US Recession Warning Indicators

As you will know the US economy is into its second longest period of economic expansion which commenced in June 2009.

Should the US economy continue to perform until July 2019, which appears likely, the US will enter its longest period of economic expansion. The longest expansion was 10 years, occurring during the tech expansion of the 1990s, the current expansion is nine years.

Similarly, the US sharemarket is into its longest bull market run, having not experienced a drop-in value of greater than 20% (bear market) since March 2009.

As a rule, sharemarkets generally enter bear markets in the event of a recession.

 

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

Since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

 

Statistically:

  • The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  • The average Bear Market period lasted 1.3 years with an average loss of -41
  • Historically, and on average, equity markets tend not to peak until six – twelve months before the start of a recession.

 

Therefore, let’s look at some of the Recession indicators.

In a recent article by Brandywine, they ran through some of the key indicators for a US recession.

Federal Reserve Bank of Atlanta’s GDP Nowcast.

This measure is forecasting annualised economic growth of 4.4% in the third quarter of 2018. This follows actual annualised growth of 4.2% in the second quarter of 2018.

Actual US economic data is strong currently. Based on the following list:

  • US unemployment is 3.7%, its lowest since 1969
  • Consumer Confidence is at an 18 year high
  • US wages are growing at around 3%, the savings rate is close to 6%, leaving plenty of room for consumers to increase spending
  • Small business confidence is at all-time highs
  • Manufacturing and non-manufacturing surveys are at their best levels for some time (cycle highs)

 

Leading Indicators

The Conference Board’s Index of Leading Indicators, an index of 10 components that includes the likes of the ISM New Order Index, building permits, stock prices, and the Treasury yield curve.

The Conference Board’s Index is supportive of ongoing economic activity in the US.

 

Yield Curve

The shape of the yield curve, which is normally upward sloping, meaning longer term interest rates are higher than short term interest rates, has come in for close attention over the last six months. I wrote a about the prospect of a negative yield curve earlier in the year.

An inverted yield curve, where shorter term interest rates (e.g. 2 years) are higher than longer term interest rates (e.g. 10 years) has a pretty good record in predicting a recession, in 18 months’ time on average.

With the recent rise of longer dated interest rates the prospect of an inverted yield curve now looks less likely.

Albeit, with the US Federal Reserve is likely to raise short term interest rates again this year and another 3-4 times next year the shape of the yield curve requires on going monitoring.

Having said that, an inverted yield curve alone is not sufficient as a predictor of economic recession and needs to be considered in conjunction with a number of other factors.

 

Brandywine conclude, “what does a review of some well-known recession indicators tell us about the current—and future—state of the U.S. expansion? The information provided by the indicators is mixed, but favors the continuation of the current expansion. The leading indicators are telling us the economy should continue to expand well into next year—at least.”

In favour of ongoing economic expansion is low unemployment, rising wages, simulative financial conditions (e.g. low interest rates are supportive of ongoing growth, as are high equity prices), high savings rate of consumer and their low levels of debt. Lastly government spending and solid corporate profitability is supportive of economic activity over the medium term.

As a word of caution, ongoing US – China trade dispute could derail global growth. Other factors to consider are higher interest rates in combination with a higher oil price.

Noting, Equity markets generally don’t contract until interest rates have gone into restrictive territory. This also appears some time away but is a key factor to monitor.

Lastly, a combination of higher oil prices and higher interest rates is negative for economic growth.

 

I have used on average a lot in this Post, just remember: “A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 Happy investing.

 

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

 

Please see my Disclosure Statement

Trustees should be aware of the shocking cost of timing markets and what is the best solution

Cambridge Associates recently published a research report concluding it does not pay to be out of the market.

” Investors who take money out of the market too early stand to “risk substantial underperformance,”

Cambridge advised investors concerned about the length of the current bull market not to bail out of equity markets earlier than necessary in an attempt to avoid exposure to downturns.

This seems timely given current market volatility.

As the article notes, it is hard to time markets “because trying to time re-entry to get back into the markets at lower levels leads to substantially lower long-term returns, the researchers found. For example, the report showed that being out of the market for just the two best quarters since the turn of the last century cut cumulative real returns on U.K. equities by more than 50 percent.”

“That effect is even more profound in the United States, where sitting out the best two quarters cut cumulative real returns by more than two thirds, according to the report.”

