The opportunity and role of active management

RBC Global Asset Management provides a strong case for the opportunity of active management and its role within a truly diversified portfolio.

As they note, there are considerable opportunities within markets for active managers to turn into reliable excess returns.

RBC’s analysis highlights that a large proportion of active share price movements, up to 75%, cannot be explained by market factors.

This is a large opportunity set for active managers. An opportunity set that is found to remain reasonably consistent over time.

The scale of the opportunity as demonstrated by RBC, if successfully captured, provides a potential source of excess returns and a true portfolio diversifier – which is a return outcome largely sourced from company/stock specific risks.

Nevertheless, active managers do need to evolve from historical practices and processes. From this perspective, the paper also provides great insights into the evaluation of a modern day active manager.

With regards to the success of active management, the Conventional Wisdom toward active management is changing. Specifically, the conventional wisdom is too negative on the value of active management.

The RBC article is well worth reading.

 

RBC emphasis “An active manager’s task is to capitalise on the fact that the market or index return is an average, and to use analysis and skill to identify those stocks that produce an above-average return and to avoid those that don’t.”

 

To capture the opportunity identified by RBC, they believe active managers need to find a way to turn share price movements into reliable excess returns.

To do this they believe that active managers must get two things right:

  1. Alpha generation: devise means of explaining and predicting the share price movements that are not explained by factors.
  2. Alpha capture: devise means of efficiently capturing alpha and turning it into reliable portfolio excess returns.

The RBC paper provides a lengthy discussion on what it likely takes to achieve this, including analysing the unique features associated with each business, including ESG factors, taking an active ownership role, and maintaining a long-term perspective.

Each company (security) has a unique performance history, which cannot all be explained by broad market factors.  Financial outcomes are partly dependent on management teams, brand, location, reputation, non-financial factors, and Culture. Analysis needs to be undertaken on the unique factors associated with each business.

Furthermore, accounting data is a poor measure of business value, there are extra financial factors, Governance, employee engagement, Health and Safety, ESG etc etc

 

RBC conclude “that the critical skill for stock pickers is understanding and evaluating extra-financial factors as well as assessing their impact on financial returns. Skill and expertise need to be developed to assess nuanced factors such as corporate culture, employee engagement, customer satisfaction, the business’s social licence to operate, maintenance and safety procedures, R&D effectiveness, brand and reputation, and these will vary from industry to industry and will also shift over time.”

See the article for fuller discussion on their perspective and type of analysis required by a modern day active manager.

 

Portfolio construction is also key, the size of portfolio positions matters.

Equity investments can be held in fractional holdings so it is possible to construct an almost infinite number of portfolios from a relatively modest number of securities.

Different combinations of securities will create portfolios with different factor exposures.   Which will cause variation in portfolio returns.

Therefore, Portfolio construction becomes the framework within which portfolio managers can assess the trade-off between “two often conflicting objectives: maximising exposure to their best investments vs. minimising exposure to unintended factor returns.“

 

My personal view is that many managers under estimate the value added from a solid portfolio construction approach, often it distracts value from a sound stock selection process.

 

One final point, the paper provides a good account of how active management has been disrupted by technology and the information revolution – computing power and access to company information. This has resulted in the rise of passive investing and factor-based investing. This has driven down fees.

The active management industry has changed dramatically, and active management has had to evolve. This is touched on within the Article.

Therefore, the Article provides insight from the perspective of manager selection and a potential lens with which to consider in evaluating modern day active managers.

 

The Role of Active management within a portfolio

From a Kiwi Investor Blog perspective, the active management described by RBC in the Paper “seeks to generate outperformance from stock-specific risk that lies outside the realms of factors. This is a different alpha source, hence it creates a return stream that is not correlated to factor returns.”, highlights the role active management can play within a truly diversified and robust portfolio.

Consistent with RBC, active managers can co-exist with passive and factor based strategies. Active management has a role to play within a Portfolio.

Why? Investors seek to access a wide range of investment risks and returns, seeking true portfolio diversification.

The source of risks and returns from active management that seeks to outperform from stock specific risks is a true portfolio diversifier, if done successfully.

This is consistent with many Posts on Kiwi Investor Blog around the disaggregation of investment returns.

Understanding the disaggregation of investment returns can assist in building a truly diversified and robust portfolio.

It can also help determine the appropriateness of fees being paid and if a manager is adding value.

 

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 and return sources.  See earlier post More Asset Classes Does not Equal More Diversification.

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.  For example, the increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.

Essentially, and from a very broad view, investment returns can be disaggregated in to the following three parts:

  1. Market beta. Think equity market exposure NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).
  2. Factor and Alternative hedge fund beta exposures.  See the Disaggregation of Investment Returns Post for a fuller discussion.
  3. Alpha. Alpha is what is left after beta and factors. It is the manager skill to capture the stock specific risks as outlined in RBC paper. Alpha is a risk adjusted return source.

