The most read Kiwi Investor Blog Posts in 2020 have been relevant to the current environment facing investors. They have also focused on building more robust portfolios.
The ultra-low interest rate environment and sobering low return forecasts present a bleak outlook for the Traditional Balanced Portfolio (60% Equities and 40% Fixed Income.) This outlook for the Balanced Portfolio was a developing theme in 2020, which gained greater prominence as the year progressed.
In essence, there are two themes that present a challenge for the Traditional Balanced Portfolio in the years ahead:
That fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest too heavily in these markets; and
With interest rates at very low levels, there is increasing doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.
My highest read Posts address the second theme above.
The Balance Portfolio has served investors well in recent years. Although equities and fixed income still have a role to play in the future, there is more that can be done.
The most read Kiwi Investor Blog Posts outline strategies that are “more that can be done”.
I have no doubt investors are going to have to look for alternative sources of returns and new asset classes outside equities and fixed income over the years ahead. In addition, investors will need to prepare for a period of higher inflation.
Not only will this help in increasing the odds of meeting investment return objectives; it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility.
The best way to manage periods of severe sharemarket declines, as experienced in the first quarter of 2020, is to have a diversified portfolio. It is impossible to time these episodes.
Arguably the most prudent course of action for an investor to pursue in the years ahead is to take advantage of modern investment strategies that deliver portfolio diversification benefits and to employ more advanced portfolio construction techniques. Both of which have been successfully implemented by large institutional investors for many years.
From my perspective, maintaining an array of diversification strategies is preferred, investors should diversify their diversifiers.
The most read Kiwi Investor Blog Posts in 2020 were:
Investment advisors who stay active across their client base in times of market volatility are more likely to add new clients from a variety of sources.
Clients and prospects want to know that their advisor is looking out for them, even when the advice they are delivering is to stay the course or focus on the long term.
Laying a foundation for communications based on behavioral finance allows advisors to better set expectations early on in client relationships, while also offering an opportunity to maintain an open dialogue when markets become turbulent.
When properly employed, behavioral finance allows advisors to pursue the twin goals of helping investors feel less financial stress while making better decisions in pursuit of their long-term goals.
A recent study found those advisors who employed behavioral finance in their approach:
Gained a better understanding of clients’ risk appetite and kept them invested during the market turbulence in early 2020;
Reported elevated client acquisition activity earlier in the year; and
Developed deeper relations with clients.
As market volatility escalated, advisors increasingly turned to behavioral finance to help keep clients invested and focused on their long-term goals.
These findings will not be surprising to most investment advisors. Nevertheless, the evidence supporting including elements of behavioral finance in the planning process is growing, and it is becoming more widely accepted.
It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalised action plans to help them achieve their goals. Clients prefer this too.
Incorporating elements of behavioral finance in the planning process will help achieve this, benefiting both the client and advisor.
We all have behavioral biases and are prone to making poor decisions, investment related or otherwise. Therefore, it is important to understand our behavioral biases. From this perspective, behavioral finance can help us make better investment decisions.
The following Table outlines the Top 5 behavioral biases identified by advisors in the Cerulli Associates study.
Being easily influenced by recent news events or experiences
Opting for less risk in portfolio than is recommended
Preferring to invest in familiar (U.S. domiciled) companies
Making decisions based on the way the information is presented
Separating wealth into different buckets based on financial goals
Not unexpectedly Recency bias was found by advisors to be the most common behavioral bias amongst clients this year. This was also the most common behavioral bias in 2019, on both occasions 35% of Advisors indicated that Recency bias was a significant contributor to their clients’ decision making.
Loss aversion held the number two spot in both years. The Paper provides a full list of Client behavioral biases identified, comparing 2020 results with those in 2019.
Clients are more than likely affected by several behavioral biases.
Advisors can help clients improve their investment outcomes by influencing the behavioral bias in a positive way. By way of example in the paper, Framing (easily influenced by recent events), “an advisor can emphasize how rebalancing a portfolio during an equity market decline allows investors to accumulate more shares of their favorite stock or funds at a reduced price.”
