The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

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

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

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

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

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

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

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

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

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

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

Implementation of the Modern-Day Wealth Management Investment Solution

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

Modern-day investment solutions have two specific investment portfolios:  

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

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

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

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

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

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

The death of the Policy Portfolio

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

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

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

It is a single Portfolio solution.

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

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

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

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

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

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

Reasons for the death of Policy Portfolio include:

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

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

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

Evolution of Wealth Management – Implementation of the new Paradigm

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

As explained by EDHEC Risk Goal-Based Investing involves:

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

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

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

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

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

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

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

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

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

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

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

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

Please see my Disclosure Statement

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

The Case for holding Government Bonds and fixed income

The case for holding Government Bonds is all about certainty.  The question isn’t why would you own bonds but, in the current environment, why wouldn’t you own bonds to deliver certainty in such uncertain times?

This is the central argument for holding government bonds within a portfolio.  The case for holding government bonds is well presented in a recent article by Darren Langer, from Nikko Asset Management, Why you can’t afford not to own government bonds.

As he argues, government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

The article examines some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It is well worth reading.

Why you can’t afford not to own government bonds

The argument against holding government bonds are based on expectations of higher interest rates, higher inflation, and current extremely low yields.

As argued in the article, although these are all very valid reasons for not holding government bonds, they all require a world economy that is growing strongly.  This is far from the case currently.

They key point being made here, in my opinion, is that the future is unknown, and there are numerous likely economic and market outcomes.

Therefore, investors need to consider an array of likely scenarios and test their assumptions of what is “likely” to happen.  For example, what is the ‘normal’ level of interest rates? Are they likely to return to normal levels when the experience since the Global Financial Crisis has been a slow grind to zero?

Personally, although inflation is not an issue now, I do think we should be preparing portfolios for a period of higher inflation, as I outline here.  Albeit, this does not negate the role of fixed income in a portfolio.

The article argues that current conditions appear to be different and given this it is not unrealistic to expect that inflation and interest rates are likely to remain low for many years and significantly lower than the past 30 years.

In an uncertain world, government bonds provide certainty. Given multiple economic and market scenarios to consider, maintaining an allocation to government bonds in a genuinely diverse and robust portfolio does not appear unreasonable on this basis.

Return expectations

Investors should be prepared for lower rates of returns across all assets classes, not just fixed income.

A likely scenario is that governments and central banks will target an environment of stable and low interest rates for a prolonged period.

In this type of environment, government bonds have the potential to provide a reasonable return with some certainty. The article argues, the benefits to owning bonds under these conditions are two-fold:

  1. A positively sloped yield curve in a market where yields are at or near their ceiling levels. Investors can move out the curve (i.e. by buying longer maturity bonds) to pick up higher coupon income without taking on more risk.
  2. Investors can, over time, ride a position down the positively-sloped yield curve (i.e. over time the bond will gain in value from the passing of time because shorter rates are lower than longer rates). This is often described as roll-down return.

The article concludes, that although fixed income may lose money during times of strong economic growth, rising interest rates, and higher inflation, these losses can be offset by the gains on riskier assets in a portfolio.  Losses on fixed income are small compared to potential losses on other asset classes and are generally recovered more quickly.

No one would suggest a 100% allocation to government bonds is a balanced investment strategy; likewise, not having an allocation to bonds should also be considered unbalanced. 

“But a known return in an uncertain world, where returns on all asset classes are likely to be lower than the past, might just be a good thing to have in a portfolio.”

The future role of fixed income in a robust portfolio has been covered regularly by Kiwi Investor Blog, the latest Post can be found here: What do Investors need in the current environment? – Rethink the 40 in 60/40 Portfolios?

The article on the case for government bonds helps bring some balance to the discussion around fixed income and the points within should be considered when determining portfolio investment strategies in the current environment.

Happy investing.

Please see my Disclosure Statement

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

Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?

Those saving for retirement face the reality that fixed income may no longer serve as an effective portfolio diversifier and source of meaningful returns.

In future fixed income is unlikely to provide the same level of offset in a portfolio as has transpired historically when the inevitable sharp decline in sharemarkets occur – which tend to happen more often than anticipated.

The expected reduced diversification benefit of fixed income is a growing view among many investment professionals.  In addition, forecast returns from fixed income, and cash, are extremely low.  Both are likely to deliver returns around, if not below, the rate of inflation over the next 5 – 10 years.

Notwithstanding this, there is still a role for fixed income within a portfolio.

However, there is still a very important portfolio construction issue to address.  It is a major challenge for retirement savings portfolios, particularly those portfolios with high allocations to cash and fixed income. 

In effect, this challenge is about exploring alternatives to traditional portfolio diversification, as expressed by the Balanced Portfolio of 60% Equities / 40% Fixed Income. I have covered this issue in previous Posts, here and here.

Outdated Investment Strategy

There are many ways to approach the current challenge, which investment committees, Trustees, and Plan Sponsors world-wide must surely be considering, at the very least analysing and reviewing, and hopefully addressing.

One way to approach this issue, and the focus of this Post, is Tail Risk Hedging. (I comment on other approaches below.)

