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.

Designing a new Retirement System and Goal-Based Wealth Management

This Post covers an article by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012.

It is a relatively long but easy article to read, very entertaining, he is a wonderful conversationalist with some great analogies.

It should be read by all, particularly those interested in developing a robust Retirement System.

The concepts underlie a move globally to the development of more innovative investment solutions to meet a growing need from those in retirement.

I have tried to summarise his concepts below, probably without full justice.

 

Before we begin, it is important to emphasis, what Professor Merton has in mind is a retirement system that supports a mass produced and truly customised investment solution.

This is not a hypothetical investment strategy/approach he is advancing, cooked up in a laboratory, investment strategies are already in place in Europe and the United States based on the concepts outlined in his article.

These concepts are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions. The performance of these solutions and those provided by the likes of BlackRock can be tracked by the indices they produce.

The behavioural finance aspects of these approaches are outlined in a previous Post.

Merton begins

Due to excessive complexity in investment choices and a focus on the wrong goals, hundreds of millions of low- to middle-income earners face a precipitous decline in their living standards upon their departure from the workforce.

But it doesn’t have to be that way. Technology, innovation and our understanding of what are meaningful choices about retirement funding mean we are now in a position to design a better system that serves all people, not just the wealthiest ones.

 

And he concludes:

In designing a new retirement system, Merton argues first we need to define the goal. He defines the goal as helping participants achieve income throughout retirement, adjusted to keep pace with inflation.

Merton notes, the current system is no longer sustainable and requires individuals to make overly complex investment decisions and the industry bombards them with jargon that is meaningless to them.

Therefore, he argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.

This requires customisation of the investment strategy. Asset allocation strategies should be personalised. And, each individual is given regular updates on how “they” are travelling in ways that make sense to them.

However, unlike simple target-date funds that mechanically set the asset allocation using a crude calculation based on a single variable — the participant’s age — Merton proposes a customised, dynamically managed solution based on each participant’s tailored goals for desired outcomes, life situation, expected future contributions and other retirement-dedicated assets, including current savings accumulated, and any other retirement Benefit entitlements.

To improve effectiveness of engagement of the Participant, all of the complexity of the investment strategy is kept under the bonnet, out of sight. The user is asked a series of simple questions around their essential and their desired income targets. Once they achieve a very strong likelihood (more than 96 per cent) of reaching that desired income, they lock in an asset allocation to match that desired lifetime income at retirement.

Merton concludes, this is not a hypothetical investment strategy/approach. Such strategies are currently being implemented in Europe and the United States.

And, it begins and ends with turning the focus back onto what superannuation should be about — ensuring people have adequate incomes in retirement.

 

Therefore, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.  Such a strategy limits the downside and upside relative to the investment objects – narrowing the variation of likely outcomes relative to a desired level of income in retirement.

Therefore, it increases the probability of reaching a desired level of income in retirement.

 

 

Now to the Body of the Article:

Background

Merton identifies the shortcomings of the current retirement system, particularly the shift from Defined Benefit (DB) to Define Contribution (DC) has burdened the users with having to make complex decisions about issues in which they have no knowledge or expertise.

The current system is far from ideal.

Therefore, in considering how to reshape the system, Merton argues we should start by establishing the goal.

What are members seeking to achieve?

To his mind, people “want an inflation adjusted level of funding that allows them to sustain the standard of living in retirement that they have grown accustomed to in the final years of their working lives.”

Merton then asks: How do we define a standard of living in financial terms?

Traditionally this has been a sufficiently large lump sum. “Indeed, that is the premise of most DC plans, including most in the Australian superannuation system. The focus is on amassing a sufficiently large lump sum in the accumulation phase“.

However, “in reality, when talking about a standard of living, people think of income”.

For example a Government sponsored pension is described in terms of an annual/weekly payment. Likewise DB plans were expressed as income per year for life and not by its lump-sum value.

This is why DB plans were so attractive to the investor. The income was to be received and there were no complex decisions to be made.

