Theses Post are consistent with the global trend toward the increasing allocation toward alternatives within investment portfolios. This survey by CAIA highlights the attraction of alternatives to investors and likely future trends of this growing investment universe, including greater allocations to Private Equity and Venture Capital.
Reflecting the current investment environment and outlook for investment returns, recent Posts have focused on the topic of Portfolio Diversification. Which have complemented the Posts above on particular investment strategies.
A different perspective was provided with a look at the psychology of Portfolio Diversification. Diversification is hard in practice, it often involves the introduction of new risks into a portfolio and there is always something “underperforming” in a truly diversified portfolio. This was one of the most read Posts over the last six months.
Positioning portfolios for the likelihood of higher levels of inflation in the future
Investors face the prospects of higher inflation in the future. Although inflation may not be an immediate threat, this article by Man strongly suggests investors should start preparing their Portfolio for a period of higher inflation.
The challenge of the current environment is also covered in this Post, which provides suggestions for Asset Allocations decisions for the conundrum of inflation or deflation.
Time to move away from the traditional Diversified Portfolio
A key theme underpinning some of the Posts above is the move away from the traditional Diversified Portfolio (the 60/40 Portfolio, being 60% Equities and 40% Fixed Income, referred to as the Balance Portfolio).
My most recent Post (#152) highlights that the Traditional Diversified Fund is outdated as it lacks the ability to customise to the client’s individual needs. Modern day investment solutions need to be more customised, particularly for those near and in retirement.
Occasions when active Management is appropriate and where to find the more consistently performing managers
Recent Posts have also covered the role of active management.
Likely poor performing investment managers are relatively easy to identify. Great fund managers much more difficult to identify.
Good performing managers who can consistently add value over time can be identified. Albeit, a well-developed and disciplined investment research process is required.
Those managers that consistently add value are likely to be found regularly in the second quartile of peer analysis. They are neither the best nor the worst performing manager but over time consistently add value over a market index or passive investment. They are not an average manager.
These are key insights I have developed from just under 30 years of researching and collaborating with high calibre and talented investment professionals.
More importantly, modern day academic research is supportive of this view. The conventional wisdom of active management is being challenged, as highlighted in a previous Post.
The author, John Paterson, of this analysis was interviewed in a i3 article.
The key points of Peterson’s analysis and emphasized in the i3 article:
Many of the studies into the ability of active managers to consistently outperform are inherently flawed.
Most of these studies merely confirm that financial markets are not static, therefore they do not say anything about manager performance.
“The failure to find repeated top quartile performance in these ‘tests of manager consistency’ simply reflects the reality that markets are not Static, and says nothing about the existence, or otherwise, of manager consistency.”
The key flaw is that many of the studies on active management focus on the performance of only the top performing managers: whether top quartile performers are able to repeat their efforts from one period to the next.
A wider view of manager performance should be considered, all quartiles should be assessed to determine whether manager performance is random or not.
Those managers that that consistently achieved above average returns are more likely to be found in the second or third quartiles.
In the i3 interview, Paterson discusses more about the results of their research:
“Someone who consistently outperforms doesn’t necessarily look like a top quartile manager. They are more likely to be found in the second quartile,”.
The following comment is also made:
“Most asset managers intuitively know this, because markets are cyclical and if you do something that shoots the lights out in one period, it is likely to do the complete opposite in another period.”
The Australian Experience
Paterson’s analysis also found “Across the studies analysed, it was found that there is very strong evidence that investment managers available to Australian superannuation funds do perform consistently.”
Lastly Paterson comments “And experience tells us that super funds with more active managers have done better than those with largely passive mandates, and often at a lower level of volatility.”
As I have previously Posted, there are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform.
Other reasons for considering an alternatives to a passive index include no readily replicable market index exists, imbedded inefficiency within the Index, and available indices are unsuitable in meeting an investor’s objectives (e.g. Defined Pension Plans).
The decision to choose an alternative to passive investing varies across asset classes and investors.
Therefore, the traditional active versus passive debate needs to be broadened.
The article by Warren and Ezra, covered in a previous Post, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.
They provide five reasons why investors might consider alternatives to passive management.
In doing so they provide examples of circumstances under which an alternative to passive management might be preferred and appreciably widen the debate.
The identification of managers that consistently add value is one reason to consider an alternative to passive management.
One of the key questions facing investors at the moment is whether inflation or deflation represents the bigger risk in the coming years.
