Month: January 2019

One Year Anniversary

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Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

Endowments and Sovereign wealth Funds lead the way in building robust investment portfolios in meeting a wide range of challenging investment objectives.   This Post covers this and amongst other things, what true diversification is, it is not having more and more asset classes, a robust portfolio is broadly diversified across different risks and returns. A lot can be learnt from how Endowments construct portfolios, take a long term view, and seek to match their client’s liability profile. Although fees are important, an overriding focus on fees may be detrimental to building a robust portfolio and in meeting client investment objectives.

 

A Robust Framework for generating Retirement Income

This Post builds on the Post above and looks at an investment framework for individuals, developed by EDHEC-Risk Institute and their Partners. It is a Goal Based Investment framework with a focus on capital value but also delivering a secure and stable level of replacement income in retirement.

 

The monkey paw of Target Date Funds (be careful what you wish for)

This Post emphasises the need to focus on generating a stable and secure level of replacement income in retirement as an investment goal and highlights the approach that is required to achieve this. Such an approach would greatly enhance the outcomes of Target Date Funds. This Post also references the thoughts of Professor Robert Merton around having a greater focus on generating replacement income in retirement as an investment objective and that volatility of replacement income is a better measure of investment risk, as it is more aligned with investment objectives, unlike the volatility of capital or standard deviation of returns.

 

Kiwi Investor blog has covered many topics over the year, including the value of active management, the shocking state of the investment management industry globally, Responsible Investing, the high cost of index funds and being out of the market.

Of these, recent research into the failure of the 4% rule in almost all markets worldwide is well worth highlighting.

 

Kiwi Investor Blog has a primary focus on topics associated with building more robust portfolios and investment solutions.

The Blog has highlighted the research of EDHEC-Risk Institute throughout the year. EDHEC draw on the concept of Flexicurity. This is the concept that individuals need both security and flexibility when approaching investment decisions. This is surely a desirable goal and the hallmark of a robust investment portfolio. The knowledge is available to achieve this and the framework and rationale is covered in the Posts above.

Flexicure is my word of 2018.

 

I don’t think the Uber moment has been reached in the investment management industry yet. Technology will be very important, but so too will be the underlying investment solution. The investment solution needs to be more tailored to an individual’s investment objectives.

As outlined in the Posts highlighted above, the framework for the investment solution has emerging and is developing.

It is a goal based investment solution, more closely tailored to an individual’s investment aspirations, so as to provide a more secure and stable level of replacement income in retirement.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Best Portfolio Does Not Mean Optimal Portfolio

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The best portfolio is not necessarily the optimal portfolio.

As this thought-provoking article by Joachim Klement, CFA, highlights, “In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given investor. Or to recall a quote variously attributed to Albert Einstein, Yogi Berra, and Richard Feynman, among others: “In theory, there is no difference between theory and practice, while in practice there is.””

The article highlights the shortcomings of a portfolio optimisation approach. No surprises there!

Nevertheless, a key point made in the article is that many people in a Trustee or Fiduciary role see the portfolio optimisation process as a black-box exercise which is full of assumptions.

If true, this can be a challenge, particularly for those presenting the results and “the client never understands how these assumptions lead to the proposed allocation”.

I am sure this occurs to varying degrees and as a result there is a real risk that there is not a good understanding of the purpose of each investment allocation within the portfolio.

This often leads to the most pertinent point made in the article:

“But since clients do not grasp the purpose of each investment in the context of the overall portfolio, they are more likely to give up on the portfolio, or parts of it, in times of trouble. As a result, the best portfolio is not the optimal portfolio, but rather the one that the client can stick with through the market’s ups and downs. This means reframing the role of different asset classes or funds relative to the investor’s goals and sophistication rather than to volatility and return.”

 

Exactly. Reframing the role of the different asset classes can be achieved by taking the discussion away from the largely two-dimensional world of an optimal portfolio, market risk and return, and focusing instead on how the allocations will help meet a client’s investment goals over time.

Therefore, we can move beyond the Markowitz portfolio (the basis of Modern Portfolio and the “Optimal” Portfolio).  This is not to diminish the Markowitz optimal portfolio and the benefits of diversification, the closest thing to a free lunch in investing. Markowitz also placed a number on risk through the variance of returns.

Nevertheless, variance of return may not be an appropriate measure of risk. Other measures of volatility can be used, just as more sophisticated portfolio optimisation approaches can be implemented. Neither of which would address the key issues of the article as outlined above. In fact, they may compound the issues, particularly the black-box nature of the process.

