Likely poor performing investment managers are relatively easy to identify. Great fund managers much more difficult to identify.
Good performing managers who can consistently add value over time can be identified. Albeit, a well-developed and disciplined investment research process is required.
Those managers that consistently add value are likely to be found regularly in the second quartile of peer analysis. They are neither the best nor the worst performing manager but over time consistently add value over a market index or passive investment. They are not an average manager.
These are key insights I have developed from just under 30 years of researching and collaborating with high calibre and talented investment professionals.
More importantly, modern day academic research is supportive of this view. The conventional wisdom of active management is being challenged, as highlighted in a previous Post.
The author, John Paterson, of this analysis was interviewed in a i3 article.
The key points of Peterson’s analysis and emphasized in the i3 article:
Many of the studies into the ability of active managers to consistently outperform are inherently flawed.
Most of these studies merely confirm that financial markets are not static, therefore they do not say anything about manager performance.
“The failure to find repeated top quartile performance in these ‘tests of manager consistency’ simply reflects the reality that markets are not Static, and says nothing about the existence, or otherwise, of manager consistency.”
The key flaw is that many of the studies on active management focus on the performance of only the top performing managers: whether top quartile performers are able to repeat their efforts from one period to the next.
A wider view of manager performance should be considered, all quartiles should be assessed to determine whether manager performance is random or not.
Those managers that that consistently achieved above average returns are more likely to be found in the second or third quartiles.
In the i3 interview, Paterson discusses more about the results of their research:
“Someone who consistently outperforms doesn’t necessarily look like a top quartile manager. They are more likely to be found in the second quartile,”.
The following comment is also made:
“Most asset managers intuitively know this, because markets are cyclical and if you do something that shoots the lights out in one period, it is likely to do the complete opposite in another period.”
The Australian Experience
Paterson’s analysis also found “Across the studies analysed, it was found that there is very strong evidence that investment managers available to Australian superannuation funds do perform consistently.”
Lastly Paterson comments “And experience tells us that super funds with more active managers have done better than those with largely passive mandates, and often at a lower level of volatility.”
As I have previously Posted, there are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform.
Other reasons for considering an alternatives to a passive index include no readily replicable market index exists, imbedded inefficiency within the Index, and available indices are unsuitable in meeting an investor’s objectives (e.g. Defined Pension Plans).
The decision to choose an alternative to passive investing varies across asset classes and investors.
Therefore, the traditional active versus passive debate needs to be broadened.
The article by Warren and Ezra, covered in a previous Post, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.
They provide five reasons why investors might consider alternatives to passive management.
In doing so they provide examples of circumstances under which an alternative to passive management might be preferred and appreciably widen the debate.
The identification of managers that consistently add value is one reason to consider an alternative to passive management.
There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.
Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.
Under these circumstances a passive approach no longer becomes optimal nor appropriate.
Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.
Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.
Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.
Framework for choosing an Alternative to Passive Investing
They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.
In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.
They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”
Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:
Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.
As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.
The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.
Below I have provided a description of the five reasons investors should seek an alternative to passive index.
Back ground Comments
Warren and Ezra provide some general comments on the state of the industry debate:
They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.
They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”
The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.
Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.
A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.
Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.
Cap-weighting is aligned with investor objectives.
It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.
The same is true for an endowment, insurance company, or foundation.
The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.
The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.
The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.
Reason #1: No Readily Replicable Index is Available
Passive investing assumes an effective index exists that can be easily and readily replicated.
In some instances, an appropriate index to replicate is simply not available, for example:
Unlisted assets such as Private Equity, unlisted infrastructure and direct property
Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.
In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.
Reason #2: The Passive Index Is at Odds with the Investor’s Objectives
Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.
By way of example:
Defined Benefit Pension Plan and tailored fixed-income mandates.
Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.
In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.
DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.
Such situations also exits for insurance companies, endowments, and foundations.
Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.
Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.
The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.
Reason #3: The Standard Passive Index is Inefficiently Constructed
Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.
The article presents two potential reasons an index might be inefficient and proves three examples.
They comment that an index might be inefficient for the following reasons:
the index is built on a narrow or unrepresentative universe; and
the index is constructed in a way that builds in some inefficiency.
As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.
Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.
The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).