Now more than ever, given the likely economic environment in the years ahead, investors need to consider all their options when building a portfolio for their future. This may mean a number of things, including: increasing diversification, investing in new or different markets, being active, and flexible to take advantage of unique opportunities as they arise.
Those portfolios overly reliant on traditional markets, such as equities and fixed income in particular, run the risk of failing to meet to their investment objectives over the next ten years.
Conundrum Facing Investors
A recent article by Alan Dunne, Managing Director, Abbey Capital, The Inflation-Deflation debate and its Implications for Asset Allocation, which recently appeared in AllAboutAlpha.com, clearly outlines the conundrum currently facing investors.
As the article highlights, one of the “key questions facing investors at the moment is whether inflation or deflation represents the bigger risk for the coming years. Economists are split on this….”
Following a detailed analysis of the current and likely future economic environment and potential influences on inflation or deflation (which is well worth reading) the article covers the Implications for Asset Allocations.
Inflation or Deflation: Implications for Asset Allocations
The article makes the following observations as far as asset class performance in different inflation environments, based on historical observations:
Deflation like in the 1930s, is negative for equities but positive for Bonds.
If inflation picks ups, or even stagflation, that would be negative for real returns on financial assets and real assets may be favoured.
They conclude: “the current uncertainty highlights the importance of holding diversified portfolios, with exposure to a range of traditional and alternative assets and strategies with the potential to deliver returns in different market environments.”
Abbey Capital anticipate greater co-ordination of policy between governments (fiscal policy) and central banks (monetary policy).
As they note, “many economists draw a parallel between the current scenario and the substantial increase in government debt during World War II. One of the consequences of higher debt levels is that we may see pressure on central banks to maintain interest rates at low levels and maintain asset purchases to ensure higher bond issuance is not disruptive for bond markets i.e. coordination of monetary and fiscal policies.”
I think this will be the case. The Bank of Japan has maintained a direct yield curve control policy for some time and the Reserve Bank of Australia has implemented a similar policy recently. Direct yield curve control is where the central bank will target an interest rate level for the likes of the 3-year government bond.
In the environment after World War II debt levels were brought back to more manageable levels by keeping interest rates low (a process known as financial repression).
From a government policy perspective, financial repression reduces the real value of debt over time. It is the most palatable of a number of options.
Financial repression is potentially negative for government bonds
With interest rates so low, and likely to remain low for some time given policies of financial repression the real return (after inflation) on many fixed income instruments and cash could be negative.
A higher level of inflation not only reduces the real return on bonds but potentially also reduces the diversification benefits of holding bonds in a portfolio with equities.
The diversification benefits of bonds in the traditional 60 / 40 equity-bond portfolio (Balanced Portfolio) has been a strong tail wind over the last 20 years.
The more recent low correlation between bonds and equities is evident in the Chart below, which was presented in the article.
The Chart also highlights that the relation of low correlation between equities and bonds, which benefits a Balanced Portfolio, has not always been present.
As can be seen in the Chart, in the 1980s, when inflation was a greater concern, inflation surprises were negative for both bonds and equities, they became positively correlated.
What should investors do?
“Investors are therefore left with the challenge of finding alternatives for government bonds, ideally with a low or negative correlation to equities and protection against possible inflation.”
The article runs through some possible investment solutions and approaches to meet the likely challenges ahead. I have outlined some of them below.
I think duration (interest rate risk) and credit can still play a role within a broad and truly diversified portfolio. Within credit this would likely involve expanding the universe to include the likes of high yield, securitised loans, private debt, inflation protections securities, and emerging market debt as examples.
The key and most important point is that a robust portfolio will be less reliant on tradition asset classes, traditional asset class betas, to drive investment return outcomes. This is likely to be vitally important in the years ahead.
Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios. Not only within asset classes, such as the fixed income example provided above, but across the portfolio to include the likes of real assets and liquid alternatives.
Abbey Capital comment that “Real assets such as property and infrastructure should provide protection against higher inflation for long-term investors but may not be attractive for investors valuing liquidity.”
Although the maintenance of portfolio liquidity is important, Real assets can play an important role within a robust portfolio.
For the different types of real assets, their investment characteristics, and likely performance and sensitivity to different economic environments, including economic growth, inflation, inflation protection, stagflation, and stagnation please see the Kiwi Investor Blog Post, Real Assets Offer Real Diversification. The extensive analysis has been undertake by PGIM.