Other measures of risk should be considered, the most important risk being failure to meet one’s investment objectives.

If your investment goal is to optimise risk and return the “optimal” portfolio is likely to be the “best” portfolio. Albeit, I am not sure this is the primary objective for most individuals and companies. For example, other investment objectives may include liquidity, income/cashflow generation, endowments. (I also don’t think the most optimal equities portfolio is the best portfolio, there are other risks to consider e.g. liquidity and concentration risk which would mean moving away from the optimal portfolio.)

There are personal and aspiration risks to take into consideration e.g. ability to weather large loses. There could be investment goals with different time periods – the optimal portfolio is generally for a single period, not multi-periods.

This is not to say don’t use an optimisation approach, it is a good starting point. Albeit, the portfolio allocation will likely need to be adjusted to take into consideration a wider set of investment objectives, risk tolerances, and behavioural factors. I would have thought this is standard practice.

 

Expanding the discussion with the client will help identify a more robust portfolio and increase the understanding of the role of each allocation within the Portfolio.

In effect, a more customising investment solution will be generated, rather than a mass-produced product.

As noted in the article, reframing the role of different asset classes within a portfolio relative to the investor’s goals and the sophistication of the client rather than to volatility and return will likely result in better outcomes for clients.

Such an approach is consistent with Liability Driven Investment (LDI), where the liabilities are matched with predictable cashflows and the excess capital is invested in a growth/return seeking portfolio, which would include the likes of equities.

Such an approach is also consistent with a Goal Based Investing approach for individuals.

It is also more consistent with a behavioural bias approach.

 

As the paper concludes:

“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box “optimal portfolios.”

“Consultants, portfolio managers, and wealth managers who take their fiduciary duty seriously should seriously consider ditching their “optimal portfolios” in favor of these theoretically less optimal but practically more robust solutions.”

“Because you are not acting in the client’s best interest if you build them a portfolio that they won’t stick with over the long term.”

 

The above would resonate with most investment professionals I know, yet strangely it does not appear to be “conventional” wisdom. Perhaps ditch is to stronger a word, too provocative.

It would be hard to argue with implementing a more practical and robust solutions aligned with a wider set of investment objectives is not in the best interest of clients, particularly if they are able to stay with the investment strategy over the longer term.

 

Referenced in the article is the work undertaken by Ashvin Chhabra, Beyond Markowitz. This work is well worth reading. Essentially he frames the investor’s risks as being:

  • Personal Risk – e.g. the risk of not losing too much that would impact on life style, this supports the safety first type portfolio
  • Market Risk – e.g. risk within the investment
  • Aspirational risk – e.g. taking risks to achieve a higher standard of living

 

This would is a great framework for a Wealth Management / Financial Planning process. Of note, market risk is only one component.

Lastly, the concept of a single Optimal Portfolio is far from the likely solution under this framework.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

The Regret Proof Portfolio

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Based on analysis involving the input of Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

Insurance companies regularly implement a two-portfolio approach as part of their Liability Driven Investment (LDI) program: a liability matching portfolio and a return seeking portfolio.

It is also consistent with a Goal Based Investing approach for an individual: Goal-hedging portfolio and a performance seeking portfolio. #EDHEC

Although there is much more to it than outlined by the article below, I find it interesting the solution of two portfolios came from the angle of behavioural economics.

I also think it is an interesting concept given recent market volatility, but also for the longer-term.

 

Background Discussion

Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.

“The idea that we had was to develop what we called a ‘regret-proof policy,’” Kahneman explained. “Even when things go badly, they are not going to rush to change their mind or change and to start over,”.

According to Kahneman, the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are “really not the same.”

In developing a “regret-proof policy” or “regret minimization” Portfolio allows advisors to bring up “things that people may not be thinking of, including the possibility of regret, including the possibility of them wanting to change their mind, which is a bad idea generally.”

 

In developing a regret proof portfolio, they asked people to imagine various scenarios, generally bad scenarios, and asked at what point do you want to bail out or change your mind.

Kahneman, noted that most people — even the very wealthy people — are extremely loss averse.

“There is a limit to how much money they’re willing to put at risk,” Kahneman said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”

 

Investment Solution

The investment solution is for people to “have two portfolios — one is the risky portfolio and one is a much safer portfolio,” Kahneman explained. The two portfolios are managed separately, and people get results on each of the portfolios separately.

“That was a way that we thought we could help people be comfortable with the amount of risk that they are taking,” he said.

In effect this places a barrier between the money that the client wants to protect and the money the client is willing to take risk on.

