Asset Allocations decisions for the conundrum of inflation or deflation?

One of the key questions facing investors at the moment is whether inflation or deflation represents the bigger risk in the coming years.

Now more than ever, given the likely economic environment in the years ahead, investors need to consider all their options when building a portfolio for their future.  This may mean a number of things, including: increasing diversification, investing in new or different markets, being active, and flexible to take advantage of unique opportunities as they arise.

Those portfolios overly reliant on traditional markets, such as equities and fixed income in particular, run the risk of failing to meet to their investment objectives over the next ten years.

Conundrum Facing Investors

A recent article by Alan Dunne, Managing Director, Abbey Capital, The Inflation-Deflation debate and its Implications for Asset Allocation, which recently appeared in AllAboutAlpha.com, clearly outlines the conundrum currently facing investors.

As the article highlights, one of the “key questions facing investors at the moment is whether inflation or deflation represents the bigger risk for the coming years. Economists are split on this….”

Following a detailed analysis of the current and likely future economic environment and potential influences on inflation or deflation (which is well worth reading) the article covers the Implications for Asset Allocations.

Inflation or Deflation: Implications for Asset Allocations

The article makes the following observations as far as asset class performance in different inflation environments, based on historical observations:

  • Deflation like in the 1930s, is negative for equities but positive for Bonds.
  • If inflation picks ups, or even stagflation, that would be negative for real returns on financial assets and real assets may be favoured.

They conclude: “the current uncertainty highlights the importance of holding diversified portfolios, with exposure to a range of traditional and alternative assets and strategies with the potential to deliver returns in different market environments.”

Current Environment

Abbey Capital anticipate greater co-ordination of policy between governments (fiscal policy) and central banks (monetary policy). 

As they note, “many economists draw a parallel between the current scenario and the substantial increase in government debt during World War II. One of the consequences of higher debt levels is that we may see pressure on central banks to maintain interest rates at low levels and maintain asset purchases to ensure higher bond issuance is not disruptive for bond markets i.e. coordination of monetary and fiscal policies.”

I think this will be the case.  The Bank of Japan has maintained a direct yield curve control policy for some time and the Reserve Bank of Australia has implemented a similar policy recently.  Direct yield curve control is where the central bank will target an interest rate level for the likes of the 3-year government bond.

In the environment after World War II debt levels were brought back to more manageable levels by keeping interest rates low (a process known as financial repression).

From a government policy perspective, financial repression reduces the real value of debt over time.  It is the most palatable of a number of options.

Financial repression is potentially negative for government bonds

With interest rates so low, and likely to remain low for some time given policies of financial repression the real return (after inflation) on many fixed income instruments and cash could be negative.

A higher level of inflation not only reduces the real return on bonds but potentially also reduces the diversification benefits of holding bonds in a portfolio with equities.

The diversification benefits of bonds in the traditional 60 / 40 equity-bond portfolio (Balanced Portfolio) has been a strong tail wind over the last 20 years.

The more recent low correlation between bonds and equities is evident in the Chart below, which was presented in the article.

The Chart also highlights that the relation of low correlation between equities and bonds, which benefits a Balanced Portfolio, has not always been present.

As can be seen in the Chart, in the 1980s, when inflation was a greater concern, inflation surprises were negative for both bonds and equities, they became positively correlated.

What should investors do?

“Investors are therefore left with the challenge of finding alternatives for government bonds, ideally with a low or negative correlation to equities and protection against possible inflation.”

The article runs through some possible investment solutions and approaches to meet the likely challenges ahead.  I have outlined some of them below.

I think duration (interest rate risk) and credit can still play a role within a broad and truly diversified portfolio.  Within credit this would likely involve expanding the universe to include the likes of high yield, securitised loans, private debt, inflation protections securities, and emerging market debt as examples.

The key and most important point is that a robust portfolio will be less reliant on tradition asset classes, traditional asset class betas, to drive investment return outcomes.  This is likely to be vitally important in the years ahead.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios.  Not only within asset classes, such as the fixed income example provided above, but across the portfolio to include the likes of real assets and liquid alternatives.

Real assets

Abbey Capital comment that “Real assets such as property and infrastructure should provide protection against higher inflation for long-term investors but may not be attractive for investors valuing liquidity.”

Although the maintenance of portfolio liquidity is important, Real assets can play an important role within a robust portfolio.

For the different types of real assets, their investment characteristics, and likely performance and sensitivity to different economic environments, including economic growth, inflation, inflation protection, stagflation, and stagnation please see the Kiwi Investor Blog Post, Real Assets Offer Real Diversification.  The extensive analysis has been undertake by PGIM.  

