Month: August 2018

What is Responsible Investing?

/ Kiwi Investor / 2 Comments

There was a good article recently in GoodReturns on Responsible Investing (RI).

 

If I was to be critical, I would disagree with the comment at the beginning of the article that starting with exclusions (or negative screening) is a good first step. (As the article explains exclusions or negative screening involves removing companies in a portfolio that are in bad/sin/egregious industries, for example, controversial weapons and tobacco.)

I would argue, that a good first step is to have a Responsible Investing Policy. And that this Policy includes incorporating Environmental, Social, and Governance (ESG) considerations into the investment process. The Policy may well lead to exclusions, or may even include excluding certain sectors such as tobacco.

A good RI policy would also include a level of engagement with underlying companies and the investment management industry on RI issues.

The consideration of ESG factors will broaden the understanding of a portfolio’s and security’s risks, which involves understanding predominately non-financial risks which may very well have a financial impact.

Nevertheless, having a ESG focus does not necessarily lead to exclusions, it may do, it may also temper the size of the allocation to a stock or sector.  As a better understanding of the risks can be incorporated into the investment decision making process. Likewise, the RI approach could result in a combination of exclusions and sizing of portfolio allocations.

The ongoing RI research may lead to a blanket exclusion of sectors, which would be reflected in the RI Policy. I’d suggest this is the maturing of the RI approach over time, not the beginning, nor the beginning of the end!

I’d also suggest as the level of exclusions increases this is more ethical or social responsible investing, which is a subset of Responsible Investing i.e. exclusions is not what “Responsible Investing” is all about. RI is a very broad church.

Lastly, I would also argue that ESG is already mainstream in many parts of the world, the Responsible Investment Association of Australasia (RIAA) was set up in 2002 and many institutional investors have been embracing ESG for over a decade, as have broker reports included ESG/sustainability scores on companies.

Albeit there is confusion on just what is RI. The comments to GoodReturns article reflect this.

 

There is also a growing body of evidence, which has been around for some time, that incorporating ESG considerations into the investment process leads to better-informed investment decisions.  As noted above, RI is a broad church and there are varying degrees of implementing RI.

Therefore, the criticism of RI around the fear of missing out and underperformance due to negative screens needs to be taken with a level of perspective.  Not all RI approaches are a like, and therefore impacts on likely performance outcomes can vary.

One should not be quick to criticise RI giving the variation in approaches.

The evidence is not clear cut.  The higher the level of negative screens and constraints on a portfolio the more likely it is to underperform.

Nevertheless, an appropriate RI approach can enhance returns, and certainly reduce portfolio risk.

 

Another criticism of RI is around fees. Fees just are not an issue in implementing a successful RI approach.

The NZ Super Fund is an example, they do have an appropriate fee budget to manage the Fund, which does not exclude them investing into higher fee investment strategies, e.g. hedge Fund strategies and Private Equity, yet they run a global best practice Responsible Investing approach. It would appear you can have both, appropriate fee level and an industry best practice RI approach.  They certainly believe this will result in better investment outcomes over the longer term and will have more to pay out to the Government from the Fund in the future.

To date they have a good performance record and would not appear to have been negatively impacted from their RI approach, which includes negative screens.

 

The research on exclusions is mixed and varied. Comments to the GoodReturn’s article refer to Cliff Asness from AQR and his blog post on ESG. I have a lot of respect for Asness and read his blog.

My understanding on his position is that negative screening and divesting bad stocks is “actually at odds with the very point of ESG investing”.

Asness argues, if removing “bad/sin” stocks from a portfolio does help, it is an action that should be taken anyway for the sake of higher returns.

Nevertheless, IMO, an ESG framework helps identify those stocks that would fail or underperform due to ESG factors, thus the value of ESG focussed investment approach.

Please note AQR has an ESG policy.

Asness is not arguing against ESG investing, he is arguing against placing constraints on a portfolio, in this context of negative screens.  Too many constraints and a portfolio will underperform in his opinion, not surprising given he is an active manager!

Interesting, Asness contends that the desired outcome from negative screening will lower the level of investment returns achieved by the sin stocks given their cost of capital will rise. Thus the “Virtuous” negative screening investor will achieve their desired outcome: less investment within the sin/bad sectors by those companies. Asness argues that the Virtuous investor will achieve this but incur lower levels of returns themselves. The price of being Virtuous.

Not to pick an argument with Asness, as I’d surely lose, those companies that focus on managing ESG risks may have a lower cost of capital relative to their industry peers, and therefore make higher returns on investments. Thus positive ESG screening results in higher returns, the additional benefits of incorporating ESG considerations into the investment process. I’d certainly see this playing out in the resource sector.

