Navigating through a Bear market – what should I do?

To all Kiwi Investor Blog readers, I hope you are staying safe and healthy. My thoughts are with you from a health perspective and for those facing the economic consequences on businesses and families from the spread of the coronavirus.

 

In the current market environment there is much uncertainty and many are wondering what to do with their investments.

The key questions being asked are should we switch to a more conservative investment or get out the markets all together.

 

One of the best discussions on why to remain invested is provided by FutureSafe in a letter to their client’s 15th March.

FutureSafe provide one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

They have reproduced the letter in the hope that it might be helpful and of interest to the broader investing community.

As they emphasis, please consult your advisor or an investment professional before making any investment decisions. In New Zealand, the FMA has also provided recent guidance on this issue, KiwiSaver providers should be providing general (class) advice to members at this time. Their full guidance on Kiwisaver Advice is here.

 

I have provided the main points below of the FutureSafe letter to clients, nevertheless the letter is well worth reading in full.

The first question is do you have too much invested in the market?

As FutureSafe highlight, the average declines of bear markets since WWII have been over 30%, with some declines as large as 60%. It has generally taken on average 2 years to recover.

 

My last Post, What to expect, navigating the current Bear-Market, presented research from Goldman Sachs on the historical analysis of bear markets in US equities going back to the 1800s. At this stage, we are likely experiencing an Event-Driven Bear market.  These Bear markets tend to be less severe, but the speed of the fall in markets is quicker, as is the recover.

However, as Goldman Sachs note none of the previous Event-Driven Bear markets were triggered by the outbreak of a virus, nor were interest rates so low at the start of the market decline.

Historically Event-Driven bear markets on average see falls of 29%, last 9 months and recover within 15 months. Nevertheless, the current Bear could transform into a cyclical bear market if containment efforts lead to a larger global recession than anticipated.

 

Back to FutureSafe. You should only take the risk you can stomach, or technically speaking, is aligned with your “risk appetite”. Which is a level of risk that does not keep you awake at night.  Unfortunately, we often don’t know our risk appetite until we experience significant market events like we are experiencing currently. We are often over-confident as to the level of market volatility we can tolerate.

FurtureSafe conclude “Now that we are in a downturn, if you have come to the conclusion that your risk appetite is not what you thought it was, it’s perfectly OK to acknowledge that and change your safety net accordingly.”

However, before you do anything, FutureSafe ask you to read through and consider a few reasons why not to do anything at this time might be appropriate.

Reason 1

If management of risk appetite is not your motivation, perhaps you are planning on selling now, with the conviction markets will continue to fall, and you plan on buying back in later.

You are essentially making an active investment decision and attempting to time markets.

Timing markets is very hard to do. Professional Investors are not very good at it.

The data on the average mutual fund investor is also not very complimentary. As FutureSafe note the “the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.”  A mutual Fund is like a Unit Trust or KiwiSaver Fund in New Zealand.

I depart from the FutureSafe article and provide the graph below from PIMCO.

As PIMCO highlight, “Through no fault of their own – and especially when market volatility strikes – investors tend to be their own worst enemy.”

The graph below highlights that investors do not capture all of the returns from the market, which can be attributed to behavioural biases that leads to inappropriate timing of  buying and selling.

This investor behavioural gap is well documented.

In reference to market timing and in one short sentence, FutureSafe say “We’re probably not as good at these active calls as we think we are, and it might hurt more than help.”

PIMOC Behaviour gap

Reason 2

A large portion of returns are earned on days markets make large gains.

Although the extreme volatility being witnessed currently is very painful to watch, amongst them are explosive up days. Attempting to time markets might cause you to miss these valuable up days.

The research on this is also very clear.

As outlined in the Table below, if you had missed the top 15 biggest return days your yearly return would have been 3.6% compared to 7% per year if you had remained fully invested (this is over the period January 1990 to March 2020 and being invested in the US S&P 500 Index).

Missing large daily returns

Of course, the same can be said if you missed the largest down days. Nevertheless, good luck at avoiding these days and still being able to fully capture the returns from equity markets.  The down days represent the risk of investing in shares.

Most important is having a disciplined investment approach and an investment portfolio consistent with your risk appetite and is truly diversified so as to limit the impact of the poor periods of performance in sharemarkets.

