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.

Risk Measure of Wealth Management

Risk is not the volatility of your investment portfolio, or volatility of returns, risk is determined by your investment goals.

This is the view of Nobel laureate Professor Robert Merton. Such an assessment of risk also underpins many Goals-Based wealth management solutions.

More robust investment solutions are developed when the focus on risk moves beyond variations of returns and volatility of capital. The key risk is failure to meet your investment objectives.

 

The finance industry, many financial advisors and academics express risk as the variation in returns and capital, as measured by the standard deviation of returns, or variance.

Nevertheless, clients often see risk as the likelihood of not attaining their investment goals.

The traditional financial planning approach is to understand client’s goals, then ask questions to determine risk tolerance, which then leads to advising a client to adopt a portfolio that has a mean expected return and standard deviation corresponding to the Client’s risk appetite.  Standard deviation of returns, variation in capital, becomes the measure of risk.

 

Nevertheless, a different discussion with clients on their goals will likely result in a different investment solution. It will also improve the relationship between the Client and the Advisor.

Such a discussion will lead to more individualised advice and a better understanding of the choices being made. Clients will be in a better place to understand the impacts of their choices and the probability of achieving their goals. It will be more explicit to them in making trade-offs between playing it safe and taking risks to achieve their investment goals.

A goals based approach provides a more intuitive, transparent, and understandable planning approach.

Ultimately it leads to a more robust portfolio for the Client where information from the goals-based discussion can be mapped to a specific range of portfolios.

It is also a dynamic process, where portfolios can be updated and changed on new discussions and information. The process can adapt for multiple-goals over multiple time periods.

This is in stark contrast to the single period single objective, static portfolio traditionally implemented based on risk appetite.

There is also a strong foundation in Behaviour Economics supporting the Goals-Based investment approach.

 

I have covered Merton’s view in previous Posts, so please don’t accuse me of confirmation bias!

Merton’s views on risk is also well presented in a 2016 i3 Invest article in Australia, Risk is determined by Investment goal.

“Risk is not simply expressed as the volatility of your invested assets, but is determined by your ultimate goal, according to Nobel laureate Robert Merton.”

 

The i3 article provides an example on how your goal determines to a large degree what your risk-free asset is.

The goal provides a starting point for determining:

  • how far removed you are from achieving your objectives; and
  • importantly, how much risk you need to take to have a chance of meeting these objectives.

 

“If you had as your goal to pay your (Australian dollar) tax bill in a year from now, then what is the safe asset for you?”

“It would be an Australian dollar, one year, zero coupon, Australian Treasury Bill that matures in one year. That would be the sure thing.”

 

As the i3 article mentions Merton has criticised the idea that superannuation is a pot of money, instead of a basis for generating an income stream.

Merton argues that there should be greater focus on generating replacement income in retirement and we need to stop looking at account balances and variations in account balances. Instead, we should focus on the income that can potentially be generated in retirement from the investment portfolio, pot of money.

 

This is not a radical idea, this is looking at the system in the same way as Defined Benefit Funds did, the “old” style funds before the now “modern” defined contributions fund (where the individual takes on all the investment risk).  Defined contributions funds focus on the size of the pot.  The size of the superannuation pot (Kiwisaver account balance) does not necessarily tell you the standard of living that can be supported in retirement.  This is Merton’s critical point.

 

A greater focus on income is aligned with goals-based investment approach.

As Merton’s explains, if we accept we should focus on income, targeting sufficient replacement income in retirement, the development of a comprehensive income product in retirement is not difficult. He concludes, “This doesn’t require the smartest scientist in Australia to solve this problem. We know how to do it, we just need to go out and do it,”.

 

As noted above I have previously Posted on Merton’s retirement income views. The material from these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Professor Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.

