The Value of Financial Advice

Getting the right financial advice can deliver more than just better investment outcomes. It can result in increased peace of mind heading into retirement, lower stress in a relationship or even higher happiness levels.

The research is clear cut, people who receive Financial advice are generally happier and are likely have a higher level of wealth at the point of retirement.

Even for those who receive limited advice on specific elements of their financial situation can experience material benefits.

Analysis supporting these conclusions can be found in a recent research paper by the Australian Financial Services Council, which was prepared by Rice Warner, Titled “Future of Advice”.

The paper covers several topics, with the aim of advancing the public policy debate on Australian financial services.  Albeit the Australian focus, there are key learnings for all.

This is an important issue; the personal and broader economic impacts are material.  The benefits of sound financial advice should be championed more widely.

In addition to analysing the current landscape for Financial Advice within Australia the report covers:

  • The need for Advice, and size of the Australian market
  • The Value of Advice, both tangible and intangible benefits
  • A proposed model which seeks simplification, affordability, accessibility and quality of Advice.

I may Post some of the other topics, this short Post focusses on the Value of Financial Advice.

The Value of Financial Advice

In summary, Rice Warner conclude: “We show that people who receive advice are generally happier, with an improved peace of mind.

On a macro level, we set out that advice leads to higher wealth which in turn leads to lower dependency on government benefits such as the Age Pension.”

The Australian Age Pension is designed to provide income support to older Australians who need it, while encouraging pensioners to maximise their overall incomes. The Age Pension is paid to people who meet age and residency requirements, subject to a means test.

Rice Warner divide the benefits of Financial Advice into two categories for the individual:

  • Quantifiable financial benefits – Tangible Value
  • Intangible value – the non-quantifiable and non-financial benefits provided through advice relationships.

They also consider the economic value, the benefits which flow to the broader economy, through greater use of Financial Advice.

Tangible Benefits

Firstly Rice Warner note the plethora of pre-existing research on the benefits of Financial Advice, they provide the following examples:

  • Russell Investments estimated in 2018 that a full suite of adviser services could be worth up to 3% per annum to an investor.
  • The FSC estimated in 20117 that the provision of savings advice would lead to an individual being between $29,000 and $91,000 better off at the point of retirement. In this research individuals who received advice at a young age received greater value.
  • Survey-based research conducted in 2014 demonstrated that investors who received advice over: – Four to six years accumulated 60% more assets than those individuals who had no advice. – Periods exceeding 15 years accumulated 290% more assets than other comparable households.

They also undertook their own analysis, considering three levels of advice: No Advice; Advice where additional contributions to super and additional personal wealth savings; Asset Allocation Advice (advice in relation to Super Fund only).

They also considered five different member profiles, based on age and level of starting wealth.

They concluded:

  • For average Australians, advice will likely add value to both an individual’s superannuation and their personal wealth. For most, this value will be greatest in the personal wealth component of their wealth portfolio due to the strong existing default structures within superannuation in Australia.
  • Asset allocation advice provides the greatest cumulative increase in funds at retirement when this advice is taken at younger ages. This is because younger individuals have a greater investment period over which to compound the benefits of higher rates of return.
  • Irrespective of level of wealth, for an individual aged 40, approximately half the value of the full advice scenario is derived from simple advice in respect of savings.
  • Individuals who occupy low socio-economic wealth bands are expected to gain more from advice than those who are wealthy. This reflects the tendency of these individuals to: – Save less of their disposable income (in proportional terms). – Allocate assets to safe but low-yielding asset classes (such as Cash and Term Deposits).

The implications of this analysis is that those who seek Financial Advice will likely have a higher level of wealth at the point of retirement.

Rice Warner’s results “suggest that taking limited advice on specific elements of one’s financial situation can lead to material benefits. For example, taking advice on savings, or the construction of portfolios for an individual’s private wealth.”

Intangible Benefits

Rice Warner sum it up succinctly “Financial Advice can maximise the upside, and limit and minimise the downside, of financial decisions. However, simply focusing on a potential monetary value-add ignores other aspects such as the comfort of being secure. We also need to consider the behavioural aspects of consumer decision making in respect of advice. Their perceived need for advice is what drives the market. Consumers need to have a recognition of the need for advice, a willingness to engage with advisers and a willingness to pay. Their willingness to engage will depend on their perception of the potential for favourable outcomes, but it will also depend on their perception of risk – and the cost.”

Ricer Warner note the intangible benefits of Financial Advice include:

  • People who are advised have greater levels of overall happiness.
  •  People who are advised have greater piece of mind.
  • Taking advice can lead to improved relationships due to the alleviation of money-related issues.
  • People who are advised may have better health.

I have re-created the following Table from their report which outlines the research that supports these benefits.