They conclude: “by embracing the principles of behavioral finance, advisors can nudge clients toward more constructive ways to think about their portfolios.”
Survey Results – the benefits of Behavioral Finance
The paper defines Behavioral finance as the study of the emotional and intellectual processes that combine to drive investors’ decision making, with the goal of helping clients optimize financial outcomes and emotional satisfaction.
As the White Paper outlines “Advisors must help investors create and maintain a mental framework to help ease their concerns about the fluctuations of the market. Behavioral finance can be a crucial element of advisors’ efforts to help investors overcome their emotional reactions in pursuit of their longterm financial goals.”
There has been an increase in advisors adopting the principles of behavioral finance in America, particularly in relation to client communications.
In 2020 81% of advisors indicated adopting the principles of behavioral finance, up from 71% in 2019.
The increase is likely in response by advisors to provide a “mental framework to deal with the adversity presented by increased uncertainty in the market and in life overall in 2020.”
Benefits of Behavioral Finance
Keeping clients invested was found to be a key benefit of incorporating behavioral finance in the advice process, 55% of advisors indicated this as a benefit, up from 30% in 2019.
The benefit of developing a better understanding of client’s comfort level with risk also grew in 2020, from 20% in 2019 to 44% in 2020 (probably not surprisingly given events in March and April of this year).
In 2019, the benefits of incorporating behavioral finance most cited by advisors was: strengthening relationships (50%), improving decisions (49%), and better managing client expectations (45%). These benefits also scored highly in 2020.
The paper provides a full list of the benefits of incorporating behavioral finance, comparing the results of 2020 with 2019.
To summarise, the results highlighted the dual role of behavioral finance in client relationships as:
serving as a framework for deeper engagement to strengthen communications and prioritize goals during good times; and
to help minimize clients’ instinctual adverse reactions during periods of acute volatility.
The paper then focused on two areas:
Growing the client base
Deepening client connections
Behavioral Finance Advisors experienced greater growth of their client base in 2020
In 2020 55% of advisor respondents indicated they had added new clients since the first quarter of 2020. 4% indicated they had experienced net client losses.
However, the results differed materially between advisors who adopted elements of behavioral finance compared to those who do not.
“Two-thirds (66%) of behavioral finance users reported adding to their client base, compared to just 36% of advisors who are not incorporating behavioral finance in their practices.”
The source of these new clients?:
“Approximately two-thirds of new clients were sourced from other advisors with whom clients had become dissatisfied, or as an outcome of investors seeking to consolidate their accounts and maintain fewer advisor relationships. This is frequently attributable to satisfied clients referring friends and family who are discontented with their current advisory relationship.”
“The other third of new client relationships was attributable to the conversion of formerly selfdirected investors who found the current conditions an opportune time to seek professional advice for the first time.“
Therefore, “behavioral finance adherents are more likely to not only educate clients regarding the potential for volatility, but also to urge clients to expect it. This scenario reinforces many of the key benefits of leveraging behavioral finance in advisory relationships, especially with regard to managing expectations and remaining invested during periods of volatility.”
Behavioral Finance Advisors develop deeper connections with their client base
Cerulli’s research has found that the level of an advisor’s proactive communication during periods of market volatility is the most reliable indicator of the degree to which the advisor will add new clients during the period.
In the study that they undertook, for example, they found that 72% of those advisors who employed elements of behavioral finance and increased their outgoing calls added new clients, compared to 42% of non-users of behavioral finance.
They conclude “The unifying element in these results is that proactive personal communication was valued by investors and was especially effective for advisors who have made behavioral finance a part of their client engagement strategy.“
A key point here, is that “Instead of having to pivot from touting their investment returns to focusing on explaining volatility, behavioral finance users were able to frame current conditions as expected developments within the context of the long-term plans they had previously developed and discussed.”