 

With regards to the success of active management, the Conventional Wisdom toward active management is changing, as highlighted in this Post. The linked article in this Post is the most read from Kiwi Investor Blog.

The article undertakes a review of the most recent academic literature on active equity management and concludes by challenging the conventional wisdom of active management, “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.

 

Finally, the disaggregation of investment returns busts opens the active vs passive debate, the debate has moved on. It is no longer an emotive black vs white debate, risk and return sources come in many different shades. A truly diversified portfolio has as many different risk and return exposure as possible. It is from poor portfolio construction that portfolios fail.  The value is in implementation of a truly diversified portfolio.

 

It is evident that New Zealand portfolios need to become more diversified and that Kiwi Saver Investors are missing out.

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Beginners guide to Portfolio Diversification. And why Portfolios Fail.

It is often asked if Modern Portfolio Theory failed during the Global Financial Crisis / Great Recession (GFC).

No, Modern Portfolio Theory did not fail during the GFC. Portfolio construction did.

During the GFC many investors did not have exposure to enough different asset classes and investment risks. This limited their protection from market loses.

Therefore, Investors should consider incorporating a wide range of different investment strategies as their core investment strategy. Investors should also clearly understand the sources of risk within their portfolio.

Furthermore, investors cannot necessarily rely on “what is traditionally thought of as diversification to meet their long-term goals.”

It is likely that many investors remain under-diversified today.

These are the views of a 2013 BlackRock Article, the new diversification: open your eyes to alternatives.

 

The discussion in 2012 with Dr Christopher Geczy is still very relevant today.

As we have seen previously, from what does portfolio diversification look like, many KiwiSaver Funds are under-diversified relative to Australian Superannuation Funds. Likewise, the Australian Future Fund is very well diversified relative to the New Zealand Super Fund.

 

Highlights of the BlackRock article are provided below.

They are presented to provide the rationale for seeking true portfolio diversification, as pursued by many of the largest investors worldwide, including Super Funds, Pension Funds, Foundations, Endowments, Family Officers, and Sovereign Wealth Funds. This group also includes the ultra-wealthy.

Albeit, the opportunity to have a truly diversified portfolio is open to all investors, the value is in implementation.

Currently, many New Zealand investors are missing out.

 

What happened during the GFC?

In short, as we all know, what happened during the GFC was a spike in financial market volatility, this led to all markets behaving in a similar fashion – technically market correlations moved to one. This reduces the benefits of diversification. As a result, many markets fell sharply in tandem.

Those markets that where already quite highly correlated became more correlated e.g. listed property with the broader share market.

As we also know, this often happens at time of market crisis, nevertheless, correlations can spike higher without a crisis.

The BlackRock article provides a comparison of market correlations prior to the GFC and correlations during the GFC.

 

For clarity, there are benefits from investing in different asset classes, regions, and so forth.

Nevertheless, although a traditional “Balanced Portfolio”, 60% shares / 40% Fixed Income, provides a smoother ride than an undiversified portfolio, the risks of the Balanced Portfolio are dominated by its sharemarket exposures.

It is well understood that for the Balanced Portfolio almost all the risk comes from the sharemarket exposures. On some estimates over 90% of the risk of a Balanced Portfolio comes from sharemarkets.

Therefore, investors should not only clearly understand the sources of risk, but also the magnitude of these risks within their portfolio.

 

What is the difference between Portfolio Diversification and Portfolio Construction?

Diversification is not as obvious as many think e.g. as outlined above in relation to listed property, a portfolio exposed to different asset classes may not be that well diversified.

As a result, and a key learning from the GFC, investors need to think in terms of risk exposures – risk diversification.

Investors should not think in terms of asset class diversification.

More asset classes does not equal more Portfolio Diversification.

This is because returns from of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.

Therefore, increasingly institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

 

From a portfolio construction, and technical, perspective, this means thinking in terms of risk exposures and “getting exposure to as many different and non-correlated types of risk that they can.”

Portfolio construction = “building a portfolio based on risk exposures and not just so-called “asset classes” or “sub-classes.””

 

What does this look like?

Investors should seek exposure to a variety of risk exposures in proportion to their risk tolerances and individual circumstances.

The point being everyone should have a broadly diversified portfolio to the greatest extent they can. Investors should hold as many different assets and risk exposes as they possibly can.

Therefore, portfolios should likely include real assets, international investments, and long/ short investments. Alternative and Alternative investment strategies.

The real value is in implementing the portfolio construction, accessing the appropriate risk exposures efficiently.

As BlackRock emphases, Investors need to work with their financial professionals to choose and blend the risk exposures that make sense for their unique circumstances.

 

Low Correlated investments

If the objective is to seek a truly diversified portfolio, the exposure to low correlated assets, both in general and particularly in times of stress, is necessarily.

These exposures are largely gained via Alternative investments or Alternative Investment strategies.

“Alternatives” are a broad category, as defined by BlackRock, offering “sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio.”

