Diversifying portfolios by adding alternatives New Zealand

Investment strategies for the year(s) ahead – how to add value to a portfolio

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At this time of the year there are a plethora of economic and market forecasts for next year.  This Post is not one of them.

Outlined below are several investment strategies investors should consider in building more robust portfolios for the years ahead and to increase the odds of meeting their investment objectives.

These strategies directly address the current investment environment and the developing theme over 2020 that the traditional Balanced portfolio, of 60% equities and 40% fixed income, is facing several head winds, and likely to disappoint from a return perspective in the decade ahead.

A recent FT article captures this mood, titled: Investors wonder if the 60/40 portfolio has a future | Financial Times

In the article they make the following comment “The traditional 60/40 portfolio — the mix of equities and bonds that has been a mainstay of investment strategy for decades — is at risk of becoming obsolete as some investors predict years of underperformance by both its component parts.”

I first Posted about the potential demise of the Balanced Portfolio in 2019, see here, and again in early 2020, see here.   These Posts provide background as too why many investment professionals are questioning the likely robustness of the Balance Portfolio in the years ahead given the current investment environment.

In essence, there are two themes presented for the bleak outlook for the Balanced Portfolio.

The first is that fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest in these markets.

The second theme is that with interest rates at very low levels, there is doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.

For more on the low expected return environment, first Theme, see these Posts here and here.  This Post also outlines that although markets fell sharply in March 2020, forecast future returns remain disappointing.

The strategies discussed below address the second theme, the expected reduced effectiveness of fixed income to protect the Balance Portfolio at the time of severe sharemarket declines.

The Balance Portfolio has served investors well.  Although equities and fixed income still have a role to play in the future, there is more that can be done.

The strategies outlined below are “the more that can be done“, they aim to improve the risk and return outcomes for the Balance Portfolio in the years ahead.

For the record, I anticipate the global economy to continue to repair next year, experiencing above average growth fuelled by the roll out of the Covid-19 vaccines and underpinned by extraordinary low interest rates and generous government spending programs.  Global equities will continue to perform well in this environment, the US dollar will weaken further, commodity prices will move higher, value and emerging markets to outperform.

The Case for holding Government Bonds

Before looking at some of the strategies to improve on the Balance Portfolio, it goes without saying there is a role for equities in most portfolios.  The case for and against US equities are found here and here respectively.

There is also a role for holding Fixed Income securities, primarily government bonds.

This Post reviews some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It also brings some balance to present discussions around fixed income and the points within should be considered when determining portfolio allocations in the current market environment.

The central argument for holding government bonds within a portfolio: 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.

In a recent Financial Times article PIMCO argues the case for the 60/40 portfolio in equities and fixed income.   

In relation to fixed income they argue, that although “returns over the horizon may be harder to achieve, but bonds will still play a very important role in portfolios”.  The benefits being diversification and moderation of portfolio volatility.

However, they argue in relation to fixed income investors must target specific regions and parts of the yield curve (different maturity dates) to maximise return and diversification potential.

PIMCO see opportunities in high-quality assets such as mortgage-backed securities from US government agencies, areas of AA and AAA rated investment-grade corporate bonds, and emerging market debt that is currency hedged.

They conclude: “One answer for 60/40 portfolio investors is to divide fixed-income investments into two subcomponents — hedging and yield assets.”

Rethinking the “40” in the 60/40 Portfolio

This Post outlines a thinkadvisor.com article which provides a framework to consider potential investment ideas in the current extremely low interest rate environment, by examining the 40% fixed income allocation within the 60/40 Portfolio (Balanced Portfolio).

The basis of the article is that investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk. This likely involves investing into a broader array of fixed income securities, dividend-paying equities, and alternatives, such as real assets and private credit.

The Role of Liquid Alternatives and Hedge Funds

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 next decade.

Not only will this help in increasing the odds of meeting investment objectives, but it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility, a role traditionally played by fixed income within a multi-asset portfolio.

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.

AQR has evaluated the effectiveness of diversifying investments during market drawdowns.

They recommend adding investments that make money on average and have a low correlation to equities i.e. liquid alternatives and hedge fund type strategies. 

AQR argue diversification should be true in both normal times and when most needed: during tough periods for equities.  Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, they tend to do worse on average over the longer term.

Alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and have higher returns.

Lastly, Portfolio diversification involves adding new “risks” to a portfolio, this can be hard to comprehend.  Diversification can be harder to achieve in practice than in theory.

This Post provides a full summary and access to the AQR article.

The case for Trend (momentum) Strategies

A sub-set of Alternatives and hedge funds is Trend/Momentum.

In this recent article MAN present the benefits of introducing Trend following strategies to the traditional Balanced Portfolio. Man note, “Another element that we believe can be of great help to bond-equity portfolios in the future is time-series momentum, or trend-following.”

Their analysis highlights that adding trend-following results in a significant improvement relation to the Balanced Portfolio, by improving returns, decreases volatility, and reducing the degree of losses when experienced (lower downside risk – drawdowns).

