sustainable Responsible Investing Spectrum

The terminology used in relation to Responsible Investing can be confusing. For example, often the terminology Responsible Investing gets confused by some to mean exclusively Ethical Investing or Social Responsible Investing (SRI).  Both of which have been shown to deliver below market returns.  They are separate activities along the Responsible Investing continuum.

At an institutional Funds Management level Responsible Investing (RI) has been associated with the United Nations Principles of Responsible Investing (PRI).  PRI has six principles, see below.

Often sector/stock exclusions are implemented and/or an overlay or integration of taking into consideration Environmental, Social and Environmental (ESG) criteria is employed.

This approach to RI has been around for some time, particularly in Europe and Australia.

It is now well established that considering or integrating ESG information leads to better-informed investment decisions.

 

However, the Sustainable Development Goals (SDG) are an important recent development. The SDG are a collection of 17 global goals set by the United Nations General Assembly in 2015 for the year 2030.

The SDG take Responsible Investing, sustainability, to the next level by making it more tangible and measurable.

 

As a result, there is a growing and important change in the approach toward RI, from just avoiding those companies with a negative impact on the environment to investing in companies that have a positive way.

Therefore, SDG have impacted RI in a couple of important ways:

  • The RI continuum has become more defined with the increased focus on Impact Investing.  As presented in the Table below, the RI continuum moves from “Financial Only” to “Impact Only”
  • Industry terminology is moving on from RI to Sustainable Investing.

 

The Continuum of “Responsible Investing”

Financial Only Limited or no regard for environmental, social or governance practices
Responsible (ESG) Mitigate risky environmental, social or governance practices in order to protect value
Sustainable Adopt progressive environmental, social or governance practices that may enhance value
Impact (a)

Financial

Address societal challenges that generate competitive financial returns for investors
Impact (b)

Likely below market Returns

 

Address societal challenges which may generate a below-market financial return for investors

Impact (c)

Require below Market Returns

Address societal challenges that require a below market financial return for investors
Impact Only Address societal challenges that cannot generate financial return for investors

The information in the above Table is sourced from: Lessons from Social Impact Investment Taskforce: Asset Allocation Working Group, 12 December 2014.

 

Using the Table above, the RI continuum starts at “Financial Only” considerations and ends at “Impact Only” considerations.  Using this continuum the following observations can be made in relation to the objective(s) each RI category is focusing on achieving, there is an overlapping nature:

  1. Generating competitive financial returns are an object starting from Financial Only and persisting to Impact (b).
  2. The objective of mitigating Environmental, social and governance risks starts from Responsible (ESG) and continues right through to Impact Only
  3. The Pursuit of environmental, social, and governance “opportunities” starts at Sustainable and is maintained through to Impact Only
  4. The goal of focusing on measureable high-impact solution obvious begins with Impact (a) and until Impact Only.

 

Therefore, as mentioned, RI is increasingly encompassing sustainability. Sustainable Investing.

The UN-backed Principles for Responsible Investment explains sustainability investing as follows: “We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.”

Fund managers, such as RobecoSAM, would use the term sustainability investing to mean “the pursuit of superior financial returns coupled with positive environmental, social and corporate governance outcomes”.

Sustainable Investing can be thought of as having three main components:

Integration

Using ESG information to improve the risk and return profile.

Exclusions

Avoiding investment in areas of controversial products or business practices.

Impact

Investing for socioeconomic impact alongside the financial returns.

 

Each of these components could be done in isolation or in combination with each other.

Increasingly best practice is incorporating all three components into the investment process and implementing across a variety of asset classes i.e. not just equities.

Furthermore, while exclusions adopt a negative approach, increasingly the ESG research is being applied in a positive way i.e. investing in companies with the best ESG practices rather than just avoiding those with the worst practices.

 

Overtime, I hope to cover off each of the Sustainable Investing components outlined above in separate posts and will provide links.

 

I will leave the final thoughts to RobecoSam, where they quite rightly draw the link between sustainable investing and delivering competitive financial returns from investing.

Finance has a role to play!

“Financial materiality is the critical link at the intersection of sustainability and business performance. More specifically, investors should focus on identifying the most important intangible factors (sustainability factors) that relate to companies’ ability to create long-term value. For instance, lowering energy consumption in manufacturing processes results in significant cost-saving opportunities and has a direct impact on a company’s bottom line. Going a bit deeper, financial materiality is defined as any intangible factor that can have an impact on a company’s core business values. These are the critical competencies that produce growth, profitability, capital efficiency and risk exposure. In addition, financial materiality includes other economic, social and environmental factors such as a company’s ability to innovate, attract and retain talent, or anticipate regulatory changes.