Liquid Alternatives

Abbey Capital provide a brief discussion on liquid alternatives with a focus on managed futures.  Not surprisingly given their pedigree.

They provide the following Table which highlights the benefit of liquid alternatives and hedge funds at time of significant sharemarket declines (drawdowns).

Concluding Remarks

Being a managed futures manager, it is natural to be cautious of Abbey Capitals concluding remarks, being reminded of the Warren Buffet quote, “Never ask a barber if you need a haircut.”

Nevertheless, the Abbey Capital’s economic analysis and investment recommendations are consistent with a growing chorus, all singing from a similar song sheet. (Perhaps we could call this a “Barbers Quartet”!)

Without having an axe to grind, and in all seriousness, I have covered similar analysis and comments in previous Posts, the conclusions of which have a high degree of validity and should be considered, if not a purely from portfolio risk management perspective so as to understand any gaps in current portfolios for a number of likely economic environments.

The key and most important point is that robust portfolios will be less reliant on traditional asset classes, traditional asset class betas, to drive investment return outcomes.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios

Therefore, it is hard to disagree with one of the concluding remarks by Abbey Capital “To account for the competing requirements in a portfolio of returns, low correlation to equities, liquidity and possible inflation protection, investors may need to build robust portfolios with a broader mix of assets and strategies.”

Other Reading

For those interested, previous Kiwi Investor Blog posts of relevance to the Abbey Capital article include:

Preparing your Portfolio for a period of Higher Inflation, this is the Post of most relevance to the current Post, and covers a recent Man article which undertook an analysis of the current economic environment and historical episodes of inflation and deflation.

Man conclude that although inflation is not an immediate threat, the likelihood of a period of higher inflation is likely in the future, and the time to prepare for this is now.  Man recommends several investment strategies they think will outperform in a higher inflation environment.

Protecting your portfolio from different market environments – including tail risk hedging debate, compares the contrasting approaches of broad portfolio diversification and tail risk hedging to manage through difficult market environments. 

It also includes analysis by PIMCO, where it is suggested to “diversify your diversifiers”.

Lastly, Sharemarket crashes – what works best in minimising losses, market timing or diversification, covers a research article by AQR, which concludes the best way to manage periods of severe sharemarket decline is to have a diversified portfolio, it is impossible to time these episodes.  AQR evaluates the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

Happy investing.

Please see my Disclosure Statement

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

Protecting your Portfolio from different market environments – including tail risk hedging

Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or an ongoing and uninterrupted endowment.

 

The complexity and different approaches to providing portfolio protection (tail-risk hedging) has been highlighted by a recent twitter spat between Nassim Nicholas Taleb, author of Black Swan, and Cliff Asness, a pioneer in quant investing.

The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

I provide a summary of the contrasting perspectives in the Table below as outlined by Brown’s article, who considers both men as his friends.

There are certainly some important learnings and insights in contrasting the different approaches.

 

PIMCO recently published an article Hedging for Different Market Scenarios. This provides another perspective.

PIMCO provide a brief summary of different strategies and their trade-offs in diversifying a Portfolio.

They outline four approaches to diversify the risk from investing in sharemarkets (equity risk).

In addition to tail risk hedging, the subject of the twitter spat above between Taleb and Asness, and outlined below, PIMCO consider three other strategies to increase portfolio diversification: Long-term Fixed Income securities (Bonds), managed futures, and alternative risk premia.

PIMCO provide the following Graph to illustrate the effectiveness of the different “hedging” strategies varies by market scenario.PIMCO_Hedging_for_Different_Market_Scenarios_1100_Chart1_58109

As PIMCO note “it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.”

As they emphasise “not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.”

A brief description of the diversifying strategies is provided below:

  • Long Bonds – holding long term (duration) high quality government bonds (e.g. US and NZ 10-year or long Government Bonds) have been effective when there are sudden declines in sharemarkets. They are less effective when interest rates are rising. (Although not covered in the PIMCO article, there are some questions as to their effectiveness in the future given extremely low interest rates currently.)
  • Managed Futures, or trend following strategies, have historically performed well when markets trend i.e. there is are consistent drawn-out decline in sharemarkets e.g. tech market bust of 2000-2001. These strategies work less well when markets are very volatile, short sharp movements up and down.
  • Alternative risk premia strategies have the potential to add value to a portfolio when sharemarkets are non-trending. Although they generally provide a return outcome independent of broad market movements they struggle to provide effective portfolio diversification benefits when there are major market disruptions. Alternative risk premia is an extension of Factor investing.
  • Tail risk hedging, is often explained as providing a higher degree of reliability at time of significant market declines, this is often at the expense of short-term returns i.e. there is a cost for market protection.