 

For those wanting a greater understanding of Merton’s views and rationale please see:

  1. What matters for retirement is income not the value of Accumulated Wealth
  2. Is variability of retirement income a better measure of risk rather than variability of capital? – What matters for retirement is income not the value of Accumulated Wealth

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Behavioural Drivers of Wealth Management

Underpinning The Regret Proof Portfolio and Best Portfolio Does not Mean Optimal Portfolio is, amongst a number of things, Behavioural Economics.

 

A recent paper A New Approach to Goals-Based Wealth Management published in the Journal of Investment Management (JOIM), provides a very comprehensive framework for a Goals-Based Wealth Management approach.

 

Behavioural Economics forms the foundations of Goals-Based Wealth Management.

 

As the JOIM Paper notes “Traditionally, the financial industry, financial advisors, and academics in finance have associated the notion of “risk” with the standard deviation of an investor’s portfolio. Investors, on the other hand, typically associate “risk” with the likelihood of not attaining their goals.”

This is important from the perspective of client communications: “In traditional financial planning, advisors look to understand what an investor’s goals are, then they ask questions designed to determine the investor’s tolerance for portfolio standard deviation, which leads to advising the investor to adopt a portfolio that has a mean and standard deviation corresponding to the investor’s risk appetite”

Goals-Based Wealth Management is defined “as a process that focuses on helping investors realize their goals, both short-term and long-term,..”

Behavioural Economics comes into play by “using language and ideas that are more natural for investors” in determining appropriate investment goals.

 

Behavioural Economics Foundations

The JOIM Paper provides a very good overview of the behavioural economics that forms the foundations of their Goals-Based Wealth Management Investment solution.

Inputs comes from the:

  1. pioneering and very influential academic literature on Behavioural Economics
  2. growing practitioner literature on goals-based wealth management

 

Richard Thaler’s work, who is a 2017 Nobel prize winner for his contribution to Behavioural Economics, provides a central pillar to the Goals-Based Wealth Management solution outlined in the JOIM Paper.

Thaler’s worked on the “endowment effect”, which is the asymmetric valuation of assets by individuals.  Namely, individuals value items more when they own them as opposed to when they do not.

This is related to loss aversion in Prospect Theory. Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.  Some studies have suggested that losses are twice as powerful, psychologically, as gains.  Loss aversion was first identified by Amos Tversky and Daniel Kahneman.

 

Mental accounting theory is also a significant contribution from Thaler and it is also an essential foundation for Goals-Based Wealth Management.

Mental accounting is where people treat money with different risk-return preference, depending on what use the money is to be put to. It is a way of keeping track of our money related transactions.

From a practical perspective, mental accounting helps elicit investors goals, and is “facilitated by breaking down overall portfolio goals into sub-portfolio goals using the ideas of mental accounts, where different goals are managed in different accounts, each aggregating into the overall portfolio.”

 

Lastly the JOIM Paper notes the work undertaken that developed Behavioural Portfolio Theory.  This theory postulates that investors behave as if they have multiple mental accounts. “Each mental account portfolio has varying levels of aspiration, depending on the goals for the mental account.  These ideas naturally lead to portfolio optimization where investors are goal-seeking (aspirational), while remaining concerned about downside risk in the light of their goals. Rather than trade-off risk versus return, investors trade off goals versus safety…”.

 

Practitioner’s Perspective

The JOIM Paper also notes the growing practitioner literature on goals-based wealth management.

Specifically, they reference three major contributions:

Nevins advocates a goal-orientated approach to help investors deal with biases such as overconfidence, hindsight bias, and overreaction.   Nevins’ work extended the mental accounting approach. He also argues that traditional investment planning fails to recognize investor’s behavioural preferences and biases.

Contributions by Zwecher, complements Nevins, he argues that risk management can be “done more actively and efficiently by demonstrating how a retirement portfolio that provides income, generates growth, and protects assets from disasters, can be created by adopting a bucketing (mental accounting) approach.”

