Hedged Funds vs Equities – lessons from the Warren Buffet Bet Revisited

“The Bet” received considerable media attention following the 2017 Berkshire Hathaway shareholder letter in 2018.

To recap, the bet was between Warren Buffet and Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 Index over the 10-year period ending December 2017. Buffet took the S&P 500 to outperform.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10-year period.

There are some astute investment lessons to be learnt from this bet, which are very clearly presented in this AllAboutAlpha article, A Rhetorical Oracle, by Bill Kelly.

Before reviewing these lessons, I’d like to make three points:

  1. I’d never bet against Buffet!
  2. I would not expect a Funds of Funds Hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Funds.
  3. Most if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

This is not to say Hedged Funds should not form part of a truly diversified investment portfolio.  They should, as should other alternative investments.

Nevertheless, I am unconvinced Hedge Fund’s role is to provide equity plus like returns. 

By and large, alternatives, including Hedge Funds, offer a less expensive way of providing portfolio protection as their returns “keep up” with equities, see the previous Kiwi Investor Blog Sharemarket crashes – what works best in minimising losses, market timing or diversification

One objective in allocating to alternatives is to add return sources that make money on average and have low correlation to equities.  Importantly, diversification is not the same thing as “hedging” a portfolio

Now, I have no barrow to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed appropriately across a portfolio.

In this regard and consistent with the points in the AllAboutAlpha article:

  1. Having a well-diversified portfolio is paramount and results in better risk-adjusted returns over time.

Being diversified across non-correlated or low correlated investments is important, leading to better risk-adjusted outcomes. 

Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will likely add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime. 

Minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio will not fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting one’s investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

I am unlikely to ever suggest to be 100% invested in equities for the very reason of the second point in the article, as outlined below.

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10-12 years, particularly in the 2008 – 2014 period.  Not many I suspect.  This would also be true of the most recent market collapse in 2020.

The research is very clear, on average investors do not capture the full value of equity market returns over the full market cycle, largely because of behavioural reasons.

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See an earlier Post, the inclusion of Alternatives has been an evolutionary process, not a revolution.

Staying the course is the biggest battle for most investors.  Therefore, take a longer-term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else.

I like this analogy of using standard deviation of returns as a measure of risk. It captures the risks associated with a very high volatile investment strategy such as being 100% invested in equities:

“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.

Please see my Disclosure Statement

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

Private Equity receives a boost from the US Department of Labor – significant industry potential

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:

  1. 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;
  2. 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;
  3. 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.

The DOL letter can be accessed here.

 

Size of the Market and innovation

As noted DC plans have been reluctant to invest in Private Equity, by contrast DB plans allocate 8.7% of their assets to Private Equity, based on a 2019 survey of the US’ 200 largest retirement plans.

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.

 

Happy investing.

Please see my Disclosure Statement

 

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

CAIA Survey Results – The attraction of Alternative Investments and future trends

Alternative Investments have doubled as a share of global asset markets since 2003.

They have moved from 6% or $4.8 trillion of the global investment universe in 2003 to over $13.4 trillion, or 12% of the global investment universe in 2018.

 

CAIA Association members expect alternatives to grow to between 18% and 24% of the global investible universe by 2025.

Further growth is expected, based on the combination of very low interest rates, the shortfall in superannuation accounts to meet future retirement obligations, the maturing of emerging markets, and structural shifts in capital formation e.g. companies are remaining private for longer.

Private equity and venture capital are expected to benefit most from the future growth in alternative investments.

Private debt and real asset allocations are also expected to grow.

Although future growth in liquid alternatives is expected, hedge fund growth is anticipated to trail.

 

Manager selection is key to success within the alternatives universe given the dispersion in manager performance.

 

These are the key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The assessments and predictions of the survey are based on the results of a comprehensives survey of over 1,000 CAIA members.

CAIA = Chartered Alternative Investment Analyst, the Association website can be accessed here.

 

The Attraction of Alternatives

CAIA members expect alternatives to grow to between 18 – 24% of the global investible universe by 2025, as highlighted in the following graph from the CAIA report.

Percentage of Global Investible Market CAIA

Of note, Retail investors have around 5% of their investments in alternatives, institutional investors have substantially higher allocations.

This is significant, it is increasingly becoming apparent that continuing to invest in cash, fixed income, and developed market sharemarket alone is unlikely to generate the returns necessary to meet future retirement obligations.

Those saving for retirement have several options, including:

  1. Reducing their expectations as to the standard of living they wish to have in retirement;
  2. Increase their level of savings = work longer and/or forgo current consumption for a higher level of consumption in retirement; and
  3. Find new sources of returns.

 

From a portfolio perspective, the introduction of alternative investments, including hedge funds, liquid alternatives, private equities, and real assets can provide new sources of returns.

Investing outside of the developed markets, with appropriate exposures to emerging market currencies, fixed income, and equities can also provide new sources of return for many portfolios. The current environment offers several potential opportunities outside the developed and traditional fixed income markets.

 

In relation to alternatives, they are generally added to portfolios for two primary reasons:

  • Enhance Returns e.g. private equity and venture capital
  • Diversification – e.g. hedge funds and liquid alternative to reduce portfolio declines at time of severe sharemarket market fails as currently experienced.

Inflation hedging and yield enhancements are other reasons for allocated toward alternatives.

The following graph presents the rationale for investing in alternatives based on the CAIA Members surveyed.

Rationale for investing in Alternatives CAIA

 

As an indication to how much institutional investors have invested in alternatives, US Pension Funds increased their allocation to alternatives from 8.7% to 15.7% over the period 2001 and 2009.

Since 2009 they have increased their alternative allocations to 27%. The largest allocations include Private Equity, Real Estate, and hedged funds.