Contrast this to the DC system, there is a mirror of products and investment decisions that need to be made and it is no wonder people sit in default funds and are not engaged.

 

Furthermore, over and above the complexity Merton notes: “most DC plan allocations take no account of individual circumstances, including human capital, housing and retirement dedicated assets held outside the DC plan. Those are all important inputs for an allocation decision customised to the needs of each person.”

Therefore, he argues the next generation of retirement solutions need to meet the following criteria:

  • To be robust, scalable, low-cost investment strategies that make efficient use of all dedicated retirement assets to maximise the chance of achieving the retirement income goal and manage the risk of not achieving it.
  • A risk-managed customised solution with individually tailored goals for each member — taking into account his or her age, salary, gender, accumulation plan and other assets dedicated to retirement.
  • A solution that is effective even for individuals who never provide information or who never become involved in the decision making process at all. And, for those who do become engaged, we need a solution that gives them meaningful information about how they are travelling and what they can do if they are not on track to achieve their retirement income goals.
  • Allows plan sponsors (or pension fund trustees) to control their costs and eliminate balance sheet risk.

 

Next-generation retirement planning

Merton argues: “The simplest retirement solution is one in which the members do absolutely nothing. They provide no information and make no decisions. In fact, they are not engaged in the process at all until they reach retirement.”

He acknowledges that such extreme behaviour is rare, nevertheless, a well-designed retirement solution would display such characteristics.

It has to be to a standard that when members do engage “(it) enhances the chances of success in achieving the desired income goal.”

 

But how is that achieved?

Investment solutions need to be designed based on questions that are meaningful for people, such as:

  • What standard of living do you desire in retirement?
  • What standard of living are you willing to accept?
  • What contribution or savings rate are you willing or able to make?

 

The key point of these questions: 

“Such questions embed the trade-off between consumption during work life and consumption in retirement and they make sense to people, unlike questions about asset allocation.”

Importantly the focus is not on what investments you should have or your “risk preference”, it is on what are your retirement goals.

 

The objective is to create a simple design with only a handful of relevant choices.

Merton also argues that “we need a design that does not change, at least in the way that users interact with it. An unchanging design leads to tools that people will be more likely to learn and use. In fact, a design that is unchanging is almost as important as a design that is simple.“

Something simple and consistent is easier for people to learn and remember than something complicated and changing.

 

A point made in the article, is that the design can be simple, but what is underneath can be complex. The underlying investment solution needs to flexible and innovative to improve performance over time. Not fixed, rigid, and independent of the changing market environments.

“We must, therefore, design a system that is user friendly, one that people can become familiar with and thus are willing to use — a system in which the designers do the heavy lifting, so users need only make lifestyle decisions that they understand and the system then translates into the investment actions needed to achieve those goals.”

 

 

Wealth versus sustainable income as the goal

The second dimension is the use of wealth as a measure of economic welfare.

Merton makes a strong case Income is what matters in retirement and not how big your pot of money is i.e. Lump sum, or accumulated wealth.

It is often said that if you have enough money you will get the income and everything will be fine. This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

By way of example: A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $30k if they had remained invested in term deposits. That’s a big drop in income (-63%) and also does not take into account the erosion of buying power from inflation.  You would be a bit concerned if you lost 63% of your lump sum!

The point being, knowing you had a million dollars did not tell you about a lifestyle that could be supported in retirement.

Focusing on accumulated wealth does not distinguish between the standard of living and wealth as the objective.

As Merton says “Sustainable income flow, not the stock of wealth, is the objective that counts for retirement planning.”

 

Investment Reporting

Merton makes another, and important point, the reporting of Investment results to members is not trivial. Crucially what is reported to members by providers heavily influences behaviour e.g. volatility of capital as a measure of risk influences behaviour, often bad behaviour.

Therefore, the measure of risk is important.

From this perspective, in Merton’s mind reporting should focus on the level of income that will be generated in retirement. This is the most important measure. The volatility of likely income in retirement is a better measure risk.

And from this standpoint it is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.