Abbey Capital provide a brief discussion on liquid alternatives with a focus on managed futures. Not surprisingly given their pedigree.
They provide the following Table which highlights the benefit of liquid alternatives and hedge funds at time of significant sharemarket declines (drawdowns).
Being a managed futures manager, it is natural to be cautious of Abbey Capitals concluding remarks, being reminded of the Warren Buffet quote, “Never ask a barber if you need a haircut.”
Nevertheless, the Abbey Capital’s economic analysis and investment recommendations are consistent with a growing chorus, all singing from a similar song sheet. (Perhaps we could call this a “Barbers Quartet”!)
Without having an axe to grind, and in all seriousness, I have covered similar analysis and comments in previous Posts, the conclusions of which have a high degree of validity and should be considered, if not a purely from portfolio risk management perspective so as to understand any gaps in current portfolios for a number of likely economic environments.
The key and most important point is that robust portfolios will be less reliant on traditional asset classes, traditional asset class betas, to drive investment return outcomes.
Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios
Therefore, it is hard to disagree with one of the concluding remarks by Abbey Capital “To account for the competing requirements in a portfolio of returns, low correlation to equities, liquidity and possible inflation protection, investors may need to build robust portfolios with a broader mix of assets and strategies.”
For those interested, previous Kiwi Investor Blog posts of relevance to the Abbey Capital article include:
Man conclude that although inflation is not an immediate threat, the likelihood of a period of higher inflation is likely in the future, and the time to prepare for this is now. Man recommends several investment strategies they think will outperform in a higher inflation environment.
There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.
Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.
Under these circumstances a passive approach no longer becomes optimal nor appropriate.
Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.
Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.
Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.
Framework for choosing an Alternative to Passive Investing
They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.
In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.
They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”
Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:
Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.
As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.
The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.
Below I have provided a description of the five reasons investors should seek an alternative to passive index.
Back ground Comments
Warren and Ezra provide some general comments on the state of the industry debate:
They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.
They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”
The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.
Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.
A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.
Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.
Cap-weighting is aligned with investor objectives.
It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.
The same is true for an endowment, insurance company, or foundation.
The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.
The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.
The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.
Reason #1: No Readily Replicable Index is Available
Passive investing assumes an effective index exists that can be easily and readily replicated.
In some instances, an appropriate index to replicate is simply not available, for example:
Unlisted assets such as Private Equity, unlisted infrastructure and direct property
Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.
In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.
Reason #2: The Passive Index Is at Odds with the Investor’s Objectives
Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.
By way of example:
Defined Benefit Pension Plan and tailored fixed-income mandates.
Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.
In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.
DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.
Such situations also exits for insurance companies, endowments, and foundations.
Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.
Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.
The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.
Reason #3: The Standard Passive Index is Inefficiently Constructed
Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.
The article presents two potential reasons an index might be inefficient and proves three examples.
They comment that an index might be inefficient for the following reasons:
the index is built on a narrow or unrepresentative universe; and
the index is constructed in a way that builds in some inefficiency.
As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.
Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.
The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).
There are many shortcomings of fixed-income indices, the article focuses on two:
Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.
Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.
Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.
Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.
However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.
Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.
The following features are outlined in the article to support such a situation:
Market inefficiency situations
Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.
The following situations may provide a manager with a competitive advantage:
Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.
Opportunities arising from differing investor objectives
Opportunities for active management to benefit may exist when:
Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
Investors have differing time horizons e.g. value investors exploit short-term focus of markets
Index fails to cover the opportunity set
The article makes the following points under this heading:
There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”
Reason #5: Skilled Managers Can Be Identified
Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.
Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.
The discussion makes the following points:
At the very least bad managers should be avoided
Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
Not all fund managers are created equal, some are good and some are bad
The research capability and skill to identify and select a manager is an important consideration.
Implementation and Costs
It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.
“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”
The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.
Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.
For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.
Based on the US Department of Labor (DOL) guidance US retirement plans, Defined Contribution (DC), can include certain private equity strategies into diversified investment options, such as target date or balanced funds, while complying with ERISA (laws that govern US retirement plans).
This is anticipated to result in better outcomes for US investors.
It is also anticipated to provide a further tailwind for the Private Equity sector which is expected to experience significant growth over the decade ahead, as outlined
Private equity investments have long been incorporated in defined benefit (DB) plans, DC plans, 401(k) retirement plans similar to KiwiSaver Funds offered in New Zealand and superannuation funds around the world, have mainly steered away from incorporating Private Equity in their plans due to litigation concerns.