The case for Tail Risk Hedging

The expected reduced diversification benefits of fixed income in a Portfolio is a growing view among many investment professionals.

This presents a very important portfolio construction challenge to address, particularly for those portfolios with high allocations to fixed income.

There are many ways to approach this challenge,

This Post focuses on the case for Tail Risk Hedging.  It also outlines other approaches.

In my mind, investment strategies to address the current portfolio challenge need to be considered. The path taken is likely to be determined by individual circumstances.

Comparing a diversified approach versus Tail Risk Hedging

On this note, the complexity, and different approaches to providing portfolio protection, was highlighted by a twitter spat between Nassim Nicholas Taleb (Tail Risk Hedging) and Cliff Asness (broad Portfolio Diversification) from earlier in the year.

I provide a summary of this debate in Table format accessed in this Post, based on a Bloomberg article. 

Several learnings can be gained from their “discussion”.

Also covered the Post was an article by PIMCO on Hedging for Different Market Scenarios. This provides another perspective and a summary of different strategies and their trade-offs in different market environments.

Not every type of risk-mitigating strategy can be expected to work in every type of market environment.

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

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

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

This is a very good article presenting the benefits Alternatives would bring to a Balanced Portfolio.

Their research highlighted that Hedge Funds and Liquid Alternatives both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest that liquid alternatives are often viable options for investors compared to hedge funds.

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

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

Access to this research can be found here.

Private Equity Characteristics and benefits to a Portfolio

For those investors that can invest into illiquid investments, Private Equity (PE) is an option.

Portfolio analysis, also undertaken by Vanguard, demonstrates that PE can play a significant role in strategic, long-term, diversified portfolios.

PE is illiquid and so must be actively managed, introducing both illiquidity and manager specific risk to a multi-asset portfolio. Conventional asset allocation approaches often omit illiquidity and active risk dimensions from the risk-return trade-off. Therefore, these models do not reflect the unique aspects of PE and tend to over allocate to PE.

Vanguard addresses these issues: outlining four key reasons why the economic returns of private equity are different to those of public equities; highlighting the key risks that need to be accounted for when undertaking portfolio modelling including illiquid assets such as PE; and presenting the adjustments they make to portfolio modelling to address the illiquid features of PE and smoothed nature of historical returns.

This results in more realistic characteristics for PE that can be used for portfolio modelling purposes, reflected in the portfolio allocations generated in the article and the conclusion that PE can play a significant role in strategic, long-term, diversified portfolios.

A review of Vanguard’s analysis and their results can be found in this Post.

Real Assets Offer Real diversification benefits

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, Inflation-linked Bonds, Commodities, and Foreign Currencies offer real diversification benefits to a portfolio of just equities and fixed income.

The benefits of Real Assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation.

These are the conclusions of a recent study by PGIM.

PGIM provide a brief outline of the investment characteristics for several real assets. They then look at the sensitivity of the real assets to economic growth, inflation, equity markets, and fixed income.

They note there is wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds. These sensitivities vary over time and are best mitigated by holding a portfolio of real assets.

Therefore, PGIM construct and analyse three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection to reach their conclusions.

I provide a detailed summary of the PGIM Report in this Post.

Portfolio Tilts

Adding Emerging Markets and Value tilts to a Portfolio are potential areas to boost future investment returns in what is likely to be a low return environment over the next decade.

Value of Emerging Markets

Emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.

The case for investing into emerging markets is well documented: a growing share of global economic activity in the years ahead and current attractive valuations underpin the case for considering a higher weighting to emerging markets within portfolios. Particularly considering the low interest rate environment and stretched valuation of the US sharemarket. This is evident in market return forecasts.

Is a Value bias part of the answer in navigating today’s low interest rate environment

Value offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Value is exceptionally cheap, probably the cheapest it has ever been in history, based on several valuation measures and after making adjustments to market indices to try and prove otherwise, such as excluding all Technology, Media, and Telecom Stocks, excluding the largest stocks, and the most expensive stocks.

There is also little evidence to support the common criticisms of value, such as increased share repurchase activity, low interest rates, and rise of intangible assets.

This is not a popular view, and quite likely minority view, given the underperformance of value over the last ten years.

However, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next decade.

Please see my Disclosure Statement

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

What do Investors need in the current environment? – Rethink the ‘40’ in 60/40 Portfolios?

/ Kiwi Investor / 5 Comments

Investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk.

Investing into a broader array of fixed income securities, dividend-paying equities, and alternatives such as real assets and private credit is likely required.

Investors will need to build more diversified portfolios.

These are key conclusions from a recent article written by Tony Rodriquez, of Nuveen, Rethinking the ‘40’ in 60/40 Portfolios, which appeared recently in thinkadvisor.com.