AreaPaperFinding
Greater levels of happinessIOOF white paperIndividuals who are advised have 13% greater levels of overall personal happiness than non-advised individuals.
Greater levels of happinessAdvice and Limited Advice Report by Investment TrendsAcross individuals who use a financial planner as their main source of advice:  87% said their adviser made a positive or significantly positive difference to their life. 89% said their most recent discussion with their financial planner was valuable or very valuable.
Improved peace of mindIOOF white paperSurveys of advised clients suggested that advice lead to: 21% more peace of mind with regards to their financial future. 20% increased feelings of security regarding their day to day finances.
Improved peace of mindMLC Wealth Submission – RIRSurveys of advised clients suggested that advice lead to: 79.4% of clients being instilled with improved peace of mind. 81.5% of clients feeling that Financial Advice has left them more confident about making decisions
Improved RelationshipsIOOF white paperSurveys of advised clients suggested that advice led to: 19% less likely to have arguments with loved ones about money.21% less likely to have their personal relationships impacted due to concerns about money
Improved healthIOOF white paperConsumers who do not receive professional ongoing advice are 22 per cent more likely to have their sleep disrupted due to concerns about money than non-advised clients.

The Rice Warner report can be found here.

New Zealand Experience

In New Zealand the Financial Services Council has conducted research into the value of Financial Advice: “The good news is, the value of advice does clearly outweigh the cost. Those who are advised are delivered a 4% increase in investment returns, about 52% more in their KiwiSaver and save 3.7% more for their retirement than those who are unadvised.

Their report can be found here.  And is also covered in this article by NZ Adviser online.

Please read my Disclosure Statement

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

Source Agile Finance Radio

 

The benefits of behavioral finance in the investment planning process

Investment advisors who stay active across their client base in times of market volatility are more likely to add new clients from a variety of sources.

Clients and prospects want to know that their advisor is looking out for them, even when the advice they are delivering is to stay the course or focus on the long term.

Laying a foundation for communications based on behavioral finance allows advisors to better set expectations early on in client relationships, while also offering an opportunity to maintain an open dialogue when markets become turbulent.

When properly employed, behavioral finance allows advisors to pursue the twin goals of helping investors feel less financial stress while making better decisions in pursuit of their long-term goals.

A recent study found those advisors who employed behavioral finance in their approach:

  1. Gained a better understanding of clients’ risk appetite and kept them invested during the market turbulence in early 2020;
  2. Reported elevated client acquisition activity earlier in the year; and
  3. Developed deeper relations with clients.

As market volatility escalated, advisors increasingly turned to behavioral finance to help keep clients invested and focused on their long-term goals.

These are the key conclusions of a White Paper by Cerulli Associates, in partnership with Charles Schwab Investment Management, Inc., and the Investments & Wealth Institute: The Evolving Role of Behavioral Finance in 2020.    The Evolving Role of Behavioral Finance in 2020 | Schwab Funds

These findings will not be surprising to most investment advisors.  Nevertheless, the evidence supporting including elements of behavioral finance in the planning process is growing, and it is becoming more widely accepted.

It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalised action plans to help them achieve their goals.  Clients prefer this too. 

Incorporating elements of behavioral finance in the planning process will help achieve this, benefiting both the client and advisor.

We all have behavioral biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioral biases. From this perspective, behavioral finance can help us make better investment decisions.

For a further discussion on how investment decisions can be improved by employing behavior finance see this Kiwi Investor Blog Post, which includes access to a Behavioral Finance Toolkit.

Behavioral Biases

The following Table outlines the Top 5 behavioral biases identified by advisors in the Cerulli Associates study.

Recency biasBeing easily influenced by recent news events or experiences
Loss aversionOpting for less risk in portfolio than is recommended
Familiarity/home biasPreferring to invest in familiar (U.S. domiciled) companies
FramingMaking decisions based on the way the information is presented
Mental accountingSeparating wealth into different buckets based on financial goals

Not unexpectedly Recency bias was found by advisors to be the most common behavioral bias amongst clients this year.  This was also the most common behavioral bias in 2019, on both occasions 35% of Advisors indicated that Recency bias was a significant contributor to their clients’ decision making.

Loss aversion held the number two spot in both years.  The Paper provides a full list of Client behavioral biases identified, comparing 2020 results with those in 2019.

Clients are more than likely affected by several behavioral biases.

Source: Staib Financial Planning, LLC

Advisors can help clients improve their investment outcomes by influencing the behavioral bias in a positive way.  By way of example in the paper, Framing (easily influenced by recent events), “an advisor can emphasize how rebalancing a portfolio during an equity market decline allows investors to accumulate more shares of their favorite stock or funds at a reduced price.”

They conclude: “by embracing the principles of behavioral finance, advisors can nudge clients toward more constructive ways to think about their portfolios.”