 

A key point from the PIMCO article is that not one strategy can be effective in all market environments.

Therefore, maintaining an array of diversification strategies is preferred “investors should “diversify their diversifiers””.

 

It is well accepted you cannot time markets and the best means to protect portfolios from large market declines is via a well-diversified portfolio, as outlined in this Kiwi Investor Blog Post found here, which coincidentally covers an AQR paper. (The business Cliff Asness is a Founding Partner.)

 

A summary of the key differences in perspectives and approaches between Taleb and Asness as outlined in Aaron Brown’s Bloomberg’s article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

My categorisations Asness Taleb
Defining a tail event Asness refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index.

Research by AQR shows that steep declines that last three months or less do little or no damage to 10-year returns.

It is the long periods of mediocre returns, particularly three years or longer, that damages longer term performance.

Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. (Black Swan)

Therefore, he is scathing of strategies designed to do well in past disasters, or based on models about likely future scenarios.

 

 

 

Different Emphasis

The emphasis is not only on surviving the tail event but to design portfolios that have the highest probability of generating acceptable long-term returns.   These portfolios will give an unpleasant experience during bad times.

 

Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. Cash provides a more pleasant outcome and greater options at times of a crisis.

Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.

Different approaches AQR strategies usually involve leverage and unlimited-loss derivatives.

 

Taleb believes this approach just adds new risks to a portfolio. The potential downsides are greater than the upside.
Costs AQR responds that Taleb’s preferred approaches are expensive that they don’t reduce risk.

Also, the more successful the strategy, the more expensive it becomes to implement, that you give up your gains over time e.g. put options on stocks

Taleb argues he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk.

 

 

Investor behaviours Asness argues that investors often adopt Taleb’s like strategies after a severe market decline. Therefore, they pay the high premiums as outlined above. Eventually, they get tire of the paying the premiums during the good times, exit the strategy, and therefore miss the payout on the next crash. Taleb emphasises the bad decisions investors make during a market crisis/panic, in contrast to AQR’s emphasis on bad decisions people make after the market crisis.

 

 

 

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

The psychology of Portfolio Diversification

In a well-diversified portfolio, when one asset class is performing extremely well (like global equity markets), the diversified portfolio is unlikely to keep pace.

In these instances, the investor is likely to regret that they had reduced their exposure to that asset class in favour of greater portfolio diversification.

This is a key characteristic of having a well-diversified portfolio. On many occasions, some part of the portfolio will be “underperforming” (particularly relative to the asset class that is performing strongly).

Nevertheless, stay the course, over any given period, diversification will have won or lost but as that period gets longer diversification is more and more likely to win.

True diversification comes from introducing new risks into a portfolio. This can appear counter-intuitive. These new risks have their own risk and return profile that is largely independent of other investment strategies within the Portfolio. These new risks will perform well in some market environments and poorly in others.

Nevertheless, overtime the sum is greater than the parts.

 

The majority of the above insights are from a recent Willis Tower Watson (WTW) article on Diversification, Keep Calm and Diversify.

The article provides a clear and precise account of portfolio diversification.  It is a great resource for those new to the topic and for those more familiar.

 

WTW conclude with the view “that true diversification is the best way to achieve strong risk adjusted returns and that portfolios with these characteristics will fare better than equities and diversified growth funds with high exposures to traditional asset classes in the years to come.”

 

Playing with our minds – Recent History

As the WTW article highlights the last ten-twenty years has been very unusual for both equity and bond markets have delivered excellent returns.

This is illustrated in the following chart they provide, the last two rolling 10-year periods have been periods of exceptional performance for a Balanced Portfolio (60%/40% equity/fixed income portfolio).

WTW Balance Fund Performance

 

WTW made the following observations:

  • The last ten years has tested the patience of investors when it comes to diversification;
  • For those running truly diversified portfolios, this may be the worst time to change approach (the death of portfolio diversification is greatly exaggerated);
  • Diversification offers ‘insurance’ against getting it wrong e.g. market timing; and
  • Diversification has a positive return outcome, unlike most insurance.

 

WTW are not alone on their view of diversification, for example a AQR article from 2018 highlighted that diversification was the best way to manage periods of severe sharemarket declines, as recently experienced.  I covered this paper in a recent Post: Sharemarket crashes – what works best in minimising losses, market timing or diversification.

 

WTW also note that it is difficult to believe that the next 10-year period will look like the period that has just gone.

