Investment leadership is needed now

Investment leadership needs to step up. It needs to project confidence that it can crack through this crisis. It then needs to re-group with the benefits of extraordinary lessons learned through extraordinary times and morph into something better. While this crisis is rightly producing stories of heroes in scrubs and gowns, the investment industry will be discovering its own heroes. They are likely to be T-shaped leaders: both sure-footed in strategy and steeped in humanity.

This is the conclusion of Roger Irwin in his recent article, the hour for leadership is now, appearing on Top1000funds.com.

 

T-shaped leadership involves having deep expertise in your field and a greater awareness of societal and business issues.

As he notes, investment leaders have the opportunity to make life-changing differences for people’s savings and investments. “They will do so by drawing from the widest range of leadership skills to manoeuvre through the epic challenges this crisis presents and by emerging with stronger, fairer and more sustainable businesses.”

I couldn’t agree more.

 

The article has a wide ranging discussion on leadership, and what will be valued in the current situation. A mix of leadership approaches is required, it is not a case of either / or but and.

 

As he quite rightly points out, in the current environment, safety will be high on everyone’s needs.

“This suggests that the empathy shown to workers through this period of vulnerability will be preciously valued. For example, in the choice of what’s right to do now when family issues arise while working from home; this is the time to choose to do the family thing. For the best organisations, it’s not even close.” Quite right.

 

There is no doubt the current environment presents a unique set of challenges.

Irwin suggests the best stories will come from “organisations where leadership and culture are strongest. They will have a few things in common: a balance in the craft of exercising dominant and serving leadership styles; a purposeful culture as a north star; clarity that profit play a supporting role in that purpose; and a culture that accommodates this ‘it’s all about the people’ moment.”

 

He expects a number of disruptions to organisations, the following observations are made:

  • Good leaders always manage to stay in touch.
  • There will be a growing need for emotional intelligence among investment leadership. “Employees increasingly expect work and life to be integrated and this is central to good employee experiences where well-being, purpose and personal growth rank highly and intrinsic motivations are more lasting than extrinsic forms like pay.”
  • There needs to be a culture of openness in the workplace. The hoarding of information is old school. “Now the open-cultured organisations can create the positive state of psychological safety at all levels with everyone feeling included. This plays to better decision making all round and helps people with their resilience during tough times.”

 

As mentioned above, the current environment requires leaders to be T-shaped.

The vertical bar in the T constitutes deep expertise in their field.

The horizontal bar is about having greater awareness of societal and business issues. Being more in touch. The article provides a number of examples, including: a greater understanding of stress and fight or flight responses in brain science; and the balancing of dominant and serving leadership in management science.

He suggests, we build the vertical bar in the T through being in-touch with a wider network and other disciplines.

 

Good luck, stay healthy and safe.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Tailored Investment solutions boost superannuation outcomes – Lifecycle Funds outperform Balanced Funds

A greater level of customisation leads to better investment outcomes for investors.

For example, Multifactor Lifecycle Funds that focus on age and size of account balances are best placed to last the distance as we live for longer in retirement, compared to a Balanced Fund and Lifecycle Funds that focus on age alone.

Multifactor Lifecycle Funds:

  1. Generate higher expected lifetime income relative to a Balanced Fund (70% equities and 30% Fixed Income and Cash); and
  2. Outperform a Balanced Fund over 90% of the time based on a numerous number of different market and economic scenarios.

These are the key findings of the Rice Warner’s research paper: Lifecycle Design – To and Through Retirement.

Lifecycle Funds, also referred to as Glide Path Funds, Target Date Funds, or Lifestages Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor approaches retirement.

 

Rice Warner found that somebody aged 30 with an opening balance of $26,000 and invested in a Multifactor Lifecycle Fund had a 91.8% chance of outperforming a Balanced Fund by the time of retirement at age 63.

