Month: December 2020

Investment strategies for the year(s) ahead – how to add value to a portfolio

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At this time of the year there are a plethora of economic and market forecasts for next year.  This Post is not one of them.

Outlined below are several investment strategies investors should consider in building more robust portfolios for the years ahead and to increase the odds of meeting their investment objectives.

These strategies directly address the current investment environment and the developing theme over 2020 that the traditional Balanced portfolio, of 60% equities and 40% fixed income, is facing several head winds, and likely to disappoint from a return perspective in the decade ahead.

A recent FT article captures this mood, titled: Investors wonder if the 60/40 portfolio has a future | Financial Times

In the article they make the following comment “The traditional 60/40 portfolio — the mix of equities and bonds that has been a mainstay of investment strategy for decades — is at risk of becoming obsolete as some investors predict years of underperformance by both its component parts.”

I first Posted about the potential demise of the Balanced Portfolio in 2019, see here, and again in early 2020, see here.   These Posts provide background as too why many investment professionals are questioning the likely robustness of the Balance Portfolio in the years ahead given the current investment environment.

In essence, there are two themes presented for the bleak outlook for the Balanced Portfolio.

The first is that fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest in these markets.

The second theme is that with interest rates at very low levels, there is doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.

For more on the low expected return environment, first Theme, see these Posts here and here.  This Post also outlines that although markets fell sharply in March 2020, forecast future returns remain disappointing.

The strategies discussed below address the second theme, the expected reduced effectiveness of fixed income to protect the Balance Portfolio at the time of severe sharemarket declines.

The Balance Portfolio has served investors well.  Although equities and fixed income still have a role to play in the future, there is more that can be done.

The strategies outlined below are “the more that can be done“, they aim to improve the risk and return outcomes for the Balance Portfolio in the years ahead.

For the record, I anticipate the global economy to continue to repair next year, experiencing above average growth fuelled by the roll out of the Covid-19 vaccines and underpinned by extraordinary low interest rates and generous government spending programs.  Global equities will continue to perform well in this environment, the US dollar will weaken further, commodity prices will move higher, value and emerging markets to outperform.

The Case for holding Government Bonds

Before looking at some of the strategies to improve on the Balance Portfolio, it goes without saying there is a role for equities in most portfolios.  The case for and against US equities are found here and here respectively.

There is also a role for holding Fixed Income securities, primarily government bonds.

This Post reviews some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It also brings some balance to present discussions around fixed income and the points within should be considered when determining portfolio allocations in the current market environment.

The central argument for holding government bonds within a portfolio: Government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

In a recent Financial Times article PIMCO argues the case for the 60/40 portfolio in equities and fixed income.   

In relation to fixed income they argue, that although “returns over the horizon may be harder to achieve, but bonds will still play a very important role in portfolios”.  The benefits being diversification and moderation of portfolio volatility.

However, they argue in relation to fixed income investors must target specific regions and parts of the yield curve (different maturity dates) to maximise return and diversification potential.

PIMCO see opportunities in high-quality assets such as mortgage-backed securities from US government agencies, areas of AA and AAA rated investment-grade corporate bonds, and emerging market debt that is currency hedged.

They conclude: “One answer for 60/40 portfolio investors is to divide fixed-income investments into two subcomponents — hedging and yield assets.”

Rethinking the “40” in the 60/40 Portfolio

This Post outlines a thinkadvisor.com article which provides a framework to consider potential investment ideas in the current extremely low interest rate environment, by examining the 40% fixed income allocation within the 60/40 Portfolio (Balanced Portfolio).

The basis of the article is that investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk. This likely involves investing into a broader array of fixed income securities, dividend-paying equities, and alternatives, such as real assets and private credit.

The Role of Liquid Alternatives and Hedge Funds

I have no doubt investors are going to have to look for alternative sources of returns and new asset classes outside equities and fixed income over the next decade.

Not only will this help in increasing the odds of meeting investment objectives, but it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility, a role traditionally played by fixed income within a multi-asset portfolio.

The best way to manage periods of severe sharemarket declines, as experienced in the first quarter of 2020, is to have a diversified portfolio.  It is impossible to time these episodes.

AQR has evaluated the effectiveness of diversifying investments during market drawdowns.

They recommend adding investments that make money on average and have a low correlation to equities i.e. liquid alternatives and hedge fund type strategies. 