The case for Tail Risk Hedging is well presented in this opinion piece, Investors Are Clinging to an Outdated Strategy At the Worst Possible Time, which appeared in Institutional Investor.com

The article is written by Ron Lagnado, who is a director at Universa Investments.  Universa Investments is an investment management firm that specialises in risk mitigation e.g. tail risk hedging.

The article makes several interesting observations and lays out the case for Tail Risk Hedging in the context of the underfunding of US Pension Plans.  Albeit, there are other situations in which the consideration of Tail Risk Hedging would also be applicable.

The framework for Equity Tail Risk Hedging, recognises “that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns.”

By way of positioning, the article argues that a reduction in Portfolio volatility leads to better investment outcomes overtime, as measured by the Compound Annual Growth Return (CAGR).  There is validity to this argument, the reduction in portfolio volatility is paramount to successful investment outcomes over the longer-term.

The traditional Balance Portfolio, 60/40 mix of equities and fixed income, is supposed to mitigate the effects of extreme market volatility and deliver on return expectations.

Nevertheless, it is argued in the article that the Balanced Portfolio “limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance.”

In other words, “It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.”

The article provides some evidence of this, highlighting that “large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points.” 

Essentially, the argument is made that the Balanced Portfolio has not delivered on its promise historically and is an outdated strategy, particularly considering the current market environment and the outlook for investment returns.

Meeting the Challenge – Tail Risk Hedging

The article calls for the consideration of different approaches to the traditional Balance Portfolio.  Naturally, they call for Tail Risk Hedging.

In effect, the strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge (protection of large equity loses).

It is argued that this will result in a higher CAGR over the longer term given a higher allocation to equities and without the drag on performance from fixed income.

The Tail Risk Hedge strategy is implemented via an options strategy.

As they note, there is no free lunch with this strategy, an “options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns.”

This is the inverse to some investment strategies, which provide incremental gains over extended periods and then short sharp losses.  There is indeed no free lunch.

My View

The article concludes, “diversification for its own sake is not a strategy for success.”

I would have to disagree.  True portfolio diversification is the closest thing to a free lunch in Portfolio Management. 

However, this does not discount the use of Tail Risk Hedging.

The implementation of any investment strategy needs to be consistent with client’s investment philosophy, objectives, fee budgets, ability to implement, and risk appetite, including the level of comfort with strategies employed. 

Broad portfolio diversification versus Tail Risk Hedging has been an area of hot debate recently.  It is good to take in and consider a wide range of views.

The debate between providing portfolio protection (Tail Risk Hedging vs greater Portfolio Diversification) hit colossal proportions earlier in the year with a twitter spat between Nassim Nicholas Taleb, author of Black Swan and involved in Universa Investments, and Cliff Asness, a pioneer in quant investing and founder of AQR.

I provide a summary of their contrasting perspectives to portfolio protection as outlined in a Bloomberg article in this Post.  There are certainly some important learnings and insights in contrasting their different approaches.

The Post also covered a PIMCO article, Hedging for Different Market Environments.

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

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

They provide the following Table, which outlines an array of “Portfolio Protection” strategies.

In Short, and in general, Asness is supportive of correlation based like hedging strategies (Trend and Alternative Risk Premia) and Taleb the Direct Hedging approach.

From the Table above we can see in what type of market environment each “hedging” strategy is Most Effective and Least Effective.

For balance, more on the AQR perspective can be found here.

You could say I have a foot in both camps and are pleased I do not have a twitter account, as I would likely be in the firing line from both Asness and Taleb!

To conclude

I think we can all agree that fixed income is going to be less of a portfolio diversifier in future and produce lower returns in the future relative to the last 10-20 years. 

This is an investment portfolio challenge that must be addressed.

We should also agree that avoiding large market losses is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, ongoing and uninterrupted endowment, or meeting future Pension liabilities.

In my mind, staying still is not going to work over the next 5-10 years and the issues raised by the Institutional Investor.com article do need to be addressed. The path taken is likely to be determined by individual circumstances.

Happy investing.

Please see my Disclosure Statement

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

Endowments, Foundations, and Charities – learning from the best

The achievements of the Yale Endowment are significant and well documented. 

Their achievements can largely be attributed to the successful and bold management of their Endowment Funds.

They have been pioneers in Investment Management.  Many US Universities and global institutions have followed suit or implemented a variation of the Yale’s “Endowment Model”.

Without a shadow of a doubt, those involved with Endowments, Foundations, Charities, and saving for retirement can learn some valuable investment lessons by reviewing the investment approach undertaken by Yale.

I think these learnings are particularly relevant given where we are currently in the economic cycle and the outlook for returns from the traditional asset classes of cash, fixed income, and selected equity markets.

A growing Endowment

In fiscal 2019 the Yale Endowment provided $1.4 billion, or 32%, of the University’s $4.2 billion operating income.

To put this into context, the Yale Endowment 2019 Annual Report notes that the other major sources of revenues for the University were medical services of $1.1 billion (26%); grants and contracts of $824 million (20%); net tuition, room and board of $392 million (9%); gifts of $162 million (4%); and other income and transfers of $368 million (9%).

Spending from the Endowment has grown during the last decade from $1.2 billion to $1.4 billion, an annual growth rate of 1.5%.

The Endowment Fund’s payments have gone far and wide, including scholarships, Professorships, maintenance, and books.

Yale’s spending and investment policies provide substantial levels of cash flow to the operating budget for current scholars, while preserving Endowment purchasing power for future generations.