 

Essential and desired income goals – Goals-Based Investing

The system Merton is describing “seeks to increase the likelihood of reaching nominated income goals by sacrificing the possibility of doing significantly better than desired”.

In effect he is seeking to narrow the likely outcomes, technically speaking the “distribution” of income outcomes in retirement.

We do this by focusing on desired and essential target income goals.

These goals are what the member would see as a good retirement income given their set of circumstances and on how much risk would be acceptable in achieving those goals.

The desired income goal would be defined as a level of income that while not guaranteed, has a very high probability of being achieved and which serves to indicate the degree of risk of the member’s strategy.

Therefore, the investment objective is to maximise the estimated probability of achieving a desired level of income in retirement.

Accordingly, as the probability of reaching the desired level of income in retirement rises risk is reduced so as to “lock in” the chances of achieving the goal at retirement.

As Merton notes “by taking as much risk as possible off the table when it is no longer needed, we are trading off the possibility of achieving ‘even more’ against increasing materially the probability of achieving the goal.”

In this way, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.

Such a strategy limits the downside and upside relative to the investment objects – narrows the variation of likely outcomes relative to the desired level of income in retirement.

Therefore, it increases the probability of reaching desired level of income in retirement, particularly relative to a less focussed investment strategy.

 

Pension Alerts

Merton recommends that should a Member’s progress suggest they have a less that say 50% probability of reaching their retirement income goal they are contacted.

At which point in time they have three options:

  1. increase their monthly contributions;
  2. raise their retirement age; and/or
  3. take more risk.

The Member gets these alerts during the accumulation phase. This can be formal systematic process under which the plan sponsor and trustees, as part of their fiduciary responsibilities, seek to guide that member to a good retirement outcome.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Investing in a Challenging Investment Environment

The Global financial backdrop can be summarised as:

  1. Late Cycle
    • The US economy is into its longest period of uninterrupted growth, it has been over ten years since the Global Financial Crisis (GFC) and the US experiencing a recession.
    • Likewise, the US sharemarket is into it longest period without incurring a 20% or more fall (which would be a bear market).
  2. Exceptionally low interest rates. As you will be aware over $14 trillion of European and Japanese fixed income securities are trading on negative interest rates.
  3. Central Banks around the world are reducing short-term interest. By way of example, the US Federal Reserve has undertaken a mid-cycle adjustment, with more to come, the European Central Bank recently cut interest rates, as has China’s Central Bank. The Reserve Bank of Australia and the Reserve Bank of New Zealand have reduced cash rates very aggressively in recent months. It appears that interest rates will remain lower for longer.
  4. Rising geo-political risk, namely an ongoing and escalating trade dispute between the US and China, while Brexit has a cameo role on the global stage, and there are rising tensions in the middle-east.
  5. Global growth has slowed. The pace of economic activity has slowed around the world, this is most noticeable in Europe, Japan, and China, and is concentrated within the manufacturing sector. The service sectors have largely been unaffected.

 

Against this backdrop the US sharemarket has outperformed, continually reaching all-time highs, likewise for the New Zealand sharemarket.

Value stocks have underperformed high growth momentum stocks. The performance differential between value and growth is at historical extremes.

Lastly emerging Markets have underperformed the developed world.

 

A good assessment of the current environment is provided in this article by Byron Wien. It is a must read, Plenty to worry about but not much to do.

 

It is not all gloom and doom

The US consumer is in very good shape, reflecting record low unemployment, rising wages, and a sound property market. The US consumer is as bigger share of the global economy as is China. Although it is not growing as fast as China, a solid pace of growth is being recorded.

Overall, economic data in the US has beaten expectations over recent weeks (e.g. retail sales).

Globally the manufacturing sectors are expected to recover over the second half of this year, leading to a rebound in global growth. Low interest rates will also help global growth.  Nevertheless, growth will remain modest and inflation absent.

Globally, in most countries, Sharemarket’s dividend yields are higher than interest rates. This means that sharemarkets can fall in value over the next 5-10 years and still outperform fixed income.