There are many shortcomings of fixed-income indices, the article focuses on two:
Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.
Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.
Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.
Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.
However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.
Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.
The following features are outlined in the article to support such a situation:
Market inefficiency situations
Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.
The following situations may provide a manager with a competitive advantage:
Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.
Opportunities arising from differing investor objectives
Opportunities for active management to benefit may exist when:
Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
Investors have differing time horizons e.g. value investors exploit short-term focus of markets
Index fails to cover the opportunity set
The article makes the following points under this heading:
There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”
Reason #5: Skilled Managers Can Be Identified
Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.
Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.
The discussion makes the following points:
At the very least bad managers should be avoided
Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
Not all fund managers are created equal, some are good and some are bad
The research capability and skill to identify and select a manager is an important consideration.
Implementation and Costs
It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.
“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”
The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.
Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.
For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.
“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:
I’d never bet against Buffet!
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.
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.
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:
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.
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.”
Investment leadership needs to step up. It needs to project confidence that it can crack through this crisis. It then needs to re-group with the benefits of extraordinary lessons learned through extraordinary times and morph into something better. While this crisis is rightly producing stories of heroes in scrubs and gowns, the investment industry will be discovering its own heroes. They are likely to be T-shaped leaders: both sure-footed in strategy and steeped in humanity.
This is the conclusion of Roger Irwin in his recent article, the hour for leadership is now, appearing on Top1000funds.com.
T-shaped leadership involves having deep expertise in your field and a greater awareness of societal and business issues.
As he notes, investment leaders have the opportunity to make life-changing differences for people’s savings and investments. “They will do so by drawing from the widest range of leadership skills to manoeuvre through the epic challenges this crisis presents and by emerging with stronger, fairer and more sustainable businesses.”
I couldn’t agree more.
The article has a wide ranging discussion on leadership, and what will be valued in the current situation. A mix of leadership approaches is required, it is not a case of either / or but and.
As he quite rightly points out, in the current environment, safety will be high on everyone’s needs.
“This suggests that the empathy shown to workers through this period of vulnerability will be preciously valued. For example, in the choice of what’s right to do now when family issues arise while working from home; this is the time to choose to do the family thing. For the best organisations, it’s not even close.” Quite right.
There is no doubt the current environment presents a unique set of challenges.
Irwin suggests the best stories will come from “organisations where leadership and culture are strongest. They will have a few things in common: a balance in the craft of exercising dominant and serving leadership styles; a purposeful culture as a north star; clarity that profit play a supporting role in that purpose; and a culture that accommodates this ‘it’s all about the people’ moment.”
He expects a number of disruptions to organisations, the following observations are made:
Good leaders always manage to stay in touch.
There will be a growing need for emotional intelligence among investment leadership. “Employees increasingly expect work and life to be integrated and this is central to good employee experiences where well-being, purpose and personal growth rank highly and intrinsic motivations are more lasting than extrinsic forms like pay.”
There needs to be a culture of openness in the workplace. The hoarding of information is old school. “Now the open-cultured organisations can create the positive state of psychological safety at all levels with everyone feeling included. This plays to better decision making all round and helps people with their resilience during tough times.”
As mentioned above, the current environment requires leaders to be T-shaped.
The vertical bar in the T constitutes deep expertise in their field.
The horizontal bar is about having greater awareness of societal and business issues. Being more in touch. The article provides a number of examples, including: a greater understanding of stress and fight or flight responses in brain science; and the balancing of dominant and serving leadership in management science.
He suggests, we build the vertical bar in the T through being in-touch with a wider network and other disciplines.
Thank you to those who have provided support, encouragement and feedback. It has been greatly appreciated.
Before I briefly outline some of the key topics covered to date by Kiwiinvestorblog.com, the “intellectual framework” for the Blog has largely come from EDHEC Risk Institute in relation to Goals-Based investing and how to improve the outcomes of Target Date Funds in providing a more robust investment solution.
Likewise, Noble Laureate Professor Robert Merton’s perspective on designing an appropriate retirement system has been influential. Regulators and retirement solution providers should take note of his and EDHEC’s work.
Combined, EDHEC and Professor Merton, are helping to make finance useful again.
Their analysis into more robust retirement solutions have the potential to deliver real welfare benefits for the many people that face a challenging retirement environment.
