Investment Leadership

Generating stable and sustainable investment income

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I would like to share this blog post by AMP Capital New Zealand, Four pillars for generating income | AMP Capital, which looks at the four main pillars of an investment framework to deliver a stable and sustainable level of income over time.

The Post challenges some of the conventional wisdoms underpinning the management of traditional portfolios.

The basis of the framework is a goal orientated investment approach.

For those wishing to understand more around Goal Based Investing, this Wikipedia page, which I have contributed to, Goal-based investing may be of interest. The Wikipedia page includes:

  • A description of Goal Based Investing (GBI)
  • A comparison of GBI to traditional portfolio theory
  • History and development of GBI
  • GBI in principle
  • GBI for the retirement problem

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

Five Myths of About Investment Management Fees – Broadening the Fee Debate

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We need to change the conversation on investment management fees.  The debate on fees needs to be based on facts rather than myths. Despite often being framed in this way, the debate on investment management fees is not black versus white.

What matters is not the fee level, but the manager’s ability to deliver a satisfactory outcome to investors after fees. Either way, it is no good paying high fees or the lowest possible fees if your investment objectives have not been achieved. Therefore, amongst the key questions to ask are, are you satisfied with the investment outcomes after the fees you have paid? – have your investment objectives or retirement goals been achieved?

After fee returns are important.  Therefore, higher fee investment strategies should not necessarily be avoided if they can assist in meeting your investment objectives. In the current investment environment, the use of higher fee investment strategies may be necessary to achieve your investment objectives.

Therefore, Investors should focus on given the investment outcomes have I minimised the fees paid. 

In my mind, this would be consistent with the FMA’s value for money focus. (FMA is New Zealand’s Regulatory)

At the same time, fees should not be the overriding concern and investors must analyse fees in the overall context of managing their portfolios appropriately.

Investment management fee Myths

The 5 most common myths about investment management fees are:

  1. Fees should be as low as possible
  2. Incentive fees are always better than fixed fees
  3. High water marks always help investors
  4. Hedge Funds are where the alpha is.  They deserve their high fees
  5. You can always separate alpha from beta, and pay appropriate fees for each

This paper, Five Myths About Fees, address the above myths in detail.

Although all the myths are important, the myth that fees should be as low as possible probably resonates most with investors.

Investment management fees for active management are higher than index management and involve a wealth transfer from the investor to the investment manager.  This is a fact.

However, the paper is clear, investors should look to maximise excess returns (they term alpha) after fees.  Another way of looking at this, for a given level of excess returns, fees should be minimised.  This is an important concept when considering the discussion below around broadening the discussion on fees.

The paper also notes, investors should pay higher fees to those managers that are more consistent.  For example, if two managers provide the same level of excess return, but one does so by taking less risk, investors should pay higher fees to this manager (the manager who achieves the same excess return but with lower risk – technically speaking, this is the manager with the higher information ratio).

In summary, the take-outs on the myth fees should be as low as possible:

  • Fees must remain below expected excess returns e.g., a manager that charges active fees but only delivers enhanced index returns should be avoided.
  • Managers who consistently add value warrant higher fees.

In relation to do managers add value, see this Post, Challenging the Conventional Wisdom of Active Management.

The paper on the five fee myths is wide ranging.  It also provides insights into the key elements of the fee negotiation game and determining the conditions under which higher fees should be paid.

Key conclusions from the article, particularly after addressing Myth 4 & 5:

  • most investment strategies offer a combination of cheaply accessible market index returns (beta) and active management excess returns (alpha).  While many institutional investors look to separate beta and alpha for most investors this is too limiting and difficult.  Many talented investment managers appear in investment strategies which include both beta and excess returns (alpha).
  • Investors should consider fees before deciding on an investment strategy, not look at an investment strategy and then consider fees.
  • At the same time, fees should not be the overriding concern.
  • High fee investment strategies are worthwhile if they deliver sufficient return and lower risk.
  • Investors must analyse fees in the overall context of managing their portfolios appropriately.

A framework for Changing the discussion on fees

Despite it often framed this way, the debate on fees is not black versus white.

From this respective, understanding the disaggregation of investment returns can help in broaden the debate on fees and also help determine the appropriateness of fees being paid. 

