Investing in a Challenging Investment Environment

The Global financial backdrop can be summarised as:

  1. Late Cycle
    • The US economy is into its longest period of uninterrupted growth, it has been over ten years since the Global Financial Crisis (GFC) and the US experiencing a recession.
    • Likewise, the US sharemarket is into it longest period without incurring a 20% or more fall (which would be a bear market).
  2. Exceptionally low interest rates. As you will be aware over $14 trillion of European and Japanese fixed income securities are trading on negative interest rates.
  3. Central Banks around the world are reducing short-term interest. By way of example, the US Federal Reserve has undertaken a mid-cycle adjustment, with more to come, the European Central Bank recently cut interest rates, as has China’s Central Bank. The Reserve Bank of Australia and the Reserve Bank of New Zealand have reduced cash rates very aggressively in recent months. It appears that interest rates will remain lower for longer.
  4. Rising geo-political risk, namely an ongoing and escalating trade dispute between the US and China, while Brexit has a cameo role on the global stage, and there are rising tensions in the middle-east.
  5. Global growth has slowed. The pace of economic activity has slowed around the world, this is most noticeable in Europe, Japan, and China, and is concentrated within the manufacturing sector. The service sectors have largely been unaffected.

 

Against this backdrop the US sharemarket has outperformed, continually reaching all-time highs, likewise for the New Zealand sharemarket.

Value stocks have underperformed high growth momentum stocks. The performance differential between value and growth is at historical extremes.

Lastly emerging Markets have underperformed the developed world.

 

A good assessment of the current environment is provided in this article by Byron Wien. It is a must read, Plenty to worry about but not much to do.

 

It is not all gloom and doom

The US consumer is in very good shape, reflecting record low unemployment, rising wages, and a sound property market. The US consumer is as bigger share of the global economy as is China. Although it is not growing as fast as China, a solid pace of growth is being recorded.

Overall, economic data in the US has beaten expectations over recent weeks (e.g. retail sales).

Globally the manufacturing sectors are expected to recover over the second half of this year, leading to a rebound in global growth. Low interest rates will also help global growth.  Nevertheless, growth will remain modest and inflation absent.

Globally, in most countries, Sharemarket’s dividend yields are higher than interest rates. This means that sharemarkets can fall in value over the next 5-10 years and still outperform fixed income.

 

How to invest in current environment

Recently there has been #TINA movement: There Is No Alternative to Equities.

Certainly equities have performed strongly on a year to date basis, so have fixed income securities (their value increases as interest rates fall).

The traditional 60/40 portfolio, 60% Equities and 40% Fixed Income, has performed very strongly over the last 6-9 months, this comes after a difficult 2018.

#TINA and the longer term performance of the 60/40 portfolio is covered in this AllAboutAlpha Article, which is well worth reading.

The 60/40 portfolio has performed well over the last 10 years, and has been a strong performer over the longer term.

This performance needs to be put into the context that interest rates have been falling for the last 35 years, this has boosted the returns from the Fixed Income component of the portfolio.  Needless to say, this tail wind may not be so strong in the next 35 years.

This indicates that future returns from a 60/40 portfolio will be lower than those experienced in more recent history.

There are lots of suggestions as to what one should do in the current market environment.  This article on Livewire Markets provides some flavour.

No doubt, you will discuss any concerns you have with your Trusted Advisor.

 

At a time like this, reflect on the tried and true:

Seek “True” portfolio Diversification

The AllAboutAlpha article references a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

The above comments are technical in nature and I will explain below. Albeit, the Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

 

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes i.e. asset class silos. This has diminishing diversification benefits over the longer term and particularly at the time of market crisis e.g. adding global listed property or infrastructure to a multi-asset portfolio that already includes global equities.

True portfolio diversification is achieved by investing in different risk factors (i.e. premia) that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative and hedge fund risk premia, illiquidity e.g. Private Equity, Direct Property, and unlisted infrastructure. And of course, true alpha from active management, returns that cannot be explained by the risk exposures just outlined. There has been a disaggregation of returns.

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.

Therefore, seek true portfolio diversification, this is best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates driving portfolio outcomes.

As the Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events i.e. Black Swans.

True diversification leads to a more robust portfolio.

(I have written a number of Post on Alternatives and the expected growth in institutions investing in alternatives globally.)

 

Customised investment solution

Often the next bit advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from capital markets.

For example, income earned up to and after retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

 

Think long-term

I think this is a given, and it needs to be balanced with your customised investment objectives as outlined above. Try to see through market noise, don’t over trade and don’t take on more risk to chase returns.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Also look to financial planning options to see through difficult market conditions.