A Goals-Based approach also helps the super wealthy and the High Net worth in achieving their investment and hopefully philanthropic goals, resulting in the efficient allocation of capital.
The investment knowledge is available now to achieve this.
To summaries, the key topics of Kiwi investor blog:
Likewise, much ink has been spilt over Target Date Funds. I believe these are the vehicle to achieving the mass production of the customised investment solution. Furthermore, they are likely to be the solution to the KiwiSaver Default option. The current generation have many shortcomings and would benefit by the implementation of more advanced investment approaches such as Liability Driven Investing. This analysis highlights that Target Date Funds that are 100% invested in cash at time of retirement are scandalous.
The first kiwiinvestorblog Post was an article by EDHEC Risk Institute outlining the paradigm shift developing within the wealth management industry, including the death of the Policy Portfolio, the move toward Goals-Based Investing and the mass production of customised investment solutions. These themes have been developed upon within the Blog over the last 22 months.
The mass production of customised investment solutions has been a recurrent topic. Mass customisation enabled by technology will be the Uber Moment for the wealth management industry. Therefore, the development of BlackRock and Microsoft collaborating will be worth following.
Several Posts have been on Responsible Investing. I am in the process of writing a series of articles on Responsible Investing. The next will be on Impact Investing. The key concern, as a researcher, is identifying those managers that don’t Greenwash their investment approach and as a practitioner seeing consistency in terminology. The evidence for Responsible Investing is compelling and there is a wide spectrum of approaches.
There has been a focus on the issues faced by those near or in Retirement, such as the Retirement Planning Death Zone. These discussions have led to conclusion that Warren Buffet could be wrong in recommending high allocations to a low cost index funds. Investment returns are greatly impacted by cashflows into and out of the retirement fund.
I don’t tend to Post around current market conditions; market views and analysis are readily available. I will cover a major market development, more to provide some historical context, for example the anatomy of sharemarket corrections, the interplay between economic recession and sharemarket returns, and lastly, I first covered the topic of inverted yield curves in 2018. I provided an update more recently, Recessions, inverted yield curves, and Sharemarket returns.
The Global financial backdrop can be summarised as:
The US economy is into its longest period of uninterrupted growth, it has been over ten years since the Global Financial Crisis (GFC) and the US experiencing a recession.
Likewise, the US sharemarket is into it longest period without incurring a 20% or more fall (which would be a bear market).
Exceptionally low interest rates. As you will be aware over $14 trillion of European and Japanese fixed income securities are trading on negative interest rates.
Central Banks around the world are reducing short-term interest. By way of example, the US Federal Reserve has undertaken a mid-cycle adjustment, with more to come, the European Central Bank recently cut interest rates, as has China’s Central Bank. The Reserve Bank of Australia and the Reserve Bank of New Zealand have reduced cash rates very aggressively in recent months. It appears that interest rates will remain lower for longer.
Rising geo-political risk, namely an ongoing and escalating trade dispute between the US and China, while Brexit has a cameo role on the global stage, and there are rising tensions in the middle-east.
Global growth has slowed. The pace of economic activity has slowed around the world, this is most noticeable in Europe, Japan, and China, and is concentrated within the manufacturing sector. The service sectors have largely been unaffected.
Against this backdrop the US sharemarket has outperformed, continually reaching all-time highs, likewise for the New Zealand sharemarket.
Value stocks have underperformed high growth momentum stocks. The performance differential between value and growth is at historical extremes.
Lastly emerging Markets have underperformed the developed world.
The US consumer is in very good shape, reflecting record low unemployment, rising wages, and a sound property market. The US consumer is as bigger share of the global economy as is China. Although it is not growing as fast as China, a solid pace of growth is being recorded.
Overall, economic data in the US has beaten expectations over recent weeks (e.g. retail sales).
Globally the manufacturing sectors are expected to recover over the second half of this year, leading to a rebound in global growth. Low interest rates will also help global growth. Nevertheless, growth will remain modest and inflation absent.
Globally, in most countries, Sharemarket’s dividend yields are higher than interest rates. This means that sharemarkets can fall in value over the next 5-10 years and still outperform fixed income.
