Diversifying portfolios by adding alternatives New Zealand

Reported death of the 60/40 Portfolio

/ Kiwi Investor / 6 Comments

The reported death of 60/40 portfolio, may well be exaggerated, but it certainly is ailing.

As reported by Think Advisor in relation to the 60/40 Portfolio (60% listed equities / 40% fixed income):

“No less than three major firms have issued reports in the last few weeks declaring it dead or ailing: Bank of America Merrill Lynch, Morgan Stanley, and JPMorgan.” 

All three firms have similar reasons:

  • Low expected returns, particularly from Fixed Income
  • Reduced portfolio diversification benefits from Fixed Income

For example, JP Morgan: “Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” “The days of simply insulating exposure to risk assets with allocation to bonds are over.” (A risk asset example is listed equities.)

 

With regards to the declining diversification benefits from Fixed Income in a portfolio Bank of America make the following point: Fixed Income (Bonds) have functioned as an offset to equity market loses over the last 20 years, this may not occur in the immediate future.

Technically, fixed income has had a negative correlation to equity markets over the past 20 years, interestingly, this did not prevail in the prior 65 years.

 

Underpinning these views is the expectation of lower investment returns than experienced over the last 10 years. Access to JP Morgan’s Longer-term Capital Market assumptions are provided in the article.

There is no doubt we are living in challenging times and we are heading into a low return environment.  I covered in this in a previous Post: Low Return Environment Forecasted.  This Post provides an indication of the level of returns expected over the next 5 – 10 years.

 

What to do?

JPMorgan strategists are calling for “greater flexibility in portfolio strategy and greater precision in executing that strategy.”

I agree, to my mind, a set and forget approach won’t be appropriate in a low return environment, where higher levels of market volatility are also likely.

Naturally they are calling for a greater level of portfolio diversification and are recommending, Corporate bonds, Emerging market equities and bonds, U.S. real estate, Private equity, and Infrastructure investment.  The last three are unlisted investments.

 

 

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, more advanced approaches are available.

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).

The current market environment might quicken the evolution in portfolio construction.

 

Modern day Portfolios should reflect the lessons learnt over time, particularly from the Dot Com market collapse and the Global Financial Crisis (GFC or Great Recession).

Understanding the history of Portfolio Diversification is important. Modern Portfolio Theory (MPT) was developed in the 1950s and resulted in the 60/40 portfolio.

Although MPT is still relevant today, the Post on the Short History of Portfolio Diversification highlights much more has been learnt since the 1950s.

 

Furthermore, we can now more easily, and more cheaply, gain greater portfolio diversification.  This includes an increasing allocation to alternative investment strategies and smarter ways to access investment returns.

This in part reflects the disaggregation of investment returns as a result of increased computer power and advancements in investment research.

As a result, Portfolios do not need to be over reliant on equities and fixed income to generate returns. A broad array of risks and return sources should be pursued.

This is particularly important for portfolios that have regular cashflows.  High listed equity allocations in these portfolios is a disaster waiting to happen e.g. Charities, Foundations, Endowments.

While those near or just entering retirement are vulnerable to Sequencing Risk and should look to diverse their portfolio’s away from listed equities.

 

There is still a place for active management, where real skill and truer sources of excess return are worth exploring and accessing. In fact, they complement the above developments.

There are shades of grey in investment returns, as a result the emotive active vs passive debate is out-dated.

 

I think KiwiSaver Investors are missing out and their portfolios should be more diversified.

 

Happy investing.

Please see my Disclosure Statement

 

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

Low Return Environment Forecasted

/ Kiwi Investor / 7 Comments

Many commentators highlight the likelihood of a low return environment over the next 5 -10 years or more.

Even looking through the shorter-term challenges of the current market environment as highlighted in a recent Post, many publicly available forecasts underline the potential for a low return environment over the longer term.

The most often referenced longer-term return forecasts are the GMO 7 Year Asset Class Forecast.

As at 31 July 2019 they estimated the real returns (returns after 2.2% inflation) for the following asset classes as follows:

Share Markets

Annual Real Return Forecasts
US Large Capitalised Shares

-3.7%
International Shares

0.6%
Emerging Markets

5.3%
   
Fixed Income Markets  
US Fixed Income

-1.7%
International Fixed Income Hedged

-3.7%
Emerging Debt

0.7%
US Cash

0.2%

 

As GMO highlight, these are forward looking returns based on their reasonable beliefs and they are no guarantee of future performance.