What a wonderful contribution to society, just think of the social good the Yale Endowment has delivered.

Yale’s Investment Policy

As highlighted in their 2019 Annual Report:

  • Over the past ten years the Endowment grew from $16.3 billion to $30.3 billion;
  • The Fund has generated annual returns of 11.1% during the ten-year period; and
  • The Endowment’s performance exceeded its benchmark and outpaced institutional fund indices.

In relation to Investment Objectives the Endowment Funds seek to provide resources for current operations and preserving purchasing power (generating returns greater than the rate of inflation).

This dictates the Endowment has a bias toward equity like investments.  Yale note: 

“The University’s vulnerability to inflation further directs the Endowment away from fixed income and toward equity instruments. Hence, more than 90% of the Endowment is targeted for investment in assets expected to produce equity-like returns, through holdings of domestic and international equities, absolute return strategies, real estate, natural resources, leveraged buyouts and venture capital.”

Accordingly, Yale seeks to allocate over the longer term approximately one-half of the portfolio to illiquid asset classes of leverage buyouts, venture capital, real estate, and natural resources.

This is very evident in the Table below, which presents Yale’s asset allocation as at 30 June 2019 and the US Educational Institutional Mean allocation.

This Table appeared in the 2019 Yale Annual Report, I added the last column Yale vs the Educational Institutional Mean.

 Yale UniversityEducational Institution MeanYale vs Mean
Absolute Return23.2%20.6%2.6%
Domestic Equity2.7%20.8%-18.1%
Foreign Equity13.7%21.9%-8.2%
Leverage Buyouts15.9%7.1%8.8%
Natural Resources4.9%7.7%-2.8%
Real Estate10.1%3.4%6.7%
Venture Capital21.1%6.6%14.5%
Cash and Fixed Income8.4%11.9%-3.5%
 100%100% 
    
Non-Traditional Assets75.2%45.4%29.8%
Traditional Assets24.8%54.6% 

The Annual Report provides a comment on each asset class and their expected risk and return profile, an overview of how Yale manage the asset classes, historical performance, and future longer-term risk and return outlook.

High Allocation to Non-Traditional Assets

As can be seen in the Table above Yale has a very low allocation to traditional asset classes (domestic equities, foreign equities, cash and fixed income), and a very high allocation to non-traditional assets classes, absolute returns, leverage buyouts, venture capital, real estate, and natural resources.

This is true not only in an absolute sense, but also relative to other US Educational Institutions.  Who in their own right have a high allocation to non-traditional asset classes, 45.4%, but almost 30% lower than Yale.

“Over the last 30 years Yale has reduced their dependence on domestic markable securities by relocating assets to non-traditional assets classes.  In 1989 65% of investments were in US equities and fixed income, this compares to 9.8% today.”

By way of comparison, NZ Kiwi Saver Funds on average have less than 5% of their assets invested in non-traditional asset classes.

A cursory view of NZ university’s endowments also highlights a very low allocations to non-traditional asset classes.

There can be good reasons why other investment portfolios may not have such high allocations to non-traditional asset classes, including liquidity requirements (which are less of an issue for an Endowment, Charity, or Foundation) and investment objectives.

Rationale for High Allocation to Non-Traditional Assets

Although it is well known that Yale has high allocations to non-traditional assets, the rationale for this approach is less well known.

The 2019 Yale Annual Report provides insights as to the rationale of the investment approach.

Three specific comments capture Yale’s rationale:

“The higher allocation to non-traditional asset classes stems from their return potential and diversifying power”

Yale is active in the management of their portfolios and they allocate to those asset classes they believe offer the best long-term value.  Yale determine the mix to asset class based on their expected return outcomes and diversification benefits to the Endowment Funds.

“Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.”

Yale invest in asset classes they see offering greater opportunities to add value. For example, they see greater opportunity to add value in the alternative asset classes rather than in Cash and Fixed Income.

“The Endowment’s long time horizon is well suited to exploit illiquid and the less efficient markets such as real estate, natural resources, leveraged buyouts, and venture capital.”

This is often cited as the reason for their higher allocation to non-traditional assets.  As an endowment, with a longer-term investment horizon, they can undertake greater allocations to less liquid asset classes. 

Sovereign wealth Funds, such as the New Zealand Super Fund, often highlight the benefit of their endowment characteristics and how this is critical in shaping their investment policy. 

Given their longer-term nature Endowments are able to invest in less liquid investment opportunities. They will likely benefit from these allocations over the longer-term.

Nevertheless, other investment funds, such as the Australian Superannuation Funds, have material allocations to less liquid asset classes.

Therefore, an endowment is not a necessary condition to invest in non-traditional and less liquid asset classes, the acknowledgement of the return potential and diversification benefits are sufficient reasons to allocate to alternatives and less liquid asset classes.

In relation to the return outlook, the Yale 2019 Annual report commented the “Today’s actual and target portfolios have significantly higher expected returns than the 1989 portfolio with similar volatility.”

Smaller Endowments and Foundations are following Yale

In the US smaller Endowments and Foundations are adopting the investment strategies of the Yale Endowment model.

They have adopted an investment strategy that is more align with an endowment more than twice their size.

Portfolio size should not be an impediment to investing in more advanced and diversified investment strategies.