 

Interestingly, more than 50% of CAIA Association Members expect to have a greater allocation to private equity and venture capital in 2025 than they current hold.

According to CAIA, this is consistent with a Prequin survey that most investors are likely to continue to grow allocations to private equity and private debt over the next five years.

 

Manager Selection

As the Graph below from the CAIA report highlights there is a wide dispersion of manager performance in a number of strategies, particularly private equity, venture capital, infrastructure, and hedge funds.

By contrast, manager performance dispersion within public equities (listed markets) and global fixed income managers is relatively tight.

Therefore, avoiding underperforming managers is a key success factor when investing in alternatives.

Manager Performance Dispersion CAIA

 

Future Trends

Hedge Funds and Liquid Alternatives

Portfolio diversification was the key rationale for including hedge funds, managed futures, and liquid alternatives in a portfolio amongst more than half the CAIA members surveyed.

Lessening the impact of severe equity markets declines on portfolios was a motivating factor “over 92% believe that hedge funds will outperform global equity during times of weakening stock prices.”

As the report emphasises, “This script played out dramatically in the first quarter of 2020 and is reinforced through history: volatility of returns on hedge fund indices is approximately half that of global stock market indices.”

Assets managed by hedge funds has plateaued over recent years. “Among CAIA Members, two-thirds of those who allocate to hedge funds have an allocation of less than 10%, while more than one-quarter have an allocation exceeding 15%………….. only 37% of CAIA Members who currently allocate to hedge funds expect to have a higher allocation in 2025 than they do today.”

Growth has been experienced across liquid alternatives. Assets allocated to liquid alternatives have grown to $900 billion, up from $200 billion in 2008. Liquid alternatives have grown from 12% of hedge fund assets in 2008 to over 22% today.

With the growth in liquid alternatives, which tend to be more transparent, provide greater levels of liquidity, and cheaper fees compared to hedged funds, it is of little surprise that hedge fund fees have declined as noted in the CAIA report.

 

A comparison of the performance and characteristics of liquid alternatives compared to hedged funds, undertaken by Vanguard, can be found here.

 

Private Equity and Venture Capital

As noted above, more than 50% of CAIA Association Members expect to have a greater allocation to private equity and venture capital in 2025.

The change in capital markets, with companies remaining private for longer, and the increased globalisation of capital are underlying trends expected to boost the investment into these types of strategies.

By way of example, the CAIA report highlight that in “2012 over two-thirds of venture capital investments were made in North American companies. By the end of 2016, over 45% of portfolio companies were in Asia, while only one-third of investments were made in North American firms.”

The growing trend of Emerging Market company’s requirements for capital will see an increased asset allocation to these regions by private equity and venture capital.

Considerations in determining an optimal private equity portfolio allocation are covered in this Kiwi Investor Blog Post.

 

Real Assets

The survey highlighted that there are several reasons for investing in real assets. By way of example, Real estate and infrastructure are invested in for the following reasons, offering diversification, an inflation hedge, and as a source of income.

The report noted that investments in real assets has increased from $2.7 trillion to $4.3 trillion from 2004 to 20188.

Those CAIA Members who invest in real estate and infrastructure, the majority have an allocation of less than 10% of assets. However, nearly one-third have an allocation above 10% and nearly 90% expect to have an allocation in 2025 that is greater than or equal to what they currently hold.

 

The benefits of real assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investments where objectives are linked to inflation. In a previous Post I provide an outline of the characteristics of different real assets and the benefits they bring to a Portfolio.

 

The CAIA Report has a very good case study on climate change and real assets, highlighting the impact of increased Environment, Social, and Governance (ESG) integration within investor portfolio will in their view be transformative for the real asset classes e.g. Real Estate and Infrastructure carbon-neutrality and stranded assets within the Natural Resources sector.

 

There is also an interesting section on Private Debt, which has experienced a dramatic increase in assets, reflecting historically low interest rates and regulatory changes that have caused banks to reduce lending to risker parts of the economy. Allocations to private debt are expected to grow.

 

The CAIA also unveil a four-point call to action for the industry:

  1. Commit to Education
  2. Embrace Transparency
  3. Advocate Diversification
  4. Democratise but protect

 

The CAIA report is well worth reading.

 

Happy investing.

Please see my Disclosure Statement

 

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

Sharemarket crashes – what works best in minimising losses, market timing or diversification?

The best way to manage periods of severe sharemarket declines, as recently experienced, is to have a diversified portfolio, it is impossible to time these episodes.

A 2018 paper by AQR evaluated the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

They analysed the potential benefits and costs of shifting away from equities, including into investments that are diversifying (i.e. are lowly correlated to equities) and investments that provide a market hedge (i.e. expected to outperform in bad times).

To diversify a portfolio AQR recommends adding return sources that make money on average and have a low correlation to equities i.e. their returns are largely independent of the performance of sharemarkets.

They argue that diversification should be true both in normal times and when most needed: during tough periods for equities.

Furthermore, as AQR emphasis, “diversification is not the same thing as a hedge.” Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term.

Therefore, alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

 

The analysis highlights that the funding source can matter just as much as the new diversifying investment. Funding from equities reduces drawdown losses, however, longer term returns are on average lower when compared to funding the allocation proportionally from the 60/40 equity/fixed income split.

 

Portfolio diversification is harder to achieve in practice than in theory. It involves adding new “risks” to a portfolio. Risks that have their own return profile largely independent of other investment strategies within a Portfolio.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

Any new lowly correlated investment should be vigorously assessed and well understood before added to a portfolio.

The success of which largely rests with manager selection.

 

A summary of the AQR analysis is provided below, first, the following section discusses the challenges and characteristics of achieving portfolio diversification.

 

The challenges and characteristics of Portfolio Diversification

AQR advocate that diversification is a better solution to mitigating the pain of severe sharemarket falls than trying to time markets.