The 60/40 Portfolio being 60% equities and 40% fixed income, the Balanced Portfolio. The ‘40’ is the Balanced Portfolio’s 40% allocation to fixed income.

In my mind, the most value will be added in implementation of investment strategies and manager selection.

In addition, the opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Putting It All Together

The thinkadvisor.com article provides the following Table.

Source: Nuveen

This Table is useful in considering potential investment ideas.  Actions taken will depend on the individual’s circumstances, including investment objectives, and risk tolerance.

The Table provides a framework across three dimensions to consider how to tackle the current investment challenge of very low interest rates.

Those dimensions are:

  1. The trade-off between level of income generated and risk tolerance (measured by portfolio volatility), e.g. lower income and reduced equity risk
  2. “How to do it” in meeting the trade-off identified above e.g. increase credit and equity exposures to seek higher income
  3. “Where to find it”, types of investments to implement How to do it e.g. active core fixed income, real assets (e.g. infrastructure and real estate), higher yielding credit assets.

Current Investment Environment

These insights reflect the current investment environment of extremely low interest rates.

More specifically the article starts with the following comments: “For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.”

Tony calls for action, “With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?”

This would be a worthy discussion for Investment Advisers and Consultants to have with their clients.

Returns from fixed income are relatively predictable, unlike equity market returns.  Current fixed income yields are the best predictor of future returns.  With global government bond yields around zero and global investment grade credit providing not much more, a return of greater than 1% p.a. from traditional global bond markets over the next 10 years is unlikely.

Fixed income returns over the next 10 years are highly likely to be below the rate of inflation.  Therefore, the risk of the erosion of purchasing power from fixed income is very high.  This is a portfolio risk that needs to be managed. 

Although forecasted returns from equities are also low compared to history, they are higher than those expected from traditional fixed income markets.

What should Investors do?

The article provides some specific guidance in relation to fixed income investments and a view on the outlook for the global economy.

The key point from the article, in my mind, is that for investors to meet the current investment challenges over the next decade they are going to need a more broadly diversified portfolio than the traditional 60/40 portfolio.

I also think it is going to require greater levels of active management.

This will involve a rethink of the ‘40’ fixed income allocation.  Specifically, the focus will be on generating higher returns and that fixed income is likely to provide less protection to a Balanced Portfolio at times of sharemarket declines than has been experienced historically.

Ultimately, a broader view of the 60/40 Portfolio’s construction will need to be undertaken. 

This is likely to require thinking outside of the fixed income universe and implementing a more robust and truly diversified portfolio.

Implementation will be key, including strategy and manager selection.

There will still be a role for fixed income within a Portfolio, particularly duration.  Depending on individual circumstances, higher yielding securities, emerging market debt, and active management of the entire fixed income universe, including duration, is something to consider.  More of an absolute return focus may need to be contemplated.

Outside of fixed income, thought should be given to thinking broadly in implementing a more robust and truly diversified portfolio. 

Kiwi Investor Blog has highlighted the following areas in previous Posts as a means to diversify a portfolio and address the current investment challenge:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging.  Highlighting that that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.

There have been a number of articles over recent months calling into question the robustness of the Balanced Portfolio of 60% Equities / 40% Fixed Income going forward.  I have covered this issue in previous Posts, here and here.

Why the Balanced Portfolio is expected to underperform is outlined in this Post.

Lastly, also relevant to the above discussion, please see this Post on preparing Portfolios for higher levels of inflation.

Call to Action

In appealing to Tony’s call for action, there has probably never been a more important time in realising the value of good investment advice and honest conversations of investment objectives and portfolio allocations. 

Perhaps it is time to push against some outdated conventions, seek new investments and asset classes.

The opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Addendum

For a perspective on the current market environment this podcast by Goldman Sachs may be of interest.

In the podcast, Goldman Sachs discuss their asset allocation strategy in the current environment, noting both fixed income and equities look expensive, this points to lower returns and higher risks for a Balanced Portfolio.  They anticipate an environment of below average returns and above average volatility.

Happy investing.

Please see my Disclosure Statement

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

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

/ Kiwi Investor / 6 Comments

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

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

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

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

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

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

Outdated Investment Strategy

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

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

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

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

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

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

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

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

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

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

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

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

Meeting the Challenge – Tail Risk Hedging

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

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

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

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

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

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

My View

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

To conclude

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

This is an investment portfolio challenge that must be addressed.

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

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

Happy investing.

Please see my Disclosure Statement

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

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

/ Kiwi Investor / 8 Comments

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

 

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

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

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

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

 

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

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

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

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

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

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

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

A brief description of the diversifying strategies is provided below:

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

 

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

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

 

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

 

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

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

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

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

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

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

 

 

 
Different Emphasis

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

 

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

Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.
Different approaches AQR strategies usually involve leverage and unlimited-loss derivatives.

 

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

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

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

 

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

 

 

 

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

The psychology of Portfolio Diversification

/ Kiwi Investor / 3 Comments

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

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

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

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

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

Nevertheless, overtime the sum is greater than the parts.