These matters to investor because they can have significant impacts on a company’s competitive position and long-term financial performance. “

 

These sentiments were echoed in a recent FT article.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

UNPRI Principles

 

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

The balancing act of the least liked investment activity

A recent Research Affiliates article on rebalancing noted: “Regularly rebalancing a portfolio to its target asset mix is necessary to maintain desired risk exposure over the portfolio’s lifetime. But getting investors to do it is another matter entirely—many would rather sit in rush-hour traffic! “

“A systematic rebalancing approach can be effective in keeping investors on the road of timely rebalancing, headed toward their destination of achieving their financial goals and improving long-term risk-adjusted returns.”

Research Affiliates are referencing a Wells Fargo/ Gallup Survey, based on this survey “31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?

 

I can’t understand why rebalancing of an investment portfolio is one of least liked investment activity, it adds value to a portfolio overtime, is a simple risk management exercise, and is easy to implement.

It is important to regularly rebalance a Portfolio so that it continues to be invested as intended to be.

 

A recent article in Plansponsor highlighted the importance of rebalancing. This article also noted the reluctance of investors to rebalance their portfolio.

As the article noted, once an appropriate asset allocation (investment strategy) has been determined, based on achieving certain investment goals, the portfolio needs to be regularly rebalanced to remain aligned with these goals.

By not rebalancing, risks within the Portfolio will develop that may not be consistent with achieving desired investment goals. As expressed in the article “Participants need to make sure the risk they want to take is actually the risk they are taking,” …………..“Certain asset classes can become over- or under-weight over time.”

Based on research undertaken by BCA Research and presented in the article “Rebalancing is definitely recommended for all investors, perhaps more so for retirement plan participants than others, as they are more likely to be concerned with capital preservation than capital appreciation.”

The following observation is also made “While a portfolio that is not rebalanced will have a greater allocation to equities during a bull market and, therefore, outperform a rebalanced portfolio, all rebalanced portfolios outperformed an unbalanced portfolio during periods leading up to market corrections and recessions,” Hanafy says, citing a BCA Research study which looked at three main rebalancing scenarios of a simple 60/40 portfolio since 1973.

The potential risks outlined above is very relevant for New Zealand and USA investors currently given the great run in the respective sharemarkets over the last 10 years.

When was last time your investment fiduciary rebalanced your investment portfolio?

 

Rebalancing becomes more important as you get closer to retirement and once in retirement:

“There are two main components to retirement plans: returns and the risk you take,” …… “When you do not rebalance your portfolio, a participant could inadvertently take on too much risk, which would expose them to a market correction. This is important because, statistically, as participants reach age 40 to 45, how much risk they take on is far more important than how much they save. When you are young, the most important thing is how much you save.”

Rebalancing Policy

As the article notes, you can systematically set up a Portfolio rebalancing approach based on time e.g. rebalance the portfolio every Quarter, six-months or yearly intervals.

It is not difficult!

Alternatively, investment ranges could be set up which trigger a rebalancing of the portfolio e.g. +/- 3% of a target portfolio allocation.

Higher level issues to consider when developing a rebalancing policy include:

  • Cost, the more regularly the portfolio is rebalanced the higher the cost on the portfolio and the drag on performance. This especially needs to be considered where less liquid markets are involved;
  • Tax may also be a consideration;
  • The volatility of the asset involved;
  • Rebalancing Policy allows for market momentum. This is about letting the winners run and not buying into falling markets too soon. To be clear this is not about market timing. For example, it could include a mechanism such as not rebalancing all the way back to target when trimming market exposures.

 

My preference is to use rebalancing ranges and develop an approach that takes into consideration the above higher level issues. As with many activities in investing, trade-offs will need to be made, this requires judgement.

 

As noted above, it appears that rebalancing is an un-liked investment activity, if not an over looked and underappreciated investment activity. This seems crazy to me as there is plenty of evidence that a rebalancing policy can add value to a naïve monitoring and “wait and see” approach.

I think the key point is to have a documented Rebalancing Policy and be disciplined in implementing the Policy.

 

This also means that those implementing the Rebalancing Policy have the correct systems in place to efficiently carry out the Portfolio rebalancing so as to minimise transaction costs involved.