Specifically, they recommend adding return sources that make money on average and have a low correlation to equities.

 

Lowly correlated assets can be tremendously valuable additions to a portfolio.

Lowly correlated means returns that are not influenced by the other risks in the portfolio e.g. hedge funds and liquid alternative strategy returns are largely driven by factors other than sharemarket and fixed income returns.

Therefore, although diversifying strategies can lose money in large sharemarket drawdowns, this does not mean they are not portfolio diversifiers. The point being, is that on “average” they do not suffer when equities do.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

In contrast, a hedge is something you would expect to do better than average exactly when other parts of the portfolio are suffering. Although this sounds attractive, hedges come with a cost. This is discussed further below.

 

Adding diversifying strategies to any portfolio means adding new risks.

The diversifying strategies will have their own risk and return profile and will suffer periods of underperformance – like any investment.

Therefore, as AQR note, implementing and maintaining portfolio diversification is harder in practice than in theory.

Portfolio diversification in effect results in adding new risks to a portfolio to make it less risky.  Somewhat of a paradox.

This can be challenging for some to implement, particularly if they only view the risk of an investment in isolation and not the benefits it brings to the total portfolio.

Furthermore, adding more asset classes does not equal more diversification, as outlined in this Post.

 

Background

Most portfolios are dominated by sharemarket risk. Even a seemingly diversified balanced portfolio of 60% equities and 40% fixed income is dominated by equity risk, since equities tend to be a much higher-risk asset class. Although equities have had high average returns historically, they are subject to major drawdowns such that the overall “balanced” portfolio will suffer too.   The Balance Portfolio is riskier than many appreciated, as outlined in this Post.

 

A major sharemarket drawdown is characterised as a cumulative fall in value of 20% or more. Recent examples include the first quarter of 2020, the Global Financial Crisis (2008/09) and Tech Bust (1999/2000). Based on the AQR analysis of almost 100 year of data, drawdowns worse than 20% have happened 11 times since 1926 — a little over once per decade on average. The average peak-to-trough has been -33%, and on average it took 27 months to get back to pre-drawdown levels (assuming investors stayed invested throughout – there is considerable research that indicates they don’t stay the course and earn less than market returns over the investment cycle).

 

AQR’s analysis highlights that using market valuations as a signal to time market drawdowns has not always been fruitful. Market valuations has rarely been a good signal to tactically change a portfolio to avoid a market drawdowns.

However, it is worth noting AQR are not against the concept of small tactical tilts within portfolios based on value or other signals such as momentum, best expressed as “if market timing is a sin, we have advocated to “sin a little””.

Nevertheless, market timing is not a “panacea” for large sharemarket drawdowns.

 

Diversification Benefits

The AQR analysis highlights that diversification outside of equities and fixed income can benefit portfolios, for example the inclusion of Style strategies (long/short risk premium across several different asset classes) and Trend following. Both of which are found to be lowly correlated to equities and provide comparable returns over market cycles.

Interestingly, the benefits of diversification vary from where the source of funds is taken to invest into the diversifying strategies.

AQR look at the impact on the portfolio of making an allocation from a 60/40 portfolio to the diversifying strategies. They consider two approaches:

  1. Funding the allocation all equities; and
  2. Funding from a combination of equities and fixed income, at a 60/40 ratio.

They evaluate a 10% allocation from the funding source to the new investments and consider both the impact on returns during equity drawdowns as well as the impact on returns on average over the entire 1926–2017 period.

The analysis highlights that the funding source can matter just as much as the new diversifying investment.

Funding from equities reduces the drawdown losses, however there is a trade-off, longer term returns are on average lower when compared to funding the allocation proportionally to the 60/40 equity / fixed income split.

When allocating to other traditional asset classes as a means of diversification e.g. Cash and Fixed Income, there is also a trade-off between a lower portfolio drawdown and lower average returns over time.

 

Therefore, alternatives offer a more compelling case relative to the traditional asset classes in diversifying a portfolio, given they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

 

The Cost of Hedging

As noted above Hedging is different to adding diversifying strategies to a portfolio.

Hedges may include assets such as Gold, defensive strategies – which hedge against market falls, and Put Option strategies.

The AQR analysis found that over the past 30 years the defensive strategies provided positive returns on average during sharemarket drawdowns and almost no periods with meaningful negative performance.

This is attractive for investors who are purely focused on lessening the negative impacts of sharemarket drawdowns.

However, there is a trade-off – “the strategies that are more defensively orientated tend to have lower average returns.”

The cost of avoiding the sharemarket drawdown is lower portfolio performance over time.

 

AQR Conclude

AQR conclude “As with everything in investing, there is no perfect solution to addressing the risk of large equity market drawdowns. However, we find using nearly a century of data that diversification is probably (still) investors’ best bet. This is not to say that diversification is easy.”

“Investors should analyze the return and correlation profiles of their diversifying investments to prepare themselves for the range of outcomes that they should expect during drawdowns and also over the long term.”

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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

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

Their research highlighted that they both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest “that liquid alternatives are often viable options for investors who value the regulatory protections, ease of access, and lower costs they provide”, when compared to hedge funds.

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

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

This reflects the wide dispersion of returns and investment approaches within the categories of hedge fund and liquid alternatives.

 

The Vanguard Report undertakes an extensive analysis and comparison of the performance and characteristics of hedge funds and liquid alternatives.

The comparison of hedge funds and liquid alternative is particularly useful to those new to the subject.

For the more technically advanced, there is an in-depth performance analysis comparing the drivers of performance between hedge funds and liquid alternative strategies. Vanguard ran a seven-factor model and a customised regression model to identify the drivers of returns.