 

How to invest in current environment

Recently there has been #TINA movement: There Is No Alternative to Equities.

Certainly equities have performed strongly on a year to date basis, so have fixed income securities (their value increases as interest rates fall).

The traditional 60/40 portfolio, 60% Equities and 40% Fixed Income, has performed very strongly over the last 6-9 months, this comes after a difficult 2018.

#TINA and the longer term performance of the 60/40 portfolio is covered in this AllAboutAlpha Article, which is well worth reading.

The 60/40 portfolio has performed well over the last 10 years, and has been a strong performer over the longer term.

This performance needs to be put into the context that interest rates have been falling for the last 35 years, this has boosted the returns from the Fixed Income component of the portfolio.  Needless to say, this tail wind may not be so strong in the next 35 years.

This indicates that future returns from a 60/40 portfolio will be lower than those experienced in more recent history.

There are lots of suggestions as to what one should do in the current market environment.  This article on Livewire Markets provides some flavour.

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

 

At a time like this, reflect on the tried and true:

Seek “True” portfolio Diversification

The AllAboutAlpha article references a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

The above comments are technical in nature and I will explain below. Albeit, the Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

 

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes i.e. asset class silos. This has diminishing diversification benefits over the longer term and particularly at the time of market crisis e.g. adding global listed property or infrastructure to a multi-asset portfolio that already includes global equities.

True portfolio diversification is achieved by investing in different risk factors (i.e. premia) that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative and hedge fund risk premia, illiquidity e.g. Private Equity, Direct Property, and unlisted infrastructure. And of course, true alpha from active management, returns that cannot be explained by the risk exposures just outlined. There has been a disaggregation of returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures. They are a model of world best investment management practice.

Therefore, seek true portfolio diversification, this is best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates driving portfolio outcomes.

As the Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events i.e. Black Swans.

True diversification leads to a more robust portfolio.

(I have written a number of Post on Alternatives and the expected growth in institutions investing in alternatives globally.)

 

Customised investment solution

Often the next bit advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from capital markets.

For example, income earned up to and after retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

 

Think long-term

I think this is a given, and it needs to be balanced with your customised investment objectives as outlined above. Try to see through market noise, don’t over trade and don’t take on more risk to chase returns.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

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

 

There are a lot of Investment Behavioural issues to consider, 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.”

Kiwiinvestorblog is all about education, it does not provide investment advice nor promote any investment and receives no payments. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all weather portfolio?

 

Happy investing.

Please see my Disclosure Statement

 

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

 

In defence of Target Date Funds

This is a great article from i3 providing some interesting perspectives into Target Date Funds, referred to as Life-Cycle strategies in Australia.

Target Date Funds have been around since the 1990s and have had an increasing presence in Australia following the MySuper legislation of 2012, which set the legal requirements for the default pension (KiwiSaver) options in Australia.

As a result, many Australian providers introduced Life-Cycle Funds as default options. Target Date Funds are also increasingly the default option in the USA.

 

It is fair to say there has been wide spread criticism of Target Date Funds.

Some of this criticism is warranted, nevertheless, consistent with the point made in the i3 article, the criticism of Target Date Funds is often the result of the poor design of the Fund itself, rather than the concept of a Target Date Fund.

For example, as noted in the article, the Australian Productivity Commission “criticised a number of existing life-cycle strategies for derisking too early and not being as good as many balanced fund options.”

This is fair criticism, but it is a design issue. I have previously noted that at least one KiwiSaver provider places their clients into 100% Cash at age 65, that is scandalous.

On the positive side, the Commission “acknowledged life-cycle strategies could help in addressing sequencing risk”.

 

These themes are touched on in the interview with Michael Block, Chief Investment Officer with Australian Catholic Superannuation.

“To always place a member who is 20 years old with a 60-year old member in the same strategy is clearly ridiculous,” Block says in an interview with [i3] Insights.

“Why would any fund use a one-size strategy that clearly does not fit all?”