How to invest in current environment
Recently there has been #TINA movement: There Is No Alternative to Equities.
Certainly equities have performed strongly on a year to date basis, so have fixed income securities (their value increases as interest rates fall).
The traditional 60/40 portfolio, 60% Equities and 40% Fixed Income, has performed very strongly over the last 6-9 months, this comes after a difficult 2018.
#TINA and the longer term performance of the 60/40 portfolio is covered in this AllAboutAlpha Article, which is well worth reading.
The 60/40 portfolio has performed well over the last 10 years, and has been a strong performer over the longer term.
This performance needs to be put into the context that interest rates have been falling for the last 35 years, this has boosted the returns from the Fixed Income component of the portfolio. Needless to say, this tail wind may not be so strong in the next 35 years.
This indicates that future returns from a 60/40 portfolio will be lower than those experienced in more recent history.
There are lots of suggestions as to what one should do in the current market environment. This article on Livewire Markets provides some flavour.
No doubt, you will discuss any concerns you have with your Trusted Advisor.
At a time like this, reflect on the tried and true:
Seek “True” portfolio Diversification
The AllAboutAlpha article references a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.
The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures”
In a nutshell, the above comments are about seeking “true” portfolio diversification.
Portfolio diversification does not come from investing in more and more asset classes i.e. asset class silos. This has diminishing diversification benefits over the longer term and particularly at the time of market crisis e.g. adding global listed property or infrastructure to a multi-asset portfolio that already includes global equities.
True portfolio diversification is achieved by investing in different risk factors (i.e. premia) that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth by way of example.
Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative and hedge fund risk premia, illiquidity e.g. Private Equity, Direct Property, and unlisted infrastructure. And of course, true alpha from active management, returns that cannot be explained by the risk exposures just outlined. There has been a disaggregation of returns.
US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures. They are a model of world best investment management practice.
Therefore, seek true portfolio diversification, this is best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates driving portfolio outcomes.
As the Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events i.e. Black Swans.
True diversification leads to a more robust portfolio.
Often the next bit advice is to make sure your investments are consistent with your risk preference.
Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from capital markets.
For example, income earned up to and after retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).
I think this is a given, and it needs to be balanced with your customised investment objectives as outlined above. Try to see through market noise, don’t over trade and don’t take on more risk to chase returns.
It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.
Also look to financial planning options to see through difficult market conditions.
AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”
Kiwiinvestorblog is all about education, it does not provide investment advice nor promote any investment and receives no payments. Please follow the links provided for a greater appreciation of the topic in discussion.
And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all weather portfolio?
A recent Research Affiliates article on rebalancing noted: “Regularly rebalancing a portfolio to its target asset mix is necessary to maintain desired risk exposure over the portfolio’s lifetime. But getting investors to do it is another matter entirely—many would rather sit in rush-hour traffic! “
“A systematic rebalancing approach can be effective in keeping investors on the road of timely rebalancing, headed toward their destination of achieving their financial goals and improving long-term risk-adjusted returns.”
Research Affiliates are referencing a Wells Fargo/ Gallup Survey, based on this survey “31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?”
I can’t understand why rebalancing of an investment portfolio is one of least liked investment activity, it adds value to a portfolio overtime, is a simple risk management exercise, and is easy to implement.
It is important to regularly rebalance a Portfolio so that it continues to be invested as intended to be.
A recent article in Plansponsor highlighted the importance of rebalancing. This article also noted the reluctance of investors to rebalance their portfolio.
As the article noted, once an appropriate asset allocation (investment strategy) has been determined, based on achieving certain investment goals, the portfolio needs to be regularly rebalanced to remain aligned with these goals.
By not rebalancing, risks within the Portfolio will develop that may not be consistent with achieving desired investment goals. As expressed in the article “Participants need to make sure the risk they want to take is actually the risk they are taking,” …………..“Certain asset classes can become over- or under-weight over time.”
Based on research undertaken by BCA Research and presented in the article “Rebalancing is definitely recommended for all investors, perhaps more so for retirement plan participants than others, as they are more likely to be concerned with capital preservation than capital appreciation.”