 

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

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

 

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

 

Playing with our minds – Recent History

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

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

WTW Balance Fund Performance

 

WTW made the following observations:

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

 

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

 

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

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

 

What is diversification?

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

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

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

 

Sources of Portfolio Diversification

Hedge Funds and Liquid Alternatives

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

Access to the Vanguard paper can be found here.

 

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

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

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Private Markets

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

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

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

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

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

 

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

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

WTW provided the following graph, source data from Preqin

WTW Private Market Performance

 

Real Assets

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

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

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

 

Conclusion

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

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

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

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

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

 

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

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

 

Why the Balanced Fund is expected to underperform

/ Kiwi Investor / 4 Comments

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

 

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

 

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

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

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

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

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

 

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

 

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

 

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

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

Global duration

 

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

 

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

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

 

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

 

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

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

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

 

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

 

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

 

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

 

Possible Solution

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

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

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

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

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

 

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

 

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

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

 

Happy investing.

 

Please read my Disclosure Statement

 

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

 

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

/ Kiwi Investor / 2 Comments

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

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

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

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

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

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

 

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

 

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

 

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

 

This is attractive to donors.

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

 

What did OCCF do?

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

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

 

What changed?

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

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

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

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

 

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

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

 

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

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Real Assets offer real diversification benefits

/ Kiwi Investor / 11 Comments

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income.

They offer real diversification benefits to a Balanced portfolio (60% equities and 40% fixed income) in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. PGIM is one of the largest asset managers in the world, managing over US$1 trillion in assets, and can trace its heritage to Prudential Financial in 1875.

 

The comprehensive analysis undertaken by PGIM outlines the role Real Assets can play in an Investment Portfolio.

Initially they identify and provided a brief outline of the investment characteristics for a number of real assets (see detail below).

The analysis primarily focuses on the sensitivities of real assets to both macroeconomic variables (e.g. economic growth and inflation) and traditional financial markets (e.g., equities and fixed income returns). This analysis is undertaken for each of real assets identified.

Pertinent points of the analysis:

  • There is a wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds.
  • These sensitivities vary over time.
  • The time varying nature of these sensitivities can be mitigated by holding a portfolio of real assets or actively managing the real assets exposures.

 

An important observation from the perspective of portfolio diversification, equities and fixed income have different sensitivities to inflation and growth than many of the real assets.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

 Inflation

Sensitivity

 Accessibility Data Availability & Quality Specific Risks Sector Difference
Real Estate Core

mid

 mid high high mid

mid
Real Estate Debt

low

 low mid low low mid

Natural Resources

high

 high mid mid high

high
Infrastructure

mid

 mid mid low mid

mid
Timberland

mid

 mid mid mid high

mid
Farmland (annual crops)

mid

 high mid mid mid

mid
Farmland (permanent crops)

low

 mid low mid high

high
TIPS

low

 high high high low

low
Commodity

high

 high high high low

high
Gold

low

 high high high low

low
Currency

low

 mid high high mid

Mid

 

PGIM then constructed three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection, by including some of the real assets identified above.

While the real asset portfolios’ macro-economic and financial market sensitivities still varied over time they were more stable than holding individual real assets.

Furthermore, across various economic environments, the three strategies displayed lower risk (lower volatility of returns) compared to equities.

PGIM then showed how these strategies performed in different economic environments: ideal, overheating, stagflation and stagnation.

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

 Ideal Overheating Muddled Stagflation Stagnation
Inflation &/ Growth Low & High High & High Median/Median High & Low Low & Low
Diversification

Y

Y

Y

Y

Y
Inflation-Protection

Y

 Y Y

Stagnation Protection

Y

 Y

Y
Equities

Y

Y

Y
Fixed Income

Y
Scenario frequency

8.9%

11.4%

53.9%

10.2%

15.8%

 

The PGIM analysis concludes that an allocation to real assets can improve the investment outcomes for a traditional portfolio dominated by equities and fixed income. These benefits are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation, cost of living adjustments.

This conclusion comes as no surprise given the demonstrated diversification benefits as outlined within the Report.

 

I provide more detail below by summarising the various sections of the PGIM Report.

The sections include:

    • The Real assets universe and their investment characteristics
    • Real Assets sensitivity to Macro-economic and financial market exposures
    • Real Asset Diversification Benefits relative to equities and fixed income
    • Analysis of Real Asset Strategy Portfolios
    • Diversification Benefits of the three Real Asset Portfolios, sensitivities to equities, fixed income, economic growth, and inflation.
    • Benefits of Real Asset Strategies in Investment Portfolios

 

Access to the PGIM Report is provided below.

 

The Real Assets Universe and their investment characteristics

PGIM identify the following real assets: Farmland, Timberland, Infrastructure, private equity and debt, Natural Resources, private and public equity, Real Estate, Private Equity, Core, Value-add, opportunistic, private debt, REITS, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.