By way of summary, the DOL provides the following guidance. In adding a private equity allocation, the risks and benefits associated with the investment should be considered.
In making this determination, the fiduciary should consider:
whether adding the asset allocation fund with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees and the diversification of risks over a multi-year period;
whether using third-party investment experts as necessary or managed by investment professionals have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity effectively;
limit the allocation to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation.
It is worth noting that the SEC (U.S. Securities and Exchange Commission) has adopted a 15% limit on investments into illiquid assets by US open-ended Funds such as Mutual Funds (similar to Unit Trusts) and ETFs.
In addition, the DOL suggests consideration should be given to the plan’s features and participant profile e.g. ages, retirement age, anticipated employee turnover, and contribution and withdrawal patterns.
The DOL letter outlines a number of other appropriate considerations, such as Private Equity to be independently valued in accordance with agreed valuation procedures.
It is important to note the guidance is in relation to Private Equity being offered as part of a multi-asset class vehicle structure as a custom target date, target risk, or balanced fund. Private Equity cannot be offered as a standalone investment option.
It is estimated that as much as $400 billion of new assets could be assessed by Private Equity businesses as a result of the DOL guidance, as outlined in this FT article.
Increased innovation is expected, more Private Equity vehicles that offer lower fees and higher levels of liquidity will be developed.
A number of Private Equity firms are expected to benefit.
For example, Partners Group and Pantheon stand to benefit, see below for comments, they launched Private Equity Funds with daily pricing and liquidity in 2013. These Funds were designed for 401(k) plans.
As you would expect, they reference research by the Georgetown Center for Retirement Initiatives which concludes that including a moderate allocation to private equity in a target-date fund could increase the participant’s annual retirement income by at least 6%.
They also comment, private markets provide valuable diversification in an investment portfolio in light of a shrinking public markets sector that has seen the number of US publicly-traded companies decline by around 50% since 1996.
This observation is consistent with one of the key findings from the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.
The DOL guidance will provide another tailwind for Private Equity.
For those interested, this paper by the TIAA provides valuable insights into the optimal way of building an allocation to Private Equity within a portfolio.
Potentially significant Industry Impact
The DOL Letter has been well received by industry participants as outlined in this P&I article.
The article stresses that the guidance will help quell some sponsor’s litigation fears and with a good prudent process Private Equity can be added to a portfolio.
The DOL believes the guidance letter “helps level the playing field for ordinary investors and is another step by the department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”
The DOL Letter is in response to a Groom Law Group request on behalf of its clients Pantheon Ventures and Partners Group, who have developed private equity strategies that can accommodate DC plans. The DOL specifically referenced Partners Groups Funds and commented their Private Equity Funds are “designed to be used as a component of a managed asset allocation fund in an individual account plan.”
Partners Group said in a statement that the DOL has taken “a major step toward modernizing defined contribution plans and providing participants with a more secure retirement. At a time when working families are struggling to save, this guidance gives fiduciaries the certainty they need to finally provide main street Americans access to the same types of high-performing, diversifying investments as wealthy and large institutional investors, all within the safety of their 401(k) plans.”
Further comments by Partner Group can be found here.
After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:
Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
Its quickest period to fall into a Bear market, a fall of greater than 20%, 21 days.
The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.
The 21 day plunge from 19th February’s historical high was half the time of the previous record set in 1929.
This follows the longest Bull market in history, which is a run up in the market without incurring a 20% or more fall in value. The last Bear market occurred in 2008 during the Global Financial Crisis (GFC).
The 11-year bull market grew in tandem with one of the longest economic expansions in US history, this too now looks under threat with a recession in the US now looking likely over the first half of 2020. Certainly, global recession appears most likely.
Global sharemarkets around the world have suffered similar declines, some have suffered greater declines, particularly across Europe.
Markets lost their complacency mid-late February on the spreading of the coronavirus from China to the rest of the world and after Chinese manufacturing data that was not only way below expectations but was also the worst on record.
A crash in the oil price, which slumped more than 30%, added to market anxieties.
The recent period has been one of extreme market volatility, not just in sharemarkets, but currencies, fixed income, and commodity markets.
As the Table, courtesy of Bianco Research, below highlights, three of the five days in the week beginning 9th March are amongst the 20 biggest daily gains and losses.
After the 9.5% decline on 12th March, the market rebounded 9.3% the following day. The 7.6% decline on the 9th March was, to date, the 20th largest decline recorded by the S&P 500.