The following observation is also made “While a portfolio that is not rebalanced will have a greater allocation to equities during a bull market and, therefore, outperform a rebalanced portfolio, all rebalanced portfolios outperformed an unbalanced portfolio during periods leading up to market corrections and recessions,” Hanafy says, citing a BCA Research study which looked at three main rebalancing scenarios of a simple 60/40 portfolio since 1973.
The potential risks outlined above is very relevant for New Zealand and USA investors currently given the great run in the respective sharemarkets over the last 10 years.
When was last time your investment fiduciary rebalanced your investment portfolio?
Rebalancing becomes more important as you get closer to retirement and once in retirement:
“There are two main components to retirement plans: returns and the risk you take,” …… “When you do not rebalance your portfolio, a participant could inadvertently take on too much risk, which would expose them to a market correction. This is important because, statistically, as participants reach age 40 to 45, how much risk they take on is far more important than how much they save. When you are young, the most important thing is how much you save.”
As the article notes, you can systematically set up a Portfolio rebalancing approach based on time e.g. rebalance the portfolio every Quarter, six-months or yearly intervals.
It is not difficult!
Alternatively, investment ranges could be set up which trigger a rebalancing of the portfolio e.g. +/- 3% of a target portfolio allocation.
Higher level issues to consider when developing a rebalancing policy include:
Cost, the more regularly the portfolio is rebalanced the higher the cost on the portfolio and the drag on performance. This especially needs to be considered where less liquid markets are involved;
Tax may also be a consideration;
The volatility of the asset involved;
Rebalancing Policy allows for market momentum. This is about letting the winners run and not buying into falling markets too soon. To be clear this is not about market timing. For example, it could include a mechanism such as not rebalancing all the way back to target when trimming market exposures.
My preference is to use rebalancing ranges and develop an approach that takes into consideration the above higher level issues. As with many activities in investing, trade-offs will need to be made, this requires judgement.
As noted above, it appears that rebalancing is an un-liked investment activity, if not an over looked and underappreciated investment activity. This seems crazy to me as there is plenty of evidence that a rebalancing policy can add value to a naïve monitoring and “wait and see” approach.
I think the key point is to have a documented Rebalancing Policy and be disciplined in implementing the Policy.
This also means that those implementing the Rebalancing Policy have the correct systems in place to efficiently carry out the Portfolio rebalancing so as to minimise transaction costs involved.
Be sure, that those responsible for your investment portfolio can efficiently and easily rebalance your portfolio. Importantly, make sure the rebalancing process is not a big expense on your portfolio e.g. trading commissions and the crossing of market spreads (e.g. difference between buy and sell price), and how close to the “market price” are the trades being undertaken?
These are all hidden costs to the unsuspecting.
A couple of last points:
It was noted in the recent Kiwi Investor Blog on Behaviour Finance that rebalancing of the portfolio was an import tool in the kit in helping to reduce the negative impact on our decision making from behavioural bias. It is difficult to implement a rebalancing policy when markets are behaving badly, discipline is required.
The automatic rebalancing nature of Target Date Funds is an attractive feature of these investment solutions.
To conclude, as Research Affiliates sums up:
Systemic rebalancing raises the likelihood of improving longer-term risk-adjusted investment returns
The benefits of rebalancing result from opportunistically capitalising on human behavioural tendencies and long-horizon mean reversion in asset class prices.
Investors who “institutionalise contrarian investment behaviour” by relying on a systematic rebalancing approach increase their odds of reaping the rewards of rebalancing.
The first two are well known, the third, as PWM note, is flying under the radar. Combined they are the future of a successful wealth management business.
Quite obviously Robo Advice models use technology. Nevertheless, Goals-Based wealth management provides the opportunity for greater customisation and a more robust investment solution that better meets the needs of the customer.
Therefore, technology will play a major role in delivering more customised Investment Solutions to a wider range of people.
Technology is going to play a major role in the industry’s transformation.
As has been argued: “In order to be part of the fourth industrial revolution, the people-centric industry of wealth management must transform the production, customisation and distribution of retirement solutions, …..”
(See my first Kiwi Investor Blog Post, Advancements in Portfolio Management, for an article written by Lionel Martellini, of EDHEC Risk Institute, that appeared in the Journal of Investment Management in 2016: 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.)
The PWM article covered a recent symposium held in Paris focusing on fintech, quantitative management and big data, the technologically-led trends transforming the global industry.