There is the opportunity to capture the key benefits of the Endowment model, including less risk being taken, by implementing a more diversified investment strategy. Thus, delivering a more stable return profile.

This is attractive to donors.

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

The value is in implementation and sourcing appropriate investment strategies.

In this Post, I outline how The Orange County Community Foundation (OCCF) runs its $400m investments portfolio like a multi-billion-dollar Endowment.

Diversification and Its Long-Term Benefits

For those interested, the annual report has an in-depth section on portfolio diversification.

This section makes the following key following points while discussing the benefits of diversification in a historical context:

  • “Portfolio diversification can be painful in the midst of a bull market. When investing in a single asset class produces great returns, market observers wonder about the benefits of creating a well-structured portfolio.”
  • “The fact that diversification among a variety of equity-oriented alternative investments sometimes fails to protect portfolios in the short run does not negate the value of diversification in the long run.”
  • “The University’s discipline of sticking with a diversified portfolio has contributed to the Endowment’s market leading long-term record. For the thirty years ending June 30, 2019, Yale’s portfolio generated an annualized return of 12.6% with a standard deviation of 6.8%. Over the same period, the undiversified institutional standard of 60% stocks and 40% bonds produced an annualized return of 8.7% with a standard deviation of 9.0%. “
  • “Yale’s diversified portfolio produced significantly higher returns with lower risk.”

There are also sections on Spending Policy and Investment Performance.

Lastly, I have previously discussed the “Endowment Model” in relation to the fee debate, for those interested please see this Post: Investment Fees and Investing like an Endowment – Part 2

Happy investing.

Please see my Disclosure Statement

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

When Alternatives to Passive Index Investing are Appropriate

There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.

Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.

Under these circumstances a passive approach no longer becomes optimal nor appropriate.

Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.

Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.

Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.

Framework for choosing an Alternative to Passive Investing

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

They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.  

In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.

They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”

Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:

Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.

As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.

The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.

Below I have provided a description of the five reasons investors should seek an alternative to passive index.

Back ground Comments

Warren and Ezra provide some general comments on the state of the industry debate:

  • They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
  • They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.

They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”

Some Context

The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.

Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.

A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.

Market efficiency.

Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.

Cap-weighting is aligned with investor objectives.

It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.

The same is true for an endowment, insurance company, or foundation.

Index efficacy.

The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.

The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.

The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.

Reason #1: No Readily Replicable Index is Available

Passive investing assumes an effective index exists that can be easily and readily replicated.

In some instances, an appropriate index to replicate is simply not available, for example:

  • Unlisted assets such as Private Equity, unlisted infrastructure and direct property
  • Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.

In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.

Reason #2: The Passive Index Is at Odds with the Investor’s Objectives

Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.

By way of example:

Defined Benefit Pension Plan and tailored fixed-income mandates.

Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.

In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.

DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.

Such situations also exits for insurance companies, endowments, and foundations.

Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.

Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.

The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.

Reason #3: The Standard Passive Index is Inefficiently Constructed

Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.

The article presents two potential reasons an index might be inefficient and proves three examples.

They comment that an index might be inefficient for the following reasons:

  • the index is built on a narrow or unrepresentative universe; and
  • the index is constructed in a way that builds in some inefficiency.

As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.

Equities

Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.

The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).

Fixed income

There are many shortcomings of fixed-income indices, the article focuses on two:

  • Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
  • The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.

Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.

Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.

Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.

However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.

Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.

The following features are outlined in the article to support such a situation:

Market inefficiency situations

Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.

The following situations may provide a manager with a competitive advantage:

  • Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
  • Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
  • Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.

Opportunities arising from differing investor objectives

Opportunities for active management to benefit may exist when:

  • Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
  • Investors have differing time horizons e.g. value investors exploit short-term focus of markets

Index fails to cover the opportunity set

The article makes the following points under this heading:

  • There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
  • The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
  • Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”

Reason #5: Skilled Managers Can Be Identified

Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.

Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.

The discussion makes the following points:

  • At the very least bad managers should be avoided
  • Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
  • Not all fund managers are created equal, some are good and some are bad
  • The research capability and skill to identify and select a manager is an important consideration.

Implementation and Costs

It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.

“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”

The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.

Concluding Comments

Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.

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

For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.

Happy investing.

Please see my Disclosure Statement

 

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

Are Investment products meeting people’s needs over their working life?

A key finding by the Australian Productivity Commission is that “Well-designed life-cycle products can produce benefits greater than or equivalent to single-strategy balanced products, while better addressing sequencing risk for members.

There are also good prospects for further personalisation of life-cycle products that will better match them to diverse member needs, which would require funds to collect and use more information on their members.

Some current MySuper life-cycle products shift members into lower-risk assets too early in their working lives, which will not be in the interests of most members.”

 

This is one of many findings from of the 2018 Australian Productivity Commission Inquiry Report, Superannuation: Assessing Efficiency and Competitiveness.

Mysuper is a default option in Australia, similar to the Default Options by Kiwisaver providers in New Zealand and around the world.

 

The above findings are from the Section 4, Are Members needs being met, of the report (pg 238). This section, 4.3, Are products meeting people’s needs over their working life?, focuses on Life Cycle Funds. (Lifecycle Funds are often referred to as target-date funds in the United States, the United Kingdom, and other countries. They are popular in the US, accounting for 25% of their saving for retirement assets, and growing.)