Research undertaken by Brunel discussed the equal importance of two goals for an investor: being able to avoid nightmares while realizing dreams. “Brunel’s work focussed on demonstrating how goals-based wealth management can be achieved across multiple time horizons for multiple life goals. He also suggested how to map the language customers use in describing the importance of dreams or the severity of nightmares into acceptable probabilities that the investor will realize such dreams or avoid such nightmares.”

 

In short, Practitioners have recognized the need for a goals-based approach.

The premise is, if customers can better articulate and discuss their goals, including safety, then they are able to work with Practitioners to build more robust investment solutions that are better designed to meet their aspirations and investment objectives.

 

Happy investing.

 

Please see my Disclosure Statement

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

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

Endowments and Sovereign wealth Funds lead the way in building robust investment portfolios in meeting a wide range of challenging investment objectives.   This Post covers this and amongst other things, what true diversification is, it is not having more and more asset classes, a robust portfolio is broadly diversified across different risks and returns. A lot can be learnt from how Endowments construct portfolios, take a long term view, and seek to match their client’s liability profile. Although fees are important, an overriding focus on fees may be detrimental to building a robust portfolio and in meeting client investment objectives.

 

A Robust Framework for generating Retirement Income

This Post builds on the Post above and looks at an investment framework for individuals, developed by EDHEC-Risk Institute and their Partners. It is a Goal Based Investment framework with a focus on capital value but also delivering a secure and stable level of replacement income in retirement.

 

The monkey paw of Target Date Funds (be careful what you wish for)

This Post emphasises the need to focus on generating a stable and secure level of replacement income in retirement as an investment goal and highlights the approach that is required to achieve this. Such an approach would greatly enhance the outcomes of Target Date Funds. This Post also references the thoughts of Professor Robert Merton around having a greater focus on generating replacement income in retirement as an investment objective and that volatility of replacement income is a better measure of investment risk, as it is more aligned with investment objectives, unlike the volatility of capital or standard deviation of returns.

 

Kiwi Investor blog has covered many topics over the year, including the value of active management, the shocking state of the investment management industry globally, Responsible Investing, the high cost of index funds and being out of the market.

Of these, recent research into the failure of the 4% rule in almost all markets worldwide is well worth highlighting.

 

Kiwi Investor Blog has a primary focus on topics associated with building more robust portfolios and investment solutions.

The Blog has highlighted the research of EDHEC-Risk Institute throughout the year. EDHEC draw on the concept of Flexicurity. This is the concept that individuals need both security and flexibility when approaching investment decisions. This is surely a desirable goal and the hallmark of a robust investment portfolio. The knowledge is available to achieve this and the framework and rationale is covered in the Posts above.

Flexicure is my word of 2018.

 

I don’t think the Uber moment has been reached in the investment management industry yet. Technology will be very important, but so too will be the underlying investment solution. The investment solution needs to be more tailored to an individual’s investment objectives.

As outlined in the Posts highlighted above, the framework for the investment solution has emerging and is developing.

It is a goal based investment solution, more closely tailored to an individual’s investment aspirations, so as to provide a more secure and stable level of replacement income in retirement.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Best Portfolio Does Not Mean Optimal Portfolio

The best portfolio is not necessarily the optimal portfolio.

As this thought-provoking article by Joachim Klement, CFA, highlights, “In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given investor. Or to recall a quote variously attributed to Albert Einstein, Yogi Berra, and Richard Feynman, among others: “In theory, there is no difference between theory and practice, while in practice there is.””

The article highlights the shortcomings of a portfolio optimisation approach. No surprises there!

Nevertheless, a key point made in the article is that many people in a Trustee or Fiduciary role see the portfolio optimisation process as a black-box exercise which is full of assumptions.

If true, this can be a challenge, particularly for those presenting the results and “the client never understands how these assumptions lead to the proposed allocation”.

I am sure this occurs to varying degrees and as a result there is a real risk that there is not a good understanding of the purpose of each investment allocation within the portfolio.

This often leads to the most pertinent point made in the article:

“But since clients do not grasp the purpose of each investment in the context of the overall portfolio, they are more likely to give up on the portfolio, or parts of it, in times of trouble. As a result, the best portfolio is not the optimal portfolio, but rather the one that the client can stick with through the market’s ups and downs. This means reframing the role of different asset classes or funds relative to the investor’s goals and sophistication rather than to volatility and return.”

 

Exactly. Reframing the role of the different asset classes can be achieved by taking the discussion away from the largely two-dimensional world of an optimal portfolio, market risk and return, and focusing instead on how the allocations will help meet a client’s investment goals over time.

Therefore, we can move beyond the Markowitz portfolio (the basis of Modern Portfolio and the “Optimal” Portfolio).  This is not to diminish the Markowitz optimal portfolio and the benefits of diversification, the closest thing to a free lunch in investing. Markowitz also placed a number on risk through the variance of returns.

Nevertheless, variance of return may not be an appropriate measure of risk. Other measures of volatility can be used, just as more sophisticated portfolio optimisation approaches can be implemented. Neither of which would address the key issues of the article as outlined above. In fact, they may compound the issues, particularly the black-box nature of the process.

Other measures of risk should be considered, the most important risk being failure to meet one’s investment objectives.

If your investment goal is to optimise risk and return the “optimal” portfolio is likely to be the “best” portfolio. Albeit, I am not sure this is the primary objective for most individuals and companies. For example, other investment objectives may include liquidity, income/cashflow generation, endowments. (I also don’t think the most optimal equities portfolio is the best portfolio, there are other risks to consider e.g. liquidity and concentration risk which would mean moving away from the optimal portfolio.)

There are personal and aspiration risks to take into consideration e.g. ability to weather large loses. There could be investment goals with different time periods – the optimal portfolio is generally for a single period, not multi-periods.

This is not to say don’t use an optimisation approach, it is a good starting point. Albeit, the portfolio allocation will likely need to be adjusted to take into consideration a wider set of investment objectives, risk tolerances, and behavioural factors. I would have thought this is standard practice.

 

Expanding the discussion with the client will help identify a more robust portfolio and increase the understanding of the role of each allocation within the Portfolio.

In effect, a more customising investment solution will be generated, rather than a mass-produced product.

As noted in the article, reframing the role of different asset classes within a portfolio relative to the investor’s goals and the sophistication of the client rather than to volatility and return will likely result in better outcomes for clients.

Such an approach is consistent with Liability Driven Investment (LDI), where the liabilities are matched with predictable cashflows and the excess capital is invested in a growth/return seeking portfolio, which would include the likes of equities.

Such an approach is also consistent with a Goal Based Investing approach for individuals.

It is also more consistent with a behavioural bias approach.

 

As the paper concludes:

“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box “optimal portfolios.”

“Consultants, portfolio managers, and wealth managers who take their fiduciary duty seriously should seriously consider ditching their “optimal portfolios” in favor of these theoretically less optimal but practically more robust solutions.”

“Because you are not acting in the client’s best interest if you build them a portfolio that they won’t stick with over the long term.”

 

The above would resonate with most investment professionals I know, yet strangely it does not appear to be “conventional” wisdom. Perhaps ditch is to stronger a word, too provocative.

It would be hard to argue with implementing a more practical and robust solutions aligned with a wider set of investment objectives is not in the best interest of clients, particularly if they are able to stay with the investment strategy over the longer term.

 

Referenced in the article is the work undertaken by Ashvin Chhabra, Beyond Markowitz. This work is well worth reading. Essentially he frames the investor’s risks as being:

  • Personal Risk – e.g. the risk of not losing too much that would impact on life style, this supports the safety first type portfolio
  • Market Risk – e.g. risk within the investment
  • Aspirational risk – e.g. taking risks to achieve a higher standard of living

 

This would is a great framework for a Wealth Management / Financial Planning process. Of note, market risk is only one component.

Lastly, the concept of a single Optimal Portfolio is far from the likely solution under this framework.

 

Happy investing.

 

Please see my Disclosure Statement

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