There is no doubt we are in for a challenging investment environment based on many forecasted investment returns.

 

What is diversification?

WTW believe investors will be better served going forwards by building robust portfolios that exploit a range of return drivers such that no single risk dominates performance. (In a Balanced Portfolio of 60% equities, equities account for over 90% of portfolio risk.)

They argue true portfolio diversification is achieved by investing in a range of strategies that have low and varying levels of sensitivity (correlation) to traditional asset classes and in some instances have none at all.

Other sources of return, and risks, include investing in investment strategies with low levels of liquidity, accessing manager skill e.g. active returns above a market benchmark are a source of return diversification, and diversifying strategies that access return sources independent of traditional equity and fixed income returns. These strategies are also lowly correlated to traditional market returns.

 

Sources of Portfolio Diversification

Hedge Funds and Liquid Alternatives

Hedge Funds and Liquid Alternatives are an example of diversifying strategies mentioned above. As outlined in this Post, covering a paper by Vanguard, they both bring diversifying benefits to a traditional portfolio.

Access to the Vanguard paper can be found here.

 

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

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

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Private Markets

TWT also note there are opportunities within Private Markets to increase portfolio diversification.

There will be increasing opportunities in Private markets because fewer companies are choosing to list and there are greater restrictions on the banking sector’s ability to lend.

This is consistent with key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The factors mentioned above, along with the low interest rate environment, the expected shortfall in superannuation accounts to meet future retirement obligations, and the maturing of emerging markets are expected to drive the growth in alternative investments over the decade ahead.

A copy of the CAIA report can be found here. I covered the report in a recent Post: CAIA Survey Results – The attraction of Alternative Investments and future trends.

 

TWT expect to see increasing opportunities across private markets, including a “range from investments in the acquisition, development, and operation of natural resources, infrastructure and real estate assets, fast-growing companies in overlooked parts of capital markets, and innovative early-stage ventures that can benefit from long-term megatrends.”

Continuing the theme of lending where the banks cannot, they also see the opportunity for increasing portfolios with allocations to Private Debt.

WTW provided the following graph, source data from Preqin

WTW Private Market Performance

 

Real Assets

In addition to Hedge Funds, Liquid Alternatives, and Private markets (debt and equity), Real Assets are worthy of special mention.

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. The PGIM report on Real Assets can be found here. I provided a summary of their analysis in this Post: Real Assets offer real diversification benefits.

 

Conclusion

To diversify a portfolio it is recommended to add risk and return sources that make money on average and have a low correlation to equities.

Diversification should be true both in normal times and when most needed: during tough periods for sharemarkets.

Diversification is not the same thing as a hedge. Although “hedges” make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term. Think of this as the cost of “insurance”.

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

Importantly, investing in more and more traditional asset classes does not equal more diversification e.g. listed property.  As outlined in this Post.

 

As outlined above, we want to invest in a combination of lowly correlated asset classes, where returns are largely independent of each other. A combination of investment strategies that have largely different risk and return drivers.

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

 

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

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

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

 

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

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

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

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

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

 

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

 

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

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

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

 

The Attraction of Alternatives

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

Percentage of Global Investible Market CAIA

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

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

Those saving for retirement have several options, including:

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

 

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

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

 

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

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

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

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

Rationale for investing in Alternatives CAIA

 

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

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

 

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

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

 

Manager Selection

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

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

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

Manager Performance Dispersion CAIA

 

Future Trends

Hedge Funds and Liquid Alternatives

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

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

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

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

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

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

 

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

 

Private Equity and Venture Capital

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

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

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

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

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

 

Real Assets

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

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

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

 

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

 

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

 

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

 

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

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

 

The CAIA report is well worth reading.

 

Happy investing.

Please see my Disclosure Statement

 

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

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

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

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

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

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

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

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

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

 

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

 

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

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

 

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

The success of which largely rests with manager selection.

 

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

 

The challenges and characteristics of Portfolio Diversification

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

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

 

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

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

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

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

 

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

 

Adding diversifying strategies to any portfolio means adding new risks.

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

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

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

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

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

 

Background

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

 

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

 

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

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

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

 

Diversification Benefits

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

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

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

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

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

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

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

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

 

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

 

The Cost of Hedging

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

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

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

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

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

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

 

AQR Conclude

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

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

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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

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

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

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

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

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

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

 

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

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

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

 

Benefits of Hedge Funds and Liquid Alternatives

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

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

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

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

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Blending Alternative investment strategies can smooth the ride

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

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

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

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

 

Framework for Manager Selection

Vanguard suggest a framework for manager selection

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

 

Liquid Alternatives are often the Prudent Option

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

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

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

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

 

Performance Comparison

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

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

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

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

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

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

 

To Conclude

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

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

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

Individual preferences and constraints will largely drive allocations to each.