The PGIM paper provides a brief description of each real asset, including sources of return drivers and key investment attributes.

Investment return characteristics of the real assets over the period January 1996 – June 2017 are provided.  I have reproduced for some of the real assets in the following Table.

Asset

Annual p.a. returns

 Risk annual volatility

Sharpe Ratio
Real Estate Core

8.3%

 11.0%

0.55
Real Estate Debt

6.3%

 4.8%

0.85
REIT

10.7%

 19.8%

0.43
Natural Resources

15.9%

 23.8%

0.58
Energy Equity

9.0%

 19.7%

0.35
Infrastructure

4.0%

 12.7%

0.14
MLP

12.6%

 26.2%

0.39
Timberland

7.3%

 6.9%

0.74
Farmland

12.2%

 7.3%

1.37
TIPS

5.2%

 6.0%

0.50
Commodity

-0.9%

 28.2%

-0.11
Gold

5.6%

 16.2%

0.21
Currency

-1.2%

 8.5%

-0.40
US Cash

2.2%

 2.2%

–
US 10 yr Treasury

5.2%

 8.6%

0.35
US Equity (S&P 500)

8.6%

 18.3%

0.35

 

Sensitivity to Macro-economic and financial market exposures

PGIM reviewed the sensitivity of Real Assets to several macro-economic variables over the period 1996-2017 and subperiods 1996-2007 and 2008-2017:

Inflation and growth

PGIM found an unstable return sensitivity profile to inflation and growth i.e. variation in return outcomes to different inflation and economic growth periods.

Of note, and an important observation from the perspective of portfolio diversification, equites and fixed income have different sensitivities to inflation and growth than many of the real assets.

Inflation Protection

PGIM found that many real assets had large positive sensitivities to inflation.

They found that commodity, currency, energy equity, gold, infrastructure, TIPS and natural resource real assets provided inflation protection, not only for the full period but generally (except for gold and currency) for both subperiods as well.

Stagnation Protection

Equities have a high sensitivity to economic growth, cash a low sensitivity.

Farmland, gold, real estate debt, TIPS, and currency had insignificant sensitivity to economic growth. Their sensitivity to growth surprises were also low and statistically insignificant i.e. their return outcomes are largely independent of economic growth.

The growth surprise sensitivity for farmland was negative and statistically significant.

PGIM define a real asset as offering “stagnation protection” if its full-period estimated growth and growth surprise sensitivity were approximately equal to or less than the corresponding growth sensitivity for cash.

Therefore, farmland, currency, gold, real estate debt, and TIPS provided stagnation protection for the full period and often for both subperiods.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

 Inflation

Sensitivity

 Accessibility Data Availability & Quality Specific Risks

Sector Difference
Real Estate Core

mid

 mid high high mid

mid
Real Estate Debt

low

 low mid low low

mid
Natural Resources

high

 high mid mid high

high
Infrastructure

mid

 mid mid low mid

mid
Timberland

mid

 mid mid mid high

mid
Farmland (annual crops)

mid

 high mid mid mid

mid
Farmland (permanent crops)

low

 mid low mid high

high
TIPS

low

 high high high low

low
Commodity

high

 high high high low

high
Gold

low

 high high high low

low
Currency

low

 mid high high mid

Mid

 

Real Asset Diversification Benefits relative to equities and fixed income

The different sensitivities of real assets to economic and inflation outcomes, on an absolute basis and relative to equities and fixed income, highlights the potential diversification benefits they could bring to a traditional portfolio of just equities and fixed income.

This is confirmed by the analysis undertaken by PGIM looking into the diversification benefits of real assets relative to equities and fixed income.

 

Diversifying Real Assets

Based on their criteria of sensitivity to equities and fixed income over the performance periods, PGIM found that currency, farmland, gold, natural resource, real estate, and timberland as diversifying real assets.

Not providing meaningful diversification benefits relative to equities was energy equity, listed property, and real estate.

Likewise, real estate debt and TIPS provided little diversification benefits relative to fixed income.

Although PGIM found diversification benefits from infrastructure, real estate debt and TIPS, they also found periods of time when there was limited diversification benefits relative to equities and fixed income.

 

Analysis of Real Asset Strategy Portfolios

PGIM used equal weights to the real assets to construct three Real Asset Strategy Portfolios. Each portfolio is a mix of public and private real assets.

A description of the three real asset Portfolios is provided below.