Their research also found that by investing in a Multifactor Lifecycle Fund the expected retirement income is up to 35% higher than that expected from a Balanced Fund (Source: Australian AFR The product that can boost super by 35pc).

For somebody aged 60 with an account balance of $118,300, a Multifactor Lifecycle Fund had a 72.4 per cent chance of outperforming a Balanced Fund.

Lastly, Second Generation Lifecycle Funds, which reduce their growth allocation later, outperformed a Balanced Fund 91.2% of the time. A Multifactor Lifecycle Fund outperforms a Second Generation Lifecycle Fund 84.6% of the time.

 

A key conclusion from the Rice Warner research is that Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to enhance outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

 

They achieve this by adopting a more growth-oriented stance while an investor has a long investment horizon and shifting to defensive assets when the investor’s investment horizon grows short.

Importantly, an individual’s investment horizon is a function of not only age but also the size of their superannuation account. This is an important concept, the rationale is provided in the section below – The Benefits of a Multifactor Lifecycle Fund.

 

A summary of the Rice Warner analysis is provided below, along with key Conclusions and Implications for those aged 30 and 60.

A copy of the Rice Warner analysis can be found here.

 

To my mind, there is going to be an increased customisation of investment solutions available for those saving for retirement that will consider factors beyond age e.g. account size, salary, and assets outside of Super.  Some are available already.

Technology will enable this, Microsoft and BlackRock are well advanced in collaborating, BlackRock and Microsoft want to make retirement investing as easy as ordering an Uber.

 

In relation to Lifecycle Funds, they are subject to wide spread criticism.

Some of this criticism is warranted, nevertheless, often the criticism is the result of the poor design of the Fund itself, rather than concept of a Lifecycle Fund itself. This is highlighted in the Rice Warner research, where the first Generation of Lifecycle Funds de-risk to early.

I covered the criticism of Lifecycle Funds in a previous Post, in the defence of Lifecycle Funds.

 

Lifecycle Funds can be improved upon. For example a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

In my opinion, all investments strategies would benefit from a greater focus on tangible investment goals, this will lead to a more robust investment solution.

A Goals based investing approach is more robust than the application of “rule of thumbs”, such as the 4% rule and adjusting the growth allocation based purely as a function of age.

Goals based investing approaches provide a better framework in which to assess the risk of not meeting your retirement goals.

Greater levels of customisation are required, which is more relevant in the current investment environment.

 

 

Rice Warner – The benefits of Multifactor Lifecycle Funds

Investment literature indicates that an investor’s investment horizon is a key determinant of an appropriate investment strategy.

The consequence of longer investment horizons allows an investor to take on more risk because even if there is a severe market decline there is time to recover the losses.

Furthermore, and an important observation, Rice Warner’s analysis suggests that as we enter retirement investment horizon is a function of age and size of the superannuation account balance.

A retiree with a larger account balance has in effect a longer investment horizon. They are in a better position to weather any market volatility.

This reflects, that those with a small account size typically withdraw a greater proportion of their total assets each year, indicative of largely fixed minimum cost of living, resulting in a shorter investment horizon.

 

A very big implication of this analysis is that an investor’s investment horizon is “not bounded by the date that they choose to retire (though this point is relevant). This is as a member is likely to hold a substantial proportion of their superannuation well into the retirement phase, unless their balance is low.”

“One consequence of this is that investment strategies which consider this retirement investment horizon may deliver better outcomes for members – both to and through retirement. This is because as a member’s account balance grows, sequencing risk becomes less relevant allowing higher allocations to growth assets.”

For those wanting a better understanding of sequencing risk, please see my earlier Post.

 

Rice Warner conclude, Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to provide enhanced outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

Thus, the title of their research Paper, Lifecycle Design – To and Through Retirement, more often than not investors should still hold a relatively high allocation to growth assets in retirement.  They should be held to the day of retirement and throughout retirement.

The research clearly supports this, a higher growth asset allocations should be held to and through retirement.  In my mind this is going to be an increasingly topically issue given the current market environment.