Actual results may differ materially from those anticipated in forward looking statements.

 

The variation in sequence of returns is an additional consideration e.g. global sharemarkets could continue to move higher and then fall sharply to generate a 0.6% annual return over the next seven years. Or they could do the reverse, fall sharply within the next year and then float higher over the next 6 years to generate the 0.6% return.

 

The sequencing of returns is important for those in the retirement death zone, see my previous Post on the riskiest time of saving for and being in retirement.

 

Looking at the return forecasts the following observations can be made:

  • Within equity markets Emerging Markets are offering more value and US equities the least; and
  • The return expectations for Fixed Income are very dire, particularly for those developed markets outside of the US.

 

For comparison purposes, the long-term return of US equities is 6.5%.

 

The Fixed Income returns reflect that more than $US15 trillion of fixed income securities across Europe and Japan are trading on a negative yield.

Based on some measures, interest rates are at their lowest level in 5,000 years!

 

GMO is not alone with such longer-term market forecasts, those from Research Affiliates and State Street are provided below. They all have different methodologies and approaches to calculating their forecasts. Notably, they are all pointed in a similar direction.

 

This analysis highlights that outstanding returns have been delivered over the last 10 years, particularly if you are invested in the US and New Zealand sharemarkets and have had longer dated interest rate exposures.

The Balance Portfolio (60% Equities and 40%) has benefited from this environment.

The last 10 years have been amongst the best for a New Zealand investor invested in a Balanced Portfolio, if they had managed to stay fully invested during that time.

The New Zealand sharemarket has returned 13.3% over the last 10 years and New Zealand Government Bonds 5.9%. Therefore, a Balanced Fund has returned 10.3% over the last decade!

Global Equites have returned 10.0%, led higher by the US sharemarket, and Global Bonds 4.3% over the last 10 years. Globally, the Balanced Portfolio has benefited from the 35 year long decline in interest rates.

 

Therefore, the forecast returns are pretty frightening from a Balanced Fund perspective. Certainly, returns are not likely to be as strong over the next ten years as they have been over the last decade.

This calls into question the level diversification of a Balanced Fund of only equities and fixed income.

This issue can be considered from two angles, the need to increase the level of diversification within a Balanced Portfolio and the effectiveness of fixed income in providing diversification benefits to a Balanced Portfolio given historically low interest rates.

On the first issue, although a lack of true portfolio diversification has not disadvantaged investors greatly over the last 5-10 years, the potential to earn other sources of returns from true portfolio diversification may be of more value over the next 10 years. It is certainly a risk that should be considered and managed.

With regards the effectiveness of fixed income in diversify sharemarket risk in the future, this dynamic is best captured by the following insightful observation by Louis Grave: investors are hedging overvalued growth stocks with overvalued bonds.

What he is saying, is that given current valuations in the US of both the sharemarket and fixed income a Balanced Portfolio no longer has the degree of diversification it once had.

Of course, interest rates could fall further, and provide some offset from a falling sharemarket, as they have historically. Nevertheless, the effectiveness and extent of this offset is limited given historically low interest rates.

Most importantly, given current valuations, there is the scenario where both fixed income and sharemarkets underperform at the same time. This would be like the stagflation environment of 1970, where inflation is rising, and economic growth is muted.  This is a scenario worth considering.

In my mind the biggest risks to portfolios are in longer term fixed income securities or “bond proxies”, such as slow-growth and dividend-oriented investments.  Listed Property and infrastructure securities would fall into this definition.

It is quite likely that those looking for diversification benefits from listed property, global and domestic, and listed infrastructure, are likely to be disappointed. As they would had been during the Global Financial Crisis. They only provide limited portfolio diversification benefits, not true portfolio diversification.

 

The expected low returns environment throws up a lot of issues to consider:

  • True Portfolio diversification. Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.   True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks.

 

  • Consistent with the above, there is a growing evolution within the Wealth Management Industry, a paradigm shift which is resulting in the death of the Policy Portfolio (i.e. Balanced Portfolio).

 

  • The growing risks with traditional market indices and index funds, as highlighted by the low return forecasts.

 

  • Increased innovation within Exchange Traded Funds as investors seek to diversify their traditional market exposures.

 

I plan to write more on the last two points in future Posts.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Research Affiliates – 10 Year Forecast Real (After Inflation)

Share Markets

Real Return Forecasts
US Large Capitalised Shares

0.7%
International Shares

3.2%
Emerging Markets

7.7%
   
Fixed Income Markets  
US Fixed Income

-0.8%
International Fixed Income Hedged

-0.5%
Emerging Debt

4.2%
US Cash

-0.3%

 

State Street also provides:

  • They are more optimistic in relation to developed market sharemarket, with Emerging Markets outperforming developed markets, Global Listed Property underperforms both developed and emerging market equities
  • They see very low returns from Global Fixed Income.

Optimal Private Equity Allocation

/ Kiwi Investor / 4 Comments

TIAA (Teachers Insurance and Annuity Associations of America Endowment & Philanthropic Services) has published a paper offering insights into the optimal way of building an allocation to Private Equity (PE).

“Private equity is an important part of institutional portfolios. It provides attractive opportunities for long-term investors to harvest the illiquidity premium over time and extract the value created by hands-on private equity managers.”

 

Private equity is by its nature is illiquid. This in turn makes rebalancing a challenge. That is why a PE allocation that is too large endangers the entire portfolio, especially in times of crisis when secondary markets seize up.

 

According to recent analysis by Prequin, the popularity and growth of PE, and other alternative investments, is expected to continue.

Furthermore, recent Cambridge Associates analysis on those Endowments and Foundations with the better long-term performance records had “one thing in common: a minimum allocation of 15% to private investments.”

 

We all know, a robust portfolio is broadly diversified across different risks and returns. Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors, for which illiquidity is one factor.

In my mind, direct private investments, such as Private Equity, Direct Property, and Unlisted Infrastructure have a place in a genuinely diversified and robust Portfolio.

 

From this perspective, the TIAA paper is very useful as it considers how to build and maintain an allocation to PE within a well-diversified portfolio.  They assume building out the PE allocation over time to an equilibrium allocation.

The Paper provides valuable insights into the asset allocation process of what is a complicated asset to model given cash commitments (capital calls) are made overtime and there is uncertainty as to when invested capital will be returned (distributions). TIAA model for both of these variables, in a relatively conservative manner.

The TIAA Paper notes that investors have no control over the rate and timing of capital calls and distributions. Therefore, the paper focuses on two key variables Investors can control for: an annual commitment rate and the risk profile of the assets waiting to be invested in private equity assets i.e. where to invest the cash committed to PE but not yet called.

 

TIAA propose a robust process to determine an appropriate allocation to PE to ensure the allocation can be maintained and the benefits of PE are captured over time.

“Obtaining the benefits of an allocation to private equity, while also avoiding its inherent illiquidity pitfalls, can only occur through an effective, risk-based strategy for executing the build-out to the long-term equilibrium state.”

The goal of the paper is to develop a framework and a sound approach.

 

The results:

TIAA’s modelling suggests that a target allocation to private equity strategies in the range of 30% to 40% presents minimal liability and liquidity risks.

TIAA also suggest, that for long term investors, such as Endowments, capital awaiting investment in private equity should be invested in risk assets with higher expected returns, such as public equities (sharemarkets).

 

This level of allocation is probably high for most, and particularly KiwiSaver Funds.

Nevertheless, KiwiSaver Funds are underweight Private investments and Alternatives, particularly relative to the Superannuation industry in Australia.

Given the overall lack of allocation to private investments, including PE, Direct Property, and Unlisted Infrastructure, many KiwiSaver providers are most likely over estimating their liquidity needs to the detriment of investment performance over the longer term.

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

 

TIAA Analysis

With regards to the TIAA paper, they develop a simple three asset portfolio of Fixed Income, Public equities, and Private equities. TIAA use sophisticated modelling techniques looking at a number of variables, including:

  1. the annual commitment rate; and
  2. Risk profile of the assets waiting to be invested in private equity.

The annual commitment is defined as the new commitment to private equity every year as a percentage of last year’s total portfolio value.

“An annual commitment rate results in a long-term equilibrium percentage of the portfolio in private equity assets, as well as the portfolio’s corresponding unfunded commitment level. The unfunded commitment level is important from a risk perspective as it represents a nominal liability to fund future capital calls, regardless of the prevailing market environment at the time of capital calls.”

TIAA note that at low rates of annual commitment the equilibrium rate of PE is about twice the unfunded ratio. Therefore, a 6% annual commitment rate will result in a base case unfunded ratio of around 15%, and a PE allocation of around 30% at equilibrium.

For those wanting a brief overview of the methodology, All About Alpha provides a great summary.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in this report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

A well diversified and robust portfolio will be able to meet these motivations.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

/ Kiwi Investor / 2 Comments

“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, a robust portfolio is broadly diversified across different risks and returns.

Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative, and hedge fund risk premia. And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above. There has been a disaggregation of investment returns.

Not all of these risk exposures can be accessed cheaply.

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

 

Further growth expected for an Alternative future – Prequin

/ Kiwi Investor / 6 Comments

The outlook for Alternative investments continues to look bright according to the recent Prequin Global Alternatives Report.

Prequin note investor’s motivations for investing in alternatives are quite distinctive:

Private equity and venture capital, motives = high absolute and risk-adjusted returns

Infrastructure and real estate, motives = an inflation hedge and reliable income stream

Private debt, motives = high risk-adjusted returns and an income stream

Hedge Funds, motives = diversification and low correlation with other asset classes

Natural Resources, motives = diversification and low correlation with other asset classes

Prequin comment “Set against these objectives, it becomes clear why investors have not only consistently increased their allocations to alternative assets over the past decade, but also why they are planning to continue to do so in the years ahead (not to mention the growing number of investors that come into alternatives each year – i.e. growing ‘participation’).”

Interestingly, investors are expressing an increasing allocation not only to those alternatives that have exceeded expectations recently (Private equity and venture capital, private debt, infrastructure, real estate), but are also looking to increase allocations to areas where recent performance has disappointed – notably hedge funds and natural resources. As they note “the diversification and low correlation offered by these assets may be especially attractive in a challenging returns environment.”

 

Importantly, the Prequin survey is set against a backdrop where investors “see a challenging environment ahead for returns.”

They also note that continued growth is expected despite alternative assets having enjoyed a “tremendous decade of growth” and “becoming ever more vital in investors’ portfolios worldwide;”

 

With regards to expected growth, “Preqin is sticking with its forecast for further growth of alternative assets to 2023: from $8.8tn in assets under management in 2017 to $14.0tn in 2023.”

 

The full Prequin report is available and covers each of the Alternative strategies outlined above.

The Preqin-Alternatives-in-2019-Report, for example, provides some interesting facts and figures on Hedge Funds:

  • 59% of Surveyed investors believe we are the top of the equity cycle, 40% intend to position their portfolios defensively
  • 79% of surveyed investors intent to maintain or increase their level of allocation to hedge funds over the next 12 months

 

For further articles on Alternatives by Kiwi Investor Blog:

  1. An Alternative Future for Kiwisaver Funds
  2. Alternatives Investments will improve the investment outcomes of Target-Date Funds
  3. Future’s Hedge Funds
  4. Investment Fees and Investing like an Endowment – Part 2
  5. Perspective of the Hedge Fund Industry
  6. Adding Alternatives to and Investment Portfolio – Part 3 – Investing Like an Endowment Fund
  7. Adding Alternatives to and Investment Portfolio – Part 2
  8. Adding Alternatives to and Investment Portfolio

 

 

Happy investing.

 

Please see my Disclosure Statement

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

 

 

An Alternative Future for Kiwisaver Funds

/ Kiwi Investor / 3 Comments

I have blog previously on the benefits of Alternative investments for a robust portfolio.

They would benefit Target Date Funds (Life Cycle Funds) and they have benefited Endowments and foundations for many years.

As the Funds Under Management (FUM) grows within Kiwisaver there will be an increasing allocation to Alternative investments. This will include the likes of unlisted assets (Private equity, direct property, and direct infrastructure), hedged funds, and liquid alternative strategies such as Alternative Risk Premia strategies.

 

A recent paper by Preqin, Preqin-Future-of-Alternatives-Report-October-2018, assesses the likely size, shape and make-up of the global alternative assets industry in 2023, the emphasis being on private capital and hedge funds.

Preqin are specialist global researchers of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world.

 

Needless to say, Alternatives are going to make up a large share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018).

 

This is an issue from the perspective of capacity and ability to deliver superior returns.  Therefore, manager selection will be critical.

