We all know 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 e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.
Why? True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, inflation, 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 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, along with the heavy investment into alternative investments and factor exposures. They are a model of world best investment management practice.
Unlisted infrastructure, unlisted real estate, hedged funds, and private equity are amongst the favoured alternatives by Endowments, Sovereign Wealth Funds, and Superannuation Funds.
As reported by the New York Times recently “Yale continues to diversify its holdings into hedge funds, where it has 25 percent of its assets, and venture capital, with a 17 percent stake, in addition to foreign equity, leveraged buyouts and real estate, as well as some bonds and cash. That diversification strategy, which Mr. Swensen pioneered, is widely followed by larger institutions.”
Yale has approximately 20% allocated to listed equities, domestic and foreign combined, and seeks to allocate approximately one-half of the portfolio to the illiquid asset classes of leveraged buyouts, venture capital, real estate, and natural resources.
The Yale Endowment recently released its annual report which gained some publicity.
The following quote received a lot of press: “In advocating the adoption of a passive indexing strategy, Buffett provides sound investment advice for the vast majority of individuals and institutions that are unable (or unwilling) to commit the resources (human and financial) necessary for active management success. Yet, Buffett’s advice is not appropriate for the cohort of endowments that possess the capabilities to pursue successful active management programs.”
The Yale report was published not long after the Buffet Bet concluded.
Buffet’s investment advice was highlighted further this week surrounding publicity of the Berkshire Hathaway Annual meeting.
At the centre of this exchange is investment management fees.
Don’t get me wrong, fees are important. Yet smart investors are managing fees as part of a multi-dimensional investment puzzle that needs to be solved in meeting client investment objectives. Other parts of the puzzle may include for example liquidity risk, risk appetite, risk tolerance, cashflow requirements, investing responsibly, and client future liabilities, to name a few.
This is more pressing currently, these issues need to be considered in light of the current market conditions of an aging US equity bull market and historically low interest rates and the growing array of different investment solutions that could potential play a part in a robust investment portfolio.
The debate on fees often misses the growing complexities faced in meeting specific investment objectives. The debate becomes commoditised. The true risk of investing, failure to meet your investment objectives, often gets pushed into the background.
The importance of this? EDHEC recently highlighted many of the current retirement products do not adequately address the true retirement savings goal – replacement income in retirement.
This is not addressed by many of the target date / life cycle funds, nor is it the role of the accumulation 60/40 (equities/bonds) Fund of your standard superannuation fund. Life cycle funds predominately manage market risk, there are other risks that need to be managed, some of which are outlined above, replacement income in retirement should also be added.
As EDHEC further highlighted, this is a serious issue for the industry, and more so considering the world’s pension systems are under enormous stress due to underfunding and a rising demographic imbalance with an aging population. Furthermore, globally, there has been a shift of managing retirement risk to the individual i.e. the move away from Defined Benefit to Defined Contribution.
As a result, a greater focus is needed on investment solutions in replacing income needs in retirement. This requires a greater awareness and matching of people’s retirement liabilities, a Goal Based Investment solution (Liability Driven Investing).
The management of client liabilities, and the design of the customised investment solutions needs to be implemented prior to retirement. As many are currently discovering, a portfolio of cash and fixed interest securities, no matter how cheaply it is provided, is not meeting retirement income needs.
The debate needs to move on from fees to the appropriateness of the investment solutions in meeting an individual’s retirement needs.
The advice model is critical.
This is a big challenge, and I’ll blog more on this over time.
I’ll say it again, fees paid are important. Nevertheless, the race to be the lowest cost provider may not be in the best interest of clients from the perspective of meeting client investment objectives. The focus and design of “products” is primarily on accumulated value, a greater focus is required on replacement income in retirement.
Sophisticated investors such as endowments, insurance companies, pension funds, and Sovereign Wealth Funds, are taking a different perspective to the commoditised retail market. Albeit, their approach is not inconsistent with fees being an important “consideration” that should be managed, and managed appropriately. They likely manage to a fee “budget”, as they manage to a risk budget.
It is very critical that the Endowments get it right. Endowments are a crucial component of university budgets. During the global financial crisis of 2008 many endowments had to significantly cut back their spending due to the falling value of their Endowment Funds. It is estimated that distributions from the Yale endowment to the operating budget of the University have increased at an annualized rate of 9.2 percent over the past 20 years. The Endowment Fund is the university’s largest source of revenue. The Fund is expected to contribute $1.3 billion to the University this year, this is equal to approximately 34% of the Yale’s operating budget.
Much can be learned from how endowments construct portfolios, take a long term view, and seek to match their client’s liability profile. An overriding focus on fees will lead away from investing successfully in a similar fashion.
The endowment approach can be applied to an individual’s circumstances, particularly high net worth individuals. The more complex the situation, the better, and the more value that can be added.
There will be a growing demand for more tailored investment solutions.
EDHEC argue an industrial revolution is about to take place in money management, this will involve a shift from investment products to investment solutions “While mass production has happened a long time ago in investment management through the introduction of mutual funds and more recently exchange traded funds, a new industrial revolution is currently under way, which involves mass customization, a production and distribution technique that will allow individual investors to gain access to scalable and cost-efﬁcient forms of goal-based investing solutions.”
For the record, as reported by the Institutional Investor: For the 20-year period ending June 30, Yale’s endowment earned a 12.1 percent annualized return, beating its benchmark Wilshire 5000 stock index, which gained 7.5 percent. A passive portfolio with a 60 percent stock allocation and 40 percent in bonds, meanwhile, had a 20-year return of 6.9 percent.
Lastly, I am a very big fan of Buffet, and one should read the two books by the two key people who have reportedly had a big influence on him, number one is obvious, Benjamin Graham’s The Intelligence Investor, and the other Philip A Fisher, Common Stocks and Uncommon Profits. I preferred the later to the former.
It is also well worth reading David Swensen’s book: Pioneering Portfolio Management. Yale has generated the highest returns among its peers over the last 20 years.
Build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.”
Invest for the long-term.
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