2020 is joining an infamous group of years, which include 1929, 1987, and 2008.
To get a sense as to how much markets are likely to fall, and for how long, they look at the long-term history of the US sharemarket. They also categories Bear markets into three types, reflecting that Bear markets have different triggers and characteristics.
The three types as defined by GS are:
Structural bear market – triggered by structural imbalances and ﬁnancial bubbles. Very often there is a ‘price’ shock such as deﬂation that follows.
Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in proﬁts. They are a function of the economic cycle.
Event-driven bear markets – triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation).
They then plot US Bear Markets and Recoveries since the 1800s, as outlined in the following Table:
Source: Goldman Sachs
From this they can characterise the historical averages of the three types of Bear markets, as outlined at the bottom of the Table:
Structural bear markets on average see falls of 57%, last 42 months and take 111 months to get back to starting point in nominal terms (134 months in real terms (after inflation)).
Cyclical bear markets on average see falls of 31%, last 27 months and take 50 months to get back to starting point in nominal terms (73 months in real terms).
Event-driven bear markets on average see falls of 29%, last 9 months and recover within 15 months in nominal terms (71 months in real terms).
In their opinion GS currently think we are in an Event-driven Bear market. Generally these Bear markets are less severe, but the speed of the fall in markets is quicker, as is the recover. However, as they note none of the previous Event-Driven Bear markets were triggered by the outbreak of a Virus, nor were interest rates so low at the start of the market decline.
Therefore, they conclude, a fall of between 20-25% can be expected, and the rebound will be swift.
This makes for an interest couple of quarters, in which the economic data and company profit announcements are sure to get worse, yet equity markets will likely look through this for evidence of a recovery in economic activity over the second half of this year.
In a more recent note, GMO identify two key problems that lie ahead for the Balanced Portfolio, which are supportive of their conclusion. Which I think are problems facing all investors, but particularly for US and New Zealand investors.
First, stock and bond valuations are both extended, suggesting they will deliver less than they have historically.
As GMO point out, the math with fixed income (bonds) is straightforward. The 10-Year U.S. Treasuries yield is under 1% today. New Zealand’s yield is also near 1%.
Today’s yield is the best predicator of future returns.
Real returns, after inflation, will likely be negative over the next 10 years from fixed income.
In short, GMO highlight “It is more or less impossible for a bond index yielding roughly 2% to deliver the 5% nominal returns investors have become accustomed to over any period of time approaching or exceeding the index’s duration.”
GMO also highlight stockmarket valuations have risen. Recent market weakness provides some valuation relief, albeit, US valuations remain elevated relative to history.
GMO conclude, “the passive 60/40 portfolio will likely deliver disappointing returns. The low starting yield of a 60/40 portfolio represents the first problem we see ahead.”
The second issue identified by GMO is that risks within fixed income have risen, and not just from a valuation perspective.
As can be seen in the graph below, provided by GMO, duration is near its highest level in history. (Duration is the key measure of risk for a fixed income portfolio. It measures the sensitivity of a fixed income security’s price movements to changes in interest rates.)
So, not only are interest rates at historical lows (low expected returns), but risk, as measured by duration, is amongst highest level in history.
This dynamic, low expected returns and heightened risk highlights the folly of an Index approach, similarly a set and forget approach in allocating to different asset classes. Similar dynamics also play out in sharemarket indices. Risks within markets vary over time.
Furthermore, the credit risk of many fixed income indices is also higher now than compared to the Global Financial Crisis. BBB and AA rated securities currently make up a greater proportion of the fixed income indices. Therefore, the credit quality of these indices has fallen over the last ten years, while the amount of corporate debt has grown. These dynamics need to be considered, preferably before the next credit crisis.
As GMO point out “Today, the sensitivity of a 60/40 portfolio to a change in yield is nearly as high as it has ever been. Both stocks and bonds are levered to future changes in discount and interest rates. Even a small amount of mean reversion upward in the aggregate yield of the 60/40 portfolio will be painful because there is less underlying yield to cushion any capital losses and those capital losses should be expected to be larger than normal for any change in yield given the high duration.”
Because of the higher duration and lower yields, smaller movements higher in interest rates will result in greater capital losses from fixed income securities compared to times when yields were higher. This is also the math.
At the same time, given the high valuation of sharemarkets, they are more susceptible to a movement higher in interest rates. Particularly those sectors of the equity market more sensitive to interest rate movements such as Listed Property.