The concept of alternative investing is about going beyond what a traditional Balanced Portfolio might look like, by introducing new sources of diversification.

 

BlackRock provides a very good discussion on Alternatives, types of assets that would be considered alternatives and a discussion around implementation – highlighting the portfolio benefits of adding alternatives to a portfolio (improving the risk/reward profile). Also noting Alternative investments feared better during the GFC.

 

It is important to emphasis, as does BlackRock, that the inclusion of alternatives into the traditional portfolio is not a radical departure from the notion of managing risk and constructing portfolios. It helps in understanding what risks are being taken and broadens portfolio diversification.

The inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.

 

BlackRock makes a final and important point, the world presents countless risks, and not all those risks can be accounted for in a traditional Balanced Portfolio. Investors need to be diversified in general, but they also need to be diversified for the extreme. If not, they may be setting themselves up for failure.

Do not become too dependent on one source of investment returns.

 

Summary

Investors need to clearly understand the sources of risk in their portfolios and should consider incorporating a wide range of different investment strategies and assets as their core investment strategy.

Furthermore, investors cannot necessarily rely on what is traditionally thought of as diversification to meet their long-term goals.

It was not Portfolio Theory that failed during the GFC but Portfolio Construction.

And this is where the real value lies, the ability and knowledge to implement a truly diversified portfolio.

Many investors very likely remain under-diversified today. Their portfolios do not fully reflect the key learnings from history as outlined in this Post.

 

In my mind, many New Zealand Investors are missing out.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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

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

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

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

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

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

 

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

They note there are areas in which to be cautious:

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

 

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

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

 

The Results

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

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

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

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

 

Factor Analysis

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

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

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

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

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

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

 

Conclusions

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

 

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

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

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

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

 

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

 

Happy Investing

 

Please see my Disclosure Statement

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

 

 

 

 

New Zealand Super Fund vs the Australian Future Fund

The analysis below compares the variation in portfolio allocations between the Sovereign Wealth Funds of New Zealand and Australia, the New Zealand (NZ) Super Fund (Kiwis) and Australian Future Fund (Aussies).

Many of the insights are relevant for those saving for retirement or are in retirement.

A light-hearted approach is taken.

 

A previous Post, What Does Diversification Look Like compared Australian Superannuation Funds to the KiwiSaver universe, the Aussies won easily, with more diverse portfolio allocations.

However, this comparison is amongst the top echelon of the nation’s investment funds, a Test match of portfolio diversification comparisons, sovereign wealth fund vs sovereign wealth fund, the All Blacks vs the Wallabies, the Black Cap vs the Baggy Green, the Silver Ferns vs the Diamonds ………………

Let’s gets stuck into the Test Match Statistics.

 

Test Match in Play

 

NZS

Future Fund

Kiwi vs Aussie Difference

Int’l Equities

56.0%

18.5%

37.5%

Emerging Markets

11.0%

10.0%

Domestic Equities

4.0%

7.0%

Fixed Income

9.0%

9.0%

Alternatives
Infrastructure & Timberland

7.0%

7.5%

-0.5%

Property

2.0%

6.7%

-4.7%

PE

5.0%

15.8%

-10.8%

Alternatives 13.5%

-13.5%

Rural

1.0%

Private Mkts

3.0%

Public Mkts

2.0%

Cash

11.9%

100%

100%

           
High Level Allocations          
Equities

71.0%

35.5%

35.5%

Fixed Income

9.0%

9.0%

0.0%

Cash

11.9%

-11.9%

Alternatives

20.0%

43.5%

-23.5%

100%

100%

 

High Level Match Coverage:

  • The Kiwis are highly reliant on International Equities to drive performance – let’s hope they don’t get injured.
  • The Aussies currently have a higher allocation to Cash – are they holding something in reserve
  • The Aussies, with a higher Alternative allocation, on the surface, and looking at the detail below, have a more broadly diversified line up – depth to come off the bench
  • The Aussies have a much higher allocation to Private Equity,15.8 vs 5% – might have something to do with their schooling
  • Interestingly both have a similar allocation to Emerging Market Equities ~10% – both are willing to be adventurous

 

The standout is the difference in the international equities exposures, the Kiwis have a ~37% higher allocation, the majority of this difference is invested into Private Equity (+~10%), Property (+~4.7%), and Alternatives (+~13%) by the Aussies.

 

As for the detail

  New Zealand Australia
Infrastructure & Timberlands

Of the total 7%, 5% is in Timberlands, the Kiwis have 1% invested in NZ rural land and farms

Of the 7.5%, 1.7% is invested in listed infrastructure equities, 3.4% is invested in Australian assets, 2% is invested offshore. An array of infrastructure assets is invested in.
Alternatives Not sure how this is categorised by the Kiwis (Public Markets?), they have 2% invested in Natural Catastrophe Reinsurance and Life Settlements.

 

The Kiwis also have allocations to Merger Arbitrage.

The Aussies have 13.5% invested into Multi