From a broad view, investment returns can be disaggregated in to the following three parts:

  1. Market beta. Think equity market exposures to the NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).  Market Index funds provide market beta returns i.e. they track the returns of the market e.g. S&P 500 and NZX50. Beta is cheap, as low as 0.01% for large institutional investors.
  • Factor betas and Alternative hedge fund beta exposures.  Of the sources of investment returns these are a little more ambiguous and contentious than the others.  This mainly arises from use of terminology and the number of investable factors that are rewarding.  My take is as follows, Factor betas and Alternative hedge fund beta fit between market betas (above) and alpha (explained below).
    • Factor Beta exposures.  These are the factor exposures for which I think there are a limited number.  The common factors include value, momentum, low volatility, size, quality/profitability, carry.  They are often referred to as Smart beta.
    • Alternative hedge fund betas.  Many hedge fund returns are sourced from well understood investment strategies.  Therefore, a large proportion of hedge fund returns can be explained by common hedge fund risk exposures, also known as hedge fund beta or alternative risk premia or risk premia.  Systematic, or rule based, investment strategies can be developed to capture a large portion of hedge fund returns that can be attributed to a hedge fund strategy (risk premia) e.g. long/short equity, managed futures, global macro, and arbitrage hedge fund strategies.  The alternative hedge fund betas do not capture the full hedge fund returns as a portion can be attributed to manager skill, which is not beta and more easily accessible, it is alpha.
  • Alpha is what is left after all the betas.  It is manager skill.  Alpha is a risk adjusted measure. In this regard, a manager outperforming an index is not necessarily generating alpha.  The manager may have taken more risk than the index to generate the excess returns and/or they may have an exposure to one of the factor betas or hedge fund betas which could have been captured more cheaply to generate the excess return.  In short, what is often claimed as alpha is often explained by a factor or alternative hedge fund beta outlined above.  Albeit, there are some managers than can deliver true alpha.  Nevertheless, it is rare.

These broad sources of return are captured in the diagram below, provided in a hedge fund industry study produced by the AIMA (Alternative Investment Management Association).

The disaggregation of return framework is useful for a couple of important investment considerations.  We can use this framework to determine:

  1. Appropriateness of the fees paid. Obviously for market beta low fees are paid e.g. index fund fees.  Fees increase for the factor betas and then again for the alternative hedge fund betas.  Lastly, higher fees are paid to obtain alpha, which is the hardest to produce.
  2. If a manager is adding value – this was touched on above. Can a manager’s outperformance, “alpha”, be explained by “beta” exposures, or is it truly unique and can be put down to manager skill.

The consideration of this framework is consistent with the observations from the article above covering the 5 myths of Investment Management Fees.

Lastly, personally I think a well-diversified portfolio would include an exposure to all of the return sources outlined above, at the very least.

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors. See More Asset Classes Does not Equal More Diversification.

From this perspective, the objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.

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For Outsourced Chief Investment Officer (OCIO) and investment consulting services please see here.

 

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

Active Engagement, Stewardship, and Taxonomy key Responsible Investing Issues

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Active engagement and stewardship have leapt in importance as a way for asset managers to drive sustainable change. This is a key conclusion of a study undertaken by Schroders in 2020. 

Schroders conclude “The results suggest that engagement and voting are now increasingly being viewed as an important aspect of achieving change, rather than simply divesting.”

Their study found that nearly 60% of “institutions said active company engagement and stewardship was a key approach to integrating sustainability.” This is a significant rise on 38% a year ago.

The survey also highlighted:

  • ESG Integration into the investment process and positive screening (focusing on the best in class companies) are the top two important drivers for asset managers to drive sustainable change;
  • Positive screening has also grown sharply in importance, from 44% of survey respondence to 61%; and
  • Conversely Negative Screening has fallen in importance (53% to 36%).
Source: Schroders

Investors noted signs of successful engagement included:

  • Transparent reporting;
  • Tangible outcomes; and
  • Consistently voting against companies in order to drive change.

Greenwashing, poor data, and increased Regulation

Greenwashing, as described by Schroders “‘a lack of clear, agreed sustainable investment definitions’” was seen as the most significant obstacle to investor’s sustainable investment intentions.  60% of those surveyed found green-washing as one of the most significant obstacles impeding their sustainable investing intentions.

The lack of transparency and reported data was also raised as an issue restricting the ability to invest sustainably.

Both measures increased in importance on last year, while performance concerns continued to decline.  45% of investors cited performance as concern in relation to investing sustainably.

Source: Schroders

These results were recently picked up in an Alternative Investment Management Association (AIMA) article, which focused on the increased integration of ESG into Hedge Fund’s investment processes.  Hedge funds start integrating ESG (aima.org).

In relation to green-washing, AIMA notes that regulators are also concerned about green-washing, noting the introduction of the Sustainable Finance Disclosure Regulation (SFDR) rule in the European Union.  The SFDR came into effect on March 10 of this year, aimed at ensuring financial firms such as fund managers, insurers, and banks providing financial products and services comprehensively disclose just how committed to sustainability they truly are.

The AIMA notes “The EU rules will also create a taxonomy as regulators look to facilitate greater consistency in terms of what can be classified as being a sustainable economic activity.”

The AIMA also noted more global investors are now prioritising ESG, and it is something which hedge funds need to respond to.  Although they felt the US was behind the rest of the world, particularly Europe (I would add Australian and New Zealand as well), this was changing.

By way of example, the AIMA article highlighted “that several high profile US institutions – including the likes of CALPERS and Wespath – have signed up to the UN-backed Net Zero Asset Owner Alliance, a consortium comprised of 30 of the world’s largest investors – all of whom have committed to reduce carbon emissions linked to the companies they invest in by 29% within the next four years.”