Life cycle Funds, also referred to as Glide Path Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

 

Section 4.3 concludes “the Commission now recognises the value of well-designed MySuper life-cycle products, and the potentially significant gains that could arise from further personalisation.”

As covered in the report, they highlight that the poorer products currently on offer “requires some cleaning.”

 

Two areas of Section 4.3 are of interest to me.

 

The relative attractiveness of Lifecycle Funds

The report covers the varying views on Lifecycle Funds.

On this the Commission notes that the underperformance of some Lifecycle Funds does not “repudiate the principle of varying the management of risk as a person ages.”

Importantly, the “costs and benefits of life-cycle products depend on their design and on the characteristics of fund members (for example, the size of their balance).”

They note “the determinant of the variation between life-cycle products is the glide path from growth to defensive assets as the member ages”

“The lowest average retirement balances occur for life-cycle products with accelerated transitions to defensive assets as the member ages.”

 

As noted by several submissions, Lifecycle Funds can provide better outcomes if they maintain a higher growth allocation in the earlier years of saving for retirement. They also offer additional benefits in market downturns, particularly closer to retirement, they produce less poor outcomes than a standard single-strategy product, such as a Balanced Fund i.e. they manage sequencing risk better.

 

The criticism of Lifecycle Funds is often associated with poor design, as covered in this Post.

 

Increased Customisation of the Investment Solution

It is important to appreciate that not one investment product can meet all investor’s needs.  It does not make sense for a 29 year old and a 50 year to be in the same Default Fund.

This is an attractive feature of Lifecycle Fund offerings, they can be more tailored to the investor.

Specifically, they can be tailored for more than just age, such as Balance size, and this can in the majority of cases result in better outcomes for those saving for retirement. As outlined in this research article by Rice Warner.  Tailored investment solutions boost retirement savings outcomes.

 

On this point the Commission’s Report notes “There is significant scope for more personalised MySuper products”…

Specifically there is the scope to customise the investment strategy of Lifecycle Funds beyond age.

The report outlined a submission that observed that “… data and technology provide the opportunity for giant advancements in the design of personalised lifecycle strategies. Such strategies could account for: age, balance, contribution rate (which entails non-contribution due to career breaks etc), gender, expected returns, [and] risk.”

“Ultimately, individualised product design could also take into account other member characteristics, such as household assets, income from any partner and the potential capacity to extend a working life if there are adverse asset price shocks.”

 

The following two submissions in relation to Lifecycle Funds by David Bell and Aaron Minney are well worth reading for those wanting a greater understanding and appreciation of broader topics associated with Lifecycle Funds.

These submissions are also well worth reading by those interested in designing effective investment solutions for those saving for retirement.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Tailored Investment solutions boost superannuation outcomes – Lifecycle Funds outperform Balanced Funds

A greater level of customisation leads to better investment outcomes for investors.

For example, Multifactor Lifecycle Funds that focus on age and size of account balances are best placed to last the distance as we live for longer in retirement, compared to a Balanced Fund and Lifecycle Funds that focus on age alone.

Multifactor Lifecycle Funds:

  1. Generate higher expected lifetime income relative to a Balanced Fund (70% equities and 30% Fixed Income and Cash); and
  2. Outperform a Balanced Fund over 90% of the time based on a numerous number of different market and economic scenarios.

These are the key findings of the Rice Warner’s research paper: Lifecycle Design – To and Through Retirement.

Lifecycle Funds, also referred to as Glide Path Funds, Target Date Funds, or Lifestages Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor approaches retirement.

 

Rice Warner found that somebody aged 30 with an opening balance of $26,000 and invested in a Multifactor Lifecycle Fund had a 91.8% chance of outperforming a Balanced Fund by the time of retirement at age 63.

Their research also found that by investing in a Multifactor Lifecycle Fund the expected retirement income is up to 35% higher than that expected from a Balanced Fund (Source: Australian AFR The product that can boost super by 35pc).

For somebody aged 60 with an account balance of $118,300, a Multifactor Lifecycle Fund had a 72.4 per cent chance of outperforming a Balanced Fund.

Lastly, Second Generation Lifecycle Funds, which reduce their growth allocation later, outperformed a Balanced Fund 91.2% of the time. A Multifactor Lifecycle Fund outperforms a Second Generation Lifecycle Fund 84.6% of the time.

 

A key conclusion from the Rice Warner research is that Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to enhance outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

 

They achieve this by adopting a more growth-oriented stance while an investor has a long investment horizon and shifting to defensive assets when the investor’s investment horizon grows short.

Importantly, an individual’s investment horizon is a function of not only age but also the size of their superannuation account. This is an important concept, the rationale is provided in the section below – The Benefits of a Multifactor Lifecycle Fund.

 

A summary of the Rice Warner analysis is provided below, along with key Conclusions and Implications for those aged 30 and 60.

A copy of the Rice Warner analysis can be found here.

 

To my mind, there is going to be an increased customisation of investment solutions available for those saving for retirement that will consider factors beyond age e.g. account size, salary, and assets outside of Super.  Some are available already.

Technology will enable this, Microsoft and BlackRock are well advanced in collaborating, BlackRock and Microsoft want to make retirement investing as easy as ordering an Uber.