 

 

Rice Warner Analysis

Rice Warner considered several investment strategies applied to various hypothetical members throughout their lifetime.

They assess the distribution of outcomes of the investment strategies to establish whether adjustments can be made to provide members with better outcomes overtime.

Rice Warner considered:

  1. Balanced Strategy which adopts a fixed 70% allocation to Growth assets.
  2. High Growth strategy which adopts a fixed 85% allocation to Growth assets.
  3. First-generation Lifecycle (Lifecycle 1 (Age)) with a focus on defensive assets and de-risking at young ages.
  4. Second-generation Lifecycle (Lifecycle 2 (Age)) with a focus on growth assets and de-risking at older ages.
  5. Multi-dimensional Lifecycle (Lifecycle (Age and Balance)) which adopts a high allocation to growth assets unless a member is at an advanced age and has a low balance.

Six member profiles selected to capture low, moderate, and high wealth members at ages 30 and 60.

Rice Warner then considered the distribution of expected lifetime income under a range of investment scenarios using a stochastic model.

This allowed for a comparison of the income provided to members under each strategy in a range of investment situations for comparative purposes.

 

Conclusions

Rice Warner Conclude:

  • Investment horizon is a critical driver in setting an appropriate investment strategy. Investment strategies should take into consideration a range of investment horizon, both before and after retirement.
  • Adopting high allocations to growth assets is not inherently a poor strategy, even in cases where members are approaching retirement. These portfolios will typically provide:
    • Improved outcomes in cases where members are young, or investment performance is strong;
    • Marginally weaker outcomes where members are older and investment performance is weak.
  • Second-generation Lifecycle investment strategies (focused on growth assets and late de-risking) will typically outperform first generation strategies (which are focused on defensive assets and de-risking when a member is young).
  • Growth-oriented constant strategies will typically outperform First-generation Lifecycle strategies, except where investment performance is poor.
  • Designing Lifecycle strategies that use further factors in addition to age (such as balance) provide the ability to better tailor a portfolio to provide enhanced outcomes by:
    • Adopting a more growth-oriented stance while a member has a long investment horizon.
    • Shifting to defensive assets when a member’s investment horizon grows short.

 

Implications

Overall the results, aged 30:

  • High Growth strategies can provide significant scope for outperformance with minimal risk of underperformance relative to a Balanced Fund due to the members’ long investment horizon.
  • First-generation Lifecycle strategies will typically underperform each of the other strategies considered except where investment outcomes are poor for a protracted period. This underperformance is a result of the defensive allocation of these strategies being compounded over the member’s long investment horizon.
  • Second-generation Lifecycle can mitigate the risk faced by the members over their lifetime, albeit at the cost of a reduced expected return on their portfolio relative to a portfolio with a higher constant allocation to growth assets.
  • Lifecycle strategies which adjust based on multiple factors are able to manage the risk and return trade-off inherent to investments in a more effective way than single strategies or Lifecycle strategies only based on age. This is a result of the increased tailoring allowing the portfolio to adopt a more aggressive stance when members are young and thereby accumulate a high balance and extend their investment horizon further. This leads to this portfolio often outperforming the other strategies considered.

 

For those aged 60

  • High Growth strategies can provide significant outperformance in strong investment conditions. This comes at the cost of a modest level of underperformance in a poor investment scenario (a reduction in total lifetime income for members ranging between 2% and 5% relative to a Balanced fund).
  • First-generation Lifecycle strategies will underperform in neutral or strong market conditions due to their lack of growth assets. In cases where investment performance is poor these strategies outperform the other strategies considered particularly for those with low levels of wealth (due to their short investment horizons).
  • Two-dimensional Lifecycles provide enhanced risk management (but not necessarily better expected performance) by providing:
    • Protection for members who are vulnerable to sequencing risk with short investment horizons (low and moderate wealth profiles) by adopting a Balanced stance.
    • High allocations to growth for members whose investment horizon is long (high wealth profiles).