Therefore, the historical diversification benefits from holding fixed income and equities are likely to less in the future.
GMO conclude “While investors have become conditioned to believe that a 60/40 portfolio delivers consistently strong returns, history shows this has not always been the case and the twin problems weighing on such a construction today suggest robust returns are unlikely going forward. Due to elevated valuations (low yields) and extended durations of both stocks and bonds, it is possible that in a future downturn investors will not receive the diversification they expect from their bond portfolio. Stocks and bonds have risen together and could certainly fall in unison as well.”
Although recent market events may have delayed this moment, they have not derailed the underlying dynamics within a Balanced Portfolio which will see it struggling to meet investor’s expectations over the next decade. The risks identify above remain.
The Balanced Portfolio is riskier than many appreciate. I covered this in a previous Post. It is not uncommon for the Balanced Portfolio to have a lost decade of returns and losses of up to 30% over a twelve-month period.
To address the threats to the Balanced Portfolio identified above GMO suggest the inclusion of Liquid Alternatives across multi-asset portfolios.
Such strategies provided portfolio diversification, importantly they have very little duration risk within them, a risk both equities and fixed income are exposed too.
GMO articulate the benefits of such strategies as follows: “Liquid Alternatives can provide diversifying and uncorrelated returns. While Alternatives should not be expected to keep up with robust equity markets, they can help shield large drawdowns given their lower equity beta exposure.”
Liquid alternatives largely generate their return outcomes independently from the returns generated by equity markets (beta) and fixed income market (duration). Thus they provide exposure to different risk and return outcomes from equities and fixed income.
GMO conclude “Liquid alternatives improve the robustness of our multi-asset portfolios by helping to protect against the problems that today’s low yields and high durations present.”
The benefits of such strategies has been evident over the last few weeks, helping to diversify portfolios from the sharp fall in global sharemarkets as a result of the spreading of the coronavirus.
To finish, I would add to the GMO commentary that well diversified portfolios should also have an exposure to Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold. These assets offer real diversification benefits relative to equities and fixed income, and to Balanced Portfolio in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.
I covered the investment characteristics and benefits of Real Assets to a Balanced Portfolio in different economic environments in a recent Post.
The reported death of 60/40 portfolio, may well be exaggerated, but it certainly is ailing.
As reported by Think Advisor in relation to the 60/40 Portfolio (60% listed equities / 40% fixed income):
“No less than three major firms have issued reports in the last few weeks declaring it dead or ailing: Bank of America Merrill Lynch, Morgan Stanley, and JPMorgan.”
All three firms have similar reasons:
Low expected returns, particularly from Fixed Income
Reduced portfolio diversification benefits from Fixed Income
For example, JP Morgan: “Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” “The days of simply insulating exposure to risk assets with allocation to bonds are over.” (A risk asset example is listed equities.)
With regards to the declining diversification benefits from Fixed Income in a portfolio Bank of America make the following point: Fixed Income (Bonds) have functioned as an offset to equity market loses over the last 20 years, this may not occur in the immediate future.
Technically, fixed income has had a negative correlation to equity markets over the past 20 years, interestingly, this did not prevail in the prior 65 years.
There is no doubt we are living in challenging times and we are heading into a low return environment. I covered in this in a previous Post: Low Return Environment Forecasted. This Post provides an indication of the level of returns expected over the next 5 – 10 years.
What to do?
JPMorgan strategists are calling for “greater flexibility in portfolio strategy and greater precision in executing that strategy.”
I agree, to my mind, a set and forget approach won’t be appropriate in a low return environment, where higher levels of market volatility are also likely.
Naturally they are calling for a greater level of portfolio diversification and are recommending, Corporate bonds, Emerging market equities and bonds, U.S. real estate, Private equity, and Infrastructure investment. The last three are unlisted investments.
Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, more advanced approaches are available.
Furthermore, we can now more easily, and more cheaply, gain greater portfolio diversification. This includes an increasing allocation to alternative investment strategies and smarter ways to access investment returns.
We need to change the conversation on investment management fees.
Kiwi Wealth recently released an insightful article on the case for having your money managed actively.
This article has, inevitably, being meet with a passionate defence of Index Management (also referred to as Passive Management). A debate that has been going on for some time, and we really need to move on!
Kiwi Wealth make the following comment in the introduction:
“The “active versus passive” debate has been a fixture in the investment industry for nearly 50 years. Passive investing is one of the cheapest ways to access equity markets globally, and has helped to drive down fees across the board. Passive investment managers and their suppliers have gone further than just offering low cost products however, and have portrayed actively-managed portfolios as a bad option for investors. We disagree, and believe, headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.”