Failure to transition towards net zero is widely seen as a important risk management issue for companies. Arguably, companies failing to adapt or transition towards net zero will see their businesses and valuations suffer.

Lastly, AIMA highlighted the concerns over the quality of ESG data being disclosed by managers to their investors.

“One of the primary problems is that there are no harmonised ESG data standards. Instead, there are many different ESG standards and protocols, all of which have their own characteristics. With different managers subscribing to different ESG standards, the reports they produce for clients are often inconsistent and even contradictory. Similarly, ratings agencies will often have their own bespoke methods of collecting data from companies they are scoring. ……… Without a common data collection methodology, the ratings agencies’ scoring processes will be fragmented.”

Key Engagement Issues

The survey by Schroders found environmental issues remained the most important engagement issue for investors.

In total, 68% of investors globally said they expected investing sustainably to grow in importance over the next five years.

“Driving this focus were institutions looking to align their investments with their own corporate values, responding to regulatory and industry pressure, and, positively, the belief that investing sustainably can drive higher returns and lower risk.”

The Schroder study included 650 institutional investors encompassing $25.9 trillion in assets.

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

Most read Kiwi Investor Blog Posts in 2020

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The most read Kiwi Investor Blog Posts in 2020 have been relevant to the current environment facing investors.  They have also focused on building more robust portfolios.

The ultra-low interest rate environment and sobering low return forecasts present a bleak outlook for the Traditional Balanced Portfolio (60% Equities and 40% Fixed Income.)  This outlook for the Balanced Portfolio was a developing theme in 2020, which gained greater prominence as the year progressed.

In essence, there are two themes that present a challenge for the Traditional Balanced Portfolio in the years ahead:

  1. That fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest too heavily in these markets; and
  2. With interest rates at very low levels, there is increasing doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.

My highest read Posts address the second theme above.

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

The most read Kiwi Investor Blog Posts outline strategies that are “more that can be done”.

I have no doubt investors are going to have to look for alternative sources of returns and new asset classes outside equities and fixed income over the years ahead.  In addition, investors will need to prepare for a period of higher inflation. 

Not only will this help in increasing the odds of meeting investment return objectives; it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility.

The best way to manage periods of severe sharemarket declines, as experienced in the first quarter of 2020, is to have a diversified portfolio.  It is impossible to time these episodes.

Arguably the most prudent course of action for an investor to pursue in the years ahead is to take advantage of modern investment strategies that deliver portfolio diversification benefits and to employ more advanced portfolio construction techniques.  Both of which have been successfully implemented by large institutional investors for many years.

From my perspective, maintaining an array of diversification strategies is preferred, investors should diversify their diversifiers.

The most read Kiwi Investor Blog Posts in 2020 were:

Posts closely following were Understanding the impact of Volatility on your Portfolio and Optimal Private Equity Allocation.

Thank you all for you continued support and all the best for the year ahead.

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

The value of Emerging Markets within a Robust Portfolio – The Attraction of Emerging Markets

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Canada’s largest Pension Funds plan to increase their investments into emerging markets over the following years.  Asia, particularly India and China, are set to benefit.

The increased exposures are expected to be achieved by increasing portfolio target allocations to emerging markets, partnering on new deals, and boosting staff with expertise to the area.

The expected growth in the share of global economic activity in the years ahead and current attractive sharemarket valuations underpin the case for considering a higher weighting to emerging markets within portfolios.  Particularly considering the low interest rate environment and stretched valuation of the US sharemarket.  This dynamic is very evident in the market return forecasts provided below.

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

Increasing allocations to Emerging Markets

As covered in this Pension & Investment ((P&I) online article emerging markets are set to become a large share of Canadian Pension Plan’s portfolios. 

As outlined in the P&I article, the Ontario Teachers’ Pension Plan (C$201.4 billion) is investing significantly into emerging markets, particularly Asia.  Their exposure to emerging markets fluctuates between 10% and 20% of the total Portfolio.

The Fund’s investments across the emerging markets includes fixed income, infrastructure, and public and private equities.  They plan to double the number of investment staff in Asia over the next few years, they already have an office in Hong Kong. 

The Canada Pension Plan Investment Board (CPPIB) (C$400.6 billion) anticipates up to one-third of their fund to be invested in emerging markets by 2025.

CPPIB sees opportunities in both equity and debt.  Investments in India are expected to grow, along with China.

The Attraction of Emerging Markets

The case for investing into emerging markets is well documented: rising share of global economic activity, under-representation in global market indices, and currently very attractive sharemarket valuations.

Although the current global economic and pandemic uncertainty provides pause for concern, the longer-term prospects for emerging market are encouraging.

From the P&I article “CPPIB estimates the share of global gross domestic product represented by emerging markets will reach 47% by 2025 and surpass the GDP of developed economies by 2029”.