The participants at the symposium gathered to consider: what should be the role of technology in client acquisition and servicing, data analysis, and portfolio management?
With regards to technology in general PWM note, “Private banks need to put technological solutions at the heart of their operations if they are to meet the demands raised by clients and relationship managers, though there will always be a need for human interaction”
However, having acknowledged that technology is critical for a successful Wealth Management business of the future, it appears to be a difficult issue to address. PWM “calculate that of the 150 global private banks we monitor closely for technological, business, customer-facing and portfolio management trends, less than one third have implemented a serious technological solution to the challenges encountered by their clients and relationship managers.”
“Many have only devised client-interfaces such as online forms, apps and screens allowing choices of services. But a handful have gone much further…….”
Under the radar
PWM noted that “…there is probably one technology-led sphere which is totally under-appreciated by the industry, which was highlighted at the summit. This is that of goals-driven wealth management (GDWM), ….”
Goals-Based investing is an improvement on the generic industry approach. Rather than viewing your investments as one single diversified portfolio, where the allocations are primarily based on your risk tolerance and the concept of risk is measured by volatility or standard deviation of returns, Goals-Based investing creates distinct milestones (goals) that are closely aligned with the priorities in your life.
Goals-Based investing closely matches your investment assets with your unique goals and objectives (customisation). It is the Wealth Management counterpart to Liability Driven Investing (LDI), which is implemented by pensions and insurance companies where their investment problems are reflected in the terms of their future liabilities (expected future insurance claims), much like a Wealth Management client’s future priorities (goals). LDI is also implemented by Pension Funds, particularly those with Defined Benefits, which are known future liabilities/cashflows.
More efficient use of capital – potentially need less retirement savings;
Better framework to make trade-off between allocations to equities and fixed income; and
Improved likelihood of reaching desired standard of living in retirement.
In summary, a Goals-Based investment strategy increases the likelihood of reaching a customer’s retirement income objectives. It can also achieve this with a more efficient allocation of capital. This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.
As the PWM article points out, technology is allowing “wealth managers to use institutional tools, helping clients to prepare for key life events….. Length of investment terms, risk tolerances, prices, taxes, depreciation levels can all be plugged into a model by relationship managers. Optimal asset allocations can then be arrived at and modified to plan for specific goals.“
“While few private banks currently approach this topic seriously, it surely must become the wealth management paradigm for the future. It will still require human wealth managers to advise clients and shepherd them through the process, but it will put an algorithmic system at the centre of the asset allocation decision. There is no substitute for this and it will most likely steal the very soul of wealth management.”
The Bold is mine, LDI is an institutional tool implemented to meet specific goals.
This is beyond a straight forward Robo Advice model and the filling out of a generic risk profile questionnaire. Technology is being applied to determine more customised investment solutions, taking into consideration a greater array of personal information and then implementing an investment solution using more advanced portfolio techniques, such as LDI.
The article covers other technology related issues in relation to wealth management, such as increasing competition from the likes of Google, Facebook, Alibabas and Tencents.
Importantly, PWM see room for a human element in all of this.
PWM conclude we are at the beginning of the industry’s “revolution”, technology will play a part in the success of the modern wealth manager and in capturing the next generation of investors:
“The battle for the hearts and minds of the next generation and for the soul of wealth management has yet to be fought and won. But the opening salvos have been fired.”
“Private banks have interesting weapons in their armouries. Some still need to be modernised for effectiveness. But at the moment, those that appear to be vital for future success appear to be GDWM (goals-driven wealth management) tools, networking apps and screens for impact and ethics.“
“The private bank of the future will manage, introduce and evaluate, as well as working closely with the next generation. These disciplines require a raft of technological systems and an army of relationship managers, not just to operate them, but to take the output which they deliver and use this to help build a long-term relationship with families of the future.”
Again bold is mine.
The future, according to PWM, is a raft of technology solutions with Goals-Based investing as the underlying investment solution.
The appropriate use of technology and the mass production of customised investment solutions will be the Uber moment for the Wealth Management industry. The technology and investment knowledge is available now.
The customisation of investment solutions involves a Goals-Based investment approach, based on the principles of LDI.