AQR argue diversification should be true in both normal times and when most needed: during tough periods for equities.  Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, they tend to do worse on average over the longer term.

Alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and have higher returns.

Lastly, Portfolio diversification involves adding new “risks” to a portfolio, this can be hard to comprehend.  Diversification can be harder to achieve in practice than in theory.

This Post provides a full summary and access to the AQR article.

The case for Trend (momentum) Strategies

A sub-set of Alternatives and hedge funds is Trend/Momentum.

In this recent article MAN present the benefits of introducing Trend following strategies to the traditional Balanced Portfolio. Man note, “Another element that we believe can be of great help to bond-equity portfolios in the future is time-series momentum, or trend-following.”

Their analysis highlights that adding trend-following results in a significant improvement relation to the Balanced Portfolio, by improving returns, decreases volatility, and reducing the degree of losses when experienced (lower downside risk – drawdowns).

The case for Tail Risk Hedging

The expected reduced diversification benefits of fixed income in a Portfolio is a growing view among many investment professionals.

This presents a very important portfolio construction challenge to address, particularly for those portfolios with high allocations to fixed income.

There are many ways to approach this challenge,

This Post focuses on the case for Tail Risk Hedging.  It also outlines other approaches.

In my mind, investment strategies to address the current portfolio challenge need to be considered. The path taken is likely to be determined by individual circumstances.

Comparing a diversified approach versus Tail Risk Hedging

On this note, the complexity, and different approaches to providing portfolio protection, was highlighted by a twitter spat between Nassim Nicholas Taleb (Tail Risk Hedging) and Cliff Asness (broad Portfolio Diversification) from earlier in the year.

I provide a summary of this debate in Table format accessed in this Post, based on a Bloomberg article. 

Several learnings can be gained from their “discussion”.

Also covered the Post was an article by PIMCO on Hedging for Different Market Scenarios. This provides another perspective and a summary of different strategies and their trade-offs in different market environments.

Not every type of risk-mitigating strategy can be expected to work in every type of market environment.

Therefore, maintaining an array of diversification strategies is preferred “investors should diversify their diversifiers”.

Hedge Funds vs Liquid Alternatives – both bring diversification benefits to a traditional portfolio say Vanguard

Vanguard recently concluded that investors should carefully consider liquid alternatives and hedge funds.

This is a very good article presenting the benefits Alternatives would bring to a Balanced Portfolio.

Their research highlighted that Hedge Funds and Liquid Alternatives both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest that liquid alternatives are often viable options for investors compared to hedge funds.

Although hedge funds and liquid alternatives deliver valuable portfolio diversification benefits, “it is crucial that investors assess funds on a standalone basis, as the benefits from any alternative investment allocation will be dictated by the specific strategy of the manager(s).”

The most important feature in gaining the benefits of hedge funds and liquid alternatives is manager selection.  Implementation is key.

Access to this research can be found here.

Private Equity Characteristics and benefits to a Portfolio

For those investors that can invest into illiquid investments, Private Equity (PE) is an option.

Portfolio analysis, also undertaken by Vanguard, demonstrates that PE can play a significant role in strategic, long-term, diversified portfolios.

PE is illiquid and so must be actively managed, introducing both illiquidity and manager specific risk to a multi-asset portfolio. Conventional asset allocation approaches often omit illiquidity and active risk dimensions from the risk-return trade-off. Therefore, these models do not reflect the unique aspects of PE and tend to over allocate to PE.

Vanguard addresses these issues: outlining four key reasons why the economic returns of private equity are different to those of public equities; highlighting the key risks that need to be accounted for when undertaking portfolio modelling including illiquid assets such as PE; and presenting the adjustments they make to portfolio modelling to address the illiquid features of PE and smoothed nature of historical returns.

This results in more realistic characteristics for PE that can be used for portfolio modelling purposes, reflected in the portfolio allocations generated in the article and the conclusion that PE can play a significant role in strategic, long-term, diversified portfolios.

A review of Vanguard’s analysis and their results can be found in this Post.

Real Assets Offer Real diversification benefits

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, Inflation-linked Bonds, Commodities, and Foreign Currencies offer real diversification benefits to a portfolio of just equities and fixed income.

The benefits of Real Assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation.

These are the conclusions of a recent study by PGIM.