Based on the expected growth outlook CPPIB “feel there are attractive returns available over the long term to those investors who take the time to study the characteristics and fundamentals of these markets and are able to identify trends and opportunities in those markets,”…..

CPPIB also highlight the benefit of diversification into different geographies and asset classes for the Fund.

Lastly, the valuations within emerging market sharemarkets are attractive. 

This is highlighted in the following Table from GMO, which provides their latest (Sept 2020) Forecasts Annual Real Returns over the next 7 years (after inflation).

As can be seen, emerging market is one of only two asset classes that provides a positive return forecast.  Emerging market value offers the prospect of the highest returns over the next 7 years.  As GMO highlight, the forecasts are subject to numerous assumptions, risks and uncertainties.  Actual results may differ from those forecasted.

Nevertheless, GMO provided the following brief commentary in this LinkedIn Post “From an absolute perspective, broad markets in the US are frighteningly bad; non-US developed markets, however, are not as bad, but that is faint praise, as our official forecast for this basket is also in negative territory. “Safe” bond forecasts are not much better. With yields this low, the very foundational justification for holding bonds — as providers of income and/or as anti-correlated money makers when equities decline — has been shaken to its core. The traditional 60/40 portfolio, consisting of heavy doses of US and International stocks and Government Bonds, is poised for a miserable and prolonged period.”

GMO Annual Real Returns over 7 years

In February 2020, GMO advised that it was time to move away from the Balanced Portfolio, as outlined in this Kiwi Investor Blog Post. GMO provide a historical performance of the traditional Balanced Portfolio (60% equities and 40% fixed income).  Overall, the Balanced Fund is riskier than people think.

In the LinkedIn Post mentioned above, GMO comment that “Our Asset Allocation team believes this is the best opportunity set we’ve seen since 1999 in terms of looking as different as possible from a traditional benchmarked portfolio.”  Where the traditional benchmarked portfolio is the Balanced Portfolio of 60% equities and 40% fixed income.

Why the Balanced Portfolio is expected to underperform and potential solutions to enhancing future portfolio returns is covered in this Post.

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

Kiwi Investor Blog has published 150 Posts….. so far

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Kiwi Investor Blog has published over 150 Posts, so far! 

Thank you to those who have provided support, encouragement, and feedback. It has been greatly appreciated. Kiwi Investor Blog achieved 100 Posts in October 2019.

Consistent with the current investment environment and the outlook for future investment returns, the key themes of the Kiwi Investor Blog Posts over the last twelve months have been:

  1. Future returns are unlikely to be as strong as those experienced over the last decade
  2. Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to alternatives e.g. Private Equity
  3. What portfolio diversification is, and looks like
  4. Positioning portfolios for the likelihood of higher levels of inflation in the future
  5. Time to move away from the traditional Diversified Balanced Portfolio
  6. Occasions when active Management is appropriate and where to find the more consistently performing managers – who outperform
  7. Investing for Endowments, Charities, and Foundations
  8. Navigating a Bear market, including the benefits of disciplined portfolio rebalancing

Links to the key Posts to each of these themes is provided below.

Kiwi Investor Blog’s primary objective is to make available insights into Institutional investment strategies, practices, and processes to a wider audience in simple language.

The Posts are written in the spirit of encouraging industry debate, challenging the status quo and “conventional wisdoms”, and striving to improve investment outcomes for clients.

Future returns are unlikely to be as strong as those experienced over the last decade

The year started with a sobering outlook for long-term investment returns as outlined in this article by AQR.  The long-term outlook for investment markets has been a dominant theme this year, where the strong returns experienced over the Past Decade are unlikely to be repeated in the next 10 years.  Also see a related Bloomberg article here.

Interestingly, even after the strong declines in March and April of this year, Forecasted investment returns remain disappointing, given the nature of longer-term market returns.

If anything, the outlook for fixed income returns has deteriorated over the course of 2020.

Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to Alternatives

The challenging return environment led to a series of Posts on potential investment strategies to protect your Portfolio from different market environments in the future.

This includes the potential benefits of Tail Risk Hedging and an allocation to Real Assets.

A primary focus of many investment professions currently is what to do with the fixed income allocations of portfolios, as outlined in this article.

This series of Posts also included the case against investing in US equities and the case for investing in US equities (based on 10 reasons by Goldman Sachs that the current US Bull market has further to run).

The investment case for a continued allocation to Government Bonds was also provided.

Theses Post are consistent with the global trend toward the increasing allocations toward alternatives within investment portfolios.  This survey by CAIA highlights the attraction of alternatives to investors and likely future trends of this growing investment universe, including greater allocations to Private Equity and Venture Capital.

One of the most read Post this year has been a comparison between Hedge Funds and Liquid Alternatives by Vanguard, with their paper concluded both bring diversification benefits to a traditional portfolio.

What Portfolio Diversification is, and looks like

Reflecting the current investment environment and outlook for investment returns, recent Posts have focused on the topic of Portfolio Diversification. These Posts have complemented the Posts above on particular investment strategies.