 

In relation to Lifecycle Funds, they are subject to wide spread criticism.

Some of this criticism is warranted, nevertheless, often the criticism is the result of the poor design of the Fund itself, rather than concept of a Lifecycle Fund itself. This is highlighted in the Rice Warner research, where the first Generation of Lifecycle Funds de-risk to early.

I covered the criticism of Lifecycle Funds in a previous Post, in the defence of Lifecycle Funds.

 

Lifecycle Funds can be improved upon. For example a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

In my opinion, all investments strategies would benefit from a greater focus on tangible investment goals, this will lead to a more robust investment solution.

A Goals based investing approach is more robust than the application of “rule of thumbs”, such as the 4% rule and adjusting the growth allocation based purely as a function of age.

Goals based investing approaches provide a better framework in which to assess the risk of not meeting your retirement goals.

Greater levels of customisation are required, which is more relevant in the current investment environment.

 

 

Rice Warner – The benefits of Multifactor Lifecycle Funds

Investment literature indicates that an investor’s investment horizon is a key determinant of an appropriate investment strategy.

The consequence of longer investment horizons allows an investor to take on more risk because even if there is a severe market decline there is time to recover the losses.

Furthermore, and an important observation, Rice Warner’s analysis suggests that as we enter retirement investment horizon is a function of age and size of the superannuation account balance.

A retiree with a larger account balance has in effect a longer investment horizon. They are in a better position to weather any market volatility.

This reflects, that those with a small account size typically withdraw a greater proportion of their total assets each year, indicative of largely fixed minimum cost of living, resulting in a shorter investment horizon.

 

A very big implication of this analysis is that an investor’s investment horizon is “not bounded by the date that they choose to retire (though this point is relevant). This is as a member is likely to hold a substantial proportion of their superannuation well into the retirement phase, unless their balance is low.”

“One consequence of this is that investment strategies which consider this retirement investment horizon may deliver better outcomes for members – both to and through retirement. This is because as a member’s account balance grows, sequencing risk becomes less relevant allowing higher allocations to growth assets.”

For those wanting a better understanding of sequencing risk, please see my earlier Post.

 

Rice Warner conclude, Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to provide enhanced outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

Thus, the title of their research Paper, Lifecycle Design – To and Through Retirement, more often than not investors should still hold a relatively high allocation to growth assets in retirement.  They should be held to the day of retirement and throughout retirement.

The research clearly supports this, a higher growth asset allocations should be held to and through retirement.  In my mind this is going to be an increasingly topically issue given the current market environment.

 

 

Rice Warner Analysis

Rice Warner considered several investment strategies applied to various hypothetical members throughout their lifetime.

They assess the distribution of outcomes of the investment strategies to establish whether adjustments can be made to provide members with better outcomes overtime.

Rice Warner considered:

  1. Balanced Strategy which adopts a fixed 70% allocation to Growth assets.
  2. High Growth strategy which adopts a fixed 85% allocation to Growth assets.
  3. First-generation Lifecycle (Lifecycle 1 (Age)) with a focus on defensive assets and de-risking at young ages.
  4. Second-generation Lifecycle (Lifecycle 2 (Age)) with a focus on growth assets and de-risking at older ages.
  5. Multi-dimensional Lifecycle (Lifecycle (Age and Balance)) which adopts a high allocation to growth assets unless a member is at an advanced age and has a low balance.

Six member profiles selected to capture low, moderate, and high wealth members at ages 30 and 60.

Rice Warner then considered the distribution of expected lifetime income under a range of investment scenarios using a stochastic model.

This allowed for a comparison of the income provided to members under each strategy in a range of investment situations for comparative purposes.

 

Conclusions

Rice Warner Conclude:

  • Investment horizon is a critical driver in setting an appropriate investment strategy. Investment strategies should take into consideration a range of investment horizon, both before and after retirement.
  • Adopting high allocations to growth assets is not inherently a poor strategy, even in cases where members are approaching retirement. These portfolios will typically provide:
    • Improved outcomes in cases where members are young, or investment performance is strong;
    • Marginally weaker outcomes where members are older and investment performance is weak.
  • Second-generation Lifecycle investment strategies (focused on growth assets and late de-risking) will typically outperform first generation strategies (which are focused on defensive assets and de-risking when a member is young).
  • Growth-oriented constant strategies will typically outperform First-generation Lifecycle strategies, except where investment performance is poor.
  • Designing Lifecycle strategies that use further factors in addition to age (such as balance) provide the ability to better tailor a portfolio to provide enhanced outcomes by:
    • Adopting a more growth-oriented stance while a member has a long investment horizon.
    • Shifting to defensive assets when a member’s investment horizon grows short.

 

Implications

Overall the results, aged 30:

  • High Growth strategies can provide significant scope for outperformance with minimal risk of underperformance relative to a Balanced Fund due to the members’ long investment horizon.
  • First-generation Lifecycle strategies will typically underperform each of the other strategies considered except where investment outcomes are poor for a protracted period. This underperformance is a result of the defensive allocation of these strategies being compounded over the member’s long investment horizon.
  • Second-generation Lifecycle can mitigate the risk faced by the members over their lifetime, albeit at the cost of a reduced expected return on their portfolio relative to a portfolio with a higher constant allocation to growth assets.
  • Lifecycle strategies which adjust based on multiple factors are able to manage the risk and return trade-off inherent to investments in a more effective way than single strategies or Lifecycle strategies only based on age. This is a result of the increased tailoring allowing the portfolio to adopt a more aggressive stance when members are young and thereby accumulate a high balance and extend their investment horizon further. This leads to this portfolio often outperforming the other strategies considered.