I can’t disagree with that.
As the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio.
The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).
The black and white debate is evident in this GoodReturns article, Passive Managers Reject Criticism. Also note the comments section as well.
I have written a number of Posts on Index management, highlighting their limitations, and risks, albeit I can see a role for them as part of a portfolio, as I can active management.
As with active management, it is important to understand and appreciate the limitations of what you are investing in.
I also hope we don’t follow Australia’s lead as an industry and focus too much on investment management fees. There is an appropriate level of fees, but it is not the lowest cost provider.
Index Funds do buy high and sell low, primarily because companies move in and out of indices.
Analysis by Research Affiliates highlights the trading costs of Index Funds (Passive Funds). Index Fund providers understand this and seek to minimise these costs.
As an aside, passive index funds are not passive, they are actively managed.
Albeit, there are huge trading costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns. Index Funds incur these costs.
These costs are high, Research Affiliates estimates the difference in return between a company exiting and entering an Index to be 9.52%. The majority of this performance difference occurs on the day of index changes. It also only occurs on that proportion of the portfolio that is changing.
Stocks entering an Index tend to underperform over the next 12 months, while those leaving an Index tend to outperform over the following year.
For more, see this article on why low cost index investing is not necessarily low risk.
In another Post I highlighted that Index Funds have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated.
These articles are separate to the current issue of overvaluation in sectors of the US market, recently labelled, rather misleadingly, an Index Bubble, by Michael Burry, who was one of the first investors to call and profit from the subprime mortgage crisis of 2007-08 that triggered the Global Financial Crisis.
The research Paper attached to this Post is the most downloaded paper from Kiwiinvestorblog.
Closely related, and what has busted open the active vs passive debate, leading to the shades of grey, is the disaggregation of investment returns – the isolation of drivers of investment returns.
As the Post highlights returns can be broadly attributed to three drivers: Market returns (beta), factors and hedge fund strategies beta, and alpha (returns after the betas, which can be purely attributed to manager skill).
The disaggregation of investment returns is prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge. These are “active” returns.
The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.
As you know, the isolation of the drivers of investment returns is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay high fees for an “active” return outcome that can be sourced more cheaply.
“The evidence is compelling: Sustainable investing can be a clear win for investors and for companies. However, many SRI fund managers, who have tended to use exclusionary screens, have historically struggled to capture this. We believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value. ESG best-in-class focussed funds should be able to capture superior risk-adjusted return if well executed.”
The DB report looked at more than 100 academic studies of sustainable investing around the world, and then closely examined and categorized 56 research papers, as well as 2 literature reviews and 4 meta studies.
To the point, they comment “… most importantly, “Environmental, Social and Governance” (ESG) factors are correlated with superior risk-adjusted returns at the securities level…..”
DB were surprised by the clarity of results. Which are as follows:
100% of academic studies agree that companies with high ratings for Corporate Social Responsibility (CSR) and most importantly ESG factors have a lower cost of capital, for debt and equity. The market recognises them as having lower levels of risk.
80% of studies show that companies with high ESG ratings exhibit market-based outperformance. The market is showing correlation between financial performance and what is perceived as the advantages of ESG strategies.
The single most important factor is Governance, Environment is next, closely followed by Social.
The study shows quite clearly that ESG factors matter at the security level, with consistent evidence of better financial performance.
The key for investors and fund managers is the ability to identify and capture these factors. This is a key issue as it comes down to the ESG scoring approach (whether active or index based) implemented, level and definition of portfolio exclusions.
It comes down to how ESG is integrated into the investment process.
Unscrambling Fund performance
A common perception is that Sustainable Investing is hard to define and provides mixed results – there is no really clear evidence it leads to a superior risk-adjusted return.
A key conclusion from DB is that “Sustainable investing has been too closely associated for too long with the performance of SRI Funds. These funds are not only an extremely broad category (i.e. in terms of investment mandate), but historically were based more exclusionary (or negative) – as opposed to positive best-in-class-screening.”
DB note that the Academic studies have not been aggregated and classified into appropriate categories, but have been mixed together, thus providing mixed results.
DB: “ By “unscrambling” them – as we do in this paper – a clearer picture emerges.”