Be sure, that those responsible for your investment portfolio can efficiently and easily rebalance your portfolio. Importantly, make sure the rebalancing process is not a big expense on your portfolio e.g. trading commissions and the crossing of market spreads (e.g. difference between buy and sell price), and how close to the “market price” are the trades being undertaken?

These are all hidden costs to the unsuspecting.

 

A couple of last points:

  • It was noted in the recent Kiwi Investor Blog on Behaviour Finance that rebalancing of the portfolio was an import tool in the kit in helping to reduce the negative impact on our decision making from behavioural bias. It is difficult to implement a rebalancing policy when markets are behaving badly, discipline is required.
  • The automatic rebalancing nature of Target Date Funds is an attractive feature of these investment solutions.

 

To conclude, as Research Affiliates sums up:

  1. Systemic rebalancing raises the likelihood of improving longer-term risk-adjusted investment returns
  2. The benefits of rebalancing result from opportunistically capitalising on human behavioural tendencies and long-horizon mean reversion in asset class prices.
  3. Investors who “institutionalise contrarian investment behaviour” by relying on a systematic rebalancing approach increase their odds of reaping the rewards of rebalancing.

 

It is not hard to do.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Technology focus that will transform the Wealth Management Industry – Robo Advice alone won’t be enough

The Professional Wealth Magazine (PWM) argues that Private Banks must take “goaled-based tech to heart”.

In their recent article they see technology assisting Wealth Managers in the following areas:

  1. Customer facing;
  2. Client relationship management; and
  3. Goals-Based wealth management Investment Solutions.

The first two are well known, the third, as PWM note, is flying under the radar. Combined they are the future of a successful wealth management business.

Quite obviously Robo Advice models use technology. Nevertheless, Goals-Based wealth management provides the opportunity for greater customisation and a more robust investment solution that better meets the needs of the customer.

Therefore, technology will play a major role in delivering more customised Investment Solutions to a wider range of people.

 

Technology is going to play a major role in the industry’s transformation.

As has been argued: “In order to be part of the fourth industrial revolution, the people-centric industry of wealth management must transform the production, customisation and distribution of retirement solutions, …..”

(See my first Kiwi Investor Blog Post, Advancements in Portfolio Management, for an article written by Lionel Martellini, of EDHEC Risk Institute, that appeared in the Journal of Investment Management in 2016: Mass Customization versus Mass Production – How an Industrial Revolution is about to take place in money management and why it involves a shift from investment products to investment solutions.)

 

The PWM article covered a recent symposium held in Paris focusing on fintech, quantitative management and big data, the technologically-led trends transforming the global industry.

The participants at the symposium gathered to consider: what should be the role of technology in client acquisition and servicing, data analysis, and portfolio management?

With regards to technology in general PWM note, “Private banks need to put technological solutions at the heart of their operations if they are to meet the demands raised by clients and relationship managers, though there will always be a need for human interaction”

However, having acknowledged that technology is critical for a successful Wealth Management business of the future, it appears to be a difficult issue to address. PWM “calculate that of the 150 global private banks we monitor closely for technological, business, customer-facing and portfolio management trends, less than one third have implemented a serious technological solution to the challenges encountered by their clients and relationship managers.”

“Many have only devised client-interfaces such as online forms, apps and screens allowing choices of services. But a handful have gone much further…….”

 

Under the radar

PWM noted that “…there is probably one technology-led sphere which is totally under-appreciated by the industry, which was highlighted at the summit. This is that of goals-driven wealth management (GDWM), ….”

 

Goals-Based investing is an improvement on the generic industry approach. Rather than viewing your investments as one single diversified portfolio, where the allocations are primarily based on your risk tolerance and the concept of risk is measured by volatility or standard deviation of returns, Goals-Based investing creates distinct milestones (goals) that are closely aligned with the priorities in your life.

Goals-Based investing closely matches your investment assets with your unique goals and objectives (customisation). It is the Wealth Management counterpart to Liability Driven Investing (LDI), which is implemented by pensions and insurance companies where their investment problems are reflected in the terms of their future liabilities (expected future insurance claims), much like a Wealth Management client’s future priorities (goals). LDI is also implemented by Pension Funds, particularly those with Defined Benefits, which are known future liabilities/cashflows.

Goals-Based Investing offers a more robust investment solution, provides a closer alignment of retirement goals and investment assets. It will also help investors avoid some common behavioural biases, such as regret and hindsight bias.