 

Benefits of Hedge Funds and Liquid Alternatives

Vanguard’s analysis highlights that hedge funds and liquid alternatives provide diversification benefits to a traditional portfolio of equities and fixed income. As noted above, capturing these benefits is heavily reliant on manager selection.

It is important to note that the diversification benefits of the different hedge funds and liquid alternatives strategy types vary over time, they have time varying sensitivity to equity markets and fixed income.

It is also worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity markets and fixed income markets.

Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Blending Alternative investment strategies can smooth the ride

Vanguard note that an additional layer of portfolio diversification can be attained by combining different hedge funds and alternative strategies.

Vanguard’s analysis suggested global macro (including managed futures) and the market neutral strategies are the best diversifiers when combined with other hedge fund and liquid alternative strategies.

Their research highlighted that combining multi-strategy hedge fund and liquid alternatives with a few other strategy types provided additional portfolio diversification benefits.

Again they highlight the importance of undertaking fund-by-fund basis analysis to better capture these diversification benefits – i.e. manager selection is important

 

Framework for Manager Selection

Vanguard suggest a framework for manager selection

  1. Identify your investment objective for including hedge funds and liquid alternatives. Investors have an array of objectives, which may include return enhancement, portfolio diversification and risk reduction, and inflation protection.
  2. Before selecting a manager determine a suitable strategy type(s). This is undertaken in consideration of investment objective(s) and any constraints. This could take into consideration risk and fee budgets, tolerance for level of leverage, and operational implementation issues. Ideally you would want to identify a number of strategy types so as to gain the diversification benefits from having a blended investment solution.
  3. Undertake manager selection within the strategy types. Undertake research as to the benefits of a particular manager and their ability to consistently deliver return outcomes consistent with the overarching investment objectives within the strategy type.
  4. Maintain a policy of regular review and monitoring of the manager and strategies in meeting desired investment objectives.

 

Liquid Alternatives are often the Prudent Option

The report highlights that investors will place varying degrees of value on the relative benefits of hedge funds and liquid alternatives.

Vanguard note that liquid alternatives may provide valuable portfolio construction benefits for investors who are not interested in undertaking the additional due diligence required for, or paying the costs associated with, investing in hedge funds.

They conclude that liquid alternatives maybe a viable option. Compared to hedge funds liquid alternative often have:

  • Lower fee structure that are easier to understand;
  • Greater transparency of underlying holdings; and
  • Greater liquidity i.e. easier access to getting your money back.

 

Performance Comparison

The Vanguard analysis reveals that hedge funds have performed better than liquid alternatives. They have also performed better on a risk adjusted basis.

However, the dispersion of returns between hedge fund managers is greater.

Vanguard undertook extensive performance analysis of hedge funds and liquid alternative returns, using factor analysis. Vanguard ran a seven-factor model and a customised regression model.

This analysis highlighted that liquid alternatives have more consistent factor exposures than hedge funds. Their returns are driven more by market factors such as value, momentum, low volatility, credit, quality, and liquidity.

Different factors drove the returns of different liquid alternative strategies – thus the diversification benefits of combining different strategy types.

Conversely, hedge funds are driven more by manager skill, returns are less sensitive to market factor returns.

 

To Conclude

Liquid alternatives provide an exposure to more “generic” hedge fund strategies – “hedge fund beta” exposures that have been found to be relatively stable over time. The market sensitivities vary across the different strategy types.

Investing in hedge funds, provides access to more unique return sources (alpha). Albeit this is harder to identify. Therefore, manager selection is even more important, given the larger dispersion of returns amongst hedge fund strategies and managers.

However, both the hedge fund alpha and the liquid alternative beta can provide diversification benefits to a traditional portfolio. Therefore, both can play a role in a portfolio.

Individual preferences and constraints will largely drive allocations to each.

Appropriate due diligence and focus on returns after fees will increase the likelihood of capturing the portfolio diversification benefits.

Manager selection is key.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Beginners guide to Portfolio Diversification. And why Portfolios Fail.

It is often asked if Modern Portfolio Theory failed during the Global Financial Crisis / Great Recession (GFC).

No, Modern Portfolio Theory did not fail during the GFC. Portfolio construction did.

During the GFC many investors did not have exposure to enough different asset classes and investment risks. This limited their protection from market loses.

Therefore, Investors should consider incorporating a wide range of different investment strategies as their core investment strategy. Investors should also clearly understand the sources of risk within their portfolio.

Furthermore, investors cannot necessarily rely on “what is traditionally thought of as diversification to meet their long-term goals.”

It is likely that many investors remain under-diversified today.

These are the views of a 2013 BlackRock Article, the new diversification: open your eyes to alternatives.

 

The discussion in 2012 with Dr Christopher Geczy is still very relevant today.

As we have seen previously, from what does portfolio diversification look like, many KiwiSaver Funds are under-diversified relative to Australian Superannuation Funds. Likewise, the Australian Future Fund is very well diversified relative to the New Zealand Super Fund.

 

Highlights of the BlackRock article are provided below.

They are presented to provide the rationale for seeking true portfolio diversification, as pursued by many of the largest investors worldwide, including Super Funds, Pension Funds, Foundations, Endowments, Family Officers, and Sovereign Wealth Funds. This group also includes the ultra-wealthy.

Albeit, the opportunity to have a truly diversified portfolio is open to all investors, the value is in implementation.

Currently, many New Zealand investors are missing out.

 

What happened during the GFC?

In short, as we all know, what happened during the GFC was a spike in financial market volatility, this led to all markets behaving in a similar fashion – technically market correlations moved to one. This reduces the benefits of diversification. As a result, many markets fell sharply in tandem.

Those markets that where already quite highly correlated became more correlated e.g. listed property with the broader share market.

As we also know, this often happens at time of market crisis, nevertheless, correlations can spike higher without a crisis.