In summary, FutureSafe note, “Missing just a few of the top up days, can cost you a large chunk of the market’s returns.”

 

Reason 3

Take a long-term perspective.

Overtime, and with hindsight, large market declines look like minor setbacks over the longer term, the very long term.

This is quite evident from the following graph.

Remember, the stock market fell by 20% over one day in 1987, the dot-com crash of 2000 or even the Great Financial Crisis of 2008 don’t look to bad with a longer term perspective.

Take a longer term perspective

As FutureSafe conclude “If you really don’t need the money for a long period of time (e.g. 10 or 15 years) these are best to ride out because they look a lot better in the rear view mirror than when you are going through it.”

“If you have a long enough horizon (10 to 15 years or more), the chances of doing well in the stock market is still quite good.”

 

Therefore, the key points to consider are:

  • Risk Appetite should primarily drive your allocation to sharemarkets, not the current market environment;
  • We can’t time markets, not even the professionals;
  • Be disciplined and maintain a well-diversified investment portfolio, this is the best way to limit market declines, rather than trying to time markets;
  • Take a longer-term view; and
  • Seek out professional investment advice

 

Keep safe and healthy.

 

Happy investing.

 

Please read my Disclosure Statement

 

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

Why the Balanced Fund is expected to underperform

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

 

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

 

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

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

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

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

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

 

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

 

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

 

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

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

Global duration

 

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

 

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

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

 

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

 

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

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

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

 

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

 

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

 

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

 

Possible Solution

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

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

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

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

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

 

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

 

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

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

 

Happy investing.

 

Please read my Disclosure Statement

 

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

 

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

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

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

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

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

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

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

 

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

 

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

 

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

 

This is attractive to donors.

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

 

What did OCCF do?

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

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

 

What changed?

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

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

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

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

 

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

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

 

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

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Real Assets offer real diversification benefits

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

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

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

 

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

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

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

Pertinent points of the analysis:

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

 

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

 

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

Asset

Growth

Sensitivity

Inflation

Sensitivity

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

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

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

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

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

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

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

Portfolio Strategy

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

Y

Y

Y

Y

Y

Inflation-Protection

Y

Y Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y

Y

Fixed Income

Y

Scenario frequency

8.9%

11.4%

53.9%

10.2%

15.8%

 

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

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

 

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

The sections include:

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

 

Access to the PGIM Report is provided below.

 

The Real Assets Universe and their investment characteristics

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

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

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

Asset

Annual p.a. returns

Risk annual volatility

Sharpe Ratio

Real Estate Core

8.3%

11.0%

0.55

Real Estate Debt

6.3%

4.8%

0.85

REIT

10.7%

19.8%

0.43

Natural Resources

15.9%

23.8%

0.58

Energy Equity

9.0%

19.7%

0.35

Infrastructure

4.0%

12.7%

0.14

MLP

12.6%

26.2%

0.39

Timberland

7.3%

6.9%

0.74

Farmland

12.2%

7.3%

1.37

TIPS

5.2%

6.0%

0.50

Commodity

-0.9%

28.2%

-0.11

Gold

5.6%

16.2%

0.21

Currency

-1.2%

8.5%

-0.40

US Cash

2.2%

2.2%

US 10 yr Treasury

5.2%

8.6%

0.35

US Equity (S&P 500)

8.6%

18.3%

0.35

 

Sensitivity to Macro-economic and financial market exposures

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

Inflation and growth

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

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

Inflation Protection

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

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

Stagnation Protection

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

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

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

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

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

 

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

Asset

Growth

Sensitivity

Inflation

Sensitivity

Accessibility Data Availability & Quality Specific Risks

Sector Difference

Real Estate Core

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low

mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

Real Asset Diversification Benefits relative to equities and fixed income

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

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

 

Diversifying Real Assets

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

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

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

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

 

Analysis of Real Asset Strategy Portfolios

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

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

 

Diversification (80% private assets):

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

 

Inflation-Protection (33% private assets)

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

 

Stagnation-Protection (50% private assets)

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

 

Return Outcomes

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

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

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

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

 

Diversification Benefits of the three Real Asset Portfolios

Sensitivity to Equities and Fixed Income

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

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

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

 