“Socially Responsible Investing (SRI) in the academic literature have tended to rely on exclusionary screens – show SRI adds little upside, although it does not underperform either. Exclusion, in many senses, is essentially a value-based or ethical consideration for investors.”
With regards to the SRI Funds, the results are mixed, largely support they do not underperform, and there is no significant difference in performance. Neutral to mixed results.
These results are limited to the review of SRI Funds only, they did not look at categories of ESG Funds.
DB found that ESG factors are correlated to superior performance at the security level, as highlighted above.
The real issue is how Managers are attempting to capture the superior performance from ESG factors at the security level in their portfolios.
Therefore, implementation and the approach taken to integrate ESG into the investment process is key in capturing the excess returns available from Sustainable investing as identified by the DB.
Increasingly, positive ESG investing, commonly referred to best-in-class, approach is being employed.
Best-in-class is an investment approach that focuses on companies that have historically performed better than their peers within a particular industry or sector on measures of environmental, social, and corporate governance issues. This typically involves positive or negative screening or portfolio tilting.
Best-in-class compares to exclusion, also called negative screening, where companies involved in certain “controversial” activities, such as tobacco or weapons are removed or excluded from an investor’s portfolio.
Crucially it requires an understanding of how to integrate ESG criteria in to the investment process, so as to capture the full value of the ESG factors.
DB note that the analysis on SRI performance goes a long way towards explaining why the concept of sustainable investing has taken so long to gain acceptance, it has been too closely associated for too long with the SRI fund manager results, which is a very broad category and has historically been based on exclusions, as opposed to a best-in-class screening.
They note that ESG investing, by contrast takes a best-in-class approach. DB have analysed the various categories within the universe of sustainable investing, they confidently say that the ESG approach, at an analytical level, works for investors and companies (in terms of lower cost of capital).
“It is now a question of ESG best-in-class funds capturing the available returns.” This is a key point.
So while Sustainable investing is the term use to refer to all form of investment, DB believe using ESG factors in a best-in-class approach is emerging as the key investment methodology. It is worth noting this was forecast in 2012 and is coming into fruition now.
DB note: “Investors should seek out investment managers who understand the ESG advantages and can leverage the information arbitrage that exists in the studies we examined. Sustainable Investing can pay dividends, but it requires managers who have internalised this information into their investment process and can also create appropriate strategies to help capture the upside that undoubtedly exists in this approach.”
Or put another way: “In effect, the conclusion is that there are superior risk-adjusted returns for investors, but managers need to take the right approach toward sustainable investing in order to capture these. For corporations, these are important results but the implication of lower cost of debt and equity capital must surely make this a key issue for any CFO, not just the CEO and Sustainability Officer.”
As an aside, this has implications in relation to the fee debate and manager selection. This will be covered in a future Post.
They too found clear evidence in support of ESG investing. Their central conclusions was: “the orientation toward long term responsible investing should be important for all kinds of rational investors in order to fulﬁl their ﬁduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors……..”
As mentioned, implementation is key. Therefore, when selecting an index provider or/and active manager, their integration of ESG factors into the investment process and strategy is very important, as also highlighted by the DB study.
The full conclusion of the 2015 study:
“Through a second-level review of 60 review studies – including both, vote-count studies and meta-analyses – on the ESG–CFP relation, we are able to combine more than 3700 study results from more than 2200 unique primary studies. Based on this sample, we clearly ﬁnd evidence for the business case for ESG investing. This ﬁnding contrasts with the common perception among investors. The contrary perception of investors may be biased due to ﬁndings of portfolio studies, which exhibit, on average, a neutral/mixed ESG–CFP performance relation. It is important to be aware that the results of these (to date about 150 studies) are overlaid by various systematic and idiosyncratic risks in portfolios and, in the case of mutual funds, by implementation costs. Still more than 2100 other – in particular company-focused – empiric studies suggest a positive ESG relation. ESG outperformance opportunities exist in many areas of the market. In particular, we ﬁnd that this holds true for North America, Emerging Markets, and in non-equity asset classes. Our results propose that capital markets so far demonstrate no consistent learning effects regarding the ESG–CFP relation: Since the mid-1990s, the positive correlation patterns in primary studies have been stable over time.
Based on this exhaustive review effort, our main conclusion is: the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulﬁl their ﬁduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors. A key area for future research is to better understand the interaction of different ESG criteria in portfolios and the relevance of speciﬁc ESG sub-criteria for CFP. These insights will shed further light on the ESG determinants for long-term positive performance impacts.”