PGIM provide a brief outline of the investment characteristics for several real assets. They then look at the sensitivity of the real assets to economic growth, inflation, equity markets, and fixed income.

They note there is wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds. These sensitivities vary over time and are best mitigated by holding a portfolio of real assets.

Therefore, PGIM construct and analyse three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection to reach their conclusions.

I provide a detailed summary of the PGIM Report in this Post.

Portfolio Tilts

Adding Emerging Markets and Value tilts to a Portfolio are potential areas to boost future investment returns in what is likely to be a low return environment over the next decade.

Value of Emerging Markets

Emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.

The case for investing into emerging markets is well documented: a growing share of global economic activity in the years ahead and current attractive valuations underpin the case for considering a higher weighting to emerging markets within portfolios. Particularly considering the low interest rate environment and stretched valuation of the US sharemarket. This is evident in market return forecasts.

Is a Value bias part of the answer in navigating today’s low interest rate environment

Value offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Value is exceptionally cheap, probably the cheapest it has ever been in history, based on several valuation measures and after making adjustments to market indices to try and prove otherwise, such as excluding all Technology, Media, and Telecom Stocks, excluding the largest stocks, and the most expensive stocks.

There is also little evidence to support the common criticisms of value, such as increased share repurchase activity, low interest rates, and rise of intangible assets.

This is not a popular view, and quite likely minority view, given the underperformance of value over the last ten years.

However, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next decade.

Please see my Disclosure Statement

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

Private Equity characteristics – considerations for Portfolio inclusion

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Portfolio analysis undertaken by Vanguard demonstrates that private equity (PE) can play a significant role in strategic, long-term, diversified portfolios.

Vanguard highlight:

  • Although private equity and public equity share some risk and return characteristics, there are key structural differences. (Both have a role to play in a well-diversified and robust portfolio.)
  • Private equity investments are illiquid and so must be actively managed, introducing both illiquidity and manager specific risk to the multi-asset portfolio.
  • Conventional asset allocation approaches such as mean-variance efficient frontiers omit illiquidity and active risk dimensions from the risk-return trade-off.
  • Asset allocation models that do not reflect the unique aspects of PE tend to over allocate to PE and therefore introduce unintended risks into a multi-asset portfolio.

In this Research Paper Vanguard introduce a new portfolio construction framework that accounts for private equity’s risk and return characteristics, Vanguard Asset Allocation Model (VAAM). 

They conclude that there is no single recommended allocation for all investors.  “Private equity allocations depend on each investor’s specific set of circumstances, such as the degree of risk tolerance, including active risk tolerance, and the ability to find and access high-quality managers.”

In allocating to PE investors must carefully consider their willingness and ability to handle a long-term lack of liquidity, constraints on rebalancing, and uncertainty around the timing and size of cash inflows and outflows.

Below is a summary of the Vanguard Research Paper, which also draws on this All About Alpha article by Vanguard.

The Vanguard paper addresses the following three main issues:

  • Complexity in the structure and mechanics of PE that lead to unique sources of risk and return versus public equity investments.
  • Data limitations due to lack of standardized publicly available marked-to-market performance reporting.
  • Lack of portfolio construction frameworks that can appropriately account for PE’s unique characteristics.

Why returns from Private Equity are different to those from Public Equities

For those new to PE the Vanguard paper provides an excellent introduction, including topics such as what is a PE investment, the growth in PE over the last two decades, and how to access PE.

Their discussions on identifying the drivers of PE returns is very good.

Vanguard outline four key reasons why the economic returns of private equity should be different than those of public equity benchmarks:

Liquidity premium.

“Investors in private equity have less ability to trade their investment and do not control the timing or size of cash flows if invested in funds; therefore, they should require compensation in the form of a liquidity premium.”  Returns from the “Liquidity Premium” vary over time.

An important point in relation to liquidity, is that most long-term investors do not need a 100% liquid portfolio.  Most investors over-estimate their liquidity needs (this is not to minimise the importance of portfolio liquidity).

Vanguard note there are two different but related forms of liquidity risk:

  • Market liquidity risk – the ease with which an investment can be traded.
  • Funding liquidity risk – investors must be flexible enough to make contributions quickly and to deal with potential material delays in distributions from the PE funds

Other risk factors

“The average characteristics of private equity companies may be different than those of public companies (for example, industry, size, financial leverage, geography, and valuation).”

There is a large body of research that attempts to estimate the common risk factors of PE, such as size and value.

Vanguard provides results from a sample of academic studies which suggests PE Funds tend to have above market risk (high betas) and a small size tilt.  The research also suggests that buyout funds have a value bias, whereas venture capital funds display a negative value bias.

These are important considerations to contemplate when evaluating the inclusion of PE into a diversified and robust portfolio to minimise unintended risk exposures.

Manager-specific alpha

“Investors accept idiosyncratic manager-specific risk in exchange for the opportunity to generate alpha.”

Vanguard outlined that PE managers look to add value in the following ways:

  • Company selection. In addition to their company selection skills, some managers may have access to certain deals or parts of the market that others may not because of their reputation or skill set.
  • Thematic bets. Managers can choose to focus on secular or structural changes (such as technological, regulatory, and consumer preference) that may not be fully reflected in company valuations today.
  • Governance. PE firms can provide the oversight to help portfolio companies with the likes of strategic planning, conflicts of interest, and remaining focused on competitive advantages.
  • Finance. PE firms provide guidance in optimising capital structures of portfolio companies.
  • Operations. PE firms may have specific sector or industry expertise that can help portfolio companies make key decisions, reduce costs, and identify growth opportunities.

Manager due diligence is always important, in relation to PE investors should understand how a manager seeks to add value, why the manager believes they will be successful, and what success will look like.

Always have a set of expectations as to a manager’s expected performance, these can be both quantitative and qualitative.  Undertake ongoing monitoring and review of the manager relative to these expectations.

As the Vanguard article highlights “David Swensen, the long-time chief investment officer of the Yale University endowment who may be the most well-known evaluator of private equity managers in the world, stresses that qualitative factors (such as people and process) play a central role in manager evaluations.”

All-in costs

Vanguard make the very significant point “Investors care most about performance net of all costs.”

The size and structure of PE fees/costs are materially different to investing into Public markets.  Investors will need to understand these and most importantly assess the likely performance outcome after all fees and charges.

Private Equity Portfolio modelling challenges

Most asset allocation models are built with liquid public assets in mind (e.g. public equities, fixed income, and cash) and assume the portfolio can be rebalanced periodically and with minimum cost.

However, with the introduction of illiquid asset classes, such as PE, there are some fundamental differences that need to be accounted for when undertaking portfolio modelling.

As outlined by Vanguard, these include:

  1. Smoothed (appraisal-based) private equity return estimates: Private equity historical return data have limited holdings transparency and are based on subjective appraisal-based valuations rather than observable, transaction-based prices on a public exchange. Relying solely on appraisal-based values to calculate returns can lead to significant underestimation of the volatility of returns.
  2. Illiquidity and frictionless rebalancing: Investors in private equity have less ability to trade their investment and rebalance their portfolio back to the intended target allocation. For this reason, they should require compensation in the form of a liquidity premium.
  3. Uncertainty in timing and magnitude of cash flows: Because private equity investors cannot control the timing or size of private equity fund cash flows, they incur an additional type of risk.
  4. Illiquidity and valuation adjustment: Private equity fund investments cannot easily be accessed and liquidated unless at a discount to NAV in most cases. This implies that liquid asset prices and private equity fund NAVs are not directly comparable.

Therefore, there are three distinct sources of risk when investing into PE:

  1. Market Risk (Systematic risk) which Public Equities also have, and is best measured via decomposition of risk factors (e.g. value and small cap) that are present in the public markets.  This risk is more accurately estimated after unsmoothing the returns from PE.
  2. Illiquidity factor risk that is unique to private equity and not observed in public markets.
  3. Manager (Idiosyncratic to the manager and unsystematic risk of individual companies) risk for the specific manager(s) selected. This is effectively active risk, with the potential to generate excess returns for the risk taken (which is alpha, a great portfolio diversifier).

Portfolio modelling with the inclusion of Private Equity

One of the key issues to consider when incorporating unlisted assets, such as PE, into a portfolio is the smoothed nature of the historical return data, which reflects appraisal-based valuations.

The use of smoothed historical returns results in an underestimation of return volatility.  The underestimation of volatility could lead to an overallocation to PE when undertaking portfolio modelling.

For portfolio modelling purposes, the true underlying risk profile of PE needs to be understood to make a better assessment when comparing and combining with public market assets.

As Vanguard highlight, several “statistical methods have been proposed in the academic literature over the last few decades to try to better understand historical performance. None of them are without shortcomings, which is why there remains no universally agreed-upon approach among academics or practitioners.”

Vanguard follow a time-series technique to “unsmooth” historically reported PE returns.  For a more in-depth discussion please see the Research Paper.

The adjustment to PE returns is presented in the Table below.  Note how Private Equity (adjusted) volatility is 22.6%, up from 10.7% calculated using reported historical PE returns.

The adjusted PE returns results in a more realistic return profile for PE which can be used for portfolio modelling purposes, resulting in more sensible volatility and covariance estimations.  Note historical PE returns have been preserved, only volatility measures have been adjusted.

In addition to estimating unbiased PE return estimates, as above, Vanguard also undertake the following adjustments to the standard portfolio modelling approach to address the issues identified above:

Account for the illiquidity of PE

Vanguard’s portfolio model, VAAM, drops the assumption of low cost and regular rebalancing assumed in standard portfolio modelling frameworks.  Therefore, they assume that PE can not be fully rebalanced.  As they note, “This illiquidity-constrained rebalance feature provides a more accurate representation of the risk-return trade-offs between liquidity premium and risks associated with private equity assessed within the portfolio optimization.”

Explicitly modelling private equity cash flows

Accounting for the uncertainty in timing and magnitude of PE cashflows Vanguard explicitly model cashflows in a multi-asset portfolio.  As noted above, cash needs to put aside for future committed investments (contributions) and timing of distributions (capital returned) also needs to be accounted for.

It is important to note, this nature of PE leads to additional decision making in the management of a multi-asset portfolio that includes PE i.e. where cash tagged for future PE investment should be invested in the interim and decisions around portfolio rebalancing.

Optional valuation adjustment of the illiquid wealth of the portfolio

Vanguard also make an adjustment for the disparity in market value of liquid and illiquid assets.  This reflects that illiquid assets, such as PE, can at times be sold in a secondary market, which more often than not trades at a discount (i.e. lower price) to asset values.

The discount function they implement “effectively converts illiquid wealth into its liquid equivalent.”

The Results

Compared to a multi-asset portfolio of 70% Equities and 30% Fixed Income (70/30) the key results include:

  • Portfolio modelling that ignores private equity’s illiquid characteristics as covered above leads to a higher allocation in PE compared with Vanguard’s enhanced framework (VAAM)
  • VAAM results in the PE allocation within “Equities” to fall from 50% to 30%
  • The sensitivity to key risk parameters include: expectations the manager will generate lower excess returns results in a lower allocation (12% vs 23%); a “lower risk” manager results in a higher PE allocation (36% vs. 23%)
  • For more conservative portfolios, such as a 30/70, although the total equity allocation decreases, the target PE share of total equity does not change materially relative to that of the 70/30 investor.

Please read my Disclosure Statement

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

Drivers of Unexpected Portfolio Return Outcomes – that should be controlled for.

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Six reasons could largely explain manager underperformance or the delivery of investment return outcomes different from what is expected.

Conversely, controlling for these “risks” might be the reason why a Manager is consistently adding value.

How a manager controls for the following risks should be considered as part of the due diligence process and in the construction of a multi-manager portfolio:

  1. Levels of uncompensated vs compensated risk
  2. Incidence of underlying portfolio holdings cancelling each other out
  3. Hidden portfolio risks resulting in unintended outcomes
  4. Conventional style-box investing, which leads to index-like performance with higher fees
  5. Over-diversification
  6. Possible attempts to “time” manager changes may prove costly.

The above six risks where identified by Northern Trust following the analysis of $200 billion of assets on more than 200 equity portfolios from 64 institutional investors around the world.  The results surprised many of the institutions involved. 

Northern Trust expressed the above risks as “six common drivers of unexpected Portfolio Results.”

These risks largely explained manager underperformance in single manager portfolios and also multi-manager portfolios.

The analysis highlights, in my opinion, that implementation and portfolio construction are fundamental to capturing value and in delivering excess returns. Although the investment theory and development of investment strategy are important, implementation and portfolio construction are fundamental.  This is an important area to focus on in undertaking manager/strategy due diligence.

To the point, implementation is vital in capturing the desired investment outcomes of any proposed investment strategy.  This is where a lot of value is added, primarily by not detracted value in implementing the desired strategy!

As Northern Trust emphasis, finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  Knowing how a manager, or strategy, interacts with the rest of your portfolio can have much more impact over time.

Institutions had nearly 2x more uncompensated vs compensated risk

Northern Trust found that portfolios which became “overcrowded” with uncompensated risks tended to underperform.

Risk needs to be taken to outperform.  Nevertheless, some risks are compensated for over the longer term and others are not.  Norther Trust outlines that some styles are not compensated for over the longer term, e.g. low quality.  They also include currency, and some countries and sectors have also not historically compensated for the risk taken.

From my own experience, managers who control for some of these risks, tend to outperform, primarily because intended risks, such as company specific risks or compensated styles, end up driving investment outcomes.

Norther Trust found a high level of uncompensated risk across all institutional investment segments, including Super Funds, Endowments, Insurance, Corporate Pensions, and Family Offices.

They conclude: “The result of uncompensated risks comprising nearly 50% of total portfolio active risk was generally benchmark-like returns or underperformance.  While sometimes these risks were taken intentionally, we found that many institutions were surprised when they saw the actual numbers.”

Underlying portfolio holdings cancelled each other out – and hurt performance

This risk particularly impacts multi-manager portfolios.

The cancellation effect occurs when managers within a portfolio take opposing positions that offsets each other e.g. one manager goes overweight a stock another manager is underweight, a manager might have a growth bias which offsets a manager with a value bias.

As Northern Trust note, on a standalone basis many managers individually offer high active risk, once combined with other managers a lot of this active risk is cancelled out.

This needs to be considered in the construction of a multi-manager portfolio. 

Northern Trust conclude: “Our analysis uncovered a shocking amount of this cancellation effect.  Nearly 50% of manager active risk was lost.  Capturing just 50% of targeted active risk, while paying 100% of the manager fees, effectively translates into paying 2x more for each realized basis point of active risk than originally thought.”

Hidden Portfolio risks cause unintended outcomes

Northern Trust found that style tilts contributed 29% of active risk on average.  However, other bets where often introduced into a portfolio unintentionally and led to “unpredictable portfolio outcomes.”

Although some styles are a consistent source of excess returns over time, it was unintended style risks that negatively impacted portfolio performance.

Often, these unintended style risks are included when trying to capture a known rewarded risk e.g. value comes with common unintended style risk exposures of low quality and low momentum.

This means meaningful style exposure is lost.

They conclude: “Our research uncovered that 55% of the portfolios had material style conflicts – caused by the cancellation effect – that introduced exposures different from the managers stated objective.  This introduction of conflicting and unintended style exposures left many portfolios with no material exposure to their intended style tilts.”

Conventional style investing led to index like performance with higher fees

This is probably self-evident to many, particularly given the above research conclusions.

Northern Trust found that those portfolios based on conventional style analysis, and those of a core-satellite approach, tended to suffer more from the cancellation effect.

The “style box” approach portfolio was more likely to have managers who took opposing views or two managers where hired to generate an exposure one manager alone could achieve.

As a result, “conventional style investing, whether intentional or not, created a mix of managers that closely mimicked the benchmark and left little chance to outperform.”

Over-diversification diluted performance

The Northern Trust research highlights than “hiring too many managers or building equity portfolios with thousand of securities took a significant toll on performance.”

Obviously, adding managers and combination of strategies can reduce overall portfolio risk, Northern Trust research showed that often the risks reduced where different to what was intended.

Norther Trust conclude: “While there are many approaches to generating excess returns, our research suggests that a greater focus on eliminating uncompensated risks is a critical first step toward potentially increasing a portfolio’s ability to outperform.”

Possible attempts to “time” manager changes may prove costly

Do not chase manager performance.  The Northern Trust research highlighted that historically poor active management performance had resulted in lower allocations to active managers in the following year.  When performance was better, a higher allocation to active managers resulted.

As they conclude: “Finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  As evidenced through the preceding discoveries of this report, knowing how a manager will interact with the rest of your portfolio can ultimately be much more impactful over time.”

Access to the Northern Trust Risk Report can be found here.

Please read my Disclosure Statement

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

Monthly Financial Markets Commentary – November 2020

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The latest monthly commentary, for January 2021, can be found here.