“While no investor should be ignoring valuations, becoming too focused on timing an exit has substantial risks,” said Alex Koriath, head of Cambridge’s European pensions practice, in a statement accompanying the research. “The best periods for returns tend to be very concentrated, meaning that exiting at the wrong time could drag down cumulative returns significantly.”

 

This is a pertinent issue given the US sharemarket is into its longest bull market run in history. Also, of interest, historically on average, markets perform very strongly over the final stages of a bull market run. Lastly, bull markets tend to, more often than not, end six-twelve months prior to a recession. Noting, this is not always the case. Albeit, the consensus is not forecasting a recession in the US for some time. It appears, the probability of a US recession in the next couple of years is low.

The key forward looking indicators, such as shape of the yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US. Please see my earlier posts History of Sharemarket corrections – An Anatomy of equity market corrections

 

What is the answer?

It is difficult to time markets. AQR came to a similar conclusion in a recent article. AQR argue the best form of defence is a truly diversified portfolio. I agree and this is a core focus of this Blog.

As we know equity markets have drawdowns, declines in value of over 20%. In the recent AQR article they estimate that there have been 11 episodes of 20% plus drawdowns since 1926, a little over once every 10 years! Bearing in mind the last major drawdown was in 2008 – 09.

The average peak to trough has been -33% and on average it has taken 27 months to get back to the pre-drawdown levels.

As AQR note, we cannot consistently forecast and avoid these severe down markets. In my mind, conceptually these drawdowns are the risk of investing in equities. With that risk, comes higher returns over the longer term relative to investing in other assets.

At the very least we can try and reduce our exposure by strategically tilting portfolios, as AQR says, “if market timing is a sin, we have advocated to “sin a little””.

 

I agree with the Cambridge Associates article to never be out of the market completely and with AQR to strategically tilting the portfolio. These tilts should primarily be based on value, be subject to a disciplined research process, and focused more on risk reduction rather than chasing returns. This approach provides the opportunity to add value over the medium to longer term.

 

Nevertheless, by far a better solution is to truly diversify and build a robust portfolio. This is core to adding value, portfolio tilting is a complementary means of adding value over the medium to long term relative to truly diversifying the portfolio.

True diversification in this sense is to add investment strategies that are lowly correlated with equities, while at the same time are expected to make money over time. Specifically, they help to mitigate the drawdowns of equities. For example, adding listed property and listed infrastructure to an equity portfolio is not providing true portfolio diversification.

In this sense truly “alternative” investment strategies need to be considered e.g. Alternative Risk premia and hedge fund type strategies. Private equity and unlisted assets are also diversifiers.

Again conceptually, there is a cost to diversifying. However, it is the closest thing in finance to a free lunch from a risk/return perspective i.e. true portfolio diversification results a more efficient portfolio. Most of the diversifying investment strategies have lower returns to equities. There are costs to diversification whether using an options strategy, holding cash, or investing in alternative investment strategies as a means to reduce sharp drawdowns in portfolios.

Nevertheless, a more diversified portfolio is a more robust portfolio, and offers a better risk return outcome.

Also, very few investor’s objectives require to be 100% invested in equities. For most investors a 100% allocation to equities is too volatile for them, which raises the risk that investors act suboptimal during periods of market drawdowns and heightened levels of market volatility i.e. sell at the bottom of the market

 

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

As AQR note, diversification is not the same thing as a hedge. Uncorrelated means returns are influenced by other risks. They have different return drivers.

From this perspective, it is also worth noting that adding diversifying strategies to any portfolio means adding new risks. The diversifiers will have their own periods of underperformance, hopefully this will be at a different times to when other assets in the portfolio are also underperforming. Albeit, just because they have periods of underperformance does not mean they are not portfolio diversifiers.

AQR perform a series of model portfolios which highlight the benefits of adding truly diversifying strategies to a traditional portfolio of equities and fixed interest.

No argument there as far as I am concerned.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

For those with a real focus on retirement income solutions

Great to see EDHEC pick up on my recent post on Target Date Funds (Life Cycle Funds).  Monkey Claw – be careful what you wish for.

I have considerable appreciation for EDHEC’s approach to applying goal-based investing principles to the retirement problem.  This makes a lot of sense given my insurance (liability backing) investing background.