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

More needs to be done to address the post-retirement challenges

The next generation to retire is likely to have much lower retirement savings. Those aged 40 to 55 are effectively a lost generation.

They have limited defined benefit (DB) pensions as many occupational schemes closed early on in their careers and it took the government many years to develop and implement auto-enrolment.

These are some of the underlying themes of the 2019 UK Defined Contribution (DC) Investment Forum (DCIF) report.  A summary and discussion of this report was recently published in an IPE Article.

The key findings of the DCIF Report:

  • Members are sleepwalking into retirement and choosing the path of least resistance
  • The industry has been slow to address the challenges posed by pension freedoms
  • The best approach is seen as income drawdown in earlier years and longevity protection later in retirement
  • Further policy initiatives are required to build consensus and provide clarity

 

In summary, “The DC industry needs to do more to address post-retirement challenges”.

 

There are obviously issues specific to the UK market e.g. it has been five years since pensioners in the UK gained greater freedom to use their defined contribution (DC) pots.

Nevertheless, retirement issues are universal and key learnings can be gained from individual markets.

 

The IPE article outlined the key challenge facing providers: “how do you ensure members retain flexibility and choice, while ensuring those members can manage both the investment and longevity risk over decades of retirement?”

 

Overall, the UK industry response has been slow. It appears “Pension providers have been focused on designing the best default fund with little energy spent on the post-retirement phase.”

Interestingly, research in the UK by Nest, a €8.3bn auto-enrolment provider, found most members expect their pension pot to pay an income automatically on retirement.

Members are also surprised by the level of complexity involved in draw down products.

 

Post Retirement Investment Solution Framework

Despite the lack of innovation to date there appears to be a consensus about the shape of the post-retirement investment solution.

An appropriate Post-Retirement Investment Strategy would allow retirees to have decent levels of income during the first two active decades of retirement and longevity protection for after 80.

“Not only does this remove the burden of an unskilled person having to manage both investment and longevity risk, but it also prevents members from either underspending or overspending their pots”.

The idea is to turn a DC pension pot into an income stream with minimal interaction from the scheme member.

 

This is consistent with the vision expressed by Professor Robert Merton in 2012, see this Kiwi Investor Blog Post: Designing a new Retirement System for more detail.

 

As the IPE article highlights, it is important retirees are provided guidance to ensure they understand their choices.

Albeit, a core offering will deliver a sustainable income.  This is potentially a default solution which can be opted out of at any stage.

Some even argue that the “trustees would then make a judgement about what a sustainable income level would be for each member and then devise a product to pay this out.”

“In addition, this product could also provide a small pot of cash for members to take tax-free on retirement as well buying later-life protection. This could take the form of deferred annuities or even a mortality pool.”

 

Early Product Development in the UK

The IPE article outlines several approaches to assist those entering retirement.

By way of example, Legal & General Investment Management have developed a retirement framework which they call ‘four pots for your retirement’.”

  • First pot is to fund the early years of retirement – assuming retirees will spend the first 15 years wanting to enjoy no longer working; they will travel and be active.
  • Second pot provides a level of certainty to ensure retirees do not outlive their savings, this may include an annuity type product.
  • Third pot is a rainy-day pot for one-off expenses.
  • Final pot is for inheritance.

 

Greater Policy Direction

Unsurprisingly, there is a call for clearer policy direction from Government. Particularly in relation to adequacy, and the relation between adequacy and retirement products.

Unlike a greater consensus around what an investment solution might look like, consensus around the regulatory environment will be harder to achieve.

This may slow investment solution innovation to the detriment of retirees.

 

Concluding remarks

The following point is made within the IPE article: “While pension providers in both the US and Australia have come to the same conclusions as the UK about the way to address the retirement market, no-one in these markets has yet developed a viable product.”

As the IPE article note “It is likely the industry will be pushing at an open door if it develops a product that provides an income in retirement.”