 

There are a lot of Investment Behavioural issues to consider, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwiinvestorblog is all about education, it does not provide investment advice nor promote any investment and receives no payments. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all weather portfolio?

 

Happy investing.

Please see my Disclosure Statement

 

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

 

In defence of Target Date Funds

This is a great article from i3 providing some interesting perspectives into Target Date Funds, referred to as Life-Cycle strategies in Australia.

Target Date Funds have been around since the 1990s and have had an increasing presence in Australia following the MySuper legislation of 2012, which set the legal requirements for the default pension (KiwiSaver) options in Australia.

As a result, many Australian providers introduced Life-Cycle Funds as default options. Target Date Funds are also increasingly the default option in the USA.

 

It is fair to say there has been wide spread criticism of Target Date Funds.

Some of this criticism is warranted, nevertheless, consistent with the point made in the i3 article, the criticism of Target Date Funds is often the result of the poor design of the Fund itself, rather than the concept of a Target Date Fund.

For example, as noted in the article, the Australian Productivity Commission “criticised a number of existing life-cycle strategies for derisking too early and not being as good as many balanced fund options.”

This is fair criticism, but it is a design issue. I have previously noted that at least one KiwiSaver provider places their clients into 100% Cash at age 65, that is scandalous.

On the positive side, the Commission “acknowledged life-cycle strategies could help in addressing sequencing risk”.

 

These themes are touched on in the interview with Michael Block, Chief Investment Officer with Australian Catholic Superannuation.

“To always place a member who is 20 years old with a 60-year old member in the same strategy is clearly ridiculous,” Block says in an interview with [i3] Insights.

“Why would any fund use a one-size strategy that clearly does not fit all?”

“I absolutely concede, especially with people living longer, that moving members into a low-risk strategy at 60 is not a great idea. Even at 60 years old, a member is likely to have a 30-year investment horizon and should still have a decent amount of growth assets,” he says. (Growth asset include equities, alternatives and non-traditional assets.)

As the article notes: “The result of the shift is that half of the fund’s members now have a higher allocation to growth assets, while one-quarter, generally older members, have a lower allocation. The rest have retained a similar exposure to growth assets.”

 

Comments on De-risking

De-risking is reducing the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

Australian Catholic Super looks to reduce the allocation to equities in small annual increments, 31 steps to be precise, not the normal 3-4 lumpy transactions of many Target Date Funds.

“As long as you still contribute to your super, you’ll get a better outcome compared to a single-strategy investment option,” Block says. (An example of a single strategy is a Conservative or Balance Fund.)

“This gradual process of derisking also reduces a member’s sequencing risk as there is never more than a 2 per cent reduction in growth assets in any given year.”

This makes some sense and is a nice design feature of their Target Date Funds.

 

Customisation

The Australian Catholic Super’s life-cycle fund is based on age only. They hope to add other variables over time, such as account balance and salary.

“In a perfect world, you would ask everyone what they wanted out of a superannuation fund and tailor an individual portfolio for them, but if you don’t have complete information, then a life-cycle strategy based on age is a good attempt at mass customisation,” he says.

 

Quite true, it is a start, and a good start at that. With further sophistication of the investment approach and the helping hand of technology the mass customised investment solutions is not far away.

Increased customisation of the superannuation solution is the future.  Customisation will consider the generation of a required level of income in retirement, take into consideration income earned outside of super, risk preferences, account balance, and any likely endowments. Such customisation is available now.

 

More on Target Date Funds

For those wanting more on Target Date Funds, I have previously Posted on their Short Comings and suggested improvements.  They are also worth considering as the KiwiSaver Default Option.

Lastly, Target Date Fund can be improved upon by a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

Interestingly, Kiwis can learn from the Aussies, maybe not when it comes to rugby, or certain cricket practices, but most certainly we can learn from them when it comes to Superannuation and the management of Pension Funds.

 

Happy investing.

Please see my Disclosure Statement

 

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

KiwiSaver Investors are missing out

This is a great article by Stuff outlining the KiwiSaver risk ladder, rung by rung.

However, what struck me is that there is a rung missing on the KiwiSaver ladder.

That rung being the lack of exposure to non-traditional investments, such as Alternatives, including liquid alternatives, hedge funds, and investments into Direct Property and unlisted infrastructure.

 

Based on the Stuff article, there is just 1% within all of the KiwiSaver Funds invested outside of Cash, Fixed Interest (bonds), and Equities (the traditional asset classes).

We don’t have to look far to see how much of anomaly this.

By way of comparison, the Australian Pension Fund Industry, which is the fourth largest Pension market in the world, invests 22.0% into non-traditional assets.