Kahneman added that one of the portfolios will always be doing better than market — either the safer one or the risky one.

“[That] gives some people sense of accomplishment there,” he said. “But mainly it’s this idea of using risk to the level you’re comfortable. That turns out to not be a lot, even for very wealthy people.”

 

I would note a few important points:

  1. The allocation between the safe and return seeking portfolio should not be determined by risk profile and age alone. By way of example, the allocation should be based primarily on investment goals and the client’s other assets/source of income.
  2. The allocation over time between the two portfolios should not be changed based on a naïve glide path.
  3. There is an ability to tactically allocate between the two portfolios. This should be done to take advantage of market conditions and within a framework of increasing the probability of meeting a Client’s investment objectives / goals.
  4. The “safer portfolio” should look more like an annuity. This means it should be invested along the lines that it will likely meet an individual’s cashflow / income replacement objectives in retirement e.g. a portfolio of cash is not a safe portfolio in the context of delivering sufficient replacement income in retirement.

 

Robust investment solutions, particularly those designed as retirement solutions need to display Flexicurity.   They need to provide security in generating sufficient replacement income in retirement and yet offer flexibility in meeting other investment objectives e.g. bequests.  They also need to be cost effective.

The concepts and approaches outlined above need to be considered and implemented in any modern-day investment solution that assists clients in achieving their investment goals.

Such consideration will assist in reducing the risk of clients adjusting their investment strategies at inappropriate times because of regret and the increased fear that comes with market volatility.

Being more goal focussed, rather than return focused, will help in getting investors through the ups and downs of market cycles. A two-portfolio investment approach may well assist in this regard as well.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

2018 was a shocking Year

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Well its official, 2018 was a shocking year in which to make money. Not for some time, 1972, has so many asset classes failed to deliver 5% or more in value.

In terms of absolute loses, e.g. Global Financial Crisis (GFC 2007/08), investors have incurred far worst returns than 2018, nevertheless, as far as breadth of asset classes failing to deliver upside returns, 2018 is historical.

 

Here is a run through the numbers:

International Equities were down around 7.4% in local currency terms in 2018:

  • The US was one of the “better” performing markets, yet despite reaching historical highs in January and then again in September, had its worst year since the GFC, December was is its worst December return outcome since the 1930s.
  • The US market entered 2018 on a record run, experiencing it longest period in history without incurring a 5% or more fall in value.  This was abruptly ended in February.
  • During the year the US market reached its longest period in history without incurring a Bear market, defined as a fall in value of more than 20%. Albeit, it has come very close to ending this record in recent months.
  • Elsewhere, many global equity markets are down over 20% from their 2018 peaks and almost all are down over 10%.
  • Markets across Europe and Japan fell by over 12% – 14% in 2018
  • The US outperformed the rest of the world given its better economic performance.
  • The New Zealand sharemarket outperformed, up 4.9%!

Commodities, as measured by the Bloomberg Index, fell over 2018. Oil had its first negative year since 2015, falling 20% in November from 4 year highs reached in October. Even Gold fell in value.

Hedge Fund indices delivered negative returns.

Global credit indices also delivered negative returns, as did High Yield

Emerging Market equities where negative, underperforming developed markets.

Global listed Property and Infrastructure indices also returned negative returns.

Fixed Interest was more mixed, Global Market Indices returned around 1.7%:

  • US fixed interest delivered negative returns for the year, as did US Inflation Protected fixed interest securities. US Longer-term securities underperformed shorter-term securities.
  • NZ fixed interest managed around +4.7% for the year.

The US dollar was stronger over 2018, this provided some relief for those investing outside of their home currency and maintained a low level of currency hedging.

The above analysis does not include the unlisted asset classes such as Private Equity, Unlisted Infrastructure, and Direct Property investments.

 

Two last points:

  • Balance Bear, under normal circumstances, fixed interest, particularly longer-term securities, would perform strongly when equity markets deliver such negative returns as experienced in 2018. This certainly occurred over the last quarter of 2018 when concerns over the outlook for global economic growth became a key driver of market performance. Nevertheless, over the year, fixed interest has failed to provide the usual diversification benefits to a Balanced Portfolio (60% Equities and 40% Fixed Income). Many Balanced Portfolios around the world delivered negative returns in 2018 and failed to beat Cash.
  • Volatility has increased. Research by Goldman Sachs highlights this. In 2018 the US S&P 500 Index experienced 110 days of 1%+ movements in value, this compares to only 10 days in 2017.

 

Happy investing.

 

Please see my Disclosure Statement

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