The BlackRock article provides a comparison of market correlations prior to the GFC and correlations during the GFC.

 

For clarity, there are benefits from investing in different asset classes, regions, and so forth.

Nevertheless, although a traditional “Balanced Portfolio”, 60% shares / 40% Fixed Income, provides a smoother ride than an undiversified portfolio, the risks of the Balanced Portfolio are dominated by its sharemarket exposures.

It is well understood that for the Balanced Portfolio almost all the risk comes from the sharemarket exposures. On some estimates over 90% of the risk of a Balanced Portfolio comes from sharemarkets.

Therefore, investors should not only clearly understand the sources of risk, but also the magnitude of these risks within their portfolio.

 

What is the difference between Portfolio Diversification and Portfolio Construction?

Diversification is not as obvious as many think e.g. as outlined above in relation to listed property, a portfolio exposed to different asset classes may not be that well diversified.

As a result, and a key learning from the GFC, investors need to think in terms of risk exposures – risk diversification.

Investors should not think in terms of asset class diversification.

More asset classes does not equal more Portfolio Diversification.

This is because returns from of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.

Therefore, increasingly institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

 

From a portfolio construction, and technical, perspective, this means thinking in terms of risk exposures and “getting exposure to as many different and non-correlated types of risk that they can.”

Portfolio construction = “building a portfolio based on risk exposures and not just so-called “asset classes” or “sub-classes.””

 

What does this look like?

Investors should seek exposure to a variety of risk exposures in proportion to their risk tolerances and individual circumstances.

The point being everyone should have a broadly diversified portfolio to the greatest extent they can. Investors should hold as many different assets and risk exposes as they possibly can.

Therefore, portfolios should likely include real assets, international investments, and long/ short investments. Alternative and Alternative investment strategies.

The real value is in implementing the portfolio construction, accessing the appropriate risk exposures efficiently.

As BlackRock emphases, Investors need to work with their financial professionals to choose and blend the risk exposures that make sense for their unique circumstances.

 

Low Correlated investments

If the objective is to seek a truly diversified portfolio, the exposure to low correlated assets, both in general and particularly in times of stress, is necessarily.

These exposures are largely gained via Alternative investments or Alternative Investment strategies.

“Alternatives” are a broad category, as defined by BlackRock, offering “sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio.”

The concept of alternative investing is about going beyond what a traditional Balanced Portfolio might look like, by introducing new sources of diversification.

 

BlackRock provides a very good discussion on Alternatives, types of assets that would be considered alternatives and a discussion around implementation – highlighting the portfolio benefits of adding alternatives to a portfolio (improving the risk/reward profile). Also noting Alternative investments feared better during the GFC.

 

It is important to emphasis, as does BlackRock, that the inclusion of alternatives into the traditional portfolio is not a radical departure from the notion of managing risk and constructing portfolios. It helps in understanding what risks are being taken and broadens portfolio diversification.

The inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.

 

BlackRock makes a final and important point, the world presents countless risks, and not all those risks can be accounted for in a traditional Balanced Portfolio. Investors need to be diversified in general, but they also need to be diversified for the extreme. If not, they may be setting themselves up for failure.

Do not become too dependent on one source of investment returns.

 

Summary

Investors need to clearly understand the sources of risk in their portfolios and should consider incorporating a wide range of different investment strategies and assets as their core investment strategy.

Furthermore, investors cannot necessarily rely on what is traditionally thought of as diversification to meet their long-term goals.

It was not Portfolio Theory that failed during the GFC but Portfolio Construction.

And this is where the real value lies, the ability and knowledge to implement a truly diversified portfolio.

Many investors very likely remain under-diversified today. Their portfolios do not fully reflect the key learnings from history as outlined in this Post.

 

In my mind, many New Zealand Investors are missing out.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

New Zealand Super Fund vs the Australian Future Fund

The analysis below compares the variation in portfolio allocations between the Sovereign Wealth Funds of New Zealand and Australia, the New Zealand (NZ) Super Fund (Kiwis) and Australian Future Fund (Aussies).

Many of the insights are relevant for those saving for retirement or are in retirement.

A light-hearted approach is taken.

 

A previous Post, What Does Diversification Look Like compared Australian Superannuation Funds to the KiwiSaver universe, the Aussies won easily, with more diverse portfolio allocations.

However, this comparison is amongst the top echelon of the nation’s investment funds, a Test match of portfolio diversification comparisons, sovereign wealth fund vs sovereign wealth fund, the All Blacks vs the Wallabies, the Black Cap vs the Baggy Green, the Silver Ferns vs the Diamonds ………………

Let’s gets stuck into the Test Match Statistics.

 

Test Match in Play

 

NZS

Future Fund

Kiwi vs Aussie Difference

Int’l Equities

56.0%

18.5%

37.5%

Emerging Markets

11.0%

10.0%

Domestic Equities

4.0%

7.0%

Fixed Income

9.0%

9.0%

Alternatives
Infrastructure & Timberland

7.0%

7.5%

-0.5%

Property

2.0%

6.7%

-4.7%

PE

5.0%

15.8%

-10.8%

Alternatives 13.5%

-13.5%

Rural

1.0%

Private Mkts

3.0%

Public Mkts

2.0%

Cash

11.9%

100%

100%

           
High Level Allocations          
Equities

71.0%

35.5%

35.5%

Fixed Income

9.0%

9.0%

0.0%

Cash

11.9%

-11.9%

Alternatives

20.0%

43.5%

-23.5%

100%

100%

 

High Level Match Coverage:

  • The Kiwis are highly reliant on International Equities to drive performance – let’s hope they don’t get injured.
  • The Aussies currently have a higher allocation to Cash – are they holding something in reserve
  • The Aussies, with a higher Alternative allocation, on the surface, and looking at the detail below, have a more broadly diversified line up – depth to come off the bench
  • The Aussies have a much higher allocation to Private Equity,15.8 vs 5% – might have something to do with their schooling
  • Interestingly both have a similar allocation to Emerging Market Equities ~10% – both are willing to be adventurous

 

The standout is the difference in the international equities exposures, the Kiwis have a ~37% higher allocation, the majority of this difference is invested into Private Equity (+~10%), Property (+~4.7%), and Alternatives (+~13%) by the Aussies.