 

Diversification (80% private assets):

  • This portfolio is expected to have performance that has a low level of sensitivity with a traditional 60/40 Portfolio.
  • This ensures there will be diversification benefits regardless of the market cycle.
  • The Diversified Portfolio is made up of 20% Farmland, 20% Gold, 20% Natural Resource, 20% Real Estate, 20% Timberland

 

Inflation-Protection (33% private assets)

  • This strategy is designed to have better returns when inflation and inflation surprises are higher.
  • It is a strategy for investors with inflation-linked liabilities or a concern about overheating (high inflation and high growth) and stagflation (high inflation and low growth) economic scenarios.
  • Therefore, it includes real assets that have significant and positive exposure to both the inflation level and inflation surprise
  • The Inflation-Protection portfolio is made up of 17% Commodity, 17% Energy Equity, 17% Gold, 17% Infrastructure, 17% Natural Resource, 17% TIPS

 

Stagnation-Protection (50% private assets)

  • The Stagnation-Protection strategy portfolio is expected to perform better than cash in economic environments with below average growth.
  • This is a strategy for investors concerned about stagnation (low inflation and low growth) scenarios.
  • Included in this portfolio are real assets that have a sensitivity to both the real economic growth level and growth surprise that is lower than corresponding sensitivities for cash:
  • The Stagnation-Protection portfolio is made up of 25% Farmland, 25% Gold, 25% Real Estate Debt, and 25% TIPS.

 

Return Outcomes

PGIM measured the performance characteristic of these portfolios from January 1996 to December 2017. Including the sub-periods identified above.

The Diversification strategy produced the highest return (10.4%), with moderate risk (8.6%), and outperformed the 60/40 Portfolio (60% equities and 40% fixed income portfolio).

The Stagnation-Protection strategy offered similar absolute performance as the 60/40 portfolio, but due to its lower volatility produced much better risk-adjusted performance.

The Inflation-Protection strategy underperformed the 60/40 portfolio but generated slightly better risk adjusted returns. The Inflation-Protection strategy had the highest volatility of all three real asset strategies due to holdings of commodity and natural resource which have higher volatilities than stocks.

 

Diversification Benefits of the three Real Asset Portfolios

Sensitivity to Equities and Fixed Income

PGIM also found that the three Real Asset Portfolio strategies had low sensitivities to Equities.

The Inflation-Protection strategy tended to have the highest sensitivity to equities, while the Stagnation-Protection strategy had the lowest.

PGIM note the Stagnation-Protection portfolio had much lower sensitivity to equities than the 60/40 portfolio.

 

Relative to Fixed Income, the three strategies had on average a low and statistically insignificant sensitivity to Fixed Income. However, it was a game of two halves, all three strategies had negative sensitivity to Fixed Income in the first sub-period but positive sensitivity in the second sub-period.

 

Sensitivity to Economic variables

Economic Growth

The Inflation-Protection and Diversification strategies showed positive sensitivity to economic growth in both the full period and the second sub-period.

In contrast, the Stagnation-Protection strategy had negative sensitivity to economic growth for the full period, although not statistically significant.

While the Stagnation-Protection strategy had positive and statistically significant exposure to economic growth in the second sub-period, it was still the lowest growth exposure of all three real asset portfolio strategies.

Importantly, all three strategies display lower economic growth exposure relative to equities, this suggests they may provide investors protection at times of economic downturn (especially Stagnation-Protection and Diversification).

 

As PGIM note “To highlight the potential benefit, the Stagnation-Protection strategy offered positive exposure to inflation and negative exposure to growth, the opposite exposures for the 60/40 portfolio.”

 

Inflation Sensitivity

All three strategies had positive and significant sensitivity to inflation for the full period.

As was desired, the Inflation Protection strategy displayed the highest and statistically significant inflation sensitivity in both the full period and in both sub-periods “suggesting the strategy may provide inflation protection going forward. Notably, the Inflation-Protection strategy had much higher inflation sensitivity than stocks, bonds or the 60/40 portfolio.”

The Stagnation-Protection strategy had the lowest sensitivity to inflation.

 

Further in-depth analysis was undertaken into how the strategies would perform in different economic environments.

This analysis found:

  • All three real asset strategies perform well when inflation is high.
  • During stagflation the three strategies all have higher average returns than stocks or bonds.
  • In overheating environments stocks do well but the Diversification and Inflation-Protection strategies do even better.
  • Performance across the three real asset strategies diverges when inflation is low.
  • During periods of stagnation (low inflation/low growth) bonds do well, but so do the Stagnation-Protection and Diversification strategies.

 

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

Ideal

 Overheating Muddled Stagflation

Stagnation
Inflation &/ Growth

Low & High

 High & High Median/Median High & Low

Low & Low
Diversification

Y

 Y Y Y

Y
Inflation-Protection Y Y

Y
Stagnation Protection

Y

 Y

Y
Equities

Y

 Y Y
Fixed Income

Y
Scenario frequency

8.9%

 11.4% 53.9% 10.2%

15.8%

 

Diversification Benefits of Real Asset Strategies in Pension Plans

The last section of the PGIM report seeks to determine if an allocation to real assets will improve the outcomes for US Pension Funds. PGIM note that this research can be applied to portfolios in other countries.

It should come as no surprise, given the results of the in-depth analysis undertaken by PGIM above, that an allocation to Real Assets improves the investment outcomes to a portfolio dominated by equities and fixed income.