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

Manager selection is key.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Balanced Fund Bear Market and the benefits of Rebalancing

Balanced Funds are on track to experience one of their largest monthly losses on record.

Although this largely reflects the sharp and historical declines in global sharemarkets, fixed income has also not provided the level of portfolio diversification witnessed in previous Bear markets.

In the US, the Balanced Portfolio (60% Shares and 40% Fixed Income) is experiencing declines similar to those during the Global Financial Crisis (GFC) and 1987.

In other parts of the world the declines in the Balance Portfolio are their worst since the   1960s.

As you will be well aware the level of volatility in equity markets has been at historical highs.

After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:

  • Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
  • Its quickest period to fall into a Bear market, a fall of greater than 20%, 22 days.

The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.

The 22 day plunge from 19th February’s historical high into a Bear market was half the time of the previous record set in 1929.

Volatility has also been historical to the upside, including near record highest daily positive returns and the most recent week was the best on record since the 1930s.

 

Volatility is likely to remain elevated for some time. The following is likely needed to be seen before there is a stabilisation of markets:

  • The Policy response from Governments and Central Banks is sufficient to prevent a deepening of the global recessions;
  • Coronavirus infection rates have peaked; and
  • Cheap valuations.

Although currently there are cheap valuations, this is not sufficient to stabilise markets. Nevertheless, for those with a longer term perspective selective and measured investments may well offer attractive opportunities.

Please seek professional investment advice before making any investment decision.

For those interested, my previous Post outlined one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

 

The Impact of Market Movements and Benefits of Rebalancing

My previous Post emphasised maintaining a disciplined investment approach.

Key among these is the consideration of continuing to rebalance an investment Portfolio.

Regular rebalancing of an investment portfolio adds value, this has been well documented by the research.  The importance and benefits of Rebalancing was covered in a previous Kiwi Investor Blog Post which may be of interest: The balancing act of the least liked investment activity.

Rebalancing is a key investment discipline of a professional investment manager. A benefit of having your money professionally managed.

Assuming sharemarkets have fallen 25%, and no return from Fixed Income, within a Balanced Portfolio (60% Shares and 40% Fixed Income) the Sharemarket allocation has fallen to 53% of the portfolio.

Therefore, portfolios are less risky currently relative to longer-term investment objectives. A disciplined investment approach would suggest a strategy to address this issue needs to be developed.

 

As an aside, within a New Zealand Balanced Portfolio, if no rebalancing had been undertaken the sharemarket component would have grown from 60% to 67% over the last three years, reflecting the New Zealand Sharemarket has outperformed New Zealand Fixed Income by 10.75% per year over the last three years.

This meant, without rebalancing, Portfolios were running higher risk relative to long-term investment objectives entering the current Bear Market.

Although regular rebalancing would have trimmed portfolio returns on the way up, it would also have reduced Portfolio risk when entering the Bear Market.

As mentioned, the research is compelling on the benefits of rebalancing, it requires investment discipline. In part this reflects the drag on performance from volatility. In simple terms, if markets fall by 25%, they need to return 33% to regain the value lost.

 

Investing in a Challenging Investment Environment

No doubt, you will discuss any current concerns you have with your Trusted Advisor.

In a previous Post I reflected on the tried and true while investing in a Challenging investment environment.

I have summarised below:

 

Seek “True” portfolio Diversification

The following is technical in nature and I will explain below.

A recent AllAboutAlpha article referenced 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”.

For the professional Investor this Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

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

 

We are currently experiencing a Black Swan, an unexpected event which has a major effect.

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. This has diminishing diversification benefits over the longer term and particularly at time of market crisis.

True portfolio diversification is achieved by investing in different risk factors (also referred to as premia) that drive the asset classes e.g. duration (movements in interest rates), economic growth, low volatility, value, and market momentums by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market risk (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative, and hedge fund risk premia. 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 investment 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 the best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates to drive portfolio outcomes.  As the Deutsche Bank Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events e.g. Black Swans.

True diversification leads to a more robust portfolio.

 

Customised investment solution

Often the next bit of  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 investment markets.

For example, level of income earned up to 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).

Also look to financial planning options to see through difficult market conditions.

 

Think long-term

I think this is a given, and it needs to be balanced with your investment objectives as outlined above.

Try to see through market noise and volatility.