A different perspective was provided with a look at the psychology of Portfolio Diversification.  Diversification is hard in practice, easy in theory, it often involves the introduction of new risks into a Portfolio and there is always something “underperforming” in a truly diversified portfolio.  This was one of the most read Posts over the last six months.

A Post covered what does portfolio diversification look like.  A beginner’s guide to Portfolio diversification and why portfolios fail was also provided.

On a lighter note, the diversification of the New Zealand Super Fund was compared to the Australian Future Fund (both nation’s Sovereign Wealth Funds).

A short history of portfolio diversification was also provided, and was read widely.

The final Post in this series provided an understanding of the impact of market volatility on a Portfolio.

Positioning Portfolios for the likelihood of higher levels of inflation in the future

Investors face the prospects of higher inflation in the future.  Although inflation may not be an immediate threat, this article by Man strongly suggests investors should start preparing their Portfolio for a period of higher inflation.

The challenge of the current environment is also covered in this Post, which provides suggestions for Asset Allocations decisions for the conundrum of inflation or deflation.

Time to move away from the traditional Diversified Portfolio

A key theme underpinning some of the Posts above is the move away from the traditional Diversified Portfolio (the 60/40 Portfolio, being 60% Equities and 40% Fixed Income, referred to as the Balance Portfolio).

Posts of interest include why the Balanced Portfolio is expected to underperform and why it is time to move away from the Balanced Portfolio.  They are likely riskier than you think.

There has been a growing theme over the last nine months of the Reported death of the 60/40 Portfolio.

My most recent Post (#152) highlights that the Traditional Diversified Fund is outdated as it lacks the ability to customise to the client’s individual needs.  Modern day investment solutions need to be more customised, particularly for those near and in retirement.

Occasions when active Management is appropriate and where to find the more consistently performing managers

Recent Posts have also covered the role of active management.

They started with a Post with my “colour” on the active vs passive debate (50 shades of Grey), after Kiwi Wealth got caught up in an active storm.

RBC Global Active Management provided a strong case for the opportunities of active management and its role within a truly diversified portfolio.

While this Post covered several situations when passive management is not appropriate and different approaches should be considered.

Another popular Post was on where investment managers who consistently outperform can be found.

Investing for Endowments, Charities, and Foundations

I have written several Posts on investing for Endowments, Charities, and Foundations.

This included a Post on the key learnings from the successful management of the Yale Endowment.

How smaller Foundations and Charities are increasingly investing like larger endowments.  See here and here.

Navigating a Bear market, including the benefits of disciplined Portfolio rebalancing

Not surprisingly, there have been several Posts on navigating the Bear Market experienced in March and April of this year.

Posts on navigating the event driven Bear Market can be found here and here.

The following Post outlined what works best in minimising loses, market timing or diversification at the time of sharemarket crashes.

This Post highlighted the benefits of remaining disciplined during periods of market volatility, even as extreme as experienced this year, particularly the benefits of Rebalancing Portfolios.

Please see my Disclosure Statement

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

The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

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Although it has been evident for several years, the current investment environment highlights the shortcomings of the one size fits all multi-asset portfolio (commonly known as Diversified Funds such as Conservative, Balanced, and Growth Funds, which maintain static Strategic Asset Allocations, arising to the reference of the “Policy Portfolio”).

The mass-produced Diversified Funds downplay the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

However, saving for retirement is an individual experience requiring tailoring of the investment solution.   Different investors have different goals and circumstances.  This cannot be easily achieved within a one size fits all Diversified Fund.

Modern-day investment solutions involve greater customisation.  This is particularly true for those near or in retirement.

A massive step toward offering increased customisation of the Wealth Management investment solution is the framework of two distinctive “reference” portfolios: A Return Seeking Portfolio; and Liability-Hedging (Capital Protected) Portfolio.

Details and implementation of this framework are provided in the next section.  The benefits of the framework include:

  • A better assessment of the risks needed to be taken to reach a client’s essential goals and how much more risk is involved in potentially attaining aspirational goals;
  • An approach that will help facilitate more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework helps in assessing what is the best course of action and trade-offs involved; and
  • A more efficient use of invested capital.  This is a very attractive attribute in the current low interest rate environment.  The framework will be more responsive to changing interest rates in the future.

These benefits cannot be efficiently and effectively achieved within the traditional Diversified Fund one size fits all framework; greater customisation of the investment solution is required.

With modern-day technology greater customisation of the investment solution can easily be achieved.

The technology solution is enhanced with an appropriate investment framework also in place.

Implementation of the Modern-Day Wealth Management Investment Solution

The reasons for the death of the Policy Portfolio (Diversified Fund) and rationale for the modern-day Wealth Management investment solution are provided below.