Their focus on the need for more robust retirement solutions based on Goal Based Investing is so critical.

 

EDHEC’s and the thoughts of Professor Robert Merton, as outlined in my previous Posts of focusing on income and the volatility of income, are important concepts that will have an immediate and lasting contribution and impact on the ongoing shape of retirement solutions.

As EDHEC outlines, we need investment solutions that provide the certainty of Annuities but with more flexibility.  This is the industry challenge.  

 

EDHEC’s and Merton’s work, analysis, and insights have an important and fundamental contribution to the building of more robust retirement solutions that should be considered by anyone working in this area.

 

Happy investing.

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

 

Please see my Disclosure Statement

 

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

I have written previously about the short comings of Target Date Funds (TDF). They would certainly benefit from the inclusion of Alternative investment strategies.

Nevertheless, this is not to dismiss them. TDF have some notable advantages e.g. they have an inbuilt advice model i.e. TDF automatically de-risk the portfolio with the age of the investor by down weighting the equity allocation and increasing the allocation to cash and fixed interest. This is attractive to those who are unable to afford investment advice or are not interested in seeking investment advice.

Nevertheless, it is important to understand their short comings given their growing dominance international. (According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.”

Locally, TDF have also been raised as a possible addition to the KiwiSaver landscape as a Default Fund option. They are very much part of the investment landscape in Australia.

 

In my mind TDF don’t address the inherit weaknesses of current investment products that overly simplify the retirement investment solution by focusing on:

  • Accumulated wealth as the primary goal; and a
  • Formulaic (prescribed) approach of adjusting allocations to equities over the period up to retirement based on age.

 

Unfortunately, TDF may not be the investment solution that addresses key retirement issues, just as Annuities are also not the solution.   Arguably, TDF don’t have an investment objective.

A more goal orientated investment approach is required.

Improvements in the investment solution and a more robust portfolio can be developed by engaging in a more goal orientated investment approach that:

  • Has a focus on the generation of retirement income as an investment goal; and
  • Employs a more sophisticated cash and fixed interest solution that generates a more stable level of retirement income (much like insurance companies employ to meet future liabilities (insurance claims).

 

The investment knowledge is available now to implement these investment solution enhancements.

This approach will bring more rigor to the investment strategy and a move away from rules of thumbs such as the 4% Rule and adjusting the equity allocation based on age alone.

 

At the centre of a more robust approach is the focussing on the generation of retirement income.

Accumulated wealth is important, you can say you are rich with a million-dollar investment portfolio.

However, this million-dollars does not tell you the standard of living you may be able to support in retirement. Some may well say a very good one! And that may well depend on whether you live in Auckland or Gore.

How about the volatility of income in retirement?

By way of example, prior to the Global Financial Crisis (GFC) a New Zealand investor could get 7-8% on cash at the bank, lets say $70k in income on your million dollar investment.

Current term deposit rates are around 3.5%, that’s a 50% fall in income!! And interest rates have been at these levels for some time and if the Reserve Bank of New Zealand is right they will continue to remain at these levels for some time.

 

Of course, these issues are not the concern of the ultra-wealthy. They are nevertheless vitally important for the less wealthy. Therefore, they could have a detrimental impact on the standard of living in retirement for many people.

Furthermore, with an income focus, as interest rates rise (they will some day!) more informed investment decisions can be and most importantly investment strategies can be undertaken to help minimise the volatility of income in retirement.

 

Therefore, we should not just focus on the generation of retirement income as the investment goal but also consider how we can manage the volatility of income in retirement. As I say, the knowledge to do this is already available.

 

I have recently written a Post on why focus on Income and one on why focus on the volatility of Income.

 

This FT article on the short comings of TDF may be of interest.

 

The article highlights the risk to the industry.

 

The following section of the FT article is most relevant to the discussion above:

…….. “This underscores the importance of crafting investment products that generate sustained income for retirees, says Lionel Martellini, a professor at Edhec currently seconded to Princeton. He chairs the research unit that

Prof Martellini says the key shortcoming with target date funds the group has identified is the fact that the bond allocation, intended to be the safe portion of the portfolio, is often risky. This risk hinges on the fact that bond portfolios offer — but do not guarantee — income, according to the researchers.

The fixed income allocation should look more like an annuity, Prof Martellini says, a financial product that pays a steady stream of income to the holder. But it must avoid the pitfalls of annuities, namely a lack of flexibility that means they cannot be passed on to a next of kin, for example.