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.

Remain disciplined.

 

There are a lot of Investment Behavioural issues to consider at this time to stop people making bad decisions, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwi Investor Blog is all about education, it does not provide investment advice nor promote any investment, and receives no financial benefits. 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?

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

Navigating through a Bear market – what should I do?

To all Kiwi Investor Blog readers, I hope you are staying safe and healthy. My thoughts are with you from a health perspective and for those facing the economic consequences on businesses and families from the spread of the coronavirus.

 

In the current market environment there is much uncertainty and many are wondering what to do with their investments.

The key questions being asked are should we switch to a more conservative investment or get out the markets all together.

 

One of the best discussions on why to remain invested is provided by FutureSafe in a letter to their client’s 15th March.

FutureSafe provide one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

They have reproduced the letter in the hope that it might be helpful and of interest to the broader investing community.

As they emphasis, please consult your advisor or an investment professional before making any investment decisions. In New Zealand, the FMA has also provided recent guidance on this issue, KiwiSaver providers should be providing general (class) advice to members at this time. Their full guidance on Kiwisaver Advice is here.

 

I have provided the main points below of the FutureSafe letter to clients, nevertheless the letter is well worth reading in full.

The first question is do you have too much invested in the market?

As FutureSafe highlight, the average declines of bear markets since WWII have been over 30%, with some declines as large as 60%. It has generally taken on average 2 years to recover.

 

My last Post, What to expect, navigating the current Bear-Market, presented research from Goldman Sachs on the historical analysis of bear markets in US equities going back to the 1800s. At this stage, we are likely experiencing an Event-Driven Bear market.  These Bear markets tend to be less severe, but the speed of the fall in markets is quicker, as is the recover.

However, as Goldman Sachs note none of the previous Event-Driven Bear markets were triggered by the outbreak of a virus, nor were interest rates so low at the start of the market decline.

Historically Event-Driven bear markets on average see falls of 29%, last 9 months and recover within 15 months. Nevertheless, the current Bear could transform into a cyclical bear market if containment efforts lead to a larger global recession than anticipated.

 

Back to FutureSafe. You should only take the risk you can stomach, or technically speaking, is aligned with your “risk appetite”. Which is a level of risk that does not keep you awake at night.  Unfortunately, we often don’t know our risk appetite until we experience significant market events like we are experiencing currently. We are often over-confident as to the level of market volatility we can tolerate.

FurtureSafe conclude “Now that we are in a downturn, if you have come to the conclusion that your risk appetite is not what you thought it was, it’s perfectly OK to acknowledge that and change your safety net accordingly.”

However, before you do anything, FutureSafe ask you to read through and consider a few reasons why not to do anything at this time might be appropriate.

Reason 1

If management of risk appetite is not your motivation, perhaps you are planning on selling now, with the conviction markets will continue to fall, and you plan on buying back in later.

You are essentially making an active investment decision and attempting to time markets.

Timing markets is very hard to do. Professional Investors are not very good at it.

The data on the average mutual fund investor is also not very complimentary. As FutureSafe note the “the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.”  A mutual Fund is like a Unit Trust or KiwiSaver Fund in New Zealand.

I depart from the FutureSafe article and provide the graph below from PIMCO.

As PIMCO highlight, “Through no fault of their own – and especially when market volatility strikes – investors tend to be their own worst enemy.”

The graph below highlights that investors do not capture all of the returns from the market, which can be attributed to behavioural biases that leads to inappropriate timing of  buying and selling.

This investor behavioural gap is well documented.

In reference to market timing and in one short sentence, FutureSafe say “We’re probably not as good at these active calls as we think we are, and it might hurt more than help.”

PIMOC Behaviour gap

Reason 2

A large portion of returns are earned on days markets make large gains.

Although the extreme volatility being witnessed currently is very painful to watch, amongst them are explosive up days. Attempting to time markets might cause you to miss these valuable up days.

The research on this is also very clear.

As outlined in the Table below, if you had missed the top 15 biggest return days your yearly return would have been 3.6% compared to 7% per year if you had remained fully invested (this is over the period January 1990 to March 2020 and being invested in the US S&P 500 Index).

Missing large daily returns

Of course, the same can be said if you missed the largest down days. Nevertheless, good luck at avoiding these days and still being able to fully capture the returns from equity markets.  The down days represent the risk of investing in shares.

Most important is having a disciplined investment approach and an investment portfolio consistent with your risk appetite and is truly diversified so as to limit the impact of the poor periods of performance in sharemarkets.

In summary, FutureSafe note, “Missing just a few of the top up days, can cost you a large chunk of the market’s returns.”