This is a significant opportunity for the industry.

 

Interestingly, the investment knowledge is available now to meet the Post Retirement challenge. Also, Post-Retirement Investment solutions are increasingly being developed and are available. It is going to take a change in industry mind-set before they are universally accepted.

 

The foundations of the investment knowledge for the Post-Retirement Investment solution as outlined above have regularly been posted on Kiwi Investor Blog.

For those wanting more information, see the following links:

 

There will be change, a paradigm shift is already occurring internationally, and those savings for retirement need a greater awareness of these developments and the likely Investment Solution options available, so that they are not “sleepwalking into retirement and choosing the path of least resistance”.

 

I don’t see enough of the Post Retirement Challenges being addressed in New Zealand by solution providers. More needs to be done, the focus in New Zealand has been on accumulation products and the default option as occurred in the UK.

The approach to date has been on building as big as possible retirement pot, this may work well for some, for others not so well.

Investment strategies can be developed that more efficiently uses the pool of capital accumulated – avoiding the dual risks of overspending or underspending in the early years of retirement and providing a greater level of flexibility compared to an annuity.

These strategies are better than Rules of Thumb, such as the 4% rule which has been found to fail in most markets.

More robust and innovative retirement solutions are required.

 

In New Zealand there needs to be a greater focus on decumulation, Post Retirement solutions, including a focus on generating a secure and stable level of income throughout retirement.

The investment knowledge is available now and being implemented overseas.

Let’s not leave it until it is too late before the longevity issues arise for those retiring today and the next generation, who are most at risk, begin to retire.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Why is the Multi-Asset Portfolio so Popular?

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

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

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

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

 

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

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

 

The Concept: Absolute returns and better risk management

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

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

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

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

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

 

Return Expectations

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

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

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

 

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

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

 

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

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

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

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

 

Growth in Multi-Asset Portfolios to continue

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

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

 

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

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

 

Concluding Remarks

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

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

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

 

Happy investing.

Please read my Disclosure Statement

 

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

Developing ETF Trends and Innovations – EDHEC Risk Research

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).

Past Decade of strong returns unlikely to be repeated

The current return assumption for the average US public pension fund is 7.25%, according to the National Association of State Retirement Administrators (NASRA), highlighted in a recent CFA Institute Blog: Global Pension Funds the Coming Storm.

This compares to the CFA Institute’s (CFA) article expected return for a Balanced Portfolio of 3.1% over the next 10 years.  A Balanced Portfolio is defined as 60% Equities and 40% Fixed Income.

Therefore, the article concludes that a 7.25% return assumption is “overly optimistic in a low return interest rate environment”.

The expected low return environment will place increasing pressure on growing pension liabilities and funding deficits. This is over and above the pressures of an aging population and the shift toward Defined Contribution (DC) superannuation schemes e.g. KiwiSaver.

This environment will likely require a different approach to the traditional portfolio in meeting the growing liabilities of Define Benefit (DB) Plans and in meeting investment return objectives for DC superannuation Funds such as KiwiSaver in New Zealand.

The value will be in identifying and implementing the appropriate underlying investment strategies.

 

Past Returns

For comparison purposes an International Balanced Portfolio, as defined above, has returned around 7.8% over the last 10 years, based on international fixed income and global sharemarket indices.

A New Zealand Balanced Portfolio has returned 10.3%, based on NZ capital market indices only.

New Zealand has had one of the best performing sharemarkets in the world over the last 10 years, returning 13.5% per annum (p.a.), this compares to the US +11.3% p.a. and China -0.7% p.a.. Collectively, global sharemarkets returned 10.2% p.a. in the 2010s.

Similarly, the NZ fixed income markets, Government Bonds, returned 5.4% p.a. last decade. The NZ 5-year Government Bond fell 4.1% over the 10-year period, boosting the returns from fixed income. Interestingly, the US 5-year Bond is only 1% lower compared to what it was at the beginning of 2010.