From this perspective, it is important to understand what type of communications clients and prospects prefer.
It goes without saying, that advisors truly need to get to know their clients and use these insights to create personalized action plans to help them achieve their goals.
Clients prefer this too.
Incorporating elements of behavioral finance in the planning process will deliver this, benefiting both the client and advisor.
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
Being easily influenced by recent news events or experiences
Opting for less risk in portfolio than is recommended
Preferring to invest in familiar (U.S. domiciled) companies
Making decisions based on the way the information is presented
Separating wealth into different buckets based on financial goals
Seeking information that reinforces existing perceptions
Focusing on a specific reference point when making decisions
Following the crowd or latest investment trends
Assigning a greater value to investments or assets already owned
Failing to take action or avoiding changes to a portfolio
Recalling only positive experiences or outcomes
Fearing to take action due to previous mistakes or regret avoidance
Basing decisions only on readily available information
Being overly confident in one’s own ability
Spending excessively today at expense of the future
Sources: Cerulli Associates, in partnership with Charles Schwab Investment Management, Inc., and the Investments & Wealth Institute. Analyst Note: Advisors were asked, “To what degree do you believe the following biases may be affecting your clients’ investment decision making?”
In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”
Although the article is US centric, there are some key learnings, which are covered below.
How the Pandemic Has Impacted Financial Planning for Emergencies
The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”
Lower income families are more at-risk during times of financial emergencies. Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment. This rises to 52% for middle income households.
It is advisable to have emergency funds outside of super.
The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”
An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.
Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.
From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.
Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”
The concept of sidecar funds has recently been discussed in New Zealand.
Financial Planning for Early Retirement
The prospect of premature retirement will pose an urgent challenge for some clients.
Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.
The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.
Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….
They note the following challenges in early retirement:
Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period.
Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans. Often the decision to retire is about more than money.
Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration. Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.
Accommodating Low Yields in a Financial Plan
The low interest rate (yield) environment is a challenge for all investors.
Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.
Return expectations from fixed income securities (longer dated (maturity) securities) are very low. Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.
In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%. Expected returns on higher quality corporate bonds are not that much more enticing.
As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“
The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.
The 4% withdrawal rate equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.
For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate.
As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.
When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively. This implies a negative expected return after inflation.
The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020. The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time. A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.
As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.
Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved. They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.
This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.
Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”
The 4% withdrawal rate is an industry “rule of thumb”. Further discussion on the sustainability of the 4% withdrawal rate can be found here.
I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.
Those in the Retirement Risk Zone would benefit most from targeted investment advice.
The Retirement Risk Zone is the 10-year period before and after retirement (assumed to retire at age 65 years).
It is the 20-year period when the greatest amount of retirement savings is in play, and subsequently, risk is at its highest. It is a very important period for retirement planning.
The Retirement Risk Zone is the worst possible time to experience a large negative return. How much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of that loss.
Therefore, the value of good advice and a well-constructed portfolio aligned with one’s investment objectives is of most value during the Retirement Risk Zone.
Impact on timing of market losses
If a large loss occurs during the Retirement Risk Zone it will result in less money in retirement and raise longevity risk (the risk of running out of money in retirement).
The risk that the order of investment returns is unfavourable is referred to as sequencing risk.
Sequencing risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement.
Once an investor needs to take capital or income from a portfolio volatility of equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.
It is untrue to say that volatility does not matter for the long term when cashflows are involved. For further discussion on this issue see this Post, Could Buffett be wrong?
The portfolio size effect and sequencing risk have a direct relationship to longevity risk.
For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.
One-way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.
Materiality of Market Volatility in Retirement Risk Zone
Research by Griffith University finds “that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“
Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.
They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”
This is consistent with other international studies.
Managing Sequencing Risk
Sequencing risk is largely a retirement planning issue. Albeit a robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk.