By way of example, even a 10% allocation to a real asset strategy, depending on the investment objective, can lead to a noticeable improvement in both the final funded ratio and the risk of being further under-funded (i.e., surplus risk) of a Defined Benefit plan.  Resulting from lower levels of portfolio volatility.

In high inflation environments an allocation to real assets improves the outcomes Pension Plan, especially those with liabilities tied to inflation (cost of living adjustments).

Likewise, in low growth environments they found an allocation to real asset strategies made a big difference.

It is similar across different environments, stagflation and stagnation protection.

To conclude, the PGIM Portfolio analysis highlighted that a real asset allocation can help Defined Benefit providers improve outcomes in different economic environments of concern, like stagflation and stagnation, improving either surplus risk or the average funded ratio.

 

Access to the PGIM Report

 

Happy investing.

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Time to move away from the Balanced Portfolio. They are riskier than you think.

/ Kiwi Investor / 10 Comments

GMO, a US based value investor, has concluded “now is the time to be moving away from 60/40” Portfolio.  Which is a Balanced Portfolio consisting of 60% US equities and 40% US fixed income.

Being a “contrarian investor”, recent market returns and GMO’s outlook for future market returns are driving their conclusions.

I covered their 7-year forecasts in an earlier Post. GMO provide a brief summary of their medium term returns in the recently published article: Now is the Time to be Contrarian

 

The GMO article makes the following key observations to back up their contrarian call:

  • The last time they saw such a wide “spread” in expected returns between a traditional 60/40 portfolio and a non-traditional one was back in the late 1990s, this was just prior to the Tech bubble bursting.
  • The traditional 60/40 portfolio went on to have a “Lost Decade” in the 2000s making essentially no money, in real terms, for ten years. Starting in late 1999, the 60/40 portfolio delivered a cumulative real return over the next ten years of -3.9%.

 

As outlined in the GMO chart below, Lost Decades for a Balanced Portfolio have happened with alarming and surprising frequency, all preceded by expensive stocks or expensive bonds.

GMO note that both US equities and fixed income are expensive today. As observed by the high CAPE and negative real yield at the bottom of the Chart.

They are of course not alone with this observation, as highlighted by a recent CFA Institute article. I summarised this article in the Post: Past Decade of strong returns are unlikely to be repeated.

lost-decades_12-31-19

 

 

The Balance Portfolio is riskier than you think.

The GMO chart is consistent with the analysis undertaken by Deutsche Bank in 2012, Rethinking Portfolio Construction and Risk Management.

This analysis highlights that the Balanced Portfolio is risker than many think. This is quite evident in the following Table. The Performance period is from 1900 – 2010.

Real Returns

(after inflation)
Compound Annual Return per annum 3.8%
Volatility (standard deviation of returns) 9.8%
Maximum Drawdown (peak to bottom) -66%
% up years 67%
Best Year 51%
Worst Year -31%
% time negative returns over 10 years 22%

The Deutsche Bank analysis highlights:

  • The, 60/40 Portfolio has generated negative real returns over a rolling 10 year period for almost a quarter of the time (22%).
  • In the worst year the Portfolio lost 31%.
  • On an annual basis, real negative returns occur 1 in three years, and returns worse than -10% 1 in every six years
  • Equities dominate risk of a 60/40 Portfolio, accounting for over 90% of the risk in most countries.

 

The 4% average return, comes with volatility, much higher than people appreciate, as outlined in the Table above. The losses (drawdowns) can be large and lengthy.

This is evident the following Table of Decade returns, which line up with the GMO Chart above.

Decade Per annum return
1900s 6.3%
1910s -4.7%
1920s 12.7%
1930s -2.3%
1940s 1.1%
1950s 9.1%
1960s 4.5%
1970s -0.3%
1980s 11.7%
1990s 11.7%
2000s 0.5%

 

We know the 2010s was a great decade for the Balanced Portfolio.  A 10 year period in which the US sharemarket did not experience a bear market (a decline of 20% or more). This is the first time in history this has occurred.

Interestingly, Deutsche Bank highlight the 1920s and 1950s where post war gains, while the 1980s and 1990s were wind-full gains.

The best 4 decades returned 11.3% p.a. and the 7 others 0.7% p.a.

 

As outlined in my last Post, the case for diversifying away from traditional equity and fixed income is arguably stronger than ever before.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Why is the Multi-Asset Portfolio so Popular?

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The rise of the Multi-Asset Portfolio can be traced back to the Global Financial Crisis (GFC) in 2008, when many investors “grew disenchanted with the long-time investment mantra that equities were the one true way to wealth. That smug bromide rang hollow when the financial crisis slashed many stock portfolios in half”, according to recent Chief Investment Office (CIO) article, How Multi-Asset Investing Became So Popular.

Following the GFC, the mantra became diversify your holdings. As a result, Multi-Asset Portfolios, which combine equities, fixed income, and an array of other assets, gained greater prominence.