 

It is worth noting that the US economy has not experienced a recession for over ten years and the last decade was the only decade in which the US sharemarket has not experienced a 20% or more decline. How good the last decade has been for the US sharemarket was covered in a previous Post.

 

In New Zealand, as with the rest of the world, a Balanced Portfolio has served investors well over the last ten or more years. This reflects the strong returns from both components of the portfolio, but more particularly, the fixed income component has benefited from the continue decline in interest rates over the last 30 years to historically low levels (5000 year lows on some measures!).

 

Future Return Expectations

Future returns from fixed income are unlikely to be as strong as experienced over the last decade. New Zealand interest rates are unlikely to fall another 4% over the next 10-years!

Likewise, returns from equities may struggle to deliver the same level of returns as generated over the last 10-years. Particularly the US and New Zealand, which on several measures look expensive. As a result, lower expected returns should be expected.

The lower expected return environment is highlighted in the CFA article, they provide market forecasts and consensus return expectations for a number of asset classes.

 

As the article rightly points out, one of the best estimates of future returns from fixed income is the current interest rate.

As the graph below from the article highlights, “the starting bond yield largely determines the nominal total return over the next decade. So what you see is what you get.”

 

US Bond Returns vs. US Starting Bond Yields

US Bond Returns vs US Starting Bond Yields

 

In fact, this relation has a score of 97% out of 100%, it is a pretty good predictor.

The current NZ 10 Government Bond yield is ~1.65%, the US 10-Year ~1.90%.

 

Predicting returns from equity markets is more difficult and comes with far less predictability.

Albeit, the article concludes “low returns for US equities over the next 10 years.”

 

Expected Returns from a Balanced Portfolio

The CFA Article determines the future returns from a Balance Portfolio “By combining the expected returns from equities and bonds based on historical data, we can create a return matrix for a traditional 60/40 portfolio. Our model anticipates an annualized return of 3.1% for the next 10 years. That is well below the 7.25% assumed rate of return and is awful news for US public pension funds.”

Subsequent 10-Year Annualized Return for Traditional 60/40 Equity/Bond Portfolio

Subsequent 10 years annualized Return for Traditional 60 40 Equity Bond Portfolio.png

 

This is a sobering outlook as we head into the new decade.

Over the last decade portfolio returns have primarily been driven by traditional market returns, equity and fixed income “beta“. This may not be the case when we look back in ten-years’ time.

 

This is a time to be cautious. Portfolio strategy will be important, nevertheless, implementation of the underlying strategies and manager selection will be vitally important, more so than the last decade. The management of portfolio costs will also be an essential consideration.

It is certainly not a set and forget environment. The challenging of current convention will likely not go unrewarded.

Forewarned is forearmed.

 

Global Pension Crisis

The Global Pension crisis is well documented. It has been described as a Financial Climate Crisis, the risks are increasingly with you, the individual, as I covered in a previous Post.

As the CFA article notes, the expected low return environment adds to this crisis, as a result deeper cuts to government pensions and greater increases in the retirement age are likely. This will led to greater in-equality.

 

This is a serious issue for society, luckily there is the investment knowledge available now to help increase the probability of attaining a desired standard of living in retirement.

However, it does require a shift in paradigm and a fresh approach to planning for retirement, but not a radical departure from current thinking and practices.

For those interested, I cover this topic in more depth in my post: Designing a New Retirement System. This post has been the most read Kiwi Investor Blog post. It covers a retirement system framework as proposed by Nobel Laureate Professor Robert Merton in his 2012 article: Funding Retirement: Next Generation Design.

 

Lastly, the above analysis is consistent with recent calls for the Death of the Balanced Portfolio, which I have also Blogged on.

Nevertheless, I think the Balanced Portfolio is being replaced due to the evolution within the wealth management industry globally, which I covered in a previous Post: Evolution within Wealth Management, the death of the Policy Portfolio. This covers the work by the EDHEC-Risk Institute on Goals-Based Investing.