 

For those aged 60

  • High Growth strategies can provide significant outperformance in strong investment conditions. This comes at the cost of a modest level of underperformance in a poor investment scenario (a reduction in total lifetime income for members ranging between 2% and 5% relative to a Balanced fund).
  • First-generation Lifecycle strategies will underperform in neutral or strong market conditions due to their lack of growth assets. In cases where investment performance is poor these strategies outperform the other strategies considered particularly for those with low levels of wealth (due to their short investment horizons).
  • Two-dimensional Lifecycles provide enhanced risk management (but not necessarily better expected performance) by providing:
    • Protection for members who are vulnerable to sequencing risk with short investment horizons (low and moderate wealth profiles) by adopting a Balanced stance.
    • High allocations to growth for members whose investment horizon is long (high wealth profiles).

 

Good luck, stay healthy and safe.

 

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.

More needs to be done to address the post-retirement challenges

The next generation to retire is likely to have much lower retirement savings. Those aged 40 to 55 are effectively a lost generation.

They have limited defined benefit (DB) pensions as many occupational schemes closed early on in their careers and it took the government many years to develop and implement auto-enrolment.

These are some of the underlying themes of the 2019 UK Defined Contribution (DC) Investment Forum (DCIF) report.  A summary and discussion of this report was recently published in an IPE Article.

The key findings of the DCIF Report:

  • Members are sleepwalking into retirement and choosing the path of least resistance
  • The industry has been slow to address the challenges posed by pension freedoms
  • The best approach is seen as income drawdown in earlier years and longevity protection later in retirement
  • Further policy initiatives are required to build consensus and provide clarity

 

In summary, “The DC industry needs to do more to address post-retirement challenges”.

 

There are obviously issues specific to the UK market e.g. it has been five years since pensioners in the UK gained greater freedom to use their defined contribution (DC) pots.

Nevertheless, retirement issues are universal and key learnings can be gained from individual markets.

 

The IPE article outlined the key challenge facing providers: “how do you ensure members retain flexibility and choice, while ensuring those members can manage both the investment and longevity risk over decades of retirement?”

 

Overall, the UK industry response has been slow. It appears “Pension providers have been focused on designing the best default fund with little energy spent on the post-retirement phase.”

Interestingly, research in the UK by Nest, a €8.3bn auto-enrolment provider, found most members expect their pension pot to pay an income automatically on retirement.

Members are also surprised by the level of complexity involved in draw down products.

 

Post Retirement Investment Solution Framework

Despite the lack of innovation to date there appears to be a consensus about the shape of the post-retirement investment solution.

An appropriate Post-Retirement Investment Strategy would allow retirees to have decent levels of income during the first two active decades of retirement and longevity protection for after 80.

“Not only does this remove the burden of an unskilled person having to manage both investment and longevity risk, but it also prevents members from either underspending or overspending their pots”.

The idea is to turn a DC pension pot into an income stream with minimal interaction from the scheme member.

 

This is consistent with the vision expressed by Professor Robert Merton in 2012, see this Kiwi Investor Blog Post: Designing a new Retirement System for more detail.

 

As the IPE article highlights, it is important retirees are provided guidance to ensure they understand their choices.

Albeit, a core offering will deliver a sustainable income.  This is potentially a default solution which can be opted out of at any stage.

Some even argue that the “trustees would then make a judgement about what a sustainable income level would be for each member and then devise a product to pay this out.”

“In addition, this product could also provide a small pot of cash for members to take tax-free on retirement as well buying later-life protection. This could take the form of deferred annuities or even a mortality pool.”

 

Early Product Development in the UK

The IPE article outlines several approaches to assist those entering retirement.

By way of example, Legal & General Investment Management have developed a retirement framework which they call ‘four pots for your retirement’.”

  • First pot is to fund the early years of retirement – assuming retirees will spend the first 15 years wanting to enjoy no longer working; they will travel and be active.
  • Second pot provides a level of certainty to ensure retirees do not outlive their savings, this may include an annuity type product.
  • Third pot is a rainy-day pot for one-off expenses.
  • Final pot is for inheritance.

 

Greater Policy Direction

Unsurprisingly, there is a call for clearer policy direction from Government. Particularly in relation to adequacy, and the relation between adequacy and retirement products.

Unlike a greater consensus around what an investment solution might look like, consensus around the regulatory environment will be harder to achieve.

This may slow investment solution innovation to the detriment of retirees.

 

Concluding remarks

The following point is made within the IPE article: “While pension providers in both the US and Australia have come to the same conclusions as the UK about the way to address the retirement market, no-one in these markets has yet developed a viable product.”

As the IPE article note “It is likely the industry will be pushing at an open door if it develops a product that provides an income in retirement.”

This is a significant opportunity for the industry.

 

Interestingly, the investment knowledge is available now to meet the Post Retirement challenge. Also, Post-Retirement Investment solutions are increasingly being developed and are available. It is going to take a change in industry mind-set before they are universally accepted.