The benefits of Goals-Based Investing are a:

  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 allocations to equities and fixed income; and
  4. Improved likelihood of reaching desired standard of living in retirement.

In summary, a Goals-Based investment strategy increases the likelihood of reaching a customer’s retirement income objectives. It can also achieve 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.

 

As the PWM article points out, technology is allowing “wealth managers to use institutional tools, helping clients to prepare for key life events….. Length of investment terms, risk tolerances, prices, taxes, depreciation levels can all be plugged into a model by relationship managers. Optimal asset allocations can then be arrived at and modified to plan for specific goals.“

“While few private banks currently approach this topic seriously, it surely must become the wealth management paradigm for the future. It will still require human wealth managers to advise clients and shepherd them through the process, but it will put an algorithmic system at the centre of the asset allocation decision. There is no substitute for this and it will most likely steal the very soul of wealth management.”

The Bold is mine, LDI is an institutional tool implemented to meet specific goals.

 

This is beyond a straight forward Robo Advice model and the filling out of a generic risk profile questionnaire. Technology is being applied to determine more customised investment solutions, taking into consideration a greater array of personal information and then implementing an investment solution using more advanced portfolio techniques, such as LDI.

 

The article covers other technology related issues in relation to wealth management, such as increasing competition from the likes of Google, Facebook, Alibabas and Tencents.

Importantly, PWM see room for a human element in all of this.

 

PWM conclude we are at the beginning of the industry’s “revolution”, technology will play a part in the success of the modern wealth manager and in capturing the next generation of investors:

“The battle for the hearts and minds of the next generation and for the soul of wealth management has yet to be fought and won. But the opening salvos have been fired.”

“Private banks have interesting weapons in their armouries. Some still need to be modernised for effectiveness. But at the moment, those that appear to be vital for future success appear to be GDWM (goals-driven wealth management) tools, networking apps and screens for impact and ethics.

“The private bank of the future will manage, introduce and evaluate, as well as working closely with the next generation. These disciplines require a raft of technological systems and an army of relationship managers, not just to operate them, but to take the output which they deliver and use this to help build a long-term relationship with families of the future.”

Again bold is mine.

 

The future, according to PWM, is a raft of technology solutions with Goals-Based investing as the underlying investment solution.

The appropriate use of technology and the mass production of customised investment solutions will be the Uber moment for the Wealth Management industry. The technology and investment knowledge is available now.

The customisation of investment solutions involves a Goals-Based investment approach, based on the principles of LDI.

A winning outcome will be the combination of smart technology and the mass production of customised investment solutions that more directly meet the needs of the customer in achieving their retirement goals.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Recessions, inverted yield curves, and Sharemarket returns

Fears of economic recession, particularly in the US, peaked over the final three months of 2018.

Nevertheless, talk of economic recession has now faded into the background after the US Federal Reserve hit the pause button to further interest rate increases in January of 2019. The Fed is not expected to raise interest rates again in 2019.

This is not to say that a recession will not occur, it will at some stage, just as night follows day. The economic/business cycle has not been conquered.

Nevertheless, the timing of the next recession is unknown. Take Australia for example, their last recession was over 28 years ago. New Zealand is over 9 years since their last recession.

With regards to the US, in July of this year the US economy will enter its longest period in history without incurring a recession. Their economy remains on a sound footing: interest rates remain low, the US consumer is confident, businesses are investing, the Government is increasing spending, and forward looking indicators of economic activity remain positive. Lastly, housing activity is likely to pick up over the second half of 2019.

 

What is a Recession?

A recession is defined as at least two consecutive quarters of declining economic growth. The US National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales.”

 

A recent article by the Capital Group: Preparing for the next recession: 9 things you need to know provides a good overview of the ins-and-outs of economic recession.

 

The good news, as Capital highlight, recessions generally aren’t very long.

Capital undertook analysis of 10 US economic cycles since 1950. This analysis showed that recessions have lasted between eight and 18 months, with the average spanning about 11 months. Unfortunately New Zealand’s history is a little more chequered than the US.

Investors with a long-term investment horizon, should expect to experience a number recession over their investment horizon and therefore look through the full economic cycle. Fortunately, for most of us, we spend more time in economic expansion than in recession.

Capital note, “over the last 65 years, the U.S. has been in an official recession less than 15% of all months.”

The following graph highlights the average length, total growth, and returns from the average stock market return over the average recession and economic expansion.

Notably, “equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.”