 

In another Posts I have covered consensus expected returns, which are in line with those outlined in the CFA article and a low expected return environment.

In my Post, Investing in a Challenging Investment Environment, suggested changes to current investment approaches are covered.

Finally, Global Economic and Market outlook provides a shorter-to-medium term outlook for those interested.

 

Please note, I do not receive any payment or financial benefit from Kiwi Investor Blog, and a link to my Discloser Statement is provided below.

 

Happy investing.

Please read my Disclosure Statement

 

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

Designing a new Retirement System and Goal-Based Wealth Management

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

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

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

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

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

 

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

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

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

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

Merton begins

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

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

 

And he concludes:

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

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

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

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

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

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

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

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

 

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

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

 

 

Now to the Body of the Article:

Background

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

The current system is far from ideal.

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

What are members seeking to achieve?

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

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

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

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

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

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

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

 

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

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

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

 

Next-generation retirement planning

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

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

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

 

But how is that achieved?

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

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

 

The key point of these questions: 

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

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

 

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

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

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

 

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

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

 

 

Wealth versus sustainable income as the goal

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

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

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

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

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

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

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

 

Investment Reporting

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

Therefore, the measure of risk is important.

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

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

 

Essential and desired income goals – Goals-Based Investing

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

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

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

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

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

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

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

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

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

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

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

 

Pension Alerts

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

At which point in time they have three options:

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

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

Endowments and Sovereign wealth Funds lead the way in building robust investment portfolios in meeting a wide range of challenging investment objectives.   This Post covers this and amongst other things, what true diversification is, it is not having more and more asset classes, a robust portfolio is broadly diversified across different risks and returns. A lot can be learnt from how Endowments construct portfolios, take a long term view, and seek to match their client’s liability profile. Although fees are important, an overriding focus on fees may be detrimental to building a robust portfolio and in meeting client investment objectives.

 

A Robust Framework for generating Retirement Income

This Post builds on the Post above and looks at an investment framework for individuals, developed by EDHEC-Risk Institute and their Partners. It is a Goal Based Investment framework with a focus on capital value but also delivering a secure and stable level of replacement income in retirement.

 

The monkey paw of Target Date Funds (be careful what you wish for)

This Post emphasises the need to focus on generating a stable and secure level of replacement income in retirement as an investment goal and highlights the approach that is required to achieve this. Such an approach would greatly enhance the outcomes of Target Date Funds. This Post also references the thoughts of Professor Robert Merton around having a greater focus on generating replacement income in retirement as an investment objective and that volatility of replacement income is a better measure of investment risk, as it is more aligned with investment objectives, unlike the volatility of capital or standard deviation of returns.

 

Kiwi Investor blog has covered many topics over the year, including the value of active management, the shocking state of the investment management industry globally, Responsible Investing, the high cost of index funds and being out of the market.

Of these, recent research into the failure of the 4% rule in almost all markets worldwide is well worth highlighting.

 

Kiwi Investor Blog has a primary focus on topics associated with building more robust portfolios and investment solutions.

The Blog has highlighted the research of EDHEC-Risk Institute throughout the year. EDHEC draw on the concept of Flexicurity. This is the concept that individuals need both security and flexibility when approaching investment decisions. This is surely a desirable goal and the hallmark of a robust investment portfolio. The knowledge is available to achieve this and the framework and rationale is covered in the Posts above.

Flexicure is my word of 2018.

 

I don’t think the Uber moment has been reached in the investment management industry yet. Technology will be very important, but so too will be the underlying investment solution. The investment solution needs to be more tailored to an individual’s investment objectives.

As outlined in the Posts highlighted above, the framework for the investment solution has emerging and is developing.