Survey Results – the benefits of Behavioral Finance

The paper defines Behavioral finance as the study of the emotional and intellectual processes that combine to drive investors’ decision making, with the goal of helping clients optimize financial outcomes and emotional satisfaction.

As the White Paper outlines “Advisors must help investors create and maintain a mental framework to help ease their concerns about the fluctuations of the market. Behavioral finance can be a crucial element of advisors’ efforts to help investors overcome their emotional reactions in pursuit of their longterm financial goals.”

There has been an increase in advisors adopting the principles of behavioral finance in America, particularly in relation to client communications.

In 2020 81% of advisors indicated adopting the principles of behavioral finance, up from 71% in 2019.

The increase is likely in response by advisors to provide a “mental framework to deal with the adversity presented by increased uncertainty in the market and in life overall in 2020.”

Benefits of Behavioral Finance

Keeping clients invested was found to be a key benefit of incorporating behavioral finance in the advice process, 55% of advisors indicated this as a benefit, up from 30% in 2019.

The benefit of developing a better understanding of client’s comfort level with risk also grew in 2020, from 20% in 2019 to 44% in 2020 (probably not surprisingly given events in March and April of this year).

In 2019, the benefits of incorporating behavioral finance most cited by advisors was: strengthening relationships (50%), improving decisions (49%), and better managing client expectations (45%).  These benefits also scored highly in 2020. 

The paper provides a full list of the benefits of incorporating behavioral finance, comparing the results of 2020 with 2019.

To summarise, the results highlighted the dual role of behavioral finance in client relationships as:

  1. serving as a framework for deeper engagement to strengthen communications and prioritize goals during good times; and
  2. to help minimize clients’ instinctual adverse reactions during periods of acute volatility.

The paper then focused on two areas:

  • Growing the client base
  • Deepening client connections

Behavioral Finance Advisors experienced greater growth of their client base in 2020

In 2020 55% of advisor respondents indicated they had added new clients since the first quarter of 2020.  4% indicated they had experienced net client losses.

However, the results differed materially between advisors who adopted elements of behavioral finance compared to those who do not.

“Two-thirds (66%) of behavioral finance users reported adding to their client base, compared to just 36% of advisors who are not incorporating behavioral finance in their practices.”

The source of these new clients?:

  • “Approximately two-thirds of new clients were sourced from other advisors with whom clients had become dissatisfied, or as an outcome of investors seeking to consolidate their accounts and maintain fewer advisor relationships. This is frequently attributable to satisfied clients referring friends and family who are discontented with their current advisory relationship.”
  • “The other third of new client relationships was attributable to the conversion of formerly selfdirected investors who found the current conditions an opportune time to seek professional advice for the first time.“

Therefore, “behavioral finance adherents are more likely to not only educate clients regarding the potential for volatility, but also to urge clients to expect it. This scenario reinforces many of the key benefits of leveraging behavioral finance in advisory relationships, especially with regard to managing expectations and remaining invested during periods of volatility.”

Behavioral Finance Advisors develop deeper connections with their client base

Cerulli’s research has found that the level of an advisor’s proactive communication during periods of market volatility is the most reliable indicator of the degree to which the advisor will add new clients during the period.

In the study that they undertook, for example, they found that 72% of those advisors who employed elements of behavioral finance and increased their outgoing calls added new clients, compared to 42% of non-users of behavioral finance.

They conclude “The unifying element in these results is that proactive personal communication was valued by investors and was especially effective for advisors who have made behavioral finance a part of their client engagement strategy.“

A key point here, is that “Instead of having to pivot from touting their investment returns to focusing on explaining volatility, behavioral finance users were able to frame current conditions as expected developments within the context of the long-term plans they had previously developed and discussed.”

From this perspective, it is important to understand what type of communications clients and prospects prefer.

It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalized action plans to help them achieve their goals.

Clients prefer this too. 

Incorporating elements of behavioral finance in the planning process will deliver this, benefiting both the client and advisor. 

Please read my Disclosure Statement

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

Behavioral Biases

Recency biasBeing easily influenced by recent news events or experiences
Loss aversionOpting for less risk in portfolio than is recommended
Familiarity/home biasPreferring to invest in familiar (U.S. domiciled) companies
FramingMaking decisions based on the way the information is presented
Mental accountingSeparating wealth into different buckets based on financial goals
Confirmation biasSeeking information that reinforces existing perceptions
AnchoringFocusing on a specific reference point when making decisions
HerdingFollowing the crowd or latest investment trends
Endowment effectAssigning a greater value to investments or assets already owned
Inertia/status quoFailing to take action or avoiding changes to a portfolio
Selective memoryRecalling only positive experiences or outcomes
Regret aversionFearing to take action due to previous mistakes or regret avoidance
Availability biasBasing decisions only on readily available information
OverconfidenceBeing overly confident in one’s own ability
Self-controlSpending excessively today at expense of the future

Sources: Cerulli Associates, in partnership with Charles Schwab Investment Management, Inc., and the Investments & Wealth Institute. Analyst Note: Advisors were asked, “To what degree do you believe the following biases may be affecting your clients’ investment decision making?”

Coronavirus – Financial Planning Challenges

For those near retirement this year’s global pandemic has thrown up new challenges for them and their Financial Advisor.

Early retirement due to losing a job, the running down of emergency funds, and a low interest rate environment are new challenges facing those about to retire.

Events this year are likely to have significant repercussions for how individuals conduct their financial planning.  Specifically, how they approach spending and saving goals.

The pandemic will likely have lasting implications for how people think about creating their financial and investment plans, and therefore raises new challenges for the Advisors who assist them.

These are the key issues and conclusions outlined by Christine Benz, director of personal finance for Morningstar, in her article, What the Coronavirus Means for the Future of Financial Planning.

In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”

Although the article is US centric, there are some key learnings, which are covered below.

How the Pandemic Has Impacted Financial Planning for Emergencies

The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”

Lower income families are more at-risk during times of financial emergencies.  Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment.  This rises to 52% for middle income households.

It is advisable to have emergency funds outside of super.

The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”

An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.

Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.

From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.

Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”

The concept of sidecar funds has recently been discussed in New Zealand.

Financial Planning for Early Retirement

The prospect of premature retirement will pose an urgent challenge for some clients. 

Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.

The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.

Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….

They note the following challenges in early retirement:

  • Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
  • Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period. 

Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans.  Often the decision to retire is about more than money.

Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration.  Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.

Accommodating Low Yields in a Financial Plan

The low interest rate (yield) environment is a challenge for all investors. 

Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.

Return expectations from fixed income securities (longer dated (maturity) securities) are very low.  Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.

In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%.  Expected returns on higher quality corporate bonds are not that much more enticing.

As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“

The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.

The impact of low interest rates on “withdrawal rates” is highlighted in the graph below, which was provided by Morningstar in a separate article, The Math for Retirement Income Keeps Getting Worse, Revisiting the 4% withdrawal rule

The 4% withdrawal rate equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate. 

As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.

When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively.  This implies a negative expected return after inflation.

The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020.  The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time.  A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.

As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.

Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved.  They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.

This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.

Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”

The 4% withdrawal rate is an industry “rule of thumb”.  Further discussion on the sustainability of the 4% withdrawal rate can be found here.

I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.

The following Post on what investors should consider doing in the current market environment may be of interest. This Post outlines some investment strategies which may help in maintaining a higher withdrawal rate from an investment portfolio.

Likewise, this Post on how greater customisation of the client’s invest solution is required and who would benefit most from targeted investment advice may also be of interest.

Lastly, Wealth Management.com covers Benz’ article in Retirement Planning in a Pandemic.

Please read my Disclosure Statement

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

Is a value bias part of the answer in navigating today’s low interest rates?

The Value Factor (value) offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Exploring an array of different investment strategies and questioning the role of bonds in a portfolio are key to building a robust portfolio in the current low interest rate environment.

There will also be a need to be more dynamic and flexible to take advantage of market opportunities as they arise.

From this perspective, a value tilt within a portfolio is one investment strategy to consider in potentially boosting future investment returns.

The attraction of Value

Evidence supporting a value tilt within a robust portfolio is compelling, albeit opinion is split.

Nevertheless, longer-term, the “Rotating into Value stocks offers substantial upside in terms of return versus the broad market” according to GMO.

GMO presents the case for a value tilt to navigate today’s low interest rates in their Second Quarter 2020 Letter, which includes two insightful articles, one by Ben Inker and another by Matt Kadnar. 

Value is at cheapest relative to the broader market since 1999, based on GMO’s analysis.  Value is in the top decile of attractiveness around the world, as highlighted in the following figure.

Spread of Value for MSCI Regional Value Factors (GMO)

As of 6/30/2020 | Source: MSCI, Worldscope, GMO

Is Value Investing Dead

As mentioned, the opinion on value is split.

A research paper by AQR earlier in the year addressed the key criticisms of value, Is (Systematic) Value Investing Dead?

For a shorter read on the case for value Cliff Asness, of AQR, Blog Post of the same title is worth reading.

AQR’s analysis is consistent with GMO’s, as highlighted in the Graph and Table below.

The Graph below measures the Price-to-Book spread of the whole US sharemarket from December 1967 to March 2020.

This spread was at the 100th percentile versus 50+ years of history on the 31 March 2020 i.e. value is at it cheapest based on 50 years of data.

Price-to-Book Spread (AQR)

Asness’s Blog Post highlights “expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive.” (March 2020).

It is the same story when looking at different measures of value for the US sharemarket, as highlighted in the Table below.

Value is at its cheapest on many measures (AQR)

‘Don’t ask the barber whether you need a haircut’

This quote by Warren Buffett springs to mind when considering the analysis from GMO and AQR, both being value orientated investors.  As Asness states, AQR has a horse in the race.

However, as outlined in his Post, he undertakes the same analysis as above and controls for, just to name a few:

  • Excluding all Technology, Media, and Telcom Stocks
  • Excluding the largest stocks
  • Excluding the most expensive stocks
  • Industry bets
  • Industry neutrality
  • Quality of company

Analysis is also undertaken using other measures of value, Price-Sales, P/E, using trailing and forecast earnings (these are in addition to Price-Book).

The attraction of value remains based on different measures of value and when making the adjustments to market indices as outlined above.

Asness argues value is exceptionally cheap, probably the cheapest it has ever been in history (March 2020).

The AQR analysis shows this is not because of an outdated price-to-book nor because of the dominance of highly expensive mega-cap stocks.  Investors are paying more than usual for stocks they love versus the ones they hate.  There is a very large mispricing.

The AQR research paper mentioned above, looked at the common criticisms of value, such as:

  1. increased share repurchase activity;
  2. the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems;
  3. the changing nature of monetary policy and the potential impact of lower interest rates; and
  4. value measures are too simple to work.

 Across each criticism they find little evidence to support them.

Are we there yet?

We do not know when and how the valuation gap will be closed. 

Nevertheless, the evidence is compelling in favour of maintaining a value tilt within a portfolio, and certainly now is not the time to give up on value.

This is not a widely popular view, and quite likely a minority view, given the underperformance of value over the last ten years.  As clearly demonstrated in the Graph below provided by Top Down Charts.

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

It is too early to give up on value, news of its death are greatly exaggerated, on this, Asness makes the following point, value is “a strategy that’s “worked” through the 1920s – when a lot of stocks were railroads, steel, and steamship companies – through the Great Depression, WWII, the 1950s – which included some small technological changes like rural electrification, the space race and all the technology that it spanned – the internet age (remember these same stories for why value was broken back in 1999-2000?)………. Value certainly doesn’t depend on technological advancement being stagnant! But in a time when it’s failed for quite a while (again, that just happens sometimes even if it’s as good as we realistically think it is), it’s natural and proper that all the old questions get asked again. Is now different?”

I don’t think so.

Please see my Disclosure Statement

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

The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

Although it has been evident for several years, the current investment environment highlights the shortcomings of the one size fits all multi-asset portfolio (commonly known as Diversified Funds such as Conservative, Balanced, and Growth Funds, which maintain static Strategic Asset Allocations, arising to the reference of the “Policy Portfolio”).

The mass-produced Diversified Funds downplay the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

However, saving for retirement is an individual experience requiring tailoring of the investment solution.   Different investors have different goals and circumstances.  This cannot be easily achieved within a one size fits all Diversified Fund.

Modern-day investment solutions involve greater customisation.  This is particularly true for those near or in retirement.

A massive step toward offering increased customisation of the Wealth Management investment solution is the framework of two distinctive “reference” portfolios: A Return Seeking Portfolio; and Liability-Hedging (Capital Protected) Portfolio.

Details and implementation of this framework are provided in the next section.  The benefits of the framework include:

  • A better assessment of the risks needed to be taken to reach a client’s essential goals and how much more risk is involved in potentially attaining aspirational goals;
  • An approach that will help facilitate more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework helps in assessing what is the best course of action and trade-offs involved; and
  • A more efficient use of invested capital.  This is a very attractive attribute in the current low interest rate environment.  The framework will be more responsive to changing interest rates in the future.

These benefits cannot be efficiently and effectively achieved within the traditional Diversified Fund one size fits all framework; greater customisation of the investment solution is required.

With modern-day technology greater customisation of the investment solution can easily be achieved.

The technology solution is enhanced with an appropriate investment framework also in place.

Implementation of the Modern-Day Wealth Management Investment Solution

The reasons for the death of the Policy Portfolio (Diversified Fund) and rationale for the modern-day Wealth Management investment solution are provided below.

Modern-day investment solutions have two specific investment portfolios:  

  • Return seeking Portfolio that is a truly diversified growth portfolio, owning a wide array of different return seeking investment strategies; and
  • Capital Protected (Liability) Portfolio, is more complex, particularly in the current investment environment.  See comments below.

The allocations between the Return Seeking portfolio and Capital Protected portfolio would be different depending on the client’s individual circumstances.  Importantly, consideration is given to a greater array of client specific factors than just risk appetite and risk and return outcomes e.g. other sources of income, assets outside super.

Although the return seeking portfolio can be the same for all clients, the Capital Protected (Liability) portfolio should be tailored to the client’s needs and objectives, being very responsive to their future cashflow/income needs, it needs to be more “custom-made”.

The solution also involves a dynamic approach to allocate between the two portfolios depending on market conditions and the client’s situation in relation to the likelihood of them meeting their investment objectives.  This is a more practical and customer centric approach relative to undertaking tactical allocations in relation to a Policy Portfolio.

The framework easily allows for the inclusion of a diverse range of individual investment strategies.  Ideally a menu offering an array of investment strategies can be accessed allowing the customisation of the investment solution for the client by the investment adviser.

Implementation is key, which involves identifying and combining different investment strategies to build customised robust investment solutions for clients.

The death of the Policy Portfolio

Modern Portfolio Theory (MPT), the bedrock of most current portfolios, including the Policy Portfolio, was developed in the 1950s.

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements have been made based on the ongoing academic and practitioner research into building more robust investment solutions.  See here for a background discussion.

The Policy Portfolio is the strategic asset allocation (SAA) of a portfolio to several different asset classes deemed to be most appropriate for the investor e.g. Diversified Funds

It is a single Portfolio solution.

A key industry development, and the main driver of the move away from the old paradigm, is the realisation that investment solutions should not be framed in terms of one all-encompassing Policy Portfolio but instead should be framed in terms of two distinct reference Portfolios.

A very good example of the two portfolios framework is provided by EDHEC-Risk Institute and is explained in the context of a Wealth Management solution.  They describe the two reference portfolios framework involving:

  1. Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
  2. Performance Seeking Portfolio, this is a portfolio that seeks growth in asset value.

The concept of two separate portfolios is not new, it dates to finance studies from the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The concept of two portfolios has also been endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.  Kahneman discusses the idea of a “regret-proof policy” here.

The death of the Policy Portfolio was first raised by Peter Bernstein in 2003.

Reasons for the death of Policy Portfolio include:

  • there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.
  • Investors should be dynamic; they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Many institutional investors have moved toward liability driven investment (LDI) solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.  More can be found on LDI here.

These “institutional” investment approaches, LDI, portfolio separation, and being more dynamic are finding their way into Wealth Management solutions around the world.

Evolution of Wealth Management – Implementation of the new Paradigm

In relation to Wealth Management, the new paradigm has led to Goal-Based investing (GBI) for individuals. GBI focuses is on meeting investor’s goals along similar lines that LDI does for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  1. Disaggregation of investor preferences into a hierarchical list of goals, with a key distinction between essential and aspirational goals, and the mapping of these groups to hedging portfolios possessing corresponding risk characteristics (Liability Hedging Portfolio).
  2. On the other hand, it involves an efficient dynamic allocation to these dedicated hedging portfolios and a common performance seeking portfolio.

GBI is consistent with the two portfolios approach, fund separation, LDI, and undertaking a dynamic investment approach.

The first portfolio is the Liability Hedging Portfolio to meet future income requirements, encompassing all essential goals.

The objective of this Portfolio is to secure with some certainty future retirement income requirements. It is typically dominated by longer dated high quality fixed income securities, including inflation linked securities.  It does not have a high exposure to cash. In the context of meeting future cashflow requirements in retirement Cash is the riskiest asset, unless the cashflows need are to be met in the immediate future.  For further discussion on the riskiness of cash in the context of retirement portfolios see here.

The second portfolio is the return seeking portfolio or growth portfolio. This is used to attain aspirational goals, objectives above essential goals. It is also required if the investor needs to take on more risk to achieve their essential goals in retirement i.e. a younger investor would have a higher allocation to the Return Seeking Portfolio.

The Growth Portfolio would be exposed to a diversified array of risk exposures, including equities, developed and emerging markets, factor exposures, and unlisted assets e.g. unlisted infrastructure, direct property, and Private Equity.

Allocations between the Hedging Portfolio and the Growth Portfolio would depend on an individual’s circumstances e.g. how far away they are from reaching their desired standard of living in retirement.

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals.

This will will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

Importantly, the framework will help facilitate a more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework also helps in assessing what is the best course of action and trade-offs involved.

For those wanting a greater appreciation of EDHEC’s framework please see their short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

A more technical review of these issues has also been undertaken by EDHEC.

Please see my Disclosure Statement

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

The case against US equities

Extremely high valuations at a time of overwhelming uncertainty sits at the core of the case against US equities.  The US equity market appears to be priced for a perfect outcome. 

For those that demand a margin of safety, there is very little safety margin right now in US equities.

GMO’s James Montier recently outlined the reasons not to be cheerful toward US equities. 

This contrasts with Goldman Sachs 10 reasons why the US equity market will move higher from here, which I covered in my last Post.