A winning outcome will be the combination of smart technology and the mass production of customised investment solutions that more directly meet the needs of the customer in achieving their retirement goals.
Behavioural finance is the branch of behavioural economics that focuses on finance and investment. It encompasses elements of psychology, economics, and sociology.
Behavioural finance has gained increased prominence since Daniel Kahneman was awarded the Nobel Prize for economics in 2002. (Kahneman was recently involved in analysis of the regret-proof Portfolio.)
Kahneman is best known for identifying a range of cognitive biases in his work with the late Amos Tversky. These biases, and heuristic (which are mental shortcuts we take to solve problems and make judgments quickly), are consistent deviations away from rational behaviour (as assumed by classical economics).
Richard Thaler, also awarded a Nobel Prize, has made a large contribution to Behavioural Economics, his work has had a lasting and positive impact within Wealth Management.
There is a continued drive to better understand how our behaviour affects the decisions we make.
From an investing perspective, failing to understand our behaviour can come with a cost. By way of example, the cost could be the difference between the returns on an underlying investment and the returns received by the investor.
In short, we have behavioural biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioural biases. Behavioural Finance can help us make better investment decisions.
There are lots of good sources on Behavioural Finance, none other than from Joe Wiggins, whose blog, Behavioural Investment, provides clear and practical access to the concepts of Behavioural Finance.
By way of example, Joe has recently published “A Behavioural Finance Toolkit”. This is well worth reading (Behavioural Finance Toolkit).
The Toolkit helps us understand what Behavioural Finance is and then identifies the major impediments to making effective investment decisions.
These impediments are captured in the “MIRRORS” checklist outlined below:
As the Toolkit outlines: “An understanding of our own behaviour should be at the forefront of every decision we make. We exhibit a number of biases in our decision making. While we cannot remove these biases, we can seek to better understand them. We can build more systematic processes that prevent these biases adversely influencing the decisions we make.
Investors should focus on those biases that are most likely to impact their investment decisions – and those supported by robust evidence. We have developed a checklist to reduce errors from the key behaviours that affect our investment decisions – ‘MIRRORS’.”
Myopic Loss Aversion
We are more sensitive to losses than gains, and overly influenced by short-term considerations.
We seek to conform to group behaviour and prevailing norms.
We overweight the importance of recent events.
We are poor at assessing risks and gauging probabilities.
We over-estimate our own abilities.
We focus on outcomes – the results of our decisions – when assessing their quality.
We are often persuaded by captivating stories.
The Toolkit provides detail on each of these impediments.
Risk Perception is the big one for me, particularly the ability to gauge probabilities and to effectively probability weight risks.
This is vitally important for investors and for those that sit on Investment committees.
Identifying risks is relatively easy, we tend to focus on what could go wrong.
As this The Motley Fool article highlights, being pessimistic appears to sound smart, and being optimistic as naïve. As quoted in the article: John Steward Mill wrote 150 years ago “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”
Albeit, in truth, assigning a probability to a risk, the likelihood of an event occurring, but also its impact, is a lot more difficult than merely stating a “potential” risk.
Remember, “more things can happen than will happen” – attributed to Elroy Dimson who also said “So you manage risks by comparing them to potential returns, and through diversification. Remember, just because more things can happen than will happen doesn’t mean bad things will happen.”
The Toolkit highlights that Noise affects our decision making.
“Our decisions are affected by noise; random fluctuations in irrelevant factors. This leads to inconsistent judgement. Investors can reduce the effects of noise and bias through the consistent application of simple rules.”
As quoted “Where there is judgement, there is noise, and usually more of it than you think” – Kahneman
Accordingly, the Toolkit offers six simple steps to improve our decision making; three dos and three don’ts.
Do have a long-term investment plan.
Do automate your saving.
Do rebalance your portfolio.
Don’t check your portfolio too frequently.
Don’t make emotional decisions.
Don’t trade! Make doing nothing the default.
The central point: “These six steps seem simple but are not easy. We cannot remove our biases, or ignore the noise. Instead, we must build an investment process that helps us overcome them.”
There is a lot of common sense in the six steps outlined above.
Finally the Toolkit outlines four books that have changed the way we think about thinking!