 

As for the detail

  New Zealand Australia
Infrastructure & Timberlands

Of the total 7%, 5% is in Timberlands, the Kiwis have 1% invested in NZ rural land and farms

Of the 7.5%, 1.7% is invested in listed infrastructure equities, 3.4% is invested in Australian assets, 2% is invested offshore. An array of infrastructure assets is invested in.
Alternatives Not sure how this is categorised by the Kiwis (Public Markets?), they have 2% invested in Natural Catastrophe Reinsurance and Life Settlements.

 

The Kiwis also have allocations to Merger Arbitrage.

The Aussies have 13.5% invested into Multi-Strategy/Relative Value hedge fund strategies, Macro – Directional strategies, and Alternative Risk Premia strategies.

 

These strategies are relatively easy to invest into and provide well documented portfolio diversification benefits relative to other hedge fund type strategies.

Property   1.9% of the Fund is invested in Listed Property, 4.8% is invested in direct property.

 

Post-Match interviews

It is true, the only interview is with my keyboard, and the above is high level and rudimentary.

Nevertheless, on the surface the Aussies appear to have a more broadly diversified line up, which may play into their hands in tougher games e.g. global equity bear market.

There is certainly less of a reliance on listed equities to drive the performance of the Aussies.

Put another way, the Aussies might have a better line up to get them through a world cup campaign, able to hold up in different playing conditions (i.e. different market environments. The exception would be a strong global equity bull market, which would favour the Kiwis. Albeit the Aussie’s performance has been competitive over the last 10 years relative to the Kiwis – unlike the Wallabies!).

 

Therefore, the Aussie portfolio allocation will lead to a smoother and more consistent team performance.

 

Why the Difference

The difference in portfolio allocations can be for several reasons. I would like to highlight the following:

 

Investment Objectives

In many respects they both have similar objectives, to support future Government spending. They are both investing for future generations. The Kiwi specifically for future super payments and Aussies more so for the General Fund.

 

Return Objectives

Interestingly they have similar return objectives.

From 1 July 2017 the Aussie’s long-term benchmark return target has been CPI + 4% to 5% per annum. This has been lowered from previous years, reflecting a changed investment environment.

The Kiwi’s don’t appear to have a specific return target.

Nevertheless, the Kiwi Reference Portfolio, which they are currently reviewing, is expected to generate a return of Cash plus 2.7%.

The Reserve Bank of New Zealand (RBNZ) in a 2015 research paper estimated the long-term “neutral” 90-day interest rate is around 4.3%. Although this seems high given the current market environment, bear-in-mind it is a long-term estimate.

If we assume inflation is 2%, the mid-point of the RBNZ’s inflation target range of 1-3%, and a lower Cash rate, then Cash generates a 2% return over inflation.

Thus, the Kiwi objective is comparable to a CPI + 4.7% return.

 

Therefore, the return objectives are not too dissimilar between the two Teams, even if we make further conservative assumptions around the long-term neutral interest rate in New Zealand and its expected return above inflation – which I think will come down from its historical average.

If anything, the Kiwi’s return objective is more conservative than the Aussies, all else being equal, this would support a lower equity allocation relative to the Aussies, not a higher equity allocation as is the case.

 

It is interesting, for similar return objectives they have such a difference in equity exposure.

This is an issue of implementation.

The Aussies are seeking a broader source of returns through Private Equity, Alternative strategies, direct property, and unlisted infrastructure.  This will help them in different playing conditions – market environments.

 

Drawdown Requirements

There is a difference in when the funds will be drawn upon i.e. make payments to the Government.

In Australia, legislation permits drawdowns from the Future Fund from 1 July 2020. The Government announced in the 2017-18 budget that it will refrain from making withdrawals until at least 2026-27.

The Kiwis have a bit longer, from around 2035/36, the Government is expected to begin to withdraw money from the Fund to help pay for New Zealand superannuation. On current forecasts, a larger, permanent withdrawal period will commence in 2053/54.

 

Therefore, the Funds do have different maturity profiles and this can be a factor in determining the level of equity risk a portfolio may maintain.

 

One way of looking at this is that the Aussies are closer to “retirement”, there will no longer be deposits into the Fund and only capital withdrawals from 2026. Much like entering retirement.

Therefore, it would be prudent for them to have a lower equity allocation and higher level of portfolio diversification at this time, so there is a wider return source to draw upon.

The Kiwis have a bit longer until they enter retirement.

I would imagine that the Kiwis will move their portfolio closer to the current Aussies portfolio over time, as they “age” and get closer to the decumulation/drawdown phase (retirement), expected to commence around 2035 (16 years’ time).

The Kiwis will likely be considering this now, as they will want to reduce their sequencing risk, which is the risk of experiencing a major drawdown just before and just after entering the drawdown phase (retirement). I covered this in a previous Post, The Retirement Death Zone.

Likewise, they will not want to hold high levels of Equities once withdrawals commence (are in retirement).

Maintaining high levels of listed equities can significantly reduce the value of a portfolio that has regular withdrawals and there is a high level of market volatility. This is the case for Charities, Foundations, and Endowments.

For more on this, see my previous Post, Could Buffett be wrong, which highlights the impact on portfolios when there are regular withdrawals and equity market volatility.