Modern-day investment solutions have two specific investment portfolios:  

  • Return seeking Portfolio that is a truly diversified growth portfolio, owning a wide array of different return seeking investment strategies; and
  • Capital Protected (Liability) Portfolio, is more complex, particularly in the current investment environment.  See comments below.

The allocations between the Return Seeking portfolio and Capital Protected portfolio would be different depending on the client’s individual circumstances.  Importantly, consideration is given to a greater array of client specific factors than just risk appetite and risk and return outcomes e.g. other sources of income, assets outside super.

Although the return seeking portfolio can be the same for all clients, the Capital Protected (Liability) portfolio should be tailored to the client’s needs and objectives, being very responsive to their future cashflow/income needs, it needs to be more “custom-made”.

The solution also involves a dynamic approach to allocate between the two portfolios depending on market conditions and the client’s situation in relation to the likelihood of them meeting their investment objectives.  This is a more practical and customer centric approach relative to undertaking tactical allocations in relation to a Policy Portfolio.

The framework easily allows for the inclusion of a diverse range of individual investment strategies.  Ideally a menu offering an array of investment strategies can be accessed allowing the customisation of the investment solution for the client by the investment adviser.

Implementation is key, which involves identifying and combining different investment strategies to build customised robust investment solutions for clients.

The death of the Policy Portfolio

Modern Portfolio Theory (MPT), the bedrock of most current portfolios, including the Policy Portfolio, was developed in the 1950s.

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements have been made based on the ongoing academic and practitioner research into building more robust investment solutions.  See here for a background discussion.

The Policy Portfolio is the strategic asset allocation (SAA) of a portfolio to several different asset classes deemed to be most appropriate for the investor e.g. Diversified Funds

It is a single Portfolio solution.

A key industry development, and the main driver of the move away from the old paradigm, is the realisation that investment solutions should not be framed in terms of one all-encompassing Policy Portfolio but instead should be framed in terms of two distinct reference Portfolios.

A very good example of the two portfolios framework is provided by EDHEC-Risk Institute and is explained in the context of a Wealth Management solution.  They describe the two reference portfolios framework involving:

  1. Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
  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 to finance studies from the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The concept of two portfolios has also been endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.  Kahneman discusses the idea of a “regret-proof policy” here.

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

Reasons for the death of Policy Portfolio include:

  • there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.
  • Investors should be dynamic; they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Many institutional investors have moved toward liability driven investment (LDI) solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.  More can be found on LDI here.

These “institutional” investment approaches, LDI, portfolio separation, and being more dynamic are finding their way into Wealth Management solutions around the world.

Evolution of Wealth Management – Implementation of the new Paradigm

In relation to Wealth Management, the new paradigm has led to Goal-Based investing (GBI) for individuals. GBI focuses is on meeting investor’s goals along similar lines that LDI does for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  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 the two portfolios approach, fund separation, LDI, and undertaking a dynamic investment approach.

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

The objective of this Portfolio is to secure with some certainty future retirement income requirements. It is typically dominated by longer dated high quality fixed income securities, including inflation linked securities.  It does not have a high exposure to cash. In the context of meeting future cashflow requirements in retirement Cash is the riskiest asset, unless the cashflows need are to be met in the immediate future.  For further discussion on the riskiness of cash in the context of retirement portfolios see here.

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

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

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

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals.

This will will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

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

For those wanting a greater appreciation of EDHEC’s framework please see their short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

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

Please see my Disclosure Statement

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

The Case for holding Government Bonds and fixed income

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The case for holding Government Bonds is all about certainty.  The question isn’t why would you own bonds but, in the current environment, why wouldn’t you own bonds to deliver certainty in such uncertain times?

This is the central argument for holding government bonds within a portfolio.  The case for holding government bonds is well presented in a recent article by Darren Langer, from Nikko Asset Management, Why you can’t afford not to own government bonds.

As he argues, government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

The article examines some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It is well worth reading.

Why you can’t afford not to own government bonds

The argument against holding government bonds are based on expectations of higher interest rates, higher inflation, and current extremely low yields.

As argued in the article, although these are all very valid reasons for not holding government bonds, they all require a world economy that is growing strongly.  This is far from the case currently.

They key point being made here, in my opinion, is that the future is unknown, and there are numerous likely economic and market outcomes.

Therefore, investors need to consider an array of likely scenarios and test their assumptions of what is “likely” to happen.  For example, what is the ‘normal’ level of interest rates? Are they likely to return to normal levels when the experience since the Global Financial Crisis has been a slow grind to zero?

Personally, although inflation is not an issue now, I do think we should be preparing portfolios for a period of higher inflation, as I outline here.  Albeit, this does not negate the role of fixed income in a portfolio.

The article argues that current conditions appear to be different and given this it is not unrealistic to expect that inflation and interest rates are likely to remain low for many years and significantly lower than the past 30 years.

In an uncertain world, government bonds provide certainty. Given multiple economic and market scenarios to consider, maintaining an allocation to government bonds in a genuinely diverse and robust portfolio does not appear unreasonable on this basis.