In the GMO article it is argued the US sharemarket is priced with too much certainty for a positive outcome.  Nevertheless, with so much uncertainty, such as shape of the economic recovery and effectiveness of efforts in containing further outbreaks of the coronavirus, investors should demand a margin of safety, “wriggle room for bad outcomes if you like”. 

The article concludes there is no margin of safety in the pricing of US stocks today.

In his view, “The U.S. stock market looks increasingly like the hapless Wile E. Coyote, running off the edge of a cliff in pursuit of the pesky Roadrunner but not yet realizing the ground beneath his feet had run out some time ago”.

This view in part reflects that GMO does not fully support the narrative that has primarily driven the recovery in the US stock market over recent months and is expected to provide further support.

The centre of the positive market outlook narrative is the US Federal Reserves’ (Fed) Quantitative Easing program (QE).  QE involves the buying of market securities, leading to an expansion of the Fed’s Balance Sheet.

In short, Montier thinks it is tricky to argue any direct linkage from the Fed’s balance sheet expansion programs to equities.  In previous Fed QE periods longer-term interest rates rose, which is not supportive of equities.  It is also observed, in other parts of the world where interest rates are low, equity markets are not trading on extreme valuations like in the US.

On this he concludes the “Fed-based explanations are at best ex post justifications for the performance of the stock market; at worst they are part of a dangerously incorrect narrative driving sentiment (and prices higher).” 

Further detail is provided below on why he is skeptical of positive market outlook narrative centred around ongoing support for the Fed’s policy.

The article concludes:

“Investing is always about making decisions while under a cloud of uncertainty. It is how one deals with the uncertainty that distinguishes the long-term value-based investors from the rest. Rather than acting as if the uncertainty doesn’t exist (the current fad), the value investor embraces it and demands a margin of safety to reflect the unknown. There is no margin of safety in the pricing of U.S. stocks today. Voltaire observed, “Doubt is not a pleasant condition, but certainty is absurd.” The U.S. stock market appears to be absurd.”

This view is consistent with a “long term value” based investor and has some validity.  From this perspective, the investment rationale provides a counterbalance to Goldman’s 10 reasons.

The counter argument to GMO’s interest rate view is that the fall in interest rates reflects higher private sector savings and easier monetary policy rather than pessimism about growth and corporate earnings.  Reflecting the expansionary polices of both governments and central banks corporate earnings will recover.  Although weaker, the temporary fall in corporate earnings are not in proportion to that implied by lower interest rates.  This means lower interest rates really do justify higher market valuations.

Also, the two contrasting views could be correct, the only difference being a matter of time.

Implementation of investment strategy is key at this juncture in the economic and market cycle, more so than at any time over the last 20 years.

Historical sharemarket movements and over valuation

Since reaching the lows of 23rd March 2020, the U.S. equity market has rallied almost 50% and other world markets nearly 40%.

The movements in markets have been historic from the perspective of both the speed and scale of the market declines and their rebound.

GMO provide the following graph to demonstrate how sharp the fall and rebound by comparing the Covid-19 decline to others in history, as outlined in the following graph they provide:

Source: Global Financial Data, GMO

The sharp rebound in markets has pushed the US markets back up to extreme valuation levels.

The article outlines the following observations:

  • In 1929 the U.S. market P/E was 37% above its long-term average, and earnings relative to 10-year earnings were 46% above their normal level
  • In 2000 the market P/E was 98% above its average, and earnings relative to 10-year average earnings were 37% above their normal level.
  •  

As displayed in the following graph provided, valuations are in the 95th percentile, “right up there in terms of one of the most expensive markets of all time”.

Source: Schiller, GMO

It is clear to see there is very little margin for safety with such high valuation levels set against an uncertainty economic environment.

Accommodative US Federal Reserve Policy

A portion of the GMO article addresses the notion that an expanding Fed Balance Sheet will continue to support US equities.  The notion being that QE lowers interest rates, reducing the discount rate, and therefore drives up stock markets.

James prefers to focus on fundamentals and therefore has several issues with this viewpoint:

  1. He is skeptical of a clear link between interest rates and equity valuations.  As noted, Japan and Europe both have exceptionally low interest rates, but their stock markets are not trading on extreme market valuation like the US.
  2. Interest rates are low because economic growth is low, this needs to be reflected in company valuations.  See the note below, Role of Interest Rates for a fuller explanation.
  3. QE hasn’t actually managed to lower interest rates.  As can be seen in the Graph below, all three of the completed cycles of QE have actually ended with interest rates higher than they were when the QE began.
Source: Global Financial Data, GMO

The graph also highlights how low US interest rates are!