Two key areas from an investment perspective to focus on in managing sequencing risk include:
The Retirement Goal is Income
The OECD’s Core Principles of Private Pension Regulation emphasis that the objective is to generate retirement income. This is different to the focus on accumulated value. A key learning from the Australian Superannuation industry is that there has been too greater focus on the size of the accumulated balance and that the purpose of superannuation should be about income in retirement.
An important point to consider, without a greater focus on generating income in retirement during the accumulation phase the variation of income in retirement will likely be higher.
Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.
This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable and secure level of income in retirement.
This is aligned with a Goals Based Investment approach.
A greater focus on reducing downside risk in a portfolio (Capital Preservation)
This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.
A robust portfolio must display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.
This may include the inclusion of alternative investments, tail risk hedging, and low volatility equities may also be option.
The current ultra-low interest rate environment presents a challenging environment for preserving portfolio capital, historically the role of Fixed Income. Further discussion on this issue can be found in this Post, which includes a discussion on Tail Risk Hedging.
This article in smstrusteenews highlights the growing issue of capital preservation within the Australian Self-Managed Super Fund (SMSF) space given the current investment environment.
Meanwhile, this article from Forbes is on managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.
Many argue that sequencing risk can be managed by Product use alone.
My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing. Longevity annuities could be used to complement the Goals-Based approach, to manage longevity risk.
This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.
For a more technical read please see the following papers:
The case for a greater focus on generating retirement income is provided in this Post, summarising an article by Nobel Laureate Professor Robert Merton. 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.
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:
Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
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:
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).
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)
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.
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:
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.
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 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.
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 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.
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!
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.
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.
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.
Educational Institution Mean
Yale vs Mean
Cash and Fixed Income
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.
There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.
Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.
Under these circumstances a passive approach no longer becomes optimal nor appropriate.
Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.
Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.
Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.
Framework for choosing an Alternative to Passive Investing
They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.
In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.
They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”
Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:
Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.
As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.
The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.
Below I have provided a description of the five reasons investors should seek an alternative to passive index.
Back ground Comments
Warren and Ezra provide some general comments on the state of the industry debate:
They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.
They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”
The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.
Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.
A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.
Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.
Cap-weighting is aligned with investor objectives.
It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.
The same is true for an endowment, insurance company, or foundation.
The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.
The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.
The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.
Reason #1: No Readily Replicable Index is Available
Passive investing assumes an effective index exists that can be easily and readily replicated.
In some instances, an appropriate index to replicate is simply not available, for example:
Unlisted assets such as Private Equity, unlisted infrastructure and direct property
Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.
In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.
Reason #2: The Passive Index Is at Odds with the Investor’s Objectives
Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.
By way of example:
Defined Benefit Pension Plan and tailored fixed-income mandates.
Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.
In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.
DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.
Such situations also exits for insurance companies, endowments, and foundations.
Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.
Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.
The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.
Reason #3: The Standard Passive Index is Inefficiently Constructed
Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.
The article presents two potential reasons an index might be inefficient and proves three examples.
They comment that an index might be inefficient for the following reasons:
the index is built on a narrow or unrepresentative universe; and
the index is constructed in a way that builds in some inefficiency.
As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.
Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.
The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).
There are many shortcomings of fixed-income indices, the article focuses on two:
Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.
Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.
Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.
Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.
However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.
Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.
The following features are outlined in the article to support such a situation:
Market inefficiency situations
Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.
The following situations may provide a manager with a competitive advantage:
Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.
Opportunities arising from differing investor objectives
Opportunities for active management to benefit may exist when:
Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
Investors have differing time horizons e.g. value investors exploit short-term focus of markets
Index fails to cover the opportunity set
The article makes the following points under this heading:
There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”
Reason #5: Skilled Managers Can Be Identified
Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.
Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.
The discussion makes the following points:
At the very least bad managers should be avoided
Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
Not all fund managers are created equal, some are good and some are bad
The research capability and skill to identify and select a manager is an important consideration.
Implementation and Costs
It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.
“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”
The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.
Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.
For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.
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.