Return expectations

Investors should be prepared for lower rates of returns across all assets classes, not just fixed income.

A likely scenario is that governments and central banks will target an environment of stable and low interest rates for a prolonged period.

In this type of environment, government bonds have the potential to provide a reasonable return with some certainty. The article argues, the benefits to owning bonds under these conditions are two-fold:

  1. A positively sloped yield curve in a market where yields are at or near their ceiling levels. Investors can move out the curve (i.e. by buying longer maturity bonds) to pick up higher coupon income without taking on more risk.
  2. Investors can, over time, ride a position down the positively-sloped yield curve (i.e. over time the bond will gain in value from the passing of time because shorter rates are lower than longer rates). This is often described as roll-down return.

The article concludes, that although fixed income may lose money during times of strong economic growth, rising interest rates, and higher inflation, these losses can be offset by the gains on riskier assets in a portfolio.  Losses on fixed income are small compared to potential losses on other asset classes and are generally recovered more quickly.

No one would suggest a 100% allocation to government bonds is a balanced investment strategy; likewise, not having an allocation to bonds should also be considered unbalanced. 

“But a known return in an uncertain world, where returns on all asset classes are likely to be lower than the past, might just be a good thing to have in a portfolio.”

The future role of fixed income in a robust portfolio has been covered regularly by Kiwi Investor Blog, the latest Post can be found here: What do Investors need in the current environment? – Rethink the 40 in 60/40 Portfolios?

The article on the case for government bonds helps bring some balance to the discussion around fixed income and the points within should be considered when determining portfolio investment strategies in the current environment.

Happy investing.

Please see my Disclosure Statement

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

Optimism tempted by uncertainty

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Every year Byron Wien, from Blackstone’s Private Wealth Solutions group, holds a series of Benchmark Lunches where he invites an assortment of hedge fund managers, private equity and real estate leaders, academics, former government officials and economy and market observers.

These meetings, along with his annual “Top Ten Surprises”, not only provide great insights into current economic and market conditions but also provide perspectives to challenge consensus thinking. Particularly his top ten surprises.

In a sign of the times, this year’s Benchmark lunches where held via Zoom. 

I briefly summarise some of the topics discussed below, access to the full discussion can be found here.

Economic Conditions

In general, the tone of the sessions was one of optimism tempered by uncertainty. 

Most of the participants thought we would be back to something like the normalcy of 2019 by 2022.

There was divergence of opinion what normal would look like, albeit, to get there, a vaccine will need to be developed, tested, manufactured, and administered. 

The economy would take some time to gain its own momentum and there will be some permanent changes.

There were some more specific comments in relation to the economy.  It was felt that US unemployment would remain high for some time. 

Not surprisingly, many expressed concerns for large portions of the economy which are in serious trouble: hotels, restaurants, resorts, cruise lines and airlines will take a long time to recover.

The strong bounce in manufacturing and housing was encouraging, reflecting very low interest rates.

Vaccine

There was considerable optimism amongst the group for a vaccine, reflecting there are many companies working to develop one. Several of these companies are conducting clinical trials and manufacturing doses in anticipation of regulatory approval. Efforts were being undertaken around the world, Europe, Asia, and the United States.

Many expected an effective vaccine to be available for essential workers by the end of this year, with the general public possibly receiving it by the second half of 2021, and by the middle of 2022 most people who wanted the vaccine could have it.

Nevertheless, there were a wider range of views on the details, such as how long the vaccine would last, whether booster shots would be required annually or more frequently to maintain immunity, and the willingness of people to get the shots.

My take from the commentary, the availability of the vaccine is not the end game, there will be lots of issues to work through once it becomes available.

Working remotely, property sectors, and social impacts

The pros and cons of working from home were discussed, which I think are well understood.

Several real estate investors attend the various sessions.  They provided the following key insights:

  • Properties that were well financed could wait out the recession.
  • Some saw opportunities in the current environment.
  • Retail was most at risk, and that some damage to the sector would be permanent. It was highlighted that the US is over-stored and has nearly three times the retail space per capita than the next highest country, Canada.
  • There will be increased costs as people return to the office e.g. increased cleaning costs and perhaps the need to upgrade ventilation systems.

Another interesting statistic provided was that according to a June 2020 BLS study, around 40% of American workers have the ability to work remotely, but the other 60% have to be present physically to perform their duties, whether in hospitals, factories, service businesses or transportation.

It will be these people who will spend less on non-essential items. 

An important issue to consider is the social impacts of higher unemployment and uncertainty arising from covid-19.

From a societal perspective the impacts are wide ranging, discussions included the impact on young children and their development, along with university graduates looking to enter the work force at a time of economic recession. 

Effects of the enormous government and central bank policy response

Most participants expected interest rates and inflation to remain low for the next several years. 

There was a level of scepticism toward Modern Monetary Theory and the ability of governments to print money indefinitely.