As can be seen in the Table below, Australian Pension Funds, which manages A$2.9 trillion, invests 22.0% into non-traditional assets, meanwhile KiwiSaver has 1% invested outside of the traditional assets. (KiwiSaver Total Assets are just over $50 billion).

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

 

As recently reported by Bloomberg, allocations to non-traditional assets is expected to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

 

The increased allocations to Alternative is a global trend, which is not just in response to current market conditions.

As outlined in a previous Post, Preqin a specialist global researcher of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world, expect Alternatives to make up a larger share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018). This is an issue from the perspective of capacity and ability to deliver superior returns – manager selection will be critical.

 

Globally the trend toward increasing allocations to non-traditional assets has been in play for some time. As one of my first Posts notes, the case for adding alternatives to a traditional portfolio is strong.

This Post highlights that the movement toward Alternatives and non-traditional assets is not revolutionary nor radical, it is seen globally as evolutionary, a natural progression toward building more robust Portfolios that can better weather sharp falls in global sharemarkets.

 

Being more specific about Alternatives, Prequin note investor’s motivation for investing in alternatives are quite distinctive:

  • Private equity and venture capital = high absolute and risk-adjusted returns
  • Infrastructure and real estate = an inflation hedge and reliable income stream
  • Private debt = high risk-adjusted returns and an income stream
  • Hedge Funds = diversification and low correlation with other asset classes
  • Natural Resources = diversification and low correlation with other asset classes

 

Therefore, motives to investing in alternatives range from enhancing returns (Private Equity) and reducing risk through better diversification (Hedge Funds) and hedging against inflation (infrastructure and real estate (property), high exposures to non-traditional assets have benefited Endowments and foundations for many years.

 

I have Posted extensively on the benefits of Alternatives, for example highlighting research they would benefit Target Date Funds and the benefits of Alternatives more generally.

 

So the Question needs to be asked, why do KiwiSaver Funds not invest more into non-traditional assets? Particularly, when globally the trend is to invest in such assets is well established and further growth is expected, while the benefits are well documented.

 

Therefore, KiwiSaver Investors are potentially missing out.  Their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

The Retirement Planning Death Zone

The retirement risk zone (also known as the ‘conversion’ phase) is commonly defined as the final 10 years of working life (the ‘accumulation’ phase) and the first 10 years of retirement (the pay-out phase or decumulation).

This period is right before and right after you retire.

Importantly, it is this 20 year period when the greatest amount of retirement savings is in play and, subsequently, risk is at its highest.

 

This can be thought of along the lines of the death zone when climbing Mt Everest. The risky time is the final ascent, clambering over the Hillary Step, on the way to the summit of Mt Everest. However, once at the summit risks remain on the decent and until below the death zone when the ability to breathe becomes easier.

The summit in terms of retirement savings is generally reached at age 65, this is when the amount saved will be the “peak” in savings accumulated. It is here when accumulated wealth is at its largest.  Albeit, from an investment perspective, risks remain heightened over the first 10 years of the pay-out/decumulation phase.

 

The Retirement Risk Zone, the 10 years either side of retirement, is the worst possible time to experience a large negative return given this is when the greatness amount of money is at stake. Risks to portfolios are heightened at this stage.

It is a very important period for retirement planning.

 

During the Retirement Risk Zone two factors can potentially combine to have a detrimental impact on the standard of living in retirement:

  1. The portfolio size effect (what you do when the largest amount of your money is at risk matters); and
  2. the problem of sequencing risk (how much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of the loss, again, especially during the Retirement Risk Zone).

 

To explain, sequencing risk, is the risk that the order of investment returns are unfavourable, resulting in less money for retirement.

Sequencing risk impacts pre-and post-retirement i.e. the retirement risk zone.

 

Cashflows, investments in and withdrawals out of the retirement savings plan, add another dimension to sequencing risk.

Sequencing Risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement. This impacts on longevity risk.

This is where Warren Buffet could be wrong in recommending people maintain high equity allocations for the longer term. As noted in my previous Post, Could Buffet be Wrong? “once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives”. This is sequencing risk at play for those planning for retirement. This is also why many US Endowments do not hold large equity allocations.

It is untrue to say that volatility does not matter for the long term when cashflows are involved.

A brief explanation of interplay between the timing of returns and cashflows is provided below.

 

Longevity Risk

The portfolio size effect and sequencing risk have a direct relationship to longevity risk.

For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.

Or put another way, longevity risk is the likelihood that superannuation savings will be depleted prior to satisfying the lifetime financial needs of the dependents of those savings.

One way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.

 

The point to take away: the size of your portfolio, order in which returns are experienced, and timing of cashflows into and out of the retirement savings account have an impact on accumulated wealth and ultimately standard of living in retirement.

The basic conclusions. First, it is better to suffer negative returns early in the accumulation phase.

Secondly, it is better to suffer negative returns later in retirement.

 

Materiality of Sequencing Risk

In short, the research finds that the sequence of returns materially impacts peak accumulated wealth (terminal wealth) and heightens the probability of running out of money in retirement (longevity risk).  The research backs up the two conclusions above.

The Griffith University research paper mentioned below “finds that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“

Terminal wealth is “peak” accumulated savings in our Mt Everest example above.

Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.

They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”

This is consistent with other international studies.

 

For those wanting a more technical read please see the papers that have been drawn upon for this Post:

  1. Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
  2. Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife

 

Managing Sequencing Risk

The combination of the portfolio size effect, sequencing risk, and longevity risk combine to form a trinity of investment issues that need to be managed inside the Retirement Risk Zone.

Mitigation of sequencing risk is critical across the retirement risk zone.

Sequencing risk is largely a retirement planning issue. Albeit a more robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk:

  1. A greater focus on generating retirement income earlier

In my mind, a greater focus should be placed on positioning retirement portfolios for generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement.

This is achieved by using asset-liability matching techniques as recommended by the OECD. This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable level of income in retirement.

The investment knowledge is available now to achieve this and these techniques can improve the outcomes of Target Date Funds.

This is also consistent with the OECD’s Core Principles of Private Pension Regulation that emphasised that the objective is to generate retirement income.

The central point is, without a greater focus on generating Income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.

 

I have highlighted the OECD recommendations in a previous Post.

 

2. A greater focus on reducing downside risk in a portfolio

This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.

From this perspective Target Date Funds would be an appropriate default option for KiwiSaver, as I have previously outlined.

A more robust portfolio must also display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.

This includes the inclusion of alternative investments. Portfolios should be built more like US endowments as I outlined in a previous Post.

An allocation to Alternatives have also been shown to improve the investment outcomes of Target Date Funds.

The inclusion of low volatility equities may also be option.

 

The article from Forbes is of interest in managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.

Many argue that sequencing risk can be managed by Product use alone.

 

My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing, and is therefore using asset-liability matching type strategies.  I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk.   This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

 

Sequencing risk is currently a growing and present danger given it has been a long time since both the US and New Zealand sharemarkets have incurred a major fall in value. Hopefully, sequencing risk is getting some consideration in investment decisions being made today.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Background – Understanding Impact of returns and Cashflows

It is hard to believe, but two investors might both experience “average” returns of 8 per cent over a 20-year period and yet have materially different balances due to sequencing risk.

The 20-year periods would occur at different times, yet the “average” return is the same.

Nevertheless, the sequence of returns to generate an “average” return over the 20 year periods can result in different accumulated wealth.

This reflects there is a difference between time weighted returns and dollar invested returns. The time weighted return assumes you held the same investment over the time period. A dollar weighted return takes into consideration that money goes in and comes out of a savings account and each dollar earns a different return given the period it is invested for.  Dollar weighted returns impact on accumulated wealth.

Although the sequence of returns is crucial, so too are the timing of Cashflows into (deposits) and out (withdrawals) of a savings account.

To appreciate this, it is important to understand the impact of market volatility, it is hard to recover a dollar lost from a negative market movement. For example, if your portfolio falls in value by 40%, it’s takes a 67% return to recover your loses e.g. you have $100, this falls in value by 40%, wealth falls to $60, to get back to $100, the portfolio must recover 67%.

When there are cashflows not every dollar will experience the same return e.g. a dollar withdrawn after a 50% fall will miss out on any subsequent recovery in market prices, which can take up to six to ten years.

Therefore, the introduction of cashflows can also result in different outcomes for investors. This is why the pulling of funds out of markets following a large fall (draw-down) early in the accumulation phase can have a detrimental impact on accumulated wealth at the time of retirement.

The sequence of returns and cashflows matters during both the accumulation of retirement savings and in retirement.

During accumulation cashflows are going into the savings account and the account balance is growing. Therefore, each dollar invested has a different investment return.

In retirement, cashflows coming out of the portfolio will gradually reduce the capital base, therefore, investors will be better off if returns are stronger at the start of retirement, as the account balance will be larger and growing, meaning cashflows out will not reduce the capital base as much when returns are poorer in the earlier years of retirement.

For those wanting a more technical explanation, along with some great charts and graphs, this article by Challanger will be of real value.