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

 

Sensitivity to Economic variables

Economic Growth

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

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

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

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

 

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

 

Inflation Sensitivity

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

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

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

 

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

This analysis found:

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

 

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

Portfolio Strategy

Ideal

Overheating Muddled Stagflation

Stagnation

Inflation &/ Growth

Low & High

High & High Median/Median High & Low

Low & Low

Diversification

Y

Y Y Y

Y

Inflation-Protection Y Y

Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y Y
Fixed Income

Y

Scenario frequency

8.9%

11.4% 53.9% 10.2%

15.8%

 

Diversification Benefits of Real Asset Strategies in Pension Plans

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

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

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

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

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

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

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

 

Access to the PGIM Report

 

Happy investing.

Please read my Disclosure Statement

 

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

 

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

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

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

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

 

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

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

 

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

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

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

lost-decades_12-31-19

 

 

The Balance Portfolio is riskier than you think.

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

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

Real Returns

(after inflation)

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

The Deutsche Bank analysis highlights:

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

 

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

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

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

 

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

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

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

 

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

 

Happy investing.

 Please read my Disclosure Statement

 

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

Sobering low return estimates

AQR has updated their estimates of medium-term (5- to 10-year) expected returns for the major asset classes.

Their expected real return for the traditional U.S. 60/40 portfolio (60% Equities / 40% Bonds) is just 2.4%, around half its long-term average of nearly 5% (since 1900).

It is also down from 2.9% estimated last year.

 

AQR conclude that medium term expected returns are “sobering low”. Their return estimates are after inflation (real returns) and are compounded per annum returns.

“They suggest that over the next decade, many investors may struggle to meet return objectives anchored to a rosier past”.

“We again emphasize that our return estimates for all asset classes are highly uncertain. The estimates in this report do not in themselves warrant aggressive tactical allocation responses — but they may warrant other kinds of responses. For example, investment objectives may need to be reassessed, even if this necessitates higher contribution rates and lower expected payouts. And the case for diversifying away from traditional equity and term premia is arguably stronger than ever.”

 

The AQR estimate for a Balance Fund return are similar to those published recently in a CFA Institute article of 3.1%.

 

AQR update their estimates annually.  They manage over US$186 billion in investment assets.

 

Return Estimates

Reflecting the strong returns experienced in 2019 across all markets, particularly US equities, future returns estimates are now lower compared to last year.

This is Highlighted in the Table below.

Medium-Term Expected Real Returns

Market

2019 Estimate

2020 Estimate

US Equities

4.3%

4.0%

Non-US Developed Equities

5.1%

4.7%

Emerging Markets

5.4%

5.1%

US 10-year Government Bonds

0.8%

0.0%

Non US-10 Year Government Bonds

-0.3%

-0.6%

US Investment Grade Credit

1.6%

0.9%

 

Bloomberg have a nice summary of the key results:

  • Anticipated returns for U.S. equities dropped to 4% from 4.3% a year earlier.
  • U.S. Treasuries tracked the move, with AQR predicting buyers will merely break even.
  • Non-U.S. sovereigns slipped deeper into negative territory, with a projected loss of 0.6% a year.
  • Emerging-market equities will lead the way, the firm projects, with a return of 5.1%.

 

This article by Institutional Investor also provides a good run down of AQR’s latest return estimates.

More detail of return estimates can be found within the following document, which I accessed from LinkedIn.

 

Lastly, AQR provide the following guidance in relation to the market return estimates:

  • For shorter horizons, returns are largely unpredictable and any predictability has tended to mainly reflect momentum and the macro environment.
  • Our estimates are intended to assist investors with their strategic allocation and planning decisions, and, in particular, with setting appropriate medium-term expectations.
  • They are highly uncertain, and not intended for market timing.

 

In addition to the CFA Article mentioned above, AQRs estimates are consistent with consensus expected returns I covered in a previous Post.

 

Although AQR’s guidance to diversify away from traditional equity and fixed income might be like asking a barber whether you need a haircut, surely from a risk management perspective the diversification away from the traditional asset classes should be considered in line with the prudent management of investment portfolios and consistency with industry best practice?

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 term outlook for those interested.

 

Happy Investing

Please read 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.

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