Month: April 2018

Goal Based Investing – Retirement Solutions

/ Kiwi Investor / Leave a comment

Goal based investing

 

EDHEC-Risk Institute, along with the Princeton Operations Research and Financial Engineering Department, are in the process of developing new indices to address the key problems in retirement:

  1. Level of replacement income in retirement
  2. Performance of investment strategy invested in a goal-hedging portfolio and performance seeking portfolio

These indices are based on the application of goal-based investing principles to help solve the key retirement problems.

 

EDHEC has undertaken this initiative because they argue “existing retirement products do not fit with an individual’s actual retirement needs and could be improved by applying Goal-Based Investing principles.”

I agree.  There is much work and improvement to be undertaken in this area.

This EDHEC work goes to the heart of my first post around Advancements in Portfolio Management, Mass Customisation 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, and Liability Driven Investing.

 

It is well worth keeping an eye on the EDHEC develops in this area and I hope to make this a continued focus of future blogs.

 

Happy Investing.

 

Please see my Disclosure Statement

 

Perspectives of the Hedge Fund Industry

/ Kiwi Investor / 3 Comments

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.

This is capture in the recently published AIMA paper (Alternative Investment Management Association), Perspectives – Industry Leaders on the Future of the Hedge Fund Industry

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

Hedge fund’s largest clients are Pension Funds, University Endowments, and Sovereign Wealth Funds.

Access to hedge fund strategies is becoming increasingly available to retail investors.  Hedge Funds, and hedge fund strategies, are no longer the exclusive domain of High Net Wealth Worth individuals.

 

Summary of the Report’s Executive Summary

  1. Paradigm shift. The industry is experiencing significant transformation as investors seek new investment solutions to more cheaply access different return streams. This has witnessed an innovation of investment solutions that fit between the traditional hedge fund and the traditional actively managed listed market funds.  These new investment solutions are providing the benefits of increased portfolio diversification for lower fees and increased transparency relative to the traditional hedge fund.  These cheaper return streams are the factor betas and alternative hedge fund betas. There has been a disaggregation of investment returns as a result of recent investment solution innovation.
  1. Hedge Funds can still produce alpha (risk adjusted excess returns) but it is getting harder due to increased competition and the greater ease of access to financial data and computing power.
  1. Therefore, an increasing employment of artificial intelligence and advanced cutting-edge quantitative techniques will likely grow across the hedge fund industry.
  1. The integration of Responsible Investing will likely rise across the hedge fund industry.
  1. The hedged fund firm is likely to change from its current traditional model, employing outside of the traditional business school graduate, employing a greater diversity of talent, flatten organisational structures, and encourage more collaborative environments.
  1. Hedge Fund firms will likely look to partner more with investors and co-invest.
  1. This will see a different focus on distribution and ownership models.

 

Points One and Two are of the most relevant to the focus of Kiwiinvestorblog.

The changing dynamics of the hedge fund industry has implications for the wider funds management industry e.g. downward pressure on fees, the blurring of the lines between traditional fund managers and hedge fund managers investment solutions, and the increased weight on traditional active equity managers to deliver genuine alpha – the closest index fund is on the endangered extinction list!

Importantly, the change taking place is making it easier, cheaper, and more transparent to implement truly diversified and robust multi-asset portfolios.  This is evident in the thoughts expressed in the quotes provided below and throughout the Report.

Section One of the Report formed the basis of an earlier blog on the Disaggregation of Investment Returns between market beta, factor and hedge fund beta, and alpha (linked aboved).

Pages 37 – 43 of the Report has a good discussion on whether hedged funds can still generate alpha (risk adjusted excess returns).

Understanding these sources of returns will help in building truly diversified portfolios.  It will also make the quotes more meaningful.  A greater appreciation of where the industry is moving will also be gained.

 

The following quotes from the Report help bring this all together.

Happy investing

 

Key quotes from within the Report:

“The past years have brought significant changes to the hedge fund industry. What was once a boutique industry serving high-net-worth individuals now serves some of the world’s largest investors. The products offered by hedge fund firms are changing to meet the needs of this wider and more diverse investor universe. The alpha-beta returns dichotomy of yesteryear is being replaced with a new range of investment solutions tailored to the needs of a wider range of investors.”

 

“A majority of investable assets in the total hedge fund pot will go to some form of risk premium investment strategy or a low-to-average correlation type of investment product, because investors have become increasingly more technical and have caught on to the fact that some investment strategies can be replicated for lower fees. Going forward, I expect more than half of the hedge fund investable universe will comprise of the top ten largest investment strategies being commoditised into more low-cost investment products—the so-called liquid alternatives. The remainder of the universe will comprise of high-end niche investment strategies that are capacity constrained, and are able to deliver true alpha.”

 

“Changing investor expectations are forcing hedge fund firms to rethink the investment solutions that they offer. The pace of technological change and the rise of artificial intelligence is leading some to question whether the hedge fund proposition will even exist in a few years. Responsible investment, meanwhile, is becoming more of a priority for hedge fund firms, as they gradually overcome their reluctance to constrain themselves. All of these changes are in turn forcing hedge fund firms to re-evaluate their own inner workings, from how they service investors through to how they build a business that outlasts its founders.”

 

Please see my Disclosure Statement

Disaggregation of Investment Returns

/ Kiwi Investor / 14 Comments

Understanding the disaggregation of investment returns can assist in building a truly diversified and robust investment portfolio.

It can also help determine the appropriateness of fees being paid and if a manager is adding value.

 

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors. More Asset Classes Does not Equal More Diversification.

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.  The increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.  Alternative strategies are added so as to reduce overall portfolio volatility, resulting in a more attractive portfolio risk return profile.

The inclusion of alternative strategies can assist in providing greater probability in meeting investment objectives.

 

An understanding of the different return and risk outcomes can be gained by disaggregating investment returns.

Essentially, and from a broad view, investment returns can be disaggregated in to the following three parts:

  1. Market beta. Think equity market exposures to the NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).  Market Index funds provide market beta returns i.e. they track the returns of the market e.g. S&P 500 and NZX50
  2. Factor betas and Alternative hedge fund beta exposures.  Of the sources of investment returns these are a little more ambiguous and contentious than the others.  This mainly arises from use of terminology and number of investable factors that are rewarding.  My take is as follows, these betas fit between market betas and alpha.
    1. Factor Beta exposures.  These are the factor exposures for which I think there are a limited number.  The common factors include value, momentum, low volatility, size, quality/profitability, carry.  These were outlined in this blog and are often referred to as Smart beta – see diagram below.
    2. Alternative hedge fund betas.  Many hedge fund returns are sourced from well understood investment strategies.  Therefore, a large proportion of hedge fund returns can be explained by common hedge fund risk exposures, also known as hedge fund beta or alternative risk premia or risk premia.  Systematic, or rule based, investment strategies can be developed to capture a large portion of hedge fund returns that can be attributed to a hedge fund strategy (risk premia) e.g. long/short equity, managed futures, global macro, and arbitrage hedge fund strategies.  The alternative hedge fund betas do not capture the full hedge fund returns as a portion can be attributed to manager skill, which is not beta and more easily accessible, it is alpha.

 

Lastly, and number three, there is Alpha.  Alpha is what is left after beta.  It is manager skill.  Alpha is a risk adjusted measure. In this regard, a manager outperforming an index is not necessarily alpha.  The manager may have taken more risk than the index to generate the excess returns, they may have an exposure to one of the factor betas or hedge fund betas which could have been captured more cheaply to generate the excess return.  In short, what is often claimed as alpha is often explained by the factor and alternative hedge fund betas outlined above.  Albeit, there are some managers than can deliver true alpha.  Nevertheless, it is rare.

 

These broad sources of return are captured in the diagram below, provided in a recent hedge fund industry study produced by the AIMA (Alternative Investment Management Association).

Another key distinction, in the most beta and factor betas are captured by investing long (i.e. buying securities and holding) while alternative hedge fund betas are captured by going both long and short and generally being market neutral i.e. having a limited exposure to market betas e.g. equity market risk.

The framework above is also useful for a couple of other important investment considerations.  We can use this framework to determine:

  1. Appropriateness of the fees paid. Obviously for market beta low fees are paid e.g. index fund fees.  Fees increase for the factor betas and then again for the alternative hedge fund betas.  Lastly, higher fees are paid to obtain alpha, which is the hardest to produce.
  1. If a manager is adding value – this was touched on above. Can a manager’s outperformance, “alpha”, be explained by “beta” exposures, or it truly unique and can be put down to manager skill.

 

Lastly, and most importantly, to obtain a truly diversified portfolio, a robust portfolio should have exposures to the different return and risk sources outlined above.

Accessing the disaggregation of investment returns has come increasingly available due to advancements in technologies and the lowering of transaction costs.  It is also having a fundamental impact on the global funds management industry, including hedge funds.

Furthermore, the determination of institutional investors to pay appropriate fees for return sources has witnessed the development of investment strategies that appropriately match fees for sources of return and risk.

Happy investing.

 

Return aggregation

 

Please see my Disclosure Statement

 

Factor Investing Portfolio Construction

/ Kiwi Investor / 2 Comments

Following on from my last post on Factor Investing this article provides some good insights into the implementation of a factor portfolio.

The article makes a few key points:

  1. The best way to capture the different factors is through diversification i.e. diversify across the different factors: value, momentum, size, minimum volatility and quality. Avoid having a single factor exposure.
  1. Although factors work, their performance vary greatly given different underlying financial and economic environments (macro environment).
  1. It is difficult to pick when the macro environment will change to the benefit or otherwise of an individual factor. Therefore, successfully under or over weighting a factor to expected changes in the macro environment offers little value add.  It is nevertheless likely to be more fruitful than making country and sector allocations shifts based on anticipated changes in the macro environment.
  1. There are a number of approaches to constructing a factor portfolio. Most often implemented are equally weighted approach (i.e. equal allocation to each factor) and risk weighted approach.  Risk weighted, in simple terms, starts with an equally weighted portfolio, then reduces the portfolio allocation to the higher risk factors e.g. more volatile factors, and increases the portfolio allocation to the less risky factors (in practice this is a more sophisticated and technically advanced approach).  Whichever approach is implemented, it needs to be consistent with Investor’s risk appetite and investment objectives.

The implementation of a robust factor portfolio is more complicated than outlined above.  There are a number of nuances that need to be considered e.g. level of portfolio turnover and redundancy of portfolio holdings i.e. a portfolio holding could enhance one factor but dilute another factor exposure.

 

Finally, the article makes a key point, this applies in any portfolio, robust portfolio construction is the key to success in Factor Investing.

True portfolio diversification isn’t easy.  Many portfolios have lots of asset classes, this does not mean they have more diversification.  See More Asset Classes Does not Equal More Diversification, the failings of diversification.

A more robust portfolio is achieved through factor allocation than say sector allocations, so long as there is a broad set of factors to invest in.

 

Please see my Disclosure Statement

Factor Investing

/ Kiwi Investor / 7 Comments

Factoring Investing, along with Alternative Investment Strategies, true portfolio diversification, Goal Based Investing (Liability Driven Investing), building robust investment portfolios, behavioural economics, and Responsible Investing, will be key themes of future blogs.

I thought this was a good article to cover as the first blog on Factor Investing:  The Case For Adding Factors To Your Portfolio.

This is a good article for those new to Factor Investing or at the beginning of considering the addition of factor exposures into a portfolio.  There are many articles like this from other provides.

 

A few of key points from the article:

  1. A factor can be thought as any characteristic relating a group of securities that is important in explaining their return and risk.
  1. Factor Investing is not new. It has been around for sometime within the industry, Value and Growth in the old days.  The drivers of value and momentum have been recognised by academics and professionals for decades.

What has changed, particularly over the last 5 years, is the technology that makes it easier and cheaper to capture market factors.

  1. There are not that many rewarding factors, Value, Quality, Momentum, Size and Minimum volatility are the most robust, Carry is another (I’ll blog separately on what each of these are).

Most of these factors can be found across most “asset classes” e.g. equities, fixed interest, commodities and currencies.

  1. Factors exposures can be used to determine if an active manager is adding true excess returns (alpha – risk adjusted excess returns), or just providing a market factor exposure which can be gained cheaply. It is a tough environment for active investors, they are being squeezed by passive index funds and cheaper factor funds (sometime referred to as smart beta strategies).  Albeit, a high level of sophistication is required in developing an effective factor investment strategy.
  1. Factor investing can deliver more efficient portfolios. This means better reward for risk taken.  Well-constructed factor investment strategies eliminate or reduce the exposure to unwanted and un-reward market risks. The article uses an America’s Cup analogy of reducing frictions to make the boat go faster– note New Zealand is the current holder of the America’s Cup.

Therefore, factor investment strategies can provide a more efficient portfolio outcome than selecting Industry Sectors or active management by way of example.

  1. Not all factors will perform equally well at every moment. Factors can underperform the wider and broader equity market and the other factors for long periods of time e.g. the Value factor has underperformed the broader global equity index for about 10 years currently!

Therefore, diversification across the factors is often recommended.

 

From a more advanced perspective, a portfolio that invests across multiply factors across multiply asset classes, and that can invest both long and short, e.g. go long stocks with favourable rewarding factors and sell short those stocks that do not display the rewarding factors, is likely the most efficient means of factor investing.  Such a strategy could well make up an allocation within a Liquid Alternatives Investment Strategy.

 

As an aside and not to confuse:

The above factors e.g. value, momentum and carry are factors that can be used to explain the drivers of securities within an asset classes e.g. equities fixed interest, and currencies

There are also macro factors, these explain at a higher level what drives a multi-asset portfolio.  Macro factors can explain more than 90% of returns across a multi-asset portfolio.  These macro factors can be used to determine an appropriate allocation to the different asset classes e.g. equities versus fixed interest exposures given preferred risk tolerance and investment objectives.

Macro factors include, economic growth, real interest rates, inflation, credit, emerging markets, and liquidity.  This is a topic for a future blog.

 

Please see my Disclosure Statement