 

Team Philosophy

Differences in Investment Philosophy could account for differences in portfolio allocations. Nevertheless, there does not appear to be any measurable difference in Philosophy.

 

Resources and fee budgets

This is probably the most contentious factor. Fund size, team resources, and fee budgets can influence portfolio allocations. Those with a limited fee budget will find it challenging to diversify equity risk.

I am not saying this is an issue for the Kiwis, I would only be speculating. The Aussies have a good size budget based on their recent annual report.

Let’s hope it is not a factor for the Kiwis, an appropriate investment management fee budget will be required for them to satisfactorily meet their objectives and exceed expectations – as any good sports team know.

This is an aged old industry issue. My Post on Investment Fees and Investing like US Endowments covers my thoughts on the fee budget debate.

 

Happy investing.

Please see my Disclosure Statement

 

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

What does Portfolio Diversification look like?

What does a diversified portfolio look like?

This is answered by comparing a number of portfolios, as presented below.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.   Investors are compensated for being exposed to a range of different risks.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, illiquidity, and growth.

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.

 

This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.

The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).

To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.

 

Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe.  Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.

I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.

WTW Model Reference Portfolio Typical US Advisor
Domestic Cash 2.0%
Domestic Fixed Interest 13.0% 15.0% 28.0%
Global Fixed Interest 15.0%
Domestic Equities 15.0% 25.0% 35.0%
International Equities 20.0% 40.0% 12.0%
Emerging Markets 5.0% 5.0% 4.0%
Listed Property 3.0%
Global Property 3.0%
Listed Infrastructure 3.0%
Alternative Beta 8.0%
Hedge Funds 7.0% 8.0%
Private Equity 8.0% 4.0%
Unlisted Infrastructure 5.0%
Alternative Credit 8.0%
US High Yield 4.0%
Commodities / Real Estate 4.0%
Emerging Markets Bonds 1.0%
100.0% 100.0% 100.0%
Broad Asset Classes
Cash and Fixed Income 15.0% 30.0% 28.0%
Listed Equity 49.0% 70.0% 51.0%
Non Traditional 36.0% 0.0% 21.0%
100.0% 100.0% 100.0%

Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta

The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.

Allocations to broad asset classes KiwiSaver Aussie Pension Funds
Cash and Fixed Interest (bonds) 49 31
Equities 48 47
Other / non-traditional assets 1 22

From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.

 

If a picture tells a thousand words, the Tables above speak volumes.

The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.

 

It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).

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

Globally allocations to alternatives are set to grow, as outlined in this Post.

 

The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.

Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments.  As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).

 

Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.

The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.

Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.

Although investors can experience strong performance, they can also experience very weak performance.

 

Comparison Return Analysis

Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.

By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.

It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.

 

The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.

 

Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%

 

A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.  They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?

Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.

For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.

 

Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.

As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

A short history of Portfolio Diversification

Advancements in technology and new knowledge have made it easier to diversify portfolios and manage investment management fees. Greater clarity over sources of returns have placed downward pressure on active manager’s fees.  True sources of portfolio diversification can command a higher fee and are worth considering.

Is your portfolio managed as if it is the 1980s? the 1990s? Does it include any of the key learnings from the Tech Bubble crash of 2000 and the market meltdown of the Global Financial Crisis (GFC or Great Recession)?

Finally, is your portfolio positioned for future trends in portfolio management?

 

Below I provide a short history of the evolution of portfolio diversification. The evolution of portfolio diversification is interesting and can be referenced to determine how advanced your portfolio is.

 

The framework, idea, and some of the material comes from a very well written article by Aberdeen Standard Investments (ASI).

Unless stated otherwise, the opinions and comments below are mine.

 

Standing on the Shoulders of Giants

Nobel Laureate and pioneer of investment theory Harry Markowitz’s 1952 paper “Portfolio Selection” provided the foundations for Modern Portfolio Theory (MPT).

Markowitz’s analysis provided the mathematical underpinnings for portfolio optimisation.

The key contribution of Markowitz was the quantification of portfolio “risk”. Portfolio Risk was measured by the variation in investment returns – standard deviation of returns.

Markowitz’s paper led to the concept of an “optimal portfolio”, a framework in which both risk and returns are considered. Optimal portfolios offer the maximum expected return for a defined level of risk.

The benefits of diversification were clear to see. Diversification reduces risk without sacrificing returns.

As the ASI article noted: Markowitz called diversification “the only free lunch in finance”.

MPT led to the establishment of the 60:40 portfolio, a portfolio of 60% equities and 40% fixed income.

Increased Diversification of the 60:40 Portfolio

The 60:40 portfolio dominated for a long period time. This portfolio was also largely domestically orientated i.e. the concept of investing internationally was not widely practiced in the 1960 – 70s, even early 1980s.

The next phase in portfolio diversification largely focused on increasing the level of diversification within the equity and fixed income components of 60:40 Portfolio.

As outlined in the ASI paper, four trends combined to drive a broadening of investments in 1980s and 90s:

  • deregulation of financial markets
  • rapid growth in emerging markets
  • financial innovation
  • academic ‘discoveries’.

Deregulation played a major role, particularly the ending of fixed currency exchange rates and the relaxing of capital controls. This enabled an increased level of investing internationally.

This also coincided with the discovery of the “emerging markets”, leading to an increased allocation to emerging market equities and fixed income securities.

Financial innovation resulted in the development of several new financial instruments, including mortgage-backed securities, high-yield bonds (formally called Junk Bonds), and leverage loans.

The use of derivatives also grew rapidly following the establishment of Option Pricing Theory.

Other academic discoveries led to style investing, such as value and growth, and the rise of investing into smaller companies to add value and increase diversification.  Style investing has been superseded by factor investing, which is discussed further below.