 

Reason 3

Take a long-term perspective.

Overtime, and with hindsight, large market declines look like minor setbacks over the longer term, the very long term.

This is quite evident from the following graph.

Remember, the stock market fell by 20% over one day in 1987, the dot-com crash of 2000 or even the Great Financial Crisis of 2008 don’t look to bad with a longer term perspective.

Take a longer term perspective

As FutureSafe conclude “If you really don’t need the money for a long period of time (e.g. 10 or 15 years) these are best to ride out because they look a lot better in the rear view mirror than when you are going through it.”

“If you have a long enough horizon (10 to 15 years or more), the chances of doing well in the stock market is still quite good.”

 

Therefore, the key points to consider are:

  • Risk Appetite should primarily drive your allocation to sharemarkets, not the current market environment;
  • We can’t time markets, not even the professionals;
  • Be disciplined and maintain a well-diversified investment portfolio, this is the best way to limit market declines, rather than trying to time markets;
  • Take a longer-term view; and
  • Seek out professional investment advice

 

Keep safe and healthy.

 

Happy investing.

 

Please read my Disclosure Statement

 

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

Why the Balanced Fund is expected to underperform

GMO concluded some time ago the time was right to consider moving away from the 60/40 Portfolio. Which is a “Balanced Portfolio” of 60% equities and 40% fixed income.

 

In a more recent note, GMO identify two key problems that lie ahead for the Balanced Portfolio, which are supportive of their conclusion. Which I think are problems facing all investors, but particularly for US and New Zealand investors.

 

First, stock and bond valuations are both extended, suggesting they will deliver less than they have historically.

As GMO point out, the math with fixed income (bonds) is straightforward. The 10-Year U.S. Treasuries yield is under 1% today. New Zealand’s yield is also near 1%.

Today’s yield is the best predicator of future returns.

Real returns, after inflation, will likely be negative over the next 10 years from fixed income.

In short, GMO highlight “It is more or less impossible for a bond index yielding roughly 2% to deliver the 5% nominal returns investors have become accustomed to over any period of time approaching or exceeding the index’s duration.”

 

GMO also highlight stockmarket valuations have risen. Recent market weakness provides some valuation relief, albeit, US valuations remain elevated relative to history.

 

GMO conclude, “the passive 60/40 portfolio will likely deliver disappointing returns. The low starting yield of a 60/40 portfolio represents the first problem we see ahead.”

 

The second issue identified by GMO is that risks within fixed income have risen, and not just from a valuation perspective.

As can be seen in the graph below, provided by GMO, duration is near its highest level in history. (Duration is the key measure of risk for a fixed income portfolio. It measures the sensitivity of a fixed income security’s price movements to changes in interest rates.)

Global duration

 

So, not only are interest rates at historical lows (low expected returns), but risk, as measured by duration, is amongst highest level in history.

 

This dynamic, low expected returns and heightened risk highlights the folly of an Index approach, similarly a set and forget approach in allocating to different asset classes. Similar dynamics also play out in sharemarket indices. Risks within markets vary over time.

Furthermore, the credit risk of many fixed income indices is also higher now than compared to the Global Financial Crisis. BBB and AA rated securities currently make up a greater proportion of the fixed income indices. Therefore, the credit quality of these indices has fallen over the last ten years, while the amount of corporate debt has grown. These dynamics need to be considered, preferably before the next credit crisis.

 

As GMO point out “Today, the sensitivity of a 60/40 portfolio to a change in yield is nearly as high as it has ever been. Both stocks and bonds are levered to future changes in discount and interest rates. Even a small amount of mean reversion upward in the aggregate yield of the 60/40 portfolio will be painful because there is less underlying yield to cushion any capital losses and those capital losses should be expected to be larger than normal for any change in yield given the high duration.”

 

Because of the higher duration and lower yields, smaller movements higher in interest rates will result in greater capital losses from fixed income securities compared to times when yields were higher. This is also the math.

At the same time, given the high valuation of sharemarkets, they are more susceptible to a movement higher in interest rates. Particularly those sectors of the equity market more sensitive to interest rate movements such as Listed Property.

Therefore, the historical diversification benefits from holding fixed income and equities are likely to less in the future.

 

GMO conclude “While investors have become conditioned to believe that a 60/40 portfolio delivers consistently strong returns, history shows this has not always been the case and the twin problems weighing on such a construction today suggest robust returns are unlikely going forward. Due to elevated valuations (low yields) and extended durations of both stocks and bonds, it is possible that in a future downturn investors will not receive the diversification they expect from their bond portfolio. Stocks and bonds have risen together and could certainly fall in unison as well.”