I’d like to suggest a couple of books that I value highly, which are on topic, and with a risk focus angle as well:
The Undoing Project, A Friendship That Changed Our Mind, Michael Lewis, this book outlines the relationship between Kahneman and Tversky, and the collaboration they had in developing their theories, including highlighting the different experiments they undertook. In doing so, Lewis provides practical insights into the types of biases we have in making decisions.
Against the Gods, The Remarkable Story of Risk, Peter L. Bernstein. True to its label this book provides a history of the perception of risk and its management over time, right up to modern times, emphasising: more things can happen than will happen!
Both books provide fascinating accounts of history.
Risk is not the volatility of your investment portfolio, or volatility of returns, risk is determined by your investment goals.
This is the view of Nobel laureate Professor Robert Merton. Such an assessment of risk also underpins many Goals-Based wealth management solutions.
More robust investment solutions are developed when the focus on risk moves beyond variations of returns and volatility of capital. The key risk is failure to meet your investment objectives.
The finance industry, many financial advisors and academics express risk as the variation in returns and capital, as measured by the standard deviation of returns, or variance.
Nevertheless, clients often see risk as the likelihood of not attaining their investment goals.
The traditional financial planning approach is to understand client’s goals, then ask questions to determine risk tolerance, which then leads to advising a client to adopt a portfolio that has a mean expected return and standard deviation corresponding to the Client’s risk appetite. Standard deviation of returns, variation in capital, becomes the measure of risk.
Nevertheless, a different discussion with clients on their goals will likely result in a different investment solution. It will also improve the relationship between the Client and the Advisor.
Such a discussion will lead to more individualised advice and a better understanding of the choices being made. Clients will be in a better place to understand the impacts of their choices and the probability of achieving their goals. It will be more explicit to them in making trade-offs between playing it safe and taking risks to achieve their investment goals.
A goals based approach provides a more intuitive, transparent, and understandable planning approach.
Ultimately it leads to a more robust portfolio for the Client where information from the goals-based discussion can be mapped to a specific range of portfolios.
It is also a dynamic process, where portfolios can be updated and changed on new discussions and information. The process can adapt for multiple-goals over multiple time periods.
This is in stark contrast to the single period single objective, static portfolio traditionally implemented based on risk appetite.
There is also a strong foundation in Behaviour Economics supporting the Goals-Based investment approach.
I have covered Merton’s view in previous Posts, so please don’t accuse me of confirmation bias!
Merton’s views on risk is also well presented in a 2016 i3 Invest article in Australia, Risk is determined by Investment goal.
“Risk is not simply expressed as the volatility of your invested assets, but is determined by your ultimate goal, according to Nobel laureate Robert Merton.”
The i3 article provides an example on how your goal determines to a large degree what your risk-free asset is.
The goal provides a starting point for determining:
how far removed you are from achieving your objectives; and
importantly, how much risk you need to take to have a chance of meeting these objectives.
“If you had as your goal to pay your (Australian dollar) tax bill in a year from now, then what is the safe asset for you?”
“It would be an Australian dollar, one year, zero coupon, Australian Treasury Bill that matures in one year. That would be the sure thing.”
As the i3 article mentions Merton has criticised the idea that superannuation is a pot of money, instead of a basis for generating an income stream.
Merton argues that there should be greater focus on generating replacement income in retirement and we need to stop looking at account balances and variations in account balances. Instead, we should focus on the income that can potentially be generated in retirement from the investment portfolio, pot of money.
This is not a radical idea, this is looking at the system in the same way as Defined Benefit Funds did, the “old” style funds before the now “modern” defined contributions fund (where the individual takes on all the investment risk). Defined contributions funds focus on the size of the pot. The size of the superannuation pot (Kiwisaver account balance) does not necessarily tell you the standard of living that can be supported in retirement. This is Merton’s critical point.
As Merton’s explains, if we accept we should focus on income, targeting sufficient replacement income in retirement, the development of a comprehensive income product in retirement is not difficult. He concludes, “This doesn’t require the smartest scientist in Australia to solve this problem. We know how to do it, we just need to go out and do it,”.
As noted above I have previously Posted on Merton’s retirement income views. The material from these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Professor Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.
For those wanting a greater understanding of Merton’s views and rationale please see: