Factor Investing

Drivers of Unexpected Portfolio Return Outcomes – that should be controlled for.

/ Kiwi Investor / Leave a comment

Six reasons could largely explain manager underperformance or the delivery of investment return outcomes different from what is expected.

Conversely, controlling for these “risks” might be the reason why a Manager is consistently adding value.

How a manager controls for the following risks should be considered as part of the due diligence process and in the construction of a multi-manager portfolio:

  1. Levels of uncompensated vs compensated risk
  2. Incidence of underlying portfolio holdings cancelling each other out
  3. Hidden portfolio risks resulting in unintended outcomes
  4. Conventional style-box investing, which leads to index-like performance with higher fees
  5. Over-diversification
  6. Possible attempts to “time” manager changes may prove costly.

The above six risks where identified by Northern Trust following the analysis of $200 billion of assets on more than 200 equity portfolios from 64 institutional investors around the world.  The results surprised many of the institutions involved. 

Northern Trust expressed the above risks as “six common drivers of unexpected Portfolio Results.”

These risks largely explained manager underperformance in single manager portfolios and also multi-manager portfolios.

The analysis highlights, in my opinion, that implementation and portfolio construction are fundamental to capturing value and in delivering excess returns. Although the investment theory and development of investment strategy are important, implementation and portfolio construction are fundamental.  This is an important area to focus on in undertaking manager/strategy due diligence.

To the point, implementation is vital in capturing the desired investment outcomes of any proposed investment strategy.  This is where a lot of value is added, primarily by not detracted value in implementing the desired strategy!

As Northern Trust emphasis, finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  Knowing how a manager, or strategy, interacts with the rest of your portfolio can have much more impact over time.

Institutions had nearly 2x more uncompensated vs compensated risk

Northern Trust found that portfolios which became “overcrowded” with uncompensated risks tended to underperform.

Risk needs to be taken to outperform.  Nevertheless, some risks are compensated for over the longer term and others are not.  Norther Trust outlines that some styles are not compensated for over the longer term, e.g. low quality.  They also include currency, and some countries and sectors have also not historically compensated for the risk taken.

From my own experience, managers who control for some of these risks, tend to outperform, primarily because intended risks, such as company specific risks or compensated styles, end up driving investment outcomes.

Norther Trust found a high level of uncompensated risk across all institutional investment segments, including Super Funds, Endowments, Insurance, Corporate Pensions, and Family Offices.

They conclude: “The result of uncompensated risks comprising nearly 50% of total portfolio active risk was generally benchmark-like returns or underperformance.  While sometimes these risks were taken intentionally, we found that many institutions were surprised when they saw the actual numbers.”

Underlying portfolio holdings cancelled each other out – and hurt performance

This risk particularly impacts multi-manager portfolios.

The cancellation effect occurs when managers within a portfolio take opposing positions that offsets each other e.g. one manager goes overweight a stock another manager is underweight, a manager might have a growth bias which offsets a manager with a value bias.

As Northern Trust note, on a standalone basis many managers individually offer high active risk, once combined with other managers a lot of this active risk is cancelled out.

This needs to be considered in the construction of a multi-manager portfolio. 

Northern Trust conclude: “Our analysis uncovered a shocking amount of this cancellation effect.  Nearly 50% of manager active risk was lost.  Capturing just 50% of targeted active risk, while paying 100% of the manager fees, effectively translates into paying 2x more for each realized basis point of active risk than originally thought.”

Hidden Portfolio risks cause unintended outcomes

Northern Trust found that style tilts contributed 29% of active risk on average.  However, other bets where often introduced into a portfolio unintentionally and led to “unpredictable portfolio outcomes.”

Although some styles are a consistent source of excess returns over time, it was unintended style risks that negatively impacted portfolio performance.

Often, these unintended style risks are included when trying to capture a known rewarded risk e.g. value comes with common unintended style risk exposures of low quality and low momentum.

This means meaningful style exposure is lost.

They conclude: “Our research uncovered that 55% of the portfolios had material style conflicts – caused by the cancellation effect – that introduced exposures different from the managers stated objective.  This introduction of conflicting and unintended style exposures left many portfolios with no material exposure to their intended style tilts.”

Conventional style investing led to index like performance with higher fees

This is probably self-evident to many, particularly given the above research conclusions.

Northern Trust found that those portfolios based on conventional style analysis, and those of a core-satellite approach, tended to suffer more from the cancellation effect.

The “style box” approach portfolio was more likely to have managers who took opposing views or two managers where hired to generate an exposure one manager alone could achieve.

As a result, “conventional style investing, whether intentional or not, created a mix of managers that closely mimicked the benchmark and left little chance to outperform.”

Over-diversification diluted performance

The Northern Trust research highlights than “hiring too many managers or building equity portfolios with thousand of securities took a significant toll on performance.”

Obviously, adding managers and combination of strategies can reduce overall portfolio risk, Northern Trust research showed that often the risks reduced where different to what was intended.

Norther Trust conclude: “While there are many approaches to generating excess returns, our research suggests that a greater focus on eliminating uncompensated risks is a critical first step toward potentially increasing a portfolio’s ability to outperform.”

Possible attempts to “time” manager changes may prove costly

Do not chase manager performance.  The Northern Trust research highlighted that historically poor active management performance had resulted in lower allocations to active managers in the following year.  When performance was better, a higher allocation to active managers resulted.

As they conclude: “Finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  As evidenced through the preceding discoveries of this report, knowing how a manager will interact with the rest of your portfolio can ultimately be much more impactful over time.”

Access to the Northern Trust Risk Report can be found here.

Please read my Disclosure Statement

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

Is a value bias part of the answer in navigating today’s low interest rates?

/ Kiwi Investor / 1 Comment

The Value Factor (value) offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Exploring an array of different investment strategies and questioning the role of bonds in a portfolio are key to building a robust portfolio in the current low interest rate environment.

There will also be a need to be more dynamic and flexible to take advantage of market opportunities as they arise.

From this perspective, a value tilt within a portfolio is one investment strategy to consider in potentially boosting future investment returns.

The attraction of Value

Evidence supporting a value tilt within a robust portfolio is compelling, albeit opinion is split.

Nevertheless, longer-term, the “Rotating into Value stocks offers substantial upside in terms of return versus the broad market” according to GMO.

GMO presents the case for a value tilt to navigate today’s low interest rates in their Second Quarter 2020 Letter, which includes two insightful articles, one by Ben Inker and another by Matt Kadnar. 

Value is at cheapest relative to the broader market since 1999, based on GMO’s analysis.  Value is in the top decile of attractiveness around the world, as highlighted in the following figure.

Spread of Value for MSCI Regional Value Factors (GMO)

As of 6/30/2020 | Source: MSCI, Worldscope, GMO

Is Value Investing Dead

As mentioned, the opinion on value is split.

A research paper by AQR earlier in the year addressed the key criticisms of value, Is (Systematic) Value Investing Dead?

For a shorter read on the case for value Cliff Asness, of AQR, Blog Post of the same title is worth reading.

AQR’s analysis is consistent with GMO’s, as highlighted in the Graph and Table below.

The Graph below measures the Price-to-Book spread of the whole US sharemarket from December 1967 to March 2020.

This spread was at the 100th percentile versus 50+ years of history on the 31 March 2020 i.e. value is at it cheapest based on 50 years of data.

Price-to-Book Spread (AQR)

Asness’s Blog Post highlights “expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive.” (March 2020).

It is the same story when looking at different measures of value for the US sharemarket, as highlighted in the Table below.

Value is at its cheapest on many measures (AQR)

‘Don’t ask the barber whether you need a haircut’

This quote by Warren Buffett springs to mind when considering the analysis from GMO and AQR, both being value orientated investors.  As Asness states, AQR has a horse in the race.

However, as outlined in his Post, he undertakes the same analysis as above and controls for, just to name a few:

  • Excluding all Technology, Media, and Telcom Stocks
  • Excluding the largest stocks
  • Excluding the most expensive stocks
  • Industry bets
  • Industry neutrality
  • Quality of company

Analysis is also undertaken using other measures of value, Price-Sales, P/E, using trailing and forecast earnings (these are in addition to Price-Book).

The attraction of value remains based on different measures of value and when making the adjustments to market indices as outlined above.

Asness argues value is exceptionally cheap, probably the cheapest it has ever been in history (March 2020).

The AQR analysis shows this is not because of an outdated price-to-book nor because of the dominance of highly expensive mega-cap stocks.  Investors are paying more than usual for stocks they love versus the ones they hate.  There is a very large mispricing.

The AQR research paper mentioned above, looked at the common criticisms of value, such as:

  1. increased share repurchase activity;
  2. the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems;
  3. the changing nature of monetary policy and the potential impact of lower interest rates; and
  4. value measures are too simple to work.

 Across each criticism they find little evidence to support them.

Are we there yet?

We do not know when and how the valuation gap will be closed. 

Nevertheless, the evidence is compelling in favour of maintaining a value tilt within a portfolio, and certainly now is not the time to give up on value.

This is not a widely popular view, and quite likely a minority view, given the underperformance of value over the last ten years.  As clearly demonstrated in the Graph below provided by Top Down Charts.

However, from an investment management perspective, 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 ten years.

It is too early to give up on value, news of its death are greatly exaggerated, on this, Asness makes the following point, value is “a strategy that’s “worked” through the 1920s – when a lot of stocks were railroads, steel, and steamship companies – through the Great Depression, WWII, the 1950s – which included some small technological changes like rural electrification, the space race and all the technology that it spanned – the internet age (remember these same stories for why value was broken back in 1999-2000?)………. Value certainly doesn’t depend on technological advancement being stagnant! But in a time when it’s failed for quite a while (again, that just happens sometimes even if it’s as good as we realistically think it is), it’s natural and proper that all the old questions get asked again. Is now different?”

I don’t think so.

Please see my Disclosure Statement

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

Is ESG an Investment Factor? Can ESG be easily harvested?

/ Kiwi Investor / Leave a comment

“ESG is not an equity return factor in the traditional, academic sense”.…… “Nevertheless, ESG can be a very powerful theme in the portfolio management process in the years ahead.” 

These are two key conclusions from a recent Research Affiliates article, Is ESG a Factor?

ESG investing is incorporating Environment, Social and Governance considerations into investment portfolios.

Research Affiliates conclude “that ESG does not need to be a factor for investors to achieve their ESG and performance goals.”

They also call for greater clarity around exactly what ESG is and what it is not. 

“Currently, various stakeholders are sending a whole host of mixed messages. Investors, particularly fiduciaries, need education and alignment. If ESG remains a heterogeneous basket of claims, we will likely never see it fulfill its vast promise.”

Lastly, they believe ESG is likely to be a powerful theme for the new owners of capital, in particular woman and millennials.  Increasingly investors will prioritise ESG in their portfolios in the years ahead.

In my view, it is a stretch to say ESG is an investment factor in the context of Factor Investing.  Nevertheless, the active management of ESG considerations into the investment process has the potential to add value.

You can’t capture the benefits of ESG by just being an ESG investor.  Capturing the benefits from ESG are harder to attain relative to implementing an equity factor strategy such as value or low volatility. 

The risks, and therefore the rewards of ESG, are more company specific.

Therefore, it is not good enough to say one incorporates ESG into the investment management process to gain the benefits from ESG. 

There is no specific ESG factor that can be “harvested” passively.  The ESG value add comes from implementing successfully and having the ability to identify company specific ESG risks. 

What Is a Factor?

Before we can determine if ESG is an investment factor we first need to establish what an investment factor is.

In short, factors are characteristics associated with long-term risk and return outcomes associated with investing into a group of securities. 

The “market”, sharemarkets and fixed income markets are factors themselves (Market Factors).  We know that over time we can expect to generate a return over cash, a premia over cash (premia), from investing in sharemarkets, credit markets (corporate debt), and longer-term fixed income securities (interest rate duration).

Within markets there are also investment factors, which have been shown to deliver a premia (excess return adjusted for risk) over the “market factors” identified above.

The most common of these investment factors, and one receiving a lot of media attention currently, is the value factor.  There are other well know and academically supported factors, including momentum, carry, quality, and low volatility. Investment factors are also known as Premias or Style Premia.

To be considered a robust investment factor, it is generally considered their needs to be support from an economic perspective or there is a behavioural-based explanation for the factor.

For those interested, I have previously Posted on Factor Investing, and this article on Andrew Ang discussing Factor Investment might also be of interest.

Research Affiliates have their own framework on determining the robustness of a Factor, which can be found here.

The Evidence – Is ESG an investment Factor?

To determine if ESG is a factor, Research Affiliates maintain it should satisfy the following three critical requirements, it should be:

  1. grounded in a long and deep academic literature;
  2. robust across definitions; and
  3. robust across geographies.

Academic Literature

The common factors of value, momentum, and low beta have been thoroughly researched and have a track record spanning several decades, as Research Affiliates conclude “very little debate currently exists regarding their robustness.”

In reviewing the academic literature on ESG, Research Affiliates find little agreement on the robust of generating excess returns.  (Their article provides a good source of academic ESG research for those interested.)

In their view ESG is not an equity return factor in the traditional academic sense.

I have posted previously on the Research spanning Responsible Investing, see: Unscrambling the Sustainable Investing Return Puzzle. 

In my mind there is value in undertaking a Responsible Investing approach, including the incorporation of ESG into the investment management process.  This can be the case yet ESG not be a Factor as defined in academia.  The research covered in the above Post provides support for this view.

Factors should be robust across definitions. 

This is an interesting observation.  Research Affiliates argue that “even slight variations in the definition of a factor should still produce similar performance results.”

They use value as an example, using different valuation metrics for value results in similar results over the longer-term.  The value factor is robust across different definitions of value.

Unfortunately, ESG does not have a common definition and is a broad continuum of philosophies, approaches, and strategies.

See a previous Post discussing the continuum of Responsible Investing, which includes ESG: Sustainable Responsible Investing Spectrum

The broad spectrum is highlighted in the following Table presented in the Research Affiliates article to emphasise “ESG has no common standard definition and is a broad term that encapsulates a range of themes and subthemes.” 

As they note, the strategies align more with investor preferences rather than a particular investment factor.  

In the article Research Affiliates present the findings of their research to display how variations in the definition of ESG results in different performance outcomes.

From this analysis, they conclude:

  1. None of the ESG strategies as defined displayed material excess returns;
  2. There was a lack of historical track record, which is a significant impediment to conducting research in ESG investing; and
  3. Only after decades of quality data will it be possible to accurately test the claim that EG is a robust factor.

Research Affiliates also highlight there is an issue with the lack of consistency among ESG rating providers which hinders the ability to determine if ESG is a robust factor.  They provide an example of this in the Article.

With regards to the last requirement, Research Affiliates find that ESG performance results are not robust across regions.

ESG Is Not a Factor, but Could Be a Powerful Theme

“ESG does not need to be a factor for investors to achieve their ESG and performance goals.”

Encouragingly, Research Affiliates see a role for the incorporation of ESG within an investment portfolio. I Agree!

They highlight that there are companies with poor ESG characteristics and that these risks should be incorporated into the stock selection process.

These risks are company specific risks, idiosyncratic risks technically speaking.

Research Affiliates consider carbon as an example, particularly coal.  Notably there has been a move away from coal in the US.  Therefore, “Investment managers who do not consider and integrate the ESG risk of, in this case, climate change may be blindsided.”

The successful implementation of ESG is a key determinant in capturing the value from company specific characteristics.  Specifically, having the ability to identify mispricing of securities due to ESG risk.

It is not good enough to say one incorporates ESG into the investment management process and therefore the portfolios will benefit. 

There is no a specific ESG factor that can be “harvested” passively, the value add comes from implementing successfully and having the ability to identify company specific risks. 

Increasing Adoption of ESG Investing

Lastly, and quickly, Research Affiliates note that there is a “large shift in investor preference toward ESG is occurring as two distinct groups—women and millennials—take greater control of household assets.”  This is backed up by third party research which notes that there will be a wave of assets ready to invest in highly rated ESG companies.

A regulatory push globally is also likely to accelerate this trend.

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.

Developing ETF Trends and Innovations – EDHEC Risk Research

/ Kiwi Investor / Leave a comment

The most recent EDHEC Risk Institute’s European Exchange Trade Funds (ETF) survey* provides valuable insights into the developing trends and innovation in relation to the use of ETF in a diversified and robust portfolio.

The following Post outlines the key findings of the EDHEC ETF survey, which is well worth reading.

 

The changing Purpose of using ETFS

Increasingly ETFs are being used for tactical allocation purposes. Historically the dominant purpose of ETF usage has been to gain a truly passive investment, a long-term buy-and hold investment to gain broad market exposures via the major market indices.

Results by EDHEC indicate there is now a greater usage of ETFs for tactical allocations rather than their role for long-term positions (53% and 51% respectively).

The survey also noted:

  • Gaining broad market exposure remains the focus of ETF for 73% of users, compared with 52% of respondents using ETFs to obtain specific sub-segment exposure.

 

As EDHEC note, the increasing focus on sub-segment exposures can be linked to product development, “which has led to the introduction of new products for a multitude of sub-segments of the markets (sectors, styles etc.). It also correlates with the growing use of ETFs for tactical allocations, which tend to favour a more granular investment approach over broad exposures.”

 

ETF Use continues to Grow**

The adoption of ETF continues to grow, particularly for the traditional asset classes. “In 2019 91% of respondents used ETFs to invest in equities, compared with 45% in 2006. As for governments and corporate bonds, the result went from 13% and 6% in 2006, to 66% and 68%, respectively, in 2019…”

“Investors prefer ETFs for traditional asset classes over alternative asset classes in line with this expression of conservatism in their use of ETFs, which is mainly focused on gaining access to broad market exposure”….

The Survey recorded a high level of satisfaction by investors with ETF in the traditional asset classes.

The survey also notes:

  • A high percentage of investors (46%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates
  • Lowering investment cost is the primary driver behind investors’ future adoption of ETFs (74% of respondents in 2019).
  • ETF investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019) and replace other passive investing products through ETFs (42% of respondents in 2019)

 

Future Growth and ETF Innovation Drivers

“Ethical/SRI and smart beta equity / factor indices are the main expectations for further development of ETF products”

Further developments where called for in the following market segments:

  • 31% of respondents wished for further development of Ethical/Socially Responsible Investing (SRI) ETFs.
  • ETFs related to advanced forms of equity indices – namely those based on multi-factor and smart beta indices – 30% and 28% of respondents

 

In aggregate 45% of respondents would like further development in one of the following areas of either smart beta indices, single-factor indices, and multi-factor indices.

 

More specifically, the EDHEC Survey found that “respondents would like to see further development of smart beta and factor investing products in the area of fixed income”……“The integration of ESG into smart beta and factor investing, and strategies in alternative asset classes (currencies, commodities, etc.), closely follow.”

 

EDHEC conclude, “It is likely that the development of new products corresponding to these demands may lead to an even higher take-up of smart beta and factor investing solutions.”

 

Criteria for selecting ETF Providers

The two main drivers of selecting an ETF provider are Cost and the quality of Cost and Quality of Replication. These two criteria dominate the survey results.

The long-term commitment of the provider, range of solutions, and level of innovation also rank highly.

 

Smart Beta and Factor Investing

The EDHEC Risk Survey has a large section on the drivers of using Smart Beta and Factor Investing Strategies.

Motivation for Smart Beta and Factor investing strategies include improving performance and managing risk

Albeit, the adoption of these strategies is a small fraction of portfolio holdings.

 

Concluding Comments

EDHEC found that there was a preference for passive for open-ended passive funds to invest in equity products, and active solutions to invest in fixed income products.

In relation for smart beta and factor investing the “take-up remains partial despite more than a decade of discussion in the industry, with the vast majority of adopters investing less than 20 per cent of their portfolio in such approaches.”

They find that this is partly due to a lack of ‘transparency and difficulty in accessing information about such strategies”….“In the case of fixed income strategies, investors express doubts over the maturity of research results at this stage. They also see a need for further development of long/short equity strategies based on factors, strategies that address client-specific risk objectives, and strategies that integrate environmental, social and governance (ESG) considerations.”

Personally, I see an increasing demand for smart beta and factor investing within fixed income strategies. Whether this is within an ETF structure, time will tell.

 

Therefore, for product provides to capture the growth and innovation outlined above, as EDHEC highlight, there is work to be done “to improve their solutions for smart beta and factor investing strategies if they are to make it into the mainstream.”

This is an area of opportunity for ETF providers, particularly if it includes an ESG overlay.

 

Happy Investing

 

Please read my Disclosure Statement

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

 

* The 2019 EDHEC survey gathered information from 182 European investment professionals concerning their practices, perceptions and future plans. Respondents are high-ranking professionals within their organisations (34% belong to executive management and 42% are portfolio managers), with large assets under management (42% of respondents represent firms with assets under management exceeding €10bn). Respondents are distributed across different European countries, with 12% from the United Kingdom, 70% from other European Union member states, 14% from Switzerland and 4% from other countries outside the European Union.

* *  At the end of December 2018, the assets under management (AUM) within the 1,704 ETFs constituting the European industry stood at $726bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2018b).

How do Exchange Traded Funds (ETFs) stand up to rigorous analysis?

/ Kiwi Investor / Leave a comment

Exchange Traded Funds (EFTs) have not been subject to the same level of rigorous analysis undertaken upon actively managed funds.  Yet, ETFs are challenging conventional actively managed funds.

While performance of actively managed funds has been extensively investigated, there is not much known yet about the performance of ETFs.

A recent Paper by Robeco provides insightful analysis of ETF’s performance.

Robeco conclude “that the allure of ETFs finds little empirical support in the data and that ETFs have yet to prove that they can generate better performance than conventional actively managed funds.”

The Robeco paper provides a giant leap forward in bridging the imbalance of analysis between actively managed funds and ETFs.

 

Robeco rightly points out, the growth in ETFs has come with little supporting evidence.

They note there are areas in which to be cautious:

  1. “the main differentiator of ETFs, continuous trading, should be of little relevance to passive investors, since the whole idea of the passive approach is to buy and hold for the long term and refrain from trading altogether.”
  2. “not every ETF involves low costs. Whereas the cheapest ETFs have annual expense ratios below 0.05%, there are also ETFs with expense ratios above 1%, which makes them more expensive than many mutual funds”
  3. “if the purpose of ETFs were to facilitate passive investing, then, in theory, one ETF on the broad market portfolio would suffice. In reality one would expect perhaps a few more funds because of practical matters such as competition between different providers, different asset classes, or different time zones; however, not thousands of funds. While there is a handful of very big ETFs which track a broad market index such as the S&P 500, the vast majority of ETFs track indices that themselves represent active strategies.“

 

The Robeco analysis covers US-listed ETFs investing in US equities. It includes analysis of over 900 ETFs, almost $1.9 trillion in AUM, over the period 1993 to the end of 2017.

The Robeco paper also provides a very good analysis on the breakdown of the ETF market, history, size, and different types of strategies.

 

The Results

Robeco’s analysis is the same as that applied to actively managed funds in the academic literature.

“Based on realized returns, 60% of ETFs underperformed the market, 80% exhibited higher volatility, and 80% underperformed in terms of Sharpe ratios. Such figures do not appear to be much different from what has been reported for actively managed mutual funds.“

Robeco zoom in on the different types of ETFs, they find:

  • the small number of generally big ETFs, which aim to track one of the broad market indices, live up to their promises.
  • The weak overall performance of ETFs turns out to be mainly driven by the large number of ETFs that do not aim to replicate any of the broad market indices. In particular, leveraged and inverse equity ETFs

 

Factor Analysis

Robeco undertook analysis on ETFs invested into common investment styles e.g. size, value, momentum, quality, and low-risk.

Their analysis highlighted that none of them managed to consistently add value relative to a capitalization-weighted market portfolio of all US stocks.

“The magnitude of these alphas again appears to be quite similar to what one might expect from conventional actively managed funds.”

This can be partly attributed to the poor performance of equity factors over recent years. The recent environment has not been favourable for the performance of many equity factors e.g. Value.

As Robeco note, “Given that some factor ETFs do provide large and significant exposures to the targeted factors, they can be expected to add value if factor premiums rebound in the future. A caveat here is that the factor exposures of some ETFs may have been obtained by pure accident, which means that these exposures might change in the future.”

In other words, implementation of the factor exposure is critical, this will determine success or otherwise.  The implementation of the factor approach undertaken by the ETF needs to be appropriately researched.

 

Conclusions

Robeco conclude “the performance of ETFs is not as impressive as one might expect it to be, as investors in these ETFs have collectively realized a performance that does not appear to be much different from the performance that can be expected from the conventional actively managed mutual funds.”

 

This Post is not to be taken as an assault on ETFs, they can play a role in a robust portfolio. As can active management. There are shades of grey in investment returns, as a result the emotive active vs passive debate is outdated.

Nevertheless, the growth in Exchange Traded Funds has been spectacular over the last decade and it is only appropriate they are subject to the same level of rigorous research as an actively managed investment strategy.

All investment decisions should be based on robust, independent, diligent, and thorough investment analysis.

Although this may appear self-evident too many, there are good reasons to be cautious in the selection of ETFs as highlighted by the Robeco analysis.

 

In fact, the future trends in ETFs is rather daunting, as highlighted by a 2018 EDHEC ETF Survey.  EDHEC updated this Survey in 2019.

 

Happy Investing

 

Please see my Disclosure Statement

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

 

 

 

 

Kiwi Wealth caught in an active storm

/ Kiwi Investor / 4 Comments

We need to change the conversation on investment management fees.

Kiwi Wealth recently released an insightful article on the case for having your money managed actively.

This article has, inevitably, being meet with a passionate defence of Index Management (also referred to as Passive Management). A debate that has been going on for some time, and we really need to move on!

Kiwi Wealth make the following comment in the introduction:

“The “active versus passive” debate has been a fixture in the investment industry for nearly 50 years. Passive investing is one of the cheapest ways to access equity markets globally, and has helped to drive down fees across the board. Passive investment managers and their suppliers have gone further than just offering low cost products however, and have portrayed actively-managed portfolios as a bad option for investors. We disagree, and believe, headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.”

 

I can’t disagree with that.

As the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio.

The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).

The black and white debate is evident in this GoodReturns article, Passive Managers Reject Criticism. Also note the comments section as well.

 

I have written a number of Posts on Index management, highlighting their limitations, and risks, albeit I can see a role for them as part of a portfolio, as I can active management.

As with active management, it is important to understand and appreciate the limitations of what you are investing in.

I also hope we don’t follow Australia’s lead as an industry and focus too much on investment management fees. There is an appropriate level of fees, but it is not the lowest cost provider.

We need to change the conversation on investment management fees as recently highlighted by BlackRock, a large Index/Exchange Traded Fund (ETF) provider.

 

Index Funds do buy high and sell low, primarily because companies move in and out of indices.

Analysis by Research Affiliates highlights the trading costs of Index Funds (Passive Funds). Index Fund providers understand this and seek to minimise these costs.

As an aside, passive index funds are not passive, they are actively managed.

Albeit, there are huge trading costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns. Index Funds incur these costs.

These costs are high, Research Affiliates estimates the difference in return between a company exiting and entering an Index to be 9.52%. The majority of this performance difference occurs on the day of index changes. It also only occurs on that proportion of the portfolio that is changing.

Stocks entering an Index tend to underperform over the next 12 months, while those leaving an Index tend to outperform over the following year.

For more, see this article on why low cost index investing is not necessarily low risk.

In another Post I highlighted that Index Funds have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated.

 

These articles are separate to the current issue of overvaluation in sectors of the US market, recently labelled, rather misleadingly, an Index Bubble, by Michael Burry, who was one of the first investors to call and profit from the subprime mortgage crisis of 2007-08 that triggered the Global Financial Crisis.

 

Just on active management, there is a growing level of academic research challenging the conventional wisdom of active management and in support of active management, as I highlight in the Post Challenging the Convention Wisdom of Active Management.

The research Paper attached to this Post is the most downloaded paper from Kiwiinvestorblog.

 

Closely related, and what has busted open the active vs passive debate, leading to the shades of grey, is the disaggregation of investment returns – the isolation of drivers of investment returns.

As the Post highlights returns can be broadly attributed to three drivers: Market returns (beta), factors and hedge fund strategies beta, and alpha (returns after the betas, which can be purely attributed to manager skill).

The disaggregation of investment returns is prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge. These are “active” returns.

The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.

As you know, the isolation of the drivers of investment returns is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay high fees for an “active” return outcome that can be sourced more cheaply.

 

Happy investing.

Please see my Disclosure Statement

 

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

A short history of Portfolio Diversification

/ Kiwi Investor / 7 Comments

Advancements in technology and new knowledge have made it easier to diversify portfolios and manage investment management fees. Greater clarity over sources of returns have placed downward pressure on active manager’s fees.  True sources of portfolio diversification can command a higher fee and are worth considering.

Is your portfolio managed as if it is the 1980s? the 1990s? Does it include any of the key learnings from the Tech Bubble crash of 2000 and the market meltdown of the Global Financial Crisis (GFC or Great Recession)?

Finally, is your portfolio positioned for future trends in portfolio management?

 

Below I provide a short history of the evolution of portfolio diversification. The evolution of portfolio diversification is interesting and can be referenced to determine how advanced your portfolio is.

 

The framework, idea, and some of the material comes from a very well written article by Aberdeen Standard Investments (ASI).

Unless stated otherwise, the opinions and comments below are mine.

 

Standing on the Shoulders of Giants

Nobel Laureate and pioneer of investment theory Harry Markowitz’s 1952 paper “Portfolio Selection” provided the foundations for Modern Portfolio Theory (MPT).

Markowitz’s analysis provided the mathematical underpinnings for portfolio optimisation.

The key contribution of Markowitz was the quantification of portfolio “risk”. Portfolio Risk was measured by the variation in investment returns – standard deviation of returns.

Markowitz’s paper led to the concept of an “optimal portfolio”, a framework in which both risk and returns are considered. Optimal portfolios offer the maximum expected return for a defined level of risk.

The benefits of diversification were clear to see. Diversification reduces risk without sacrificing returns.

As the ASI article noted: Markowitz called diversification “the only free lunch in finance”.

MPT led to the establishment of the 60:40 portfolio, a portfolio of 60% equities and 40% fixed income.

Increased Diversification of the 60:40 Portfolio

The 60:40 portfolio dominated for a long period time. This portfolio was also largely domestically orientated i.e. the concept of investing internationally was not widely practiced in the 1960 – 70s, even early 1980s.

The next phase in portfolio diversification largely focused on increasing the level of diversification within the equity and fixed income components of 60:40 Portfolio.

As outlined in the ASI paper, four trends combined to drive a broadening of investments in 1980s and 90s:

  • deregulation of financial markets
  • rapid growth in emerging markets
  • financial innovation
  • academic ‘discoveries’.

Deregulation played a major role, particularly the ending of fixed currency exchange rates and the relaxing of capital controls. This enabled an increased level of investing internationally.

This also coincided with the discovery of the “emerging markets”, leading to an increased allocation to emerging market equities and fixed income securities.

Financial innovation resulted in the development of several new financial instruments, including mortgage-backed securities, high-yield bonds (formally called Junk Bonds), and leverage loans.

The use of derivatives also grew rapidly following the establishment of Option Pricing Theory.

Other academic discoveries led to style investing, such as value and growth, and the rise of investing into smaller companies to add value and increase diversification.  Style investing has been superseded by factor investing, which is discussed further below.

ASI conclude, that at the end 1990’s portfolio diversification could be characterised as including:

  • domestic and international equities
  • value and growth stocks
  • large-cap and small-cap stocks
  • developed and emerging markets
  • government, mortgage and corporate fixed income securities.

 

Fundamentally, this is still a portfolio of equities and bonds. Nevertheless, compared to the domestic two-asset class 60:40 Portfolio of the 1960 – 70s it offered more diversification and weathered the severe market declines of tech bubble burst in 2000 and GFC better.

Pioneering Portfolio Management – the Yale Endowment Model

The 2000’s witnessed the emergence of the “Endowment Model”. This followed a period of strong performance and evidence of their diversification benefits during the tech bubble burst of 1999-2000.

The Endowment model has been characterised as being based on four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets e.g. property.

The endowment model was pioneered by David Swensen at Yale University. Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.

For more on diversification approach adopted by Endowments and Sovereign Wealth Funds please see my previous Post Investment Fees and Investing like and Endowment – Part 2.

Learnings from Norway

The extreme severity the GFC tested all portfolios, including the Endowment Model.

The dislocation in markets muted the benefits of diversification from alternative investments and left many questioning the actual level of diversification within their portfolio.

In 2009 this disappointment prompted the Norwegian Government Pension fund to commission a study to investigate their returns during the GFC.

The study was undertaken by three prominent professors, Andrew Ang (Columbia Business School), William Goetzmann (Yale University) and Stephen Schaefer (London Business School). The paper is well worth reading.

This study went on to influence portfolio diversification considerations and captures some major learnings from the GFC. The study brought factor investing into greater prominence.

Factors are the underlying drivers of investment returns.  The Nordic study recommended that factor related returns should take centre stage in an investment process.

As a result, the Norwegians rethought about how they structured their portfolios. Other countries have followed, incorporating factor investing into their asset allocations.

Please see my previous Post on Factor Investing and this interview with Andrew Ang, one of the authors of Nordic study, for further details.

Innovation and pressure on Investment Management Fees

The period since the GFC has yielded an increasing level of innovation. This innovation has been driven in part by factor investing, technology advancements, pressure on reducing investment management fees, and increased demand to access more liquid alternative investment strategies to further diversify portfolios.

The disaggregation of investment turns has provided a new lens in which to view portfolio diversification. With technology advancements and the rise of factor investing returns from within markets have been isolated. Broadly speaking, investment returns can be attributed to: market exposures (beta e.g. sharemarkets); underlying factors (e.g. value and momentum); hedge fund strategy returns (e.g. relative value and merger arbitrage); and returns purely attributable to manager skill (called alpha, what is left if the previous sources cannot explain all the return outcome). For a fuller discussion please see my earlier Post on Disaggregation of Investment Returns.

These trends have resulted in the proliferation of ETFs and the downward pressure on investment management fees. The active manager has been squeezed, with investors only wanting to pay fees relative to the source of return i.e. very very low fees for beta and higher fees for alpha.

These developments have also resulted in the rise of liquid alternatives. Returns once attributed to hedge funds can now be more easily accessed, from a cost and liquid perspective.

Increasingly these strategies are available in an Exchange Trade Fund (ETF) structure.

True Portfolio Diversification

Consequently, there is a now a greater ability to significantly diversify the portfolios of the 1980s and 1990s and take on the learnings from GFC and 2000 Tech bubble.

Increasingly 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 listed liquid 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.

True diversification involves taking the learnings from the endowment model and the Norwegian Government Pension Fund study.

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.  This Post highlights that more asset classes does not equal more diversification may also be of interest.

Goal Based Investing and the extinction of the 60:40 Portfolio

Advancements in technology have helped investors understand the different dimensions of risk better and move away from the sole risk measure of MPT (standard deviation of returns).

Likewise, there has been a growing appreciation that failure to meet your investment objectives is the greatest investment risk.

More advanced portfolio construction approaches such as Liability Driven Investing (LDI) have been embraced.

Goal-Based Investing for the individual is based on the concepts of LDI.

The move toward Goal-Based Investing completely upturns portfolio construction, likely resulting in the extinction of the 60:40 Portfolio.

This paradigm shift within the industry is best captured by analysis undertaken by EDHEC Risk Institute.  I covered the most relevant EDHEC article in more depth recently for those wanting more information. This Post outlines future trends in Wealth Management.

Future Direction of Diversification

The ASI article finishes by discussing several trends they believe are reshaping portfolio construction. Some of these trends have been discussed on Kiwiinvestorblog.

I would like to highlight the following trends identified by ASI:

  1. Investors continue to shift from traditional to alternative assets, see the recent Prequin Post.
  2. Investors are increasingly integrating environmental, social and governance (ESG) analysis into their decision-making process.
  3. Opportunities to invest in emerging markets are increasing.
  4. Individuals have to take more responsibility for their financial futures. This is known as the Financial Climate Change.

 

As ASI conclude “If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.”

I would also add, and it is worth reflecting upon, although the benefits of diversification are without question, Modern Portfolio Theory of the 1950s can hardly be considered modern.

 

Happy investing.

Please see my Disclosure Statement

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

Kiwi Investor Blog achieves 100 not out

/ Kiwi Investor / 1 Comment

Kiwi Investor Blog achieves 100 Posts.

Thank you to those who have provided support, encouragement and feedback. It has been greatly appreciated.

 

Before I briefly outline some of the key topics covered to date by Kiwiinvestorblog.com, the “intellectual framework” for the Blog has largely come from EDHEC Risk Institute in relation to Goals-Based investing and how to improve the outcomes of Target Date Funds in providing a more robust investment solution.

Likewise, Noble Laureate Professor Robert Merton’s perspective on designing an appropriate retirement system has been influential. Regulators and retirement solution providers should take note of his and EDHEC’s work.

Combined, EDHEC and Professor Merton, are helping to make finance useful again.

Their analysis into more robust retirement solutions have the potential to deliver real welfare benefits for the many people that face a challenging retirement environment.

A Goals-Based approach also helps the super wealthy and the High Net worth in achieving their investment and hopefully philanthropic goals, resulting in the efficient allocation of capital.

The investment knowledge is available now to achieve this.

 

To summaries, the key topics of Kiwi investor blog:

 

  • Likewise, much ink has been spilt over Target Date Funds. I believe these are the vehicle to achieving the mass production of the customised investment solution. Furthermore, they are likely to be the solution to the KiwiSaver Default option. The current generation have many shortcomings and would benefit by the implementation of more advanced investment approaches such as Liability Driven Investing. This analysis highlights that Target Date Funds that are 100% invested in cash at time of retirement are scandalous.

 

 

  • The first kiwiinvestorblog Post was an article by EDHEC Risk Institute outlining the paradigm shift developing within the wealth management industry, including the death of the Policy Portfolio, the move toward Goals-Based Investing and the mass production of customised investment solutions. These themes have been developed upon within the Blog over the last 22 months.

I covered the EDHEC article in more depth recently.

 

 

  • The mass production of customised investment solutions has been a recurrent topic. Mass customisation enabled by technology will be the Uber Moment for the wealth management industry. Therefore, the development of BlackRock and Microsoft collaborating will be worth following.

 

 

 

  • Several Posts have been on Responsible Investing. I am in the process of writing a series of articles on Responsible Investing. The next will be on Impact Investing. The key concern, as a researcher, is identifying those managers that don’t Greenwash their investment approach and as a practitioner seeing consistency in terminology.  The evidence for Responsible Investing is compelling and there is a wide spectrum of approaches.

 

 

  • There has been a focus on the issues faced by those near or in Retirement, such as the Retirement Planning Death Zone. These discussions have led to conclusion that Warren Buffet could be wrong in recommending high allocations to a low cost index funds. Investment returns are greatly impacted by cashflows into and out of the retirement fund.

 

  • I don’t tend to Post around current market conditions; market views and analysis are readily available. I will cover a major market development, more to provide some historical context, for example the anatomy of sharemarket corrections, the interplay between economic recession and sharemarket returns, and lastly, I first covered the topic of inverted yield curves in 2018.  I provided an update more recently, Recessions, inverted yield curves, and Sharemarket returns.

 

My word for 2019 is Flexicure, as outlined in my last Post of 2018, Flexicurity in Retirement Income Solutions – making finance great again – which brings together many of the key topics outlined above.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Evolution within the Wealth Management Industry, the death of the Policy Portfolio

/ Kiwi Investor / 11 Comments

There has been a profound shift in the savings and investment industry over the last 15-20 years.

Changes to accounting rules and regulations have resulted in a large number of corporates closing their defined benefit (DB) pension schemes.

This has resulted in a major shift globally away from DB schemes and to defined contribution (DC) schemes, such as KiwiSaver here in New Zealand.

 

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.

This has been likened to a “financial climate change” by the World Economic Forum.

Couple with an aging population, growing life expectations, and strains on Government sponsored pension/superannuation schemes there is an increasing need for well-designed retirement investment solution.

 

Overarching the above dynamics is the shortcomings of many financial products currently available.

Many Products currently do not provide a stable stream of income in retirement, or if they do, they lack flexibility.

As expressed by EDHEC Risk Institute robust investment solution need to display Flexicurity.

Flexicurity is the concept that individuals need both security and flexibility when approaching retirement investment decisions.

Annuities, although providing security, do not provide any potential upside. They can also be costly, represent an irreversible investment decision, and rarely are able to contribute to inheritance and endowment objectives.

Likewise, modern day investment products, from which there are many to choose from, provide flexibility yet not the security of replacement income in retirement. Often these Products focus solely on managing capital risk at the expense of the objective of generating replacement income in retirement.

Therefore, a flexicure retirement solution is one that provides greater flexibility than an annuity and increased security in generating appropriate levels of replacement income in retirement than many modern day investment products.

 

Retirement Goal

The most natural way to frame an investor’s retirement goal is in terms of how much lifetime replacement income they can afford in retirement.

The goal of most modern investment Products is to accumulate wealth, with the management of market volatility, where risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not provide a sufficient level of income in retirement.

This is a key learning from Australia as they near the end of the “accumulation” phase of their superannuation system. After a long period of accumulating capital a growing number of people are now entering retirement and “de-cumulating” their retirement savings.

A simple example of why there should be a greater focus on generating retirement income in the accumulation phase of saving for retirement is as follows:

A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $32k if they had remained invested in term deposits. That’s a big drop in income, and it will continue to fall as the Reserve Bank undertakes further interest rate reductions over the course of 2019.

This also does not take into account the erosion of buying power from inflation.

Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.

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

 

The concept of placing a greater focus on retirement income as the investment goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton  in this Posdcast with Steve Chen, of NewRetirement.

Professor Merton highlights that for retirement, income matters, and not the value of Accumulated Wealth.

He also argues that variability of retirement income is a better measure of risk rather than variability of capital.

More robust investment solutions are being developed to address these issues.

 

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

 

The death of the Policy Portfolio

Another important consideration is that investment practices and approaches are evolving. Modern Portfolio Theory (MPT), the bedrock of most current portfolios, was developed in the 1950s. It is no longer that modern!

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements can be made based on the ongoing academic and practitioner research into building more robust investment solutions.

The momentous shift is the move away from the old paradigm of the Policy Portfolio. The Policy Portfolio is the strategic asset allocation of a portfolio to several different asset classes deemed to be most appropriate for the investor.

It is a single Portfolio solution.

Over the last 15-20 years there has been several potential enhancements to the Policy Portfolio approach, including the move away from asset classes and greater focus on underlying “factors” that drive investment returns (Although a separate Post will be published on this development, an introduction to factor investing and its implementation have been covered in previous Posts).

This interview with Andrew Ang on Factor Investing might also be of interest.

 

The focus of this Post, and probably the most significant shift away from the old paradigm, is the realisation that investments should not be framed in terms of one all-encompassing Policy Portfolio, but instead in terms of two distinct reference Portfolios.

The two portfolios as expressed by EDHEC-Risk Institute and explained in the context of a wealth Management solution are:

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

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

The idea of two portfolios was also recently endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.

 

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

Reasons for the death of Policy Portfolio include that there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.

Furthermore, Investors should be dynamic, they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Therefore, institutional investors are moving toward more liability driven investment solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.

The allocation between the two portfolios is seen as a dynamic process, which responds to the market environment and the changing likelihood of meeting investment goals.

 

Evolution of Wealth Management – the new Paradigm

These “institutional” investment approaches, liability driven investing, portfolio separation, and being more dynamic are finding their way into wealth management solutions.

Likewise, there is a growing acceptance the goal, as outlined above, is to focus on delivering income in retirement. Certainly a greater emphasis should be place on Retirement Income than previously.

Specifically, the goal is to meet with a high level of probability consumption goals in the first instance, and then aspirational goals, including healthcare, old age care and/or bequests.

Therefore, the investment solution should be designed to meet investment goals, as opposed to purely focusing on market risks as a whole, as is the case with the Policy Portfolio.

 

Goal-Based Investing

This new paradigm has led to Goal-Based investing (GBI) for individuals. Under GBI the focus is on meeting investor’s goals, much like liability-driven investing (LDI) is for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

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

 

GBI is consistent with two portfolio approach, fund separation, liability driven investing, and undertaking a dynamic investment approach.

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

The objective of this Portfolio is to secure with some certainty future income requirements. It is typically made up of longer dated high quality fixed income securities, including inflation linked securities.

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

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

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

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals. It will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

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

 

Industry Challenge

The Industry challenge, as so eloquently defined by EDHEC Risk, as a means to address the Pension Crisis as outlined at the beginning of this Post:

“investment managers must focus on the launch of meaningful mass-customized retirement solutions with a focus on generating replacement income in retirement, as opposed to keeping busy with launching financial products ill-suited to the problem at hand”

“……..The true challenge is indeed to find a way to provide a large number of individual investors with meaningful dedicated investment solutions.”

 

As expressed above, saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

Mass-production of Products, rather than Mass-Customisation of Investment Solutions, has been around for many years with the introduction of Unit Trusts/Mutual Funds, and more recently Exchange Traded Funds (ETFs).

Mass-production, and MPT, down play the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

Although the Growth Portfolio would be the same for all investors, the Liability Hedge Portfolio requires a greater level of customisation, it needs to be more “custom-made”.

 

Conclusion

Encouragingly, the limitation of “one size fits all” approach has been known for some time. The investment techniques and approaches are available now to better customise investment solutions.

The challenge, is scalability, and the good news is advancements have been made in this area as well.

This is leading to changes within funds management organisations involving the greater use of technology and new and improved risk management techniques.  New skills sets have been developed.

The important point is that the knowledge is available now and it is expected that such investment solutions will be a growing presence on the investment landscape.

This will lead to better investment outcomes for many and have a very real social benefit.

 

The inspiration for this Post comes from EDHEC Risks short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

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

 

Happy investing.

Please see my Disclosure Statement

 

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