 

Although recent market events may have delayed this moment, they have not derailed the underlying dynamics within a Balanced Portfolio which will see it struggling to meet investor’s expectations over the next decade.  The risks identify above remain.

 

The Balanced Portfolio is riskier than many appreciate. I covered this in a previous Post. It is not uncommon for the Balanced Portfolio to have a lost decade of returns and losses of up to 30% over a twelve-month period.

 

Possible Solution

To address the threats to the Balanced Portfolio identified above GMO suggest the inclusion of Liquid Alternatives across multi-asset portfolios.

Such strategies provided portfolio diversification, importantly they have very little duration risk within them, a risk both equities and fixed income are exposed too.

GMO articulate the benefits of such strategies as follows: “Liquid Alternatives can provide diversifying and uncorrelated returns. While Alternatives should not be expected to keep up with robust equity markets, they can help shield large drawdowns given their lower equity beta exposure.”

Liquid alternatives largely generate their return outcomes independently from the returns generated by equity markets (beta) and fixed income market (duration). Thus they provide exposure to different risk and return outcomes from equities and fixed income.

GMO conclude “Liquid alternatives improve the robustness of our multi-asset portfolios by helping to protect against the problems that today’s low yields and high durations present.”

 

The benefits of such strategies has been evident over the last few weeks, helping to diversify portfolios from the sharp fall in global sharemarkets as a result of the spreading of the coronavirus.

 

To finish, I would add to the GMO commentary that well diversified portfolios should also have an exposure to Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.  These assets offer real diversification benefits relative to equities and fixed income, and to Balanced Portfolio in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

I covered the investment characteristics and  benefits of Real Assets to a Balanced Portfolio in different economic environments in a recent Post.

 

Happy investing.

 

Please read my Disclosure Statement

 

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

 

Small Foundations, Charities, investing like large Endowment Funds – a developing trend

The Orange County Community Foundation (OCCF) runs its $400m investments portfolio like a multi-billion-dollar endowment.

They have adopted an investment strategy that is more active than passive, emphasizes alternative investments like hedge funds and private equity, and targets geographies and asset classes not typically found in community foundation portfolios in the US.

The result is a portfolio that looks like that of an endowment more than twice the size of OCCF.

According to a recent Institutional Investor article OCCF are not alone in taking such an approach amongst the smaller Foundations found in the US.

The Institutional Investor article emphasises that not all Foundations and Charities can look like Yale and consider the Endowment Fund model.

Having said that, smaller Funds can take the learnings from the larger Endowments and should look to access a more diverse range of investment strategies.

 

Size should not be an impediment to investing with great managers and implementing more advanced and diversified investment strategies.

 

As the article also highlights, many Foundations and Charities have a long-term endowment. Often when you take a closer look at the Foundations and Charities endowments and cashflows they have a profile that is well suited to an endowment model.

 

They key benefits of the Endowment model include less risk being taken and the implementation of a more diversified investment strategy, delivering a more stable return profile.

 

This is attractive to donors.

According to the article, OCCF’s “investment performance over the past four-and-a-half years has encouraged more contributions from donors — and this increase in donations, combined with the above-benchmark returns, has enabled the foundation to pay out more grants and scholarships without sacrificing growth.”

 

What did OCCF do?

After a review of the OCCF’s investments their asset consultant, Cambridge Associates, helped them develop a new investment strategy allocation plan that was more diversified and contained higher exposures to alternative investments.

Cambridge Associations determined that OCCF had large enough long-term pools and high enough donations coming in to support more illiquid investments in the private markets.

 

What changed?

The foundation, which had a 2 percent allocation to private equity in 2015, now has 8 percent of its investable assets committed to private equity investments, with the eventual goal of scaling the asset class to 20 percent of the total portfolio.

Other changes included adopting a 10 percent target for real assets and 15 percent allocation to hedge funds.

OCCF has also started making co-investments — deals that are usually reserved for limited partners that can put up much larger amounts of capital.

The adoption of a more diversified portfolio not only make sense on a longer-term basis, but also given where we are in the current economic and market cycle.

 

The adoption of a more diversified portfolio not only makes sense on a longer-term basis, but also given where we are in the current economic and market cycle.

This is relevant in the current investment environment, the chorus of expected low returns over the years ahead has reached a crescendo and many are recommending moving away from the traditional Balanced Portfolio of equities and fixed income only.

 

The value is in implementation and sourcing the appropriate investment strategies.

 

 

Happy investing.

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