A lot of investment professionals understand the issue outlined in this post.
Not so the investment public, for example KiwiSaver Investors. Are they aware that their “Conservative” Kiwisaver Default Funds have become more risky over recent years?
And how are Investment Committees addressing the limitations of market indices? Particularly those who blindly follow them.
It worries me with the high concentration of international fixed interest in the KiwiSaver Default Funds. There is a lot of room for disappointment.
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. See earlier post 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.
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.
An example of the benefits of this approach is very evident in fixed interest.
As we know, duration is a key risk factor that drives fixed interest securities. (Duration is a measure of a fixed interest securities price/value sensitivity to changes in interest rates. The longer the duration e.g. 10 years, the great the securities price sensitivity and change in value from movements in interest rates i.e. a 90 day cash security has very little duration risk and value sensitivity to changes in interest rates. Lastly, as interest rates increase the price/value of a fixed interest security falls. Conversely if interest rates fall the price rises.)
Fixed interest indices have become more risky over the last 10 years. Not because interest rates have reached historical lows. Many have predicted we witnessed the end of a 35 year bull market in fixed interest markets last year.
The duration of most international fixed interest indices has increased over the last 10 years. Duration being the measure of risk.
Therefore, fixed interest indices have become more risky from an interest rate perspective given an increase in duration.
By way of example, the duration of most international fixed interest indices have increased by 1.5 – 2 years over the last 8-10 years.
In a recent piece by Blackstone they noted the duration of the Bloomberg Barclays Agg Bond Index moved from 4.4 years in 2016 to 6.3 years (as of 5/2018).
Blackstone also noted that the biggest risk to investors is not recognizing that the data changed. History proves bond yields do move higher.
What does this mean for a number of the Kiwisaver Default Funds that have around 30% of their portfolio invested in international fixed interest?
In 2008, a 30% allocation to international fixed interest meant a duration contribution to a multi-asset portfolio of 1.65 years, assuming an index duration of 5.5 years.
In 2018, the 30% allocation to international fixed interest means a duration contribution to a multi-asset portfolio of 2.1 years, assuming an index duration of 7.0 years.
Therefore, the duration risk of the portfolio has increased by around half a year, an increase of almost a third.
As a result the multi-asset portfolio has become more volatile to movements in interest rates.
So what can be done?
- A new index with a lower duration could be used. It would need to be 5.5 years to bring the multi-asset portfolio’s risk back to levels displayed in 2008, all else equal.
- The portfolio allocation to global fixed interest could be reduced. The multi-asset portfolio weighting would need to be reduced to 24% from 30%, a reduction of 6%, to bring the portfolio’s duration risk back to the levels displayed in 2008, all else equal.
- A combination of the above.
However, on all occasions, Portfolio risk has been brought back to levels of 10 years ago. Further action would be required if one had a negative view on the outlook for interest rates and wanted to de-risk the portfolio further. Noting we are probably at the end of 35 year bull market in fixed interest.
This issue is often exasperated further by increasing the multi-assets portfolio’s allocation to Listed Property and Infrastructure as a means to increase yield, given a reduction in interest rates. Listed property and infrastructure are interest rate sensitive sectors of the equity markets.
Therefore, increasing allocations to these sectors often only increases portfolio duration risk and equity risk at the same time. Not great if interest rates increase sharply, as they have over the last year internationally.
Portfolio risk has not been reduced if a factor focused approach is taken. A new asset class does not necessarily reduce portfolio risk, despite what a portfolio optimisation model may say!
In conclusion, and the key point, it is not how much international and NZ Fixed Interest to allocate to within a portfolio that is important. What is importnat is how much duration risk should the portfolio have in meeting its investment objectives.
Investment committees should not be debating the level of allocation to international or NZ fixed interest without first considering what is the most appropriate level of portfolio duration risk to target. This is a different conversation and focus.
Implementation of the duration target can then be made in relation to the international and NZ fixed interest allocation split. An issue in this consideration is that NZ investors have NZ liabilities e.g. NZ inflation risk
This is a subtle but an important shift in thinking to build more robust portfolios.
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