“That’s what we’re talking about — a bond portfolio that is a good proxy for the cash flow that people need. Such a simple move will add a large benefit to how much replacement income you can generate,” Prof Martellini says. Critics say target date funds fail to achieve this because their fixed income portfolios are composed of short-term bonds that are beholden to market risks and do not take into account retirees’ different income expectations.” ………………..

 

The final comments are consistent with the point made above with having a more sophisticated cash and fixed interest investment solution.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is variability of retirement income a better measure of risk rather than variability of capital?

This is the second Post on why a greater focus should be placed on generating a level of Income in retirement as an investment goal. The first Post outlines why income matters as an investment goal.

This Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

A greater focus on Income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating Income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.

The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.

 

To set the scene Merton discusses the difference between the high and low in longer term interest rates in the United States in the last 10 years, if you retired … with a given pot of money, if you retired and you got an income of a hundred, whatever that means, at the peak of interest rates, when they’re high, you get a hundred. At the trough, at the low end of interest rate, the same amount of money, you’d only get 74.

As he says, in other words your income will be 26% lower. “Think about that, 26% less of income, that’s a big hit especially for working middle class people but for any of us.”

 

You may well argue, that the last 10 years was an extraordinary period of time and corresponding fall in interest rates. Which would be correct.

Nevertheless, this does not detract from the point being made, how can we determine if a pot of money is enough to retire on? This can only be known by focusing on income generated from that pot of money.

Importantly, if you don’t monitor this risk, generating a stable level of income in retirement, you cannot manage it. And I would argue, such a focus will lead to you making better informed investment decisions that will likely result in a more stable and secure income in retirement.

This could well mean that as interest rates rise, you need a smaller pot and don’t need to take on as much risk as thought to support your life style in retirement.

 

Back to Merton, he uses another example, and highlights a number of times, the industry focuses on the wrong metric, the value of the pot (accumulated value).

If the value of the pot rises, we are happy, if the value declines, ‘you’re frowning’!

But, that’s not reality and in most cases it is not telling how you are going to go in retirement because you really want to know what income you are going to get in retirement.

Therefore, you should not be worried about the value of your pot, but what income the pot can generate in retirement.

That is the goal, and we should measure ourselves relative to that goal.

 

Defining risk around the risk of not being able to achieve income

Merton uses the following thought piece:

You’re 62, you’ve done well in your retirement account and I say to you, “Hey, you’ve got enough money to basically lock in your goal. I can buy you inflation protect, US Treasuries with funding that will take care of you throughout retirement guaranteed full faith and credit, the government protected for inflation at this level income, that’s your goal. Then I say, “You do want to increase your goal?” You said, “No, I’m happy with that, that’s my lifestyle. If I have some extra money, I’ll do something with it but basically, I’m happy with that. That’s what I want to live on and the safety and security, that is what matters to me.”

As Merton argues, in this situation the rationale thing to do would be to implement such an investment strategy. (This is Liability Driven Investing, or Goal Based Investing. Such investment approaches can be implemented now. Such approaches are aligned with how Insurance Companies and some Pension Funds implement.)

Such strategies as outlined above will closely match a desired level of income (subject to availability of appropriate securities – which is an area Government Policy could help in securing better retirement outcomes).

Under such an investment strategy retirement income is safe and largely predicable – reflecting the use of Government securities that are linked to inflation.

 

Nevertheless, while Income is stable, the value of the portfolio of fixed interest securities is not stable.

As interest rates rise, the price of bonds, fixed interest securities such as Government Bonds, fall.

However the Income from the bond does not change.

Using Merton’s example:

“Income is absolutely stable in a bond. Its value will fluctuate with interest rate. If interest rates, especially long-term bonds, which is what you would need for retirement, if the interest rates go up and let’s say your bonds go from 100 to 85 and I send you or put it on your account that your account has gone down 15% and you’re 62, you see that, you’ll go berserk. You’re going to say, “You told me you’re being safe for me and I’ve lost 15% of my retirement.”

“In fact, that’s not correct statement. Your retirement is defined by how much income you get for life. That hasn’t changed. The value of that has, that example is the problem at the core. It’s misinformation because we show them the wrong number”.