“I absolutely concede, especially with people living longer, that moving members into a low-risk strategy at 60 is not a great idea. Even at 60 years old, a member is likely to have a 30-year investment horizon and should still have a decent amount of growth assets,” he says. (Growth asset include equities, alternatives and non-traditional assets.)

As the article notes: “The result of the shift is that half of the fund’s members now have a higher allocation to growth assets, while one-quarter, generally older members, have a lower allocation. The rest have retained a similar exposure to growth assets.”

 

Comments on De-risking

De-risking is reducing the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

Australian Catholic Super looks to reduce the allocation to equities in small annual increments, 31 steps to be precise, not the normal 3-4 lumpy transactions of many Target Date Funds.

“As long as you still contribute to your super, you’ll get a better outcome compared to a single-strategy investment option,” Block says. (An example of a single strategy is a Conservative or Balance Fund.)

“This gradual process of derisking also reduces a member’s sequencing risk as there is never more than a 2 per cent reduction in growth assets in any given year.”

This makes some sense and is a nice design feature of their Target Date Funds.

 

Customisation

The Australian Catholic Super’s life-cycle fund is based on age only. They hope to add other variables over time, such as account balance and salary.

“In a perfect world, you would ask everyone what they wanted out of a superannuation fund and tailor an individual portfolio for them, but if you don’t have complete information, then a life-cycle strategy based on age is a good attempt at mass customisation,” he says.

 

Quite true, it is a start, and a good start at that. With further sophistication of the investment approach and the helping hand of technology the mass customised investment solutions is not far away.

Increased customisation of the superannuation solution is the future.  Customisation will consider the generation of a required level of income in retirement, take into consideration income earned outside of super, risk preferences, account balance, and any likely endowments. Such customisation is available now.

 

More on Target Date Funds

For those wanting more on Target Date Funds, I have previously Posted on their Short Comings and suggested improvements.  They are also worth considering as the KiwiSaver Default Option.

Lastly, Target Date Fund can be improved upon by 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.

 

Interestingly, Kiwis can learn from the Aussies, maybe not when it comes to rugby, or certain cricket practices, but most certainly we can learn from them when it comes to Superannuation and the management of Pension Funds.

 

Happy investing.

Please see my Disclosure Statement

 

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

Fintech’s Colossal Solution – Uber Moment? Microsoft and BlackRock team up

BlackRock and Microsoft are building a platform that will help people develop better saving and investment habits through more regular engagement with their retirement assets.

This initiative was announced in December 2018 and the Wall Street Journal (WSJ) noted at the time:

“The firms plan to develop a technology platform that will provide digital financial-planning tools and new BlackRock funds offering guaranteed retirement income to employees through their workplace saving plans.”

 

This is close to the Uber moment for the Wealth Management industry: technology platform providing retirement planning tools and direct access to new generation Investment Solutions.

 

BlackRock, the world’s largest money manager, according to WSJ “wants to shape the technology plumbing that connects it to different parts of the financial ecosystem handling workers’ retirement money.”  And for Microsoft, who needs no introduction, “an investment platform built with its technology could bring in new revenue as it looks to become a bigger cloud-computing player.”

 

BlackRock and Microsoft have made progress since December and FinancialPlanning.com provided further details in July 2019:

“The technology giant and the asset manager overseeing 15 million Americans’ 401(k) portfolios are developing an app and desktop tool aimed at narrowing the widening gap between what workers will need in retirement and how much they’re saving.”  (401 (k) is like KiwiSaver)

BlackRock and Microsoft are looking to reimage America’s path toward achieving greater financial security in retirement by bringing together BlackRock’s investment capabilities and Microsoft’s technology strength.

Together, they are exploring the next generation of investment solutions to help more people make better decisions as they work toward their financial goals in retirement.

Taking advantage of Microsoft’s technologies and BlackRock’s investment products, the companies are aiming to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.

The firms will begin rolling out their tool later this year.

By all accounts, this is going to be a powerful platform.  I’d imagine some of the tools will be like the BlackRock CoRI Index, which estimates the level of lifetime retirement from current savings.