Multi-Asset Portfolios grew more popular on promises of greater capital preservation and sometimes the delivery of superior returns.

As CIO note, the increased prominence of the Multi-Asset Portfolio can be attributed to David Swensen, Yale’s investment chief since 1986. Yale has generated an impressive performance record by investing outside of just equities and fixed income. Their portfolio has included high allocations to private equity, real estate, and other non-traditional assets. (For more on the success of the Endowment model and the fee debate please see this Post.)

 

The CIO article also noted that Multi-Asset Portfolios are most prominent among target-date funds (TDFs), which have become the default offering among 401(k) plans (e.g. US superannuation schemes such as KiwiSaver in New Zealand).

“TDFs have grown five-fold since the financial crisis, reaching $1.09 trillion in 2018, a Morningstar report concluded, with an estimated $40 billion added last year.”

 

The Concept: Absolute returns and better risk management

The Multi-Asset Portfolio is based on the concept of absolute returns, where the focus is on generating a more targeted and less volatile investment return outcome. There is a greater focus on risk management relative to that undertaken within a traditional portfolio. The intensity and sophistication of risk management employed depends on the type of absolute return strategy.

The absolute return universe is very broad, ranging from Multi-Asset Portfolios to those with a much greater focus on absolute returns such as the plethora of Hedge Fund strategies, including Risk Parity as discussed in the CIO article.

This contrasts with the traditional balanced fund, which are generally less diversified, portfolio risk is dominated by the equity exposures, and returns are much more subject to the vagaries of investment markets. The management of risk is more focused on relative returns i.e. how performance goes relative to a market benchmark, rather than returns relative to an absolute return outcome.

A Multi-Asset Portfolio generally has more of an absolute return focus than a Traditional Portfolio. It achieves this by having a more truly diversified portfolio, moving beyond the traditional Balanced Portfolio (60% equities and 40% Fixed Income), to incorporate a greater array of different investment strategies and risk management approaches within the portfolio.

As the CIO article comments, “There’s a strong argument for Swensen-like multi-asset funds that range beyond stocks and bonds, adding solid helpings of commodities, real estate and all kinds of other asset classes. With such an array, the thinking goes, you’re best protected when recessions thunder in.”

 

Return Expectations

The CIO article made the following observation, Multi-Assets Portfolios are “expected to return 4.5% annually through 2024, according to Casey Quirk, an arm of Deloitte Consulting. That isn’t a daunting growth rate, but the figure should have a decent chance of holding steady, while public markets lurch around, especially in the next recession.”

To put this into perspective, a recent CFA Institute article estimated that a Balanced Portfolio will return 3.1% over the next 10 years.

It is highly likely we are heading into a “Low Return Environment”.

 

As a result, a different investment approach to that which has been successful over the last 20-30 years is likely needed to invest successfully in what is expected to be a Challenging Investment Environment.

As the CIO article notes, “But multi-asset now goes far beyond the simple stock-bond duality, which seems insufficient to deliver the best diversification. The most salient problem with the basic pairing nowadays is that bonds are paying low interest rates. Their ability to score capital gains is limited because rates don’t have much left to fall before they hit zero. “These don’t work as well as they used to,” observed Deepak Puri, CIO Americas for Deutsche Bank Wealth Management.”

 

I fear the lessons from the GFC and 2000 Tech Bubble are fading from the collective memory, as equity markets reach historical highs and investors chase income from within equity-income sectors of the sharemarket.

In addition, more advanced portfolio management approaches have been developed over the last 20 – 30 years.

It would seem crazy that these learnings are not reflected in modern day investment portfolios. In a previous Post: A Short History of Portfolio Diversification, it is not hard to see how the Multi-Asset Portfolio has developed over time and is preferred by many large institutional investors.

Meanwhile, this Post: What Portfolio Diversification looks like, compares a range of investment portfolios, including the KiwiSaver universe, to emphasis what a Multi-Asset Portfolio does look like.

 

Growth in Multi-Asset Portfolios to continue

Increasingly the Multi-Asset Portfolios are taking market share from traditional portfolios.

Institutional investors are increasingly adopting a more absolute return investing approach. This has witnessed an increased allocation, and growth in Funds Under Management, in underlying strategies, “such as private equity, hedge funds, real estate, natural resources, and other strategies whose assets aren’t publicly traded.”

 

An underlying theme of the CIO article is the Death of the Balance Portfolio, which I covered in a previous Post.

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, as noted above, more advanced approaches can be implemented. For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

 

Concluding Remarks

The current market environment, of low expected returns, might quicken the evolution in portfolio construction toward greater adoption of Multi-Asset Portfolios and a more absolute return focus.

Therefore, the value is in implementation, identifying the suitable underlying investment strategies to construct a truly diversified portfolio, within an appropriate fee budget.

Wealth management practices need to be suitably aligned with this value adding activity.

 

Happy investing.

Please read my Disclosure Statement

 

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