As Merton notes, investors get happy when the value of their portfolio goes up, but they are not actually better off if interest rates have fallen (meaning the price of a bond goes up).

Under this scenario buying new bonds will mean a lower level of income in the future.

This highlights that we focus on volatility of a capital as risk, the changing value in the pot of money, rather than volatility of future income.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

What matters for Retirement is Income not the value of Accumulated Wealth

This is the first of two Posts on why a greater focus should be placed on generating a level of income in retirement as an investment goal.

This Post outlines why income matters as an investment goal and the second Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

A greater focus on income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.

The rationale for the focus on income is provided below.

The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length, full of great conversation about retirement income, and well worth listening to.

 

During the Podcast discussion on why the focus should be on income and not accumulated wealth a definition of the standard of living in retirement needed to be determined.

From this perspective, Merton argues a standard of living in retirement is better defined as an amount of income, not a pot of money (accumulated wealth).

He argues the focus on income is consistent with what the Government provides you in retirement, a level of income. It is also much like a Defined Benefit where a level of income is provided and not a pot of money.

Also, the concept of income is easier to understand. You can see how rich I am with X amount of capital, but when converted to income that can be generated from that capital one can quickly see that the amount of capital may not be sufficient to support a desired standard of living in retirement. This is a key point.

Merton makes a strong case income is what matters in retirement and not how big your pot of money is.

As he says, people say, “If I have enough money, I’ll get the income. It will be fine.”

This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

Merton provides an example: twelve years ago in the US, if you had a million dollars you could generate $50k in interest, three years ago you could get a tenth of 1%, an income of $1k per million.

You’ve lost 98% of your income. As Merton says, what would you do if I lost 98% of your wealth!

The point being, knowing you had a million dollars did not tell you about a lifestyle that could be supported in retirement.

Merton is more direct with the following: “Let’s be clear the goal, the purpose for retirement. Not for the silly other things but for retirement is a stream of income sufficient to sustain a standard living and that standard of living is measured by income.”

“Just knowing the amount of money you have doesn’t tell you how you can live. That’s the message and we have to get that clear both so that savers and people in plans are trying to figure out how they’re doing. We need to tell them the amount they can buy as an indicator of how close to where they are.”

What Merton is saying here, is we should let people know what level of income can be generated from their pot of money. This provides a better measure and insight as to how they are placed for retirement.

Further to this point, volatility of accumulated wealth is not a good measure of how well we are doing.

More importantly, we should focus on the volatility of expected income in retirement, not current volatility of capital. This is covered in the next Post – What matters for retirement is income not the value of Accumulated Wealth – Focus on likely variability of Income not variability of Capital

For the time being: “What matters for retirement is income not the value of the pot of money” Merton.

The investment knowledge is currently available to design investment solutions that can better meet client’s income requirements in retirement to support the standard of living they wish to attain. It will result in the implementation of different investment strategies based in Liability Driven Investing (Goal Based Investing). A more Robust Retirement Income Solution is required.

The benefit being, there will be an increased likelihood that investment outcomes are more consistent with Client’s retirement objectives.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

What is Responsible Investing?

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

“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

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

Alternatives Investments will improve the investment outcomes of Target-Date Funds

Including alternative investments in Target-Date Funds (TDF) will improve their investment outcomes.

This is the conclusion of a recently published research report by the Center for Retirement Initiatives at Georgetown University’s McCourt School of Public Policy, developed in conjunction with Willis Tower Watson.   The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes

The study concludes the use of alternative investment strategies “can improve expected retirement income and mitigate loss in downside scenarios.”

 

Many TDF are over exposed to equity risk, they are not truly diversified.

The above study notes that TDF need to increase their diversification away from equities and fixed interest that dominate their portfolios.  In short, TDF need to broaden their diversification to allow access to alternative return drivers.

This is seen as very important, “even more important step is improving the performance of the underlying investments. The use of alternatives in DB (Define Benefit) plans is an investment practice that should be considered in today’s DC (Define Contribution) plans, specifically in TDFs”

The article outlines the growing popularity of TDF and therefore the opportunity that is available to build better portfolios and improve investment outcomes for clients.

 

The study compared TDF’s comprising of only equities, bonds, and cash.  To this traditional portfolio they added individual allocations to Private Equity, Unlisted Property, and Hedge Funds separately.