 

The foundations of the investment knowledge for the Post-Retirement Investment solution as outlined above have regularly been posted on Kiwi Investor Blog.

For those wanting more information, see the following links:

 

There will be change, a paradigm shift is already occurring internationally, and those savings for retirement need a greater awareness of these developments and the likely Investment Solution options available, so that they are not “sleepwalking into retirement and choosing the path of least resistance”.

 

I don’t see enough of the Post Retirement Challenges being addressed in New Zealand by solution providers. More needs to be done, the focus in New Zealand has been on accumulation products and the default option as occurred in the UK.

The approach to date has been on building as big as possible retirement pot, this may work well for some, for others not so well.

Investment strategies can be developed that more efficiently uses the pool of capital accumulated – avoiding the dual risks of overspending or underspending in the early years of retirement and providing a greater level of flexibility compared to an annuity.

These strategies are better than Rules of Thumb, such as the 4% rule which has been found to fail in most markets.

More robust and innovative retirement solutions are required.

 

In New Zealand there needs to be a greater focus on decumulation, Post Retirement solutions, including a focus on generating a secure and stable level of income throughout retirement.

The investment knowledge is available now and being implemented overseas.

Let’s not leave it until it is too late before the longevity issues arise for those retiring today and the next generation, who are most at risk, begin to retire.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Target Date Funds – 25 Years of US Learnings

Launched in 1994, target-date funds now boast assets of more than $2 trillion in the US, according to a recent Wealth Management.com article, Target-Date Funds Aging Gracefully

The article concludes: “Naturally it is difficult to foresee how target date funds will evolve over coming decades, as the list of potential innovations is endless, but one thing is certain: the benefits target-date funds present both to plan participants and sponsors ensure they will play a dominant role in building comfortable retirements for years to come.”

The growth Target-Date Funds (TDF) has significantly changed the Defined Contribution (DC), superannuation, industry in the US.

TDF are also referred to as Life Stages or Life Cycle strategies.

 

Since their launch in 1994 TDF have become to dominate DC plans. According to the Wealth Management.com article total assets in TDF mutual funds alone have grown from about $278 million at the end of 1994 to more than $1.2 trillion in the second quarter of 2019.

Considering other investments, it is estimated that $2 trillion or about 25% of total DC assets today are invested TDF.

 

Why the Growth?

The growth in TDF can be attributed to their appeal to those saving for retirement (Participants) and those offering investment solutions e.g. Sponsors such KiwiSaver Providers.

For the Participant, TDF remove the “burden of creating an asset allocation strategy and choosing the investments through which they would execute it.” Participants do not need to make complicated investment decisions.

For Sponsors, they can “streamline their investment offering (reducing complexity and administrative costs), while meeting their fiduciary responsibility to participants.”

Also, and of particular interest given New Zealand is currently reviewing the Default option for KiwiSaver, TDF have also experienced a significant boost from the enactment of the Pension Protection Act (PPA) in 2006.

As noted by the Wealth Management.com article “The PPA relieved plan sponsors from fiduciary responsibility for investment outcomes if they provided a suitable Qualified Default Investment Alternative (QDIA), such as TDFs, to anyone auto-enrolled in their plans. The combination of auto enrollment and safe harbor relief for plan sponsors paved the way for the wide adoption of TDFs.”

 

Future Growth and Innovation

The growth of funds invested into TDF is expected to grow, primarily from the ongoing innovation of the vehicle.

It is likely that the TDF will evolve into the key investment vehicle over the complete lifecycle of an investor, not only by accumulating capital for retirement (Defined Contribution Fund) but also helping generate a stable and secure income once in retirement (Defined Benefit Fund).

A recent enhancement to TDF is the addition of Guaranteed-income options. These Funds convert into a personalised investment plan for those seeking the security of a guaranteed income for life.

TDF offering guaranteed income are available now in the US, but they have not been widely embraced by either participants or plan sponsors. They do face a higher fee hurdle to be adopted. Albeit, the Wealth Management.com article notes “TDFs offering guaranteed income are likely to gain traction in the DC space. Participants contemplating decades in retirement naturally have concerns about outliving their savings, and guaranteed-income TDFs address that anxiety.”

 

The innovation and focus of these Funds is consistent with the framework proposed by EDHEC Risk Institute, as I outlined in the Post: A more Robust Investment Solution

They are also consistent with the Next Generation of Retirement solutions promoted by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012. I summarise Professor Merton’s Paper in this Post: Designing a new Retirement System, which is the most read Kiwi Investor Blog Post.

 

Such considerations will greatly increase the efficiency of TDF.

These solutions are about making Finance great Again (Flexicurity in Retirement Income Solutions – making finance great again)

 

New Zealand Perspective

TDF would make more sense as a Default KiwiSaver solution, and stack up better relative to a Balanced Fund option (Balanced Funds not the Solution for Default Kiwi Saver Investors).

Lastly, the criticism of TDF is often due to poor design (In Defence of Target Date Funds).

An example is a large Kiwi Saver provider promoting a 65+ Life Stages Fund which is 100% investment in Cash. This is scandalous as outlined in this research by Dimensional, this research is summarised in the Post High Cash holdings a scandalous investment for someone in retirement.

 

 

Happy investing.

Please read my Disclosure Statement

 

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