Vaccine Recovery

  • Risk assets (e.g. equities and commodities) performed strongly in November following encouraging Covid-19 vaccine trial results from Pfizer-BioNTech, AstraZeneca, and Moderna.
  • Global equities returned 13.3% in November, many markets had one of their best monthly returns in several years. Some markets reached historical highs, including New Zealand and the US. European markets outperformed, Spain and Italy returned 28.3% and 26.3% respectively.
  • US Food and Drug Administration (FDA) approval of a Covid-19 vaccine could be as early as 10th December 2020.  Europe is likely to approve a vaccine(s) by the end of the year.
  • A great way to finish a very challenging year.
  • Expectations are for widespread vaccinations in the US by April 2021, high-risk individuals will receive the vaccine earlier, as early as mid-December 2020.
  • Likewise, it is anticipated large proportions of the population in the UK, European Union, Japan, and Australia will be vaccinated by May 2021.  It is estimated New Zealand will get their first doses of the vaccine in March 2021.
  • In addition to the widespread public health benefits, global economic activity is expected to pick up in the second quarter of 2021, underpinning the V(accine)-Shaped Recovery, as expressed by Goldman Sachs.  They forecast 5% growth in the US over 2021, and 6% for the global economy.
  • In the interim, global economic activity is expected to weaken over the last quarter of 2020 and into the first quarter of 2021 due to the rise in Covid-19 cases over the last couple of months in Europe and the US, and as the northern hemisphere heads into the winter months (a high risk period). 
  • There has been a softening of European high-frequency data recently, such as truck milage data in Germany, UK retail sales, and cinemas and restaurants have witnessed declining revenues due to the tightening of lockdown measures.  Although less severe than actions undertaken in Europe, State and Local restrictions have increased in the USA.
  • The outcome of the US elections buoyed markets at the beginning of the month.  Although Biden has been elected the 46th President of the United States of America, congress will likely remain divided.  A divided government means regulatory risks have decline, taxes are likely to remain lower, some pro-business policies will remain in place, and government spending to be less relative to the Blue wave outcome.  A $1 trillion dollar US Government stimulus package is now expected, less than half of what was previously anticipated.
  • Recent US earnings have also surprised on the upside, supporting markets, as US companies managed to maintain profit margins better than expected despite the large hit to revenues.
  • November was characterised by a “pro-cyclical” trade, where those stocks that have lagged the market for some time and will benefit more from an opening of economies outperformed.  From a sector perspective Energy, Financials, and Consumer Discretionary performed well.  The “Covid” trade sectors, Consumer Staples, Healthcare, and Utilities lagged the broader market.  Likewise, value and high beta stocks outperformed, low volatility, momentum, and growth underperformed – this will be reflected in relative manager performance in November.
  • In other asset classes, commodities returned 8.6% in November, crude oil was up 25.7%, surpassing pre-covid-19 highs, and gold fell -5.6%.
  • Fixed income performed well, particularly corporate credit and high yield, both returning over 3% in the US.
  • Emerging markets equities underperformed developed markets, returning 8.9%.  (above returns based on S&P Index data.)
  • The US dollar continued to weaken over the month.  This saw the New Zealand dollar (Kiwi) trade at a two and half year high versus the Greenback, rising from 66.25 cents to 70.41 cents (+6.3%).  
  • The strength in the Kiwi partly reflects a scaling back of expectations the Reserve Bank of New Zealand (RBNZ) will move the Official Cash Rate (OCR) into negative territory, given rising house prices e.g. house prices in New Zealand’s largest city, Auckland, have risen 10.8% since June averages based on sales by New Zealand’s biggest real estate business, Barfoot and Thompson.
  • Key risks include ongoing uncertainty over transition of power in the US, global economic activity slows more than expected due to recent rise in covid-19 cases, US government stimulus package disappoints, and vaccine roll out is slower than anticipated.
  • Albeit the medium-term outlook for equities is well supported by an eventual roll out of a vaccine and ultra-low interest rates.  Low interest rates are expected to remain in place for some time, the US Federal Reserve is not expected to raise interest rates until 2025.
  • Equities remain attractive relative to bonds.  Although longer-term interest rates are likely to drift higher over the next few years, a significant move higher is unlikely given an absence of inflation.  Therefore, higher interest rates are not expected to be a threat to global equity markets for some time. 

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