The study first looked at outcomes of adding these alternative strategies in isolation to the Traditional Portfolio, and then when all are added to the Portfolio all together.

When adding the alternatives in isolation to a traditional equities and fixed interest portfolio they concluded that investment outcomes for TDF were improved by:

  • Increasing the amount of income that can be generated in retirement from the portfolio;
  • Increase the probability of maintaining positive assets after 30 years of retirement spending;
  • Delivering higher expected returns; and
  • Reducing downside risk, particularly reduce the negative impact of a negative market at time of retirement (reducing sequencing risk)

 

Therefore, investment outcomes for Target-Date Funds can be improved with greater levels of diversification (as can any portfolio which only invests in equities, bonds, and cash).

Investment outcomes were improved with any one of the alternative strategies implemented in isolation.

 

The study then looked at TDF when all the alternative strategies were added to the Traditional Portfolio.

As they note “previous examples look attractive in isolation, we now turn to considering how these strategies contribute to a diversified implementation that includes allocations to all these assets. Not only do these alternative asset classes provide diversification or differentiated return drivers relative to equities and fixed income, but they also provide attractive cross-correlation benefits when viewed in combination with each other (meaning they outperform and underperform at different times from one another).”

 

Importantly, portfolios were constructed to be of similar risk along the glide path, the increased diversification of adding alternative provides risk benefits over time.

A higher allocation to return seeking assets is able to be maintained over time given the diversification benefits of adding alternatives to the TDF.

Again investment outcome were improved upon compared to a Traditional Portfolio of Equities and Fixed Interest, higher retirement income (+17%) and improved downside risk outcomes (+11%)

 

Importantly, they noted:  “One straightforward way to mitigate downside risk is to shift more equities into fixed income, though that approach would materially lower expected returns and adversely impact participants who intended to utilize the funds as a source for income throughout retirement.  Additionally, shifting from equities to core fixed income lessens equity risk but increases other risks such as interest rate and inflation. Instead, participants may be better off by further diversifying their portfolios.”

 

Notably they comment that this is part of an overall plan to improve retirement income outcomes:

“In order to improve retirement income outcomes, plan sponsors must pull all of the levers at their disposal across their organizations. While a number of enhancements have been made with investment vehicles …., plan design…….., and communications, DC plans still lag behind other large investment pools in the use of alternative asset classes. There is a reason why alternative assets are used more often in other investment pools: They can improve investment efficiency and the net-of-fee value proposition.”

 

Implementation Considerations

The paper covers a number of implementation issues, such as Governance, liquidity, and fees.

Their comments of fees hits the mark:

“To include the potential benefits of alternatives in TDFs, plan sponsors need to be comfortable increasing total fund fees, which can be accomplished through a prudent process focused on enhancing potential outcomes for participants. The fee compression in TDFs has come at the expense of the potential increased returns, lower volatility and portfolio efficiency alternatives could provide.”

Think about after fee outcomes.

 

Concluding remarks

Overall the outcomes from this Study are hardly surprising.  The use of alternatives has been shown to improve the investment outcomes of other investment portfolios and are widely used e.g. endowments, Insurance Companies, Super (Pension) Funds, and as mentioned Defined Benefit Funds.

The Study notes “As of 2016, the largest corporate pension plans in the Fortune 1000 (assets greater than $2.1 billion) held average allocations of 4.2 percent to hedge funds, 3.4 percent to private equity, 3.0 percent to real estate and 3.6 percent to “other” asset classes.” And “public pensions allocate even more to alternative investments (approximately 25 percent), according to the National Association of State Retirement Administrators.”

This is not to take anything away from the Study, it is great analysis, enhances our understanding of TDF, and is well worth reading.

 

Lastly, investment outcomes for Target-Date Funds can also be enhanced with the more active management of the glide path strategy.  This may include delaying the pace of transitioning from risky assets (which would include alternatives!) to safer assets or stepping off the glide path given extreme risk environments.

Investment outcomes for clients can also be improved if more client information is used over and above age to determine an investment glide paths e.g. changes in salary leading to a higher expected standard of living.  This is where technology can have a massive impact on the industry.

Many TDF have their limitations, particularly they have no goal and the glide path is based solely on age.

The experience in retirement is changing, we are living longer, more robust retirement solutions are needed.

 

Happy investing.

 

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

 

Please see my Disclosure Statement