It is a goal based investment solution, more closely tailored to an individual’s investment aspirations, so as to provide a more secure and stable level of replacement income in retirement.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Shocked to see the State of the Asset Management industry

“The asset management industry is at the crossroads of enjoying rising markets and growing pools of capital to manage, and navigating significant disruption, changes and pressures from all sides. Taking the right path and making the right choices to adapt, evolve and transform will distinguish winners from losers.”

That is the thoughts of KPMG following the publication of report in to State of the Asset Management Industry

KPMG have identified three game changes that they believe are “fundamentally changing the landscape for this industry. How the asset and wealth management firms respond to these will likely determine their success in the next 5 -10 years.”

KPMG identify three main Game Changers:

  1. ETFs
  2. China
  3. Responsible Investing

 

Responsible Investing

The focus on Responsible Investing (RI) was interesting and a little concerning.

KMPG notes the global asset management has a lower level of trust than the banks and insurers. This is a big issue for the industry.

Therefore KMPG calls for the industry to “truly embrace responsible investment and embed Environmental, Social and Governance criteria into the investment process”

KMPG see this as an important part in restoring trust within the industry. They encourage the industry to be much more wholehearted and convincing in embracing responsible investment and embedding ESG factors into the investment process.”

“The next generation of retail, pension fund and institutional investors want to see their capital being used to create an impact and contribute to a better world”.

 

Of course Responsible Investment and ESG are not new. The Responsible Investment Association of Australia (RIAA) was set up in 2002. Australia has likely lead the rest of the world in this respect.

Therefore, a key issue is that Asset Managers, and Asset Owners, can clearly demonstrate to clients and regulators they are doing what they say they are doing, a point noted by KPMG. A more convincing approach is required.

 

The other two changes are well understood, ETFs and China.

ETFs

KPMG note:

  • Exchange Traded Fund (ETF) assets are already bigger than hedge funds and index tracker funds, and are expected to overtake mutual funds within the next 10 years. Currently the global ETF market is at US$5 trillion and is expected to more than double in the next 5 years.
  • There are rapidly growing markets where ETFs are the vehicle of choice. They fit well with digital technology used by Roboadvisers. They work well as efficient building blocks for asset allocation solutions and model portfolios in the wealth management industry and in the increasingly important self-directed market.
  • Wealth Managers are increasing their use of ETFs. Areas of growth include smart beta, while active ETFs are increasing in popularity

KMPG sum it up: “The traditional asset management industry is at an inflection point. Regulatory scrutiny around value for money and transparency, disruptive D2C technology and new investor preferences, necessitate that firms adapt and innovate if they are to flourish in the new order.

 

China

Pretty simple, “KPMG expects the industry to grow at a double digit rate, year on year, over the next 15 years.”

“In 1998, six Fund Management Companies (FMCs) managed US$1.27 billion, while today 132 firms manage US$2.0 trillion of funds. KPMG forecast USD$5.6 trillion of assets under management in China by 2025, which would make it the second-largest asset management market in the world.”

 

It is certainly a challenging environment for which industry leaders need to be aware.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is the 4% rule dead? – Approaches to Generating Retirement Income

The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

Bill Bengen developed this rule in 1994.

There have been numerous other studies since and the rule has gained wide acceptance.

Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.

Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?

 

The 4% rule has been challenged in a recent article by Wade Pfau.

Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.

Pfau concluded:

  • the 4% real withdrawal rule has simply not been safe;
  • even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
  • a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.

 

At a minimum, investment outcomes can be improved from:

  • Increasing levels of portfolio diversification e.g. the use of alternatives;
  • A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
  • An appropriate rebalancing strategy.

 

Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”

 

The most insightful observation

In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”

I say this given the sharp reduction in equities by many Target Date Funds and many Target Date Funds have limitations, see a recent post and another I posted earlier in the year.

 

More robust and innovative retirement solutions are required

We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.

Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.

These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.

The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.

 

EDHEC-Risk Institute

From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.

EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

 

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.

 

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.

Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.

 

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.

Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.

 

Happy investing.

 

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

 

Please see my Disclosure Statement