A Note on the Role of Interest Rates

The following extract from the Article outlines James’ explanation as to the Role of Interest Rates:

“I am no longer unique in my questioning of the role of interest rates. The good people at AQR Capital released a paper in May 2020 entitled “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” In it they say, “As the risk-free interest rate is one component of the discount rate, when interest rates go up, the discount rate increases and the asset price falls – if everything else stays constant. Hence, if expected cash flows are unchanged and if the risk premium associated with those cash flows is unchanged (where the risk premium is determined by both the amount of risk exposure the cash flows have and the price of aggregate risk to those exposures in the economy), then the formula tells us how prices will change when riskless interest rates change. However, in the case of stocks, these other components rarely stay constant. Changes in real or nominal interest rates are often accompanied by (or are often a response to) changes in expected inflation and/or changes in expected economic growth, and hence expected cashflows are often changing as well. There may also be a change in the required risk premium, which is the other (and often larger) component of the discount rate. All of these components have their own dynamics and are likely simultaneously being affected by macroeconomic conditions in possibly different ways.”

Please see my Disclosure Statement

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

The case for owning equities – 10 reasons why the current bull market has further to run by Goldman Sachs

In what has been an extraordinary year, and despite a sharp bounce back from the sharemarket lows in March 2020, Goldman Sachs (GS) provides 10 strong reasons why they think US equity markets can continue to move higher from here.

GS issued their report earlier this week, 7th September 2020, after last week’s sharp declines. 

Quite rightly they highlight markets are currently susceptible to a pull back given their strong run since earlier in the year.  Nevertheless, over the longer term they think there are good reasons for them to move higher.

GS provide context in relation to the current market environment.

Firstly, the current global recession is unusual, not only to how sudden, sharp, and widespread the recession has been, also that it was not triggered by economic or market factors.  The recession was caused by government actions to restrict economic activity to contain the coronavirus.

Secondly, GS provides analysis as to the characteristics of the bear market (sharemarket fall of greater than 20%) earlier in the year.  They note it was characteristic of an “event driven” bear market (other types include structural and cyclical).  GS note that event driven bear markets typically experience falls of ~30% and are generally shorter in nature.  A sharp fall is often followed by a quick rebound.  They estimate that on average event driven bear markets take 9 months to reach their lows and fully recover within 15 months.  This compares to a structural bear market which take 3-4 years to reach their lows and around 10 years to recover.

See this Post for the history and comprehensive analysis of previous bear markets by Goldman Sachs: What too expect, navigating the current bear market.

GS also see lower returns than historically in the current investment cycle, this is expected across all asset classes.

Reasons why the current bull market has further to run

Goldman Sachs provide 10 reason why the current bull market has further to run.

Below I cover some of their reasons:

  • The market is in the first phase of a new investment cycle.  GS outline four phases of a cycle, hope, growth, optimism, and despair.  They see markets in the phase of hope, the first part of a new cycle.  2019 had the hallmarks of optimism.  The hope phase usually begins when economies are in recession as investors start to anticipate an economic recovery. 
  • The outlook for a vaccine has become more likely.  This is a positive for economic growth.  This combined with the expansionary policies by governments and central banks suggest economies will recover. 
  • The Policy environment is supportive for risk assets, including sharemarkets.
  • GS economists have recently revised up their economic forecasts.  This will likely lead to upward revisions to corporate earnings, which will help drive share prices higher.
  • Their proprietary analysis indicates there is a low level of risk for a new bear market, despite current high valuations.
  • Equities look attractive relative to other assets.  Dividend yields are attractive relative to government bonds and in GS’s view cheap relative to corporate debt, particularly those companies with strong balance sheets.
  • Although higher levels of inflation are not likely in the short/medium term, Equities offer a reasonable hedge to higher inflation expectations.
  • They see the technology sector continuing to dominate as the digital revolution continues to gather pace. They also note that many of the large tech stocks have high levels of cash and strong balance sheets. 

This article by the Financial News provides a good review of Goldman Sachs’ 10 reasons why the current bull market has further to run.

In my last Post I looked at the investment case for holding government bonds and fixed income which might be of interest.

Happy investing.

Please see my Disclosure Statement

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

Where Investment Managers Who Consistently Outperform can be found

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.

Analyzing Consistency of Manager Performance

A recent relevant study is a submission to the Australian Productivity Commission in respect of the Draft Report on ‘How to Assess the Competitiveness and Efficiency of the Superannuation System’. The analysis was undertaken by Peterson Research Institute in 2016.

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.”

Concluding Remarks

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.

Happy investing.

Please see my Disclosure Statement

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

When Alternatives to Passive Index Investing are Appropriate

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

This article by Warren and Ezra, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.

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.”

Some Context

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.

Market efficiency.

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.

Index efficacy.

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.

Equities

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).

Fixed income

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.

Concluding Comments

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.

They are not alone on this, as outlined on this previous Kiwi Investor Blog Post, there are many studies that challenge the conventional wisdom of active management.

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.

Happy investing.

Please see my Disclosure Statement

 

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

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.

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