Month: March 2018

Shortcomings of Target Date and Life Cycle Funds

/ Kiwi Investor / 13 Comments

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.

They do this on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through human capital (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 that does not take into consideration the individual circumstances of the investor nor market conditions.

Target Funds are becoming increasingly popular.  Particularly in situations where the Investor does not want or can afford investment advice.  The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice provided.

 

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

No, it is not that they are moving investors into cash and fixed interest at a time of record low cash returns and over-valued fixed interest markets.  This is an issue, but a topic for another Blog.  Albeit this is touched on below from a slightly different angle.

 

Essentially, Target Date Funds have too main short comings:

  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, level of income generated up retirement, or the investors risk profile, appetite for risk, or risk tolerance.
  • 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.
  1. 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 the pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme market risk environments

 

Therefore, there is the risk that some Target Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income.

 

Target Date Funds, Life Cycle Funds, focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.

The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk.

As noted above, most target date funds don’t make revisions to asset allocations due to market conditions.  This is inconsistent with academic prescriptions, and also common sense, both of which suggest that the optimal investment strategy should also display an element of dependence on the current state of the economy.

 

The optimal target date or life cycle 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

 

All up, this requirements a more Liability Driven Investment approach, Goal Based Investing.

My first blog outlines the revolution required within the industry to Mass Customisations.

 

Please see my Disclosure Statement

US Equity Market 9 Years of Advancement

/ Kiwi Investor / 1 Comment

The US equity market recently celebrated 9 years of advancement without a bear market (a Bear market is defined as an equity market decline of greater than 20% from its peak).

This 9 year Bull market is closing in on the historical record of 9 years and five and half months.  The longest post-war Bull market stretched from 11 October 1990 to 24 March 2000.  To break that record the current Bull market will have to continue until the last week of August 2018.

The US equity market experienced a “correction” in February 2018 (a correction is defined as a fall in market value of between 10 and 20%) on inflation and higher interest rate concerns.  I wrote about this in this blog and also put into historical perspective here and here.  

 

Bull markets end with a Bear market.  Bear markets usually coincide with recession.  Very rarely has there been a Bear Equity Market without recession.  Nevertheless, there have been bear markets without a recession.

Fortunately the global economy has good momentum and recession does not look imminent. Most economic forecasts are for economic growth throughout 2018 and into 2019.

Albeit, the current Bull market does face some risks.  Key amongst those risks are:

  • Earnings disappointment in 2019. Earnings momentum is vulnerable this late in the economic cycle
  • Economic data disappoints – global equity markets are priced for continuation of the current “Goldilocks” economic environment, not too hot and not too cold.
  • Inflation data surprises on the upside
  • Policy mistake by a Central Bank given the extraordinary policy positions over the last 10 years of very low interest rates and Quantitative Easing, e.g. US Reserve Bank needs to raise short term interest rates more quickly than currently anticipated
  • Longer term interest rates rise much higher than currently expected

 

Therefore, lots to consider as the year progresses.

 

I enjoyed this quote from Howard Marks “there are two things I would never say (since they require far more certainty than I consider attainable): “get out” and “it’s time.”  It’s rare for the market pendulum to reach such an extreme that views can properly be black-or-white.  Most markets are far too uncertain and nuanced to permit such unequivocal, sweeping statements.”

Well worth thinking about when making portfolio investment decisions.

 

Please see my Disclosure Statement

More Asset Classes Does Not Equal More Diversification

/ Kiwi Investor / 10 Comments

The Failings of Diversification.

Diversification has been the central tenant of portfolio construction since the early 1950s.

Diversification simply explained, you don’t put all your eggs in one basket.

Nevertheless, technically we want to invest in a combination of lowly correlated asset classes. This will lower portfolio volatility.  (Lowly correlated means returns from assets are largely independent of each other – they have largely different risk and return drivers.)

The article highlights that more asset classes does not equal more diversification.

“This is because the investment returns of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.”

 

These are key messages from earlier blogs, focus on true portfolio diversification so as to ride out the volatility and on Liquid Alternative investment strategies.

 

From the Article

Key Points

  • Diversification is just one risk management tool, not a comprehensive risk management solution.
  • Multiple asset classes won’t lower portfolio risk when the same factors drive each asset classes’ investment returns.
  • Diversification cannot provide protection against systematic risk, such as a global recession, when all major asset classes tend to fall in unison.

Risk comes in many forms but investors are acutely aware of two: the impact of capital losses and extreme bouts of volatility.

Both can have a devastating impact on a portfolio.

Capital losses, such as we saw during the global financial crisis, may never be recouped by some unlucky investors. Meanwhile, volatility can prompt investors to withdraw their money at just the wrong time or quickly erode a lifetime’s savings when an investor is drawing down their capital.

Liquid Alternatives

/ Kiwi Investor / 2 Comments

This is a great article on the benefits of Liquid Alternatives (“Liquid Alternatives Coming of Age”)

One of the big lessons from the Global Financial Crisis (GFC) ten years ago was for investors to seek true portfolio diversification.  Specifically, increase the diversification within portfolios so as to reduce the level of equity risk within them.  Thus reducing the level of portfolio volatility.  This will likely lead to better outcomes for investors in meeting their investment objectives over time.

For investors, increasing the level of true portfolio diversification comes with the added challenge of reducing costs, maintaining high levels of liquidity, and having transparency of the underlying investment strategies.

For these reasons Liquid Alternative strategies have gained increasing acceptance around the world.

The article covers the benefits of Liquid Alternative strategies and a variety of implementation approaches undertaken by a number of Australian Institutional Investors.

Liquid Alternative Investment strategies are a growing allocations across many investment portfolios globally and are an effective means of increasing the true diversification of a multi-asset class (diversified) portfolio.

 

I have written previous Posts on adding Alternatives to Investment Portfolios.

 

Please see my Disclosure Statement

The Buffet Bet

/ Kiwi Investor / 2 Comments

Receiving much attention from the 2017 Berkshire Hathaway shareholder letter has been “The Bet”.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

 

I have some sympathy with this well written article.

 

Firstly I’d like to make three points:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Fund hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.

Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. Most, if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

 

Albeit, as the article points out (A Rhetorical Oracle?), key investment points are missed by the media’s focus on the drag race over a 10 year period.

Now, I have no barrel to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed across a portfolio.

 

In this regard and consistent with the points in the article:

  1. Having a well-diversified multi-asset portfolio is paramount.

Being diversified across non-correlated or low correlated investments is important.  Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime.  If you like, minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off, as they have over the last 24 months, a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio won’t fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his recent Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting ones investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

In fact, I’d never suggest someone to be 100% invested in equities for the very reason of the second point in the article.

 

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10 years, particularly in the 2008 – 2014 period.  Not many I suspect.

 

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See earlier Post

Staying the course is the biggest battle for most investors.  Therefore, take a longer term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else!

 

I like this analogy of using standard deviation of returns as a measure of risk, average volatility:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

 

Please see my Disclosure Statement