ASI conclude, that at the end 1990’s portfolio diversification could be characterised as including:

  • domestic and international equities
  • value and growth stocks
  • large-cap and small-cap stocks
  • developed and emerging markets
  • government, mortgage and corporate fixed income securities.

 

Fundamentally, this is still a portfolio of equities and bonds. Nevertheless, compared to the domestic two-asset class 60:40 Portfolio of the 1960 – 70s it offered more diversification and weathered the severe market declines of tech bubble burst in 2000 and GFC better.

Pioneering Portfolio Management – the Yale Endowment Model

The 2000’s witnessed the emergence of the “Endowment Model”. This followed a period of strong performance and evidence of their diversification benefits during the tech bubble burst of 1999-2000.

The Endowment model has been characterised as being based on four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets e.g. property.

The endowment model was pioneered by David Swensen at Yale University. Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.

For more on diversification approach adopted by Endowments and Sovereign Wealth Funds please see my previous Post Investment Fees and Investing like and Endowment – Part 2.

Learnings from Norway

The extreme severity the GFC tested all portfolios, including the Endowment Model.

The dislocation in markets muted the benefits of diversification from alternative investments and left many questioning the actual level of diversification within their portfolio.

In 2009 this disappointment prompted the Norwegian Government Pension fund to commission a study to investigate their returns during the GFC.

The study was undertaken by three prominent professors, Andrew Ang (Columbia Business School), William Goetzmann (Yale University) and Stephen Schaefer (London Business School). The paper is well worth reading.

This study went on to influence portfolio diversification considerations and captures some major learnings from the GFC. The study brought factor investing into greater prominence.

Factors are the underlying drivers of investment returns.  The Nordic study recommended that factor related returns should take centre stage in an investment process.

As a result, the Norwegians rethought about how they structured their portfolios. Other countries have followed, incorporating factor investing into their asset allocations.

Please see my previous Post on Factor Investing and this interview with Andrew Ang, one of the authors of Nordic study, for further details.

Innovation and pressure on Investment Management Fees

The period since the GFC has yielded an increasing level of innovation. This innovation has been driven in part by factor investing, technology advancements, pressure on reducing investment management fees, and increased demand to access more liquid alternative investment strategies to further diversify portfolios.

The disaggregation of investment turns has provided a new lens in which to view portfolio diversification. With technology advancements and the rise of factor investing returns from within markets have been isolated. Broadly speaking, investment returns can be attributed to: market exposures (beta e.g. sharemarkets); underlying factors (e.g. value and momentum); hedge fund strategy returns (e.g. relative value and merger arbitrage); and returns purely attributable to manager skill (called alpha, what is left if the previous sources cannot explain all the return outcome). For a fuller discussion please see my earlier Post on Disaggregation of Investment Returns.

These trends have resulted in the proliferation of ETFs and the downward pressure on investment management fees. The active manager has been squeezed, with investors only wanting to pay fees relative to the source of return i.e. very very low fees for beta and higher fees for alpha.

These developments have also resulted in the rise of liquid alternatives. Returns once attributed to hedge funds can now be more easily accessed, from a cost and liquid perspective.

Increasingly these strategies are available in an Exchange Trade Fund (ETF) structure.

True Portfolio Diversification

Consequently, there is a now a greater ability to significantly diversify the portfolios of the 1980s and 1990s and take on the learnings from GFC and 2000 Tech bubble.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or listed liquid infrastructure to a multi-asset portfolio that includes global equities.   True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks.

True diversification involves taking the learnings from the endowment model and the Norwegian Government Pension Fund study.

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.  This Post highlights that more asset classes does not equal more diversification may also be of interest.

Goal Based Investing and the extinction of the 60:40 Portfolio

Advancements in technology have helped investors understand the different dimensions of risk better and move away from the sole risk measure of MPT (standard deviation of returns).

Likewise, there has been a growing appreciation that failure to meet your investment objectives is the greatest investment risk.

More advanced portfolio construction approaches such as Liability Driven Investing (LDI) have been embraced.

Goal-Based Investing for the individual is based on the concepts of LDI.

The move toward Goal-Based Investing completely upturns portfolio construction, likely resulting in the extinction of the 60:40 Portfolio.

This paradigm shift within the industry is best captured by analysis undertaken by EDHEC Risk Institute.  I covered the most relevant EDHEC article in more depth recently for those wanting more information. This Post outlines future trends in Wealth Management.

Future Direction of Diversification

The ASI article finishes by discussing several trends they believe are reshaping portfolio construction. Some of these trends have been discussed on Kiwiinvestorblog.

I would like to highlight the following trends identified by ASI:

  1. Investors continue to shift from traditional to alternative assets, see the recent Prequin Post.
  2. Investors are increasingly integrating environmental, social and governance (ESG) analysis into their decision-making process.
  3. Opportunities to invest in emerging markets are increasing.
  4. Individuals have to take more responsibility for their financial futures. This is known as the Financial Climate Change.

 

As ASI conclude “If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.”

I would also add, and it is worth reflecting upon, although the benefits of diversification are without question, Modern Portfolio Theory of the 1950s can hardly be considered modern.

 

Happy investing.

Please see my Disclosure Statement

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

KiwiSaver Investors are missing out

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

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

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

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

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

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

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

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

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

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

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

Preqin’s estimates are staggering:

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

The expected growth in Alternative investments was also highlighted by a recent CAIA Association Survey, which outlined the drivers of this expected growth and likely trends.

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

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

Interestingly, the US Department of Labor (DOL) recently provided guidance that US Defined Contribution retirement plans can invest into certain Private Equity strategies, where previously there had been a hesitation to do so.

The DOL emphasised this would be of benefit to “ordinary investors”.

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

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

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

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

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

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

Happy investing.

Please see my Disclosure Statement

 

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