For the time being, the policy approach remains appropriate, so long as real growth is higher than the rate of inflation.

The recent weakness in the US dollar was noted.  There could be several reasons for this, including Europe and Asia have done a better job of controlling the virus and are recovering more favourably.

Likewise, US factors could be playing a role, such as social unrest, poor discipline in limiting the spread of the virus, and gridlock in Washington.  In addition, “The prospect of a sweep in November with both the presidency and the Senate moving to the Democrats and a less business-friendly environment in Congress may also have had an influence on the dollar.”

US Elections

Not everyone thought a Biden victory was a sure thing.  There are a lot of issues to consider, albeit Biden has a considerable lead and he will be hard to beat.

The group felt the US as a country overall had shifted to the left.

US China relationship

The growing tensions between China and US is seen as an inevitable outgrowth of the long-term shift towards nationalism and away from globalization.

There was concern in relation to China’s policy towards Hong Kong and its military operations in the South China Sea.

On the positive side, Phase One trade negotiations were moving forward and imports from and exports to China continue. A Phase Two deal seems to be off the table for now.

Although bringing production home or relocating will be difficult, costly, and time-consuming, this trend is partially underway.

Energy Sector

A wide-ranging discussion on the energy sector was undertaken.

For a period of time the drop in oil demand this year was four times greater than during the Global Financial Crisis (GFC).  The situation has improved, and it was noted China is consuming more oil currently compared to a year ago.

The US has accumulated excess inventory and US production will remain depressed for some time.  At the current oil price shale oil production is unprofitable.

The expectation was that the Oil price will not exceed $50 a barrel for West Texas Intermediate until 2022 when the economy gets back to something close to normal.  Political conditions in the Middle East will be more unstable until the price of crude recovers.

Happy investing.

Please see my Disclosure Statement

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



Where Investment Managers Who Consistently Outperform can be found

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Likely poor performing investment managers are relatively easy to identify.  Great fund managers much more difficult to identify.

Good performing managers who can consistently add value over time can be identified.  Albeit, a well-developed and disciplined investment research process is required.

Those managers that consistently add value are likely to be found regularly in the second quartile of peer analysis.  They are neither the best nor the worst performing manager but over time consistently add value over a market index or passive investment.  They are not an average manager.

These are key insights I have developed from just under 30 years of researching and collaborating with high calibre and talented investment professionals. 

More importantly, modern day academic research is supportive of this view.  The conventional wisdom of active management is being challenged, as highlighted in a previous Post.

Analyzing Consistency of Manager Performance

A recent relevant study is a submission to the Australian Productivity Commission in respect of the Draft Report on ‘How to Assess the Competitiveness and Efficiency of the Superannuation System’. The analysis was undertaken by Peterson Research Institute in 2016.

The author, John Paterson, of this analysis was interviewed in a i3 article.

The key points of Peterson’s analysis and emphasized in the i3 article:

  • Many of the studies into the ability of active managers to consistently outperform are inherently flawed. 
  • Most of these studies merely confirm that financial markets are not static, therefore they do not say anything about manager performance.

“The failure to find repeated top quartile performance in these ‘tests of manager consistency’ simply reflects the reality that markets are not Static, and says nothing about the existence, or otherwise, of manager consistency.”

  • The key flaw is that many of the studies on active management focus on the performance of only the top performing managers: whether top quartile performers are able to repeat their efforts from one period to the next.
  • A wider view of manager performance should be considered, all quartiles should be assessed to determine whether manager performance is random or not.
  • Those managers that that consistently achieved above average returns are more likely to be found in the second or third quartiles.

In the i3 interview, Paterson discusses more about the results of their research:

“Someone who consistently outperforms doesn’t necessarily look like a top quartile manager. They are more likely to be found in the second quartile,”.

The following comment is also made:

“Most asset managers intuitively know this, because markets are cyclical and if you do something that shoots the lights out in one period, it is likely to do the complete opposite in another period.”

The Australian Experience

Paterson’s analysis also found “Across the studies analysed, it was found that there is very strong evidence that investment managers available to Australian superannuation funds do perform consistently.”

Lastly Paterson comments “And experience tells us that super funds with more active managers have done better than those with largely passive mandates, and often at a lower level of volatility.”

Concluding Remarks

As I have previously Posted, there are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform.

Other reasons for considering an alternatives to a passive index include no readily replicable market index exists, imbedded inefficiency within the Index, and available indices are unsuitable in meeting an investor’s objectives (e.g. Defined Pension Plans).

The decision to choose an alternative to passive investing varies across asset classes and investors.

Therefore, the traditional active versus passive debate needs to be broadened.

The article by Warren and Ezra, covered in a previous Post, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.

They provide five reasons why investors might consider alternatives to passive management.

In doing so they provide examples of circumstances under which an alternative to passive management might be preferred and appreciably widen the debate. 

The identification of managers that consistently add value is one reason to consider an alternative to passive management.

Happy investing.

Please see my Disclosure Statement

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