 

Interestingly the recently released RIAA annual benchmark report noted “a lack of awareness and advice among retail investors…., and… Financial advisers…. (but the) truth is in some pockets of the advisor community, they’ve been slow to understand what this is all about and often somewhat dismissive about clients’ interests in ethical and responsible investing. There are a lot of deeply entrenched myths that still pervade that space, ……………… there’s still a perception that there’s a performance cost, this latest research shows responsible investment funds have performed consistently over time. ”

RIAA saw “ESG integration as having a positive impact on performance and the historical question marks that hung over the relative performance of responsible investment funds were starting to lift.’

Therefore, you can still have an ESG approach without negative screening.  Of course, you can also have varying levels of negative screening and maintain an ESG approach.

All up though, there is growing body of evidence that incorporating ESG considerations into the investment process leads to better-informed investment decisions.  The performance impact from negative screening is more contentious and motives to implement negative screens more varied.

 

I argue strongly, incorporating ESG into the investment process and maintaining a robust and evolving RI policy will result in better investment outcomes over time.

 

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Shocked to see the State of the Asset Management industry

/ Kiwi Investor / Leave a comment

“The asset management industry is at the crossroads of enjoying rising markets and growing pools of capital to manage, and navigating significant disruption, changes and pressures from all sides. Taking the right path and making the right choices to adapt, evolve and transform will distinguish winners from losers.”

That is the thoughts of KPMG following the publication of report in to State of the Asset Management Industry

KPMG have identified three game changes that they believe are “fundamentally changing the landscape for this industry. How the asset and wealth management firms respond to these will likely determine their success in the next 5 -10 years.”

KPMG identify three main Game Changers:

  1. ETFs
  2. China
  3. Responsible Investing

 

Responsible Investing

The focus on Responsible Investing (RI) was interesting and a little concerning.

KMPG notes the global asset management has a lower level of trust than the banks and insurers. This is a big issue for the industry.

Therefore KMPG calls for the industry to “truly embrace responsible investment and embed Environmental, Social and Governance criteria into the investment process”

KMPG see this as an important part in restoring trust within the industry. They encourage the “industry to be much more wholehearted and convincing in embracing responsible investment and embedding ESG factors into the investment process.”

“The next generation of retail, pension fund and institutional investors want to see their capital being used to create an impact and contribute to a better world”.

 

Of course Responsible Investment and ESG are not new. The Responsible Investment Association of Australia (RIAA) was set up in 2002. Australia has likely lead the rest of the world in this respect.

Therefore, a key issue is that Asset Managers, and Asset Owners, can clearly demonstrate to clients and regulators they are doing what they say they are doing, a point noted by KPMG. A more convincing approach is required.

 

The other two changes are well understood, ETFs and China.

ETFs

KPMG note:

  • Exchange Traded Fund (ETF) assets are already bigger than hedge funds and index tracker funds, and are expected to overtake mutual funds within the next 10 years. Currently the global ETF market is at US$5 trillion and is expected to more than double in the next 5 years.
  • There are rapidly growing markets where ETFs are the vehicle of choice. They fit well with digital technology used by Roboadvisers. They work well as efficient building blocks for asset allocation solutions and model portfolios in the wealth management industry and in the increasingly important self-directed market.
  • Wealth Managers are increasing their use of ETFs. Areas of growth include smart beta, while active ETFs are increasing in popularity

KMPG sum it up: “The traditional asset management industry is at an inflection point. Regulatory scrutiny around value for money and transparency, disruptive D2C technology and new investor preferences, necessitate that firms adapt and innovate if they are to flourish in the new order.

 

China

Pretty simple, “KPMG expects the industry to grow at a double digit rate, year on year, over the next 15 years.”

“In 1998, six Fund Management Companies (FMCs) managed US$1.27 billion, while today 132 firms manage US$2.0 trillion of funds. KPMG forecast USD$5.6 trillion of assets under management in China by 2025, which would make it the second-largest asset management market in the world.”

 

It is certainly a challenging environment for which industry leaders need to be aware.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is the 4% rule dead? – Approaches to Generating Retirement Income

/ Kiwi Investor / 6 Comments

The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

Bill Bengen developed this rule in 1994.

There have been numerous other studies since and the rule has gained wide acceptance.

Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.

Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?

 

The 4% rule has been challenged in a recent article by Wade Pfau.

Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.

Pfau concluded:

  • the 4% real withdrawal rule has simply not been safe;
  • even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
  • a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.

 

At a minimum, investment outcomes can be improved from:

  • Increasing levels of portfolio diversification e.g. the use of alternatives;
  • A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
  • An appropriate rebalancing strategy.

 

Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”

 

The most insightful observation

In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”

I say this given the sharp reduction in equities by many Target Date Funds and many Target Date Funds have limitations, see a recent post and another I posted earlier in the year.

 

More robust and innovative retirement solutions are required

We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.

Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.

These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.

The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.

 

EDHEC-Risk Institute

From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.

EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

 

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.

 

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.

Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.

 

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.

Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.

 

Happy investing.

 

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

 

Please see my Disclosure Statement