 

Preqin outlined the drivers of future growth as the following:

  • Alternatives’ track record and enduring ability to deliver superior risk-adjusted returns to its investors, Investors need to access alternative sources of return, and risk, such as private capital.
  • They note the steady decline in the number of listed stocks, as private capital is increasingly able to fund businesses through more of their lifecycle;
  • A similar theme is playing out in the debt markets, there are increasing opportunities in private debt as traditional lenders have exited the market; and
  • The emerging markets are seen as a high growth area.

 

According to Preqin the following factors are also likely to drive growth:

  • Technology (especially blockchain) will facilitate private networks and help investors and fund managers transact and monitor their portfolios, and reduce costs vs public markets.
  • Control and ESG: investors increasingly want more control and influence over their investments, and the ability to add value; private capital provides this.
  • Emerging markets: the Chinese venture capital industry already matches that of the US in size; further emerging markets growth will be a ‘double whammy’ of GDP growth + higher penetration of alternative assets.
  • Private individuals: the ‘elephant in the room’, as the mass affluent around the world would like to increase their investment in private capital if only the structures and vehicles (and regulation) permitted; technology will help.

 

The Preqin report covers many other topics and interviews in relation to the Alternative sector.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Future trends in ETFs are rather daunting. Are you prepared?

/ Kiwi Investor / 3 Comments

The recent survey by EDHEC-Risk Institute (EDHEC) of European professional investors into their practices, perceptions and future plans for investing into Exchange Trade Funds (ETF) is of interest and well worth reading.

The survey gathered information from 163 European investment professionals. Respondents to the survey were high-ranking professionals within their respective organisations, representing firms with large assets under management (36% of respondents represent firms with assets under management exceeding €10bn). Respondents to the survey are from the United Kingdom, European Union, Switzerland, and a small sample from other countries outside the European Union.

 

What is the dominant purpose of ETF usage?

The survey results clearly indicate that the current usage of ETFs is dominated by a truly passive investment approach. “Despite the possibilities that ETFs offer – due to their liquidity – for implementing tactical changes, they are mainly used for long-term exposure.”

Gaining broad market exposure remains the main focus of ETF users – 71% of respondents use ETFs to gain broad market exposure, versus 45% who use ETFs to obtain specific sub-segment exposure (sector, style).

“In line with this expression of conservatism in their use of ETFs, which is mainly focused on traditional passive management, it can also be noted that investors are largely satisfied by ETFs in traditional asset classes but more reserved about ETFs for alternative asset classes”

 

What are the future growth drivers?

The European ETF market has seen tremendous growth over the past decade or so. At the end of December 2017, the assets under management (AUM) within the 1,610 ETFs constituting the European industry stood at $762bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2017).

“A remarkable finding from our survey is that a high percentage of investors (50%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates.”

Why? lowering investment cost is the primary driver behind investors’ future adoption of ETFs for 86% of respondents in 2018 (which is an increase from 70% in 2014).

Interestingly, EDHEC find investors are not only planning to increase their ETF allocation to replace active managers (70% of respondents in 2018), but are also seeking to replace other passive investing products through ETFs (45% of respondents in 2018).

 

How do investors select ETFs?

Cost and quality of replication. Both of which are more easy to identify from a quantitative perspective.

EDHEC argue” Given that the key decision criteria are more product-specific and are actually “hard” measurable criteria, while “soft” criteria that may be more provider-specific have less importance, competition for offering the best products can be expected to remain strong in the ETF market. This implies that it will be difficult to build barriers of entry for existing providers unless they are related to hurdles associated with an ability to offer products with low cost and high replication quality.”

 

A section I found more interesting:

What are the Key Objectives Driving the Use of Smart Beta and Factor Investing Strategies?

EDHEC find that “the quest for outperformance is the main driver of interest in smart beta and factor investing. In fact, 73% of respondents agree that smart beta and factor investing indices offers significant potential for outperformance”

The most important motivation behind adopting such strategies is to improve performance.

Interestingly they find that the actual implementation of such strategies is still at an early stage

EDHEC found that among those respondents who have made investments in smart beta and factor investing strategies, these investments typically made up only a small fraction of portfolio holdings.

“More than four-fifths of respondents (83%) invest less than 20% of their total investments in smart beta and factor investing strategies and only 11% of respondents invest more than 40% of their total investments in smart beta and factor investing strategies”

As they say, ”It is perhaps surprising that almost a decade after the influential report on Norway’s Sovereign Wealth Fund (see Ang, Goetzmann and Schaefer, 2009), which emphasised the benefits of factor investing for investors, adoption of such an approach remains partial at best.

 

Not surprisingly, those that use factor strategies, the use of them is not related to factor timing and more to extracting the long term premia from the factors.

 

In relation to fixed interest, “17% of the whole sample of respondents already use smart beta and factor investing for fixed-income. Some 80% of this sub-sample of respondents invest less than 20% of their total investment in smart beta and factor investing for fixed-income.”

It appears that respondents show a significant interest for smart beta and factor investing for fixed-income. The interest appears to be there, but likelihood of implementation not so much.

Interestingly, from responses “it thus appears that investors are doubtful that research on factor investing in fixed-income is sufficiently mature at this stage. Given the strong interest in such strategies indicated by investors, furthering research in fixed-income factor investing is a promising venture for the industry.”

 

The survey looked into a number of other areas, for example do investors have the necessary information to evaluate smart beta and factor investing strategies? What requirements do investors have about smart beta and factor investing strategy factors?

 

Future Developments

What are investor expectations for further development of ETF products?

The following areas where identified as potential are of further ETF product development:

  • Ethical/Socially Responsible Investing (SRI) ETFs,
  • emerging market equity ETFs and emerging market bond ETFs,
  • ETF indices based on smart beta and on multi-factor indices, EDHEC note that more than two-fifths of the respondents want further developments in at least one of the categories related to smart beta equity or factor indices. “This shows that the development of ETFs based on advanced forms of equity indices is now by far the highest priority for respondents.”……… “We also note that additional demand for ETFs based on smart bond indices is not so far behind”…..

 

Fixed Income and Alternatives

The survey results indicate that respondents desire further development in the area of fixed income and alternative asset classes.

Also there is an increased interest in integration of ESG in smart beta and factor investing, and strategies in alternative asset classes.

“So, there is still a lack of products when it comes to asset classes other than equity, and this lack is particularly critical for the fixed-income asset class, which is largely used by investors.”… “It is likely that the development of new products corresponding to these demands may lead to an even wider adoption of smart beta and factor investing solutions.”

  

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Trustees should be aware of the shocking cost of timing markets and what is the best solution

/ Kiwi Investor / 1 Comment

Cambridge Associates recently published a research report concluding it does not pay to be out of the market.

” Investors who take money out of the market too early stand to “risk substantial underperformance,”

Cambridge advised investors concerned about the length of the current bull market not to bail out of equity markets earlier than necessary in an attempt to avoid exposure to downturns.

This seems timely given current market volatility.

As the article notes, it is hard to time markets “because trying to time re-entry to get back into the markets at lower levels leads to substantially lower long-term returns, the researchers found. For example, the report showed that being out of the market for just the two best quarters since the turn of the last century cut cumulative real returns on U.K. equities by more than 50 percent.”

“That effect is even more profound in the United States, where sitting out the best two quarters cut cumulative real returns by more than two thirds, according to the report.”

“While no investor should be ignoring valuations, becoming too focused on timing an exit has substantial risks,” said Alex Koriath, head of Cambridge’s European pensions practice, in a statement accompanying the research. “The best periods for returns tend to be very concentrated, meaning that exiting at the wrong time could drag down cumulative returns significantly.”

 

This is a pertinent issue given the US sharemarket is into its longest bull market run in history. Also, of interest, historically on average, markets perform very strongly over the final stages of a bull market run. Lastly, bull markets tend to, more often than not, end six-twelve months prior to a recession. Noting, this is not always the case. Albeit, the consensus is not forecasting a recession in the US for some time. It appears, the probability of a US recession in the next couple of years is low.

The key forward looking indicators, such as shape of the yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US. Please see my earlier posts History of Sharemarket corrections – An Anatomy of equity market corrections

 

What is the answer?

It is difficult to time markets. AQR came to a similar conclusion in a recent article. AQR argue the best form of defence is a truly diversified portfolio. I agree and this is a core focus of this Blog.

As we know equity markets have drawdowns, declines in value of over 20%. In the recent AQR article they estimate that there have been 11 episodes of 20% plus drawdowns since 1926, a little over once every 10 years! Bearing in mind the last major drawdown was in 2008 – 09.

The average peak to trough has been -33% and on average it has taken 27 months to get back to the pre-drawdown levels.

As AQR note, we cannot consistently forecast and avoid these severe down markets. In my mind, conceptually these drawdowns are the risk of investing in equities. With that risk, comes higher returns over the longer term relative to investing in other assets.

At the very least we can try and reduce our exposure by strategically tilting portfolios, as AQR says, “if market timing is a sin, we have advocated to “sin a little””.

 

I agree with the Cambridge Associates article to never be out of the market completely and with AQR to strategically tilting the portfolio. These tilts should primarily be based on value, be subject to a disciplined research process, and focused more on risk reduction rather than chasing returns. This approach provides the opportunity to add value over the medium to longer term.

 

Nevertheless, by far a better solution is to truly diversify and build a robust portfolio. This is core to adding value, portfolio tilting is a complementary means of adding value over the medium to long term relative to truly diversifying the portfolio.

True diversification in this sense is to add investment strategies that are lowly correlated with equities, while at the same time are expected to make money over time. Specifically, they help to mitigate the drawdowns of equities. For example, adding listed property and listed infrastructure to an equity portfolio is not providing true portfolio diversification.

In this sense truly “alternative” investment strategies need to be considered e.g. Alternative Risk premia and hedge fund type strategies. Private equity and unlisted assets are also diversifiers.

Again conceptually, there is a cost to diversifying. However, it is the closest thing in finance to a free lunch from a risk/return perspective i.e. true portfolio diversification results a more efficient portfolio. Most of the diversifying investment strategies have lower returns to equities. There are costs to diversification whether using an options strategy, holding cash, or investing in alternative investment strategies as a means to reduce sharp drawdowns in portfolios.

Nevertheless, a more diversified portfolio is a more robust portfolio, and offers a better risk return outcome.

Also, very few investor’s objectives require to be 100% invested in equities. For most investors a 100% allocation to equities is too volatile for them, which raises the risk that investors act suboptimal during periods of market drawdowns and heightened levels of market volatility i.e. sell at the bottom of the market

 

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

As AQR note, diversification is not the same thing as a hedge. Uncorrelated means returns are influenced by other risks. They have different return drivers.

From this perspective, it is also worth noting that adding diversifying strategies to any portfolio means adding new risks. The diversifiers will have their own periods of underperformance, hopefully this will be at a different times to when other assets in the portfolio are also underperforming. Albeit, just because they have periods of underperformance does not mean they are not portfolio diversifiers.

AQR perform a series of model portfolios which highlight the benefits of adding truly diversifying strategies to a traditional portfolio of equities and fixed interest.

No argument there as far as I am concerned.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is All-Passive Really the Best Thing for Target-Date Funds?

/ Kiwi Investor / 1 Comment

A recent AB article highlights the limitation of some Target-Date Funds (Life Cycle Funds).

AB propose:

“With market returns expected to be lower going forward, target-date funds that invest in passively managed underlying components are at risk of underdelivering. We think diversifying beyond traditional asset classes and tapping alpha opportunities with a multi-manager structure can increase the chances of success. “

 

I would argue more broadly, despite the market outlook, any passive portfolio that only invests into the traditional markets of equities, bonds, and cash are not well diversified for a range of possible economic and market outcomes. They are further at risk if they take a set and forget approach to the overarching strategic asset class positioning of the fund i.e. these short-comings are not limited to passively managed Target-Date Funds.

 

In short, AB argue that the outlook for traditional markets (beta) is challenging. As a result, this environment pose:

“major headwinds to target-date funds as they work to provide the growth participants need. Target-date funds that invest only in traditional asset classes, such as large-cap equities and core bonds through indices, face limitations in their glide path designs. This can make it a struggle for target-date funds to meet participants’ needs in anything but a high-return, low-risk market environment. And in terms of environments, that ship has likely sailed for now.”

Further: “A lower-beta landscape challenges a popular line of thinking that says investing in funds with the lowest fees will ensure compliance with plan sponsors’ fiduciary responsibilities. Low fees aren’t the end all and be all. For one thing, focusing too much on fees could cause sponsors to overlook other factors in retirement investing that also have fiduciary implications.”

The bold is mine.

 

My Opinion and solution

Increase the diversification of the Target-Date Fund and more actively manage the glide path of the strategy.

There could well be a blend of active and passive strategies.

Quite obviously increasing true portfolio diversification is paramount to building robust portfolios and increasing the likelihood of achieving investment objectives.

The prospect of a low returning environment only reinforces this position.

As mentioned in my last post, Reports of the death of Diversification are greatly exaggerated, also see my post Invest more like an Endowment, which also touches on the fee debate, investors should seek true portfolio diversification. The portfolio should be constructed to meet an investor’s objectives “through a range of potential outcomes”. There would appear to be a diverse range of likely economic and market outcomes currently.

Robust portfolios are positioned for a range of outcomes and are “forecast-free as possible”.

We all know a robust portfolio is broadly diversified across different risks and returns.   Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

 

Limitations of Target Date Funds

The AB article touches on the limitations of most Target-Date Funds, weather the underlying asset classes are actively or Index (passively) managed.

Essentially, most Target-Date Funds have two main short comings:

  • They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration by way of example future income requirements or likely endowments, level of income earned to retirement, or investor’s risk profile.

They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.

  • The glide path does not take into account current market conditions.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

      • Delays in pace of transitioning from risky assets to safer assets
      • May require step off the glide path given extreme risk environments

Most Target-Date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, which both suggest that the optimal strategy should also display an element of dependence on the current state of the economy.

 

Therefore, there is the risk that some Target-Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income. See A more Robust Retirement Income Solution is needed.

Target-Date Funds (Life Cycle Funds) focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.   The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk. A better solution is required.

 

The optimal Target-Date fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within market

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Asness on Hedge Fund Returns and Buffet Bet Revisited

/ Kiwi Investor / Leave a comment

Earlier in the year I wrote a post about the Buffett Bet.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of funds” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

I made three points earlier in the year:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Funds hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.  Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. Most, if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

Finally, someone from the Hedge Fund Industry has come out a said it: Hedge Funds should not be compared to the performance of investing in equities.

Cliff Asness from AQR has, and not for the first time, recently written an article about why Hedge Fund returns should not be compared to equity market returns such as the S&P 500 Index, see The Hedgie in Winter.

The key point Asness makes is that Hedge Funds are not 100% invested in equities.  He estimates that they are in effect 50% invested in equities.  If we use beta terms, where a beta of 1.0 =  100% equities, Hedge Funds have a beta of 0.5.  (For those who are wondering what Beta is, Beta is a measure of how sensitivity an investment is to a market index e.g. S&P 500.  Put another way, how much of the returns from the market index can explain the returns of the investment.  Therefore, with a beta of 0.5 we would expect hedge funds to be less volatile than equities and equity markets performance would only explain some of the returns from hedge funds.)

Asness expresses it more succinctly:

“Comparing hedge funds to 100% equities is flat-out silly. Hedge funds have historically, rather consistently, delivered equity exposure (beta to my fellow geeks) just under 50%. In fact much of their point is, supposedly, to be different from equities. I mean that they are at least partly hedged investments. Put more bluntly, it is in the freaking name!”

That’s right, Hedge Funds look to reduce their equity market exposure, hedge it out.  Therefore they will not capture all of an equities market upside.  Similarly, when equity markets fall significantly, they are not capturing all of this downside as well! i.e. Hedge Funds tend to outperform equity markets in equity bear markets.

Certainly, hedge funds are not going to outperform equities in a strong bull market, as we have recently experienced, as they are not 100% invested in equities.  They are not equities.

Well, you probably would expect a hedge fund manager to say this.  Yip, but I would say he is right on the money.

Furthermore, it is not as if Asness lets Hedge Funds off the hook.  From further analysis in the paper Asness notes that Hedge Fund performance has been “petering out” since the Global Financial Crisis (GFC).  This means they have not added or subtracted much value since the GFC.

I take this to mean they have struggled to meet their investment objectives and historical rate of returns, albeit they may well have delivered mildly positive returns.  Which is not as disastrous as often reported.

The “petering out” of Hedge Fund performance is highlighted by Asness as an area of concern.  The data he presents provides no proofs as to why.  He concludes that Hedge Funds may be less special than before.

That is certainly something to dwell upon.  Hedge Funds can play an important role in a robust portfolio and achieving true portfolio diversification.  The observation by Asness should be considered in the selection of Hedge Fund managers and strategies.

Lastly, there is change occurring across the Hedge Funds industry.  This expected change is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund IndustryAIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry. This includes more transparency and lower fee structures.

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

This is consistent with Hedge Funds playing a valuable role in a truly diversified portfolio.

Happy investing.

Please see my Disclosure Statement

 

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

cropped-title-picture-enhanced.jpg