The human cost of economic recession is provided in the form of jobs lost and this should not be forgotten.

 

Economic cycles Capital.jpg

 

From a sharemarket perspective, a bear market, defined as a 20% or more fall in value, usually overlaps with recessions.

Share markets tend to lead the economic cycle, given they are forward looking. Sharemarkets on average peak six months prior to the onset of a recession. They continue to fall during the early stages of a recession.

The recovery in sharemarkets often takes hold while the economy is still in recession (economic growth is still contracting).

The initial bounce in sharemarkets is often a period of strong performance and occurs before there is any hard evidence of a pickup in economic activity.

The following graph presents the above sequencing and overlapping nature of sharemarket returns and recessions.

Sharemarket returns and recession cycles.png

 

Having said all that, stock markets are not good predictors of economic recession i.e. a sharp fall in global sharemarket does not mean there will be an onset of global economic recession.

This is captured by the well know quote from Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

 

Sharemarket Returns and Inverted Yield Curves

There has been a lot of discussion over the last twelve months about the implications of an inverted US yield curve. (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months). A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Parts of the US yield curve are currently inverted, and this inversion has increased over recent days.

The significance of this is that prior to the last 7 US recessions the yield curve has inverted prior each time. An inverted yield curve has by and large been a good predictor of recession.

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.

 

The following analysis undertaken by Wellington Management looks at the performance of the US sharemarket in relation to yield curves inversions.

The period of analysis is from the 1950s at which time the US Federal Reserve gained full, independent control over interest rates from the US Treasury. As Wellington note, “it was after this transition that the yield curve became an effective tool for gauging the impact of monetary policy on the economy and the prospect of a recession.”

Wellington present the following analysis and the Table below:

  • “As shown in the third column (of Table below), the S&P 500 peaked ahead of a yield-curve inversion only twice (1959 and 1973).
  • “The median time between inversion and peak equity returns was 17 months, and in several cases the market peaked almost two years or more after inversion.”
  • “Aggregate equity returns post-inversion have been partly dependent on the length of time between the initial inversion and the start of the recession.”
  • “Since returns tend to be negative right around the time a recession begins, the instances in which there was a shorter period between the initial inversion and the start of the recession were more likely to have a negative return.”

 

Just like there is a period of time between economic recession and an inverted yield curve, the sharemarket often peaks after the yield curves inverts.

Sharemarket returns and inverted yield curves.png

 

Back to the Capital article, for it also runs through a number of other recession related questions.

Of interest are:

What economic indicators can warn of a recession?

  • Capital outline some generally reliable signals worth watching closely, such as an inverted yield curve, corporate profits, unemployment, and leading economic indices.
  • Importantly it is appropriate to look at and consider several different economic indicators.

 

What Causes Recessions?

  • There are many reasons for a recession, chief amongst them are rising interest rates, particularly by Central Banks such as the US Federal Reserve and Reserve Bank of New Zealand, imbalances within an economy e.g. excess housing prices, high debt levels
  • Every economic cycle is unique, but anything that impacts on corporate profits or consumer spending, such as rising unemployment, are factors to consider.

 

Just remember is it notoriously difficult to predict economic recession and they are normally the result of a number of factors that have a cascading effect leading to an economic downturn.

 

The following Kiwi Investor Blog Posts maybe of interest to those wanting a better understanding of inverted yield curves, leading economic indicators, and historical performance of equity market corrections.

Recession predictability of inverted yield curves and other economic indicators to considered:

 

Analysis of Sharemarket corrections and market declines

 

Lastly the Capital article provides some suggestions as to how to position your portfolio for a recession. I think it is exceedingly difficult to finesse a portfolio in the expectations of a recession.

From my perspective, the following is most critical:

  • Maintain a long-term perspective;
  • Implement a balanced and broadly diversified portfolio. 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 (movements in interest rate), economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks;
  • Know you risk tolerance: what level of volatility in capital are you prepared to handle without changing your mind;
  • Understand your risk capacity: the amount of risk you need to take in order to reach your financial goals;
  • Implement a goals-based investment approach, where success is measured on how you are tracking relative to your investment goals, rather than market index performances; and
  • Always maintain a high quality portfolio, with plenty of liquidity, and limit the level of turnover across the portfolio e.g. amount of trading (buying and selling)

 

A good advisor should be able to help you with the above and see you through bouts of sharemarket volatility, including a recession environment.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

cropped-title-picture-enhanced.jpg

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.