 

Lifetime Income Focus – Next Generation of Investment Products

From an investment perspective the retirement tool will include guaranteed retirement income planning.

As part of the rollout Microsoft and BlackRock are designing methods of showing workers how much extra contributions today could end up netting them in retirement.  The intended result is that employees “have a clearer picture of how their contributions today will translate to long-term retirement income”.

BlackRock intends to offer the platform in connection with next generation investment products that it will design and manage. The new products from BlackRock will seek to provide a lifetime of income in retirement.

 

Therefore, BlackRock will be offering more sophisticated products than widely available now.  These Funds will seek to provide guaranteed income streams to participants as they get older, an element not common in 401(k) (like KiwiSaver) and other retirement plans.

The funds will be like Target Date Funds, a blend of investments that get more conservative as investors head into retirement. However, the funds BlackRock wants to roll out will also increase their concentration in financial instruments that provide regular payouts as participants reach retirement.  This is a massive enhancement.

As an aside, Target Date Funds would be a good option as the Default Fund for KiwiSaver.

 

Importantly, the focus is on providing an income stream in retirement.  There is a strong argument this should be the primary investment goal and not the targeting of a lump sum at time of retirement. What matters in retirement is income.

The OECD encourages the retirement objective to be the generation of income in retirement and for there to be coherency between the accumulation and pay-out phase of retirement.

Currently most investment products are poorly positioned to meet these objectives.

The central point is, without a greater focus on generating Income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

Therefore, volatility of income in retirement is a good risk measure.

It is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.

 

More specifically, the focus on retirement income and use of more advanced portfolio construction techniques as liability-driven investing overcomes one of the main criticisms of Target Date Funds.  Particularly, Target Date Funds should have a greater focus on generating income in retirement.  This means the fixed income allocation should act more like an annuity so that is pays a steady stream of income to the investor once they reach retirement.

The investment knowledge is available to achieve this.

 

Accordingly, BlackRock’s solutions appear to be more aligned with Goals-Based Investing and will be a more robust Retirement Income Solution than those available now.

There is a real need for these new generation investment solutions as many of the current financial products have shortcomings in meeting future customer needs, particularly the delivery of a stable and secure level of retirement income.

It is also important to note that there is a paradigm shift underway within the wealth management industry in relation to the development of new and improved investment solutions.

The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions to meet a growing savings crisis.

 

Defining Social Challenge – Addressing the Savings Crisis with Technology

As BlackRock outlined when making the initial announcement in December 2018:

Retirement systems worldwide are under stress and providing financial security to retirees has become one of the most defining societal challenges of our time,” said Laurence Fink, chairman and chief executive of BlackRock.

BlackRock has a tremendous responsibility to help solve this challenge, and we recognise the need to act now. Working with Microsoft will enable us to build a powerful solution for millions of hardworking Americans.”

There has been a major shift globally away from Defined Benefit (DB) schemes to Defined Contribution (DC).

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.   This has been likened “financial climate change” by the World Economic Forum

In America, millions are struggling to achieve their financial goals in retirement.  BlackRock and Microsoft are aiming to narrow the “gap” between what workers will need in retirement and how much they are saving.  This gap is estimated to be expanding by $3 trillion each year!

Therefore, there is a very real need to help people who are struggling with the difficult task of saving, investing, and turning this into a retirement income.

In BlackRock and Microsoft’s view the “shift in responsibility, from corporations to individuals, combined with ever increasing life-spans, has created a need to reimagine a new approach to securing a sound financial future in retirement – one that is powered by innovative investment solutions and the most advanced, trusted and cutting-edge technologies.”

“Technology is already revolutionizing entire industries and the way people interact with everything from health care to education and transportation. And yet, retirement solutions of today have been slow to keep pace. Taking advantage of Microsoft’s cutting-edge technologies and innovative investment products from BlackRock, the companies aim to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.”

 

Thus, the need for new innovative investment solutions and technology platforms.

This is close to the Uber moment for the Wealth Management industry.

 

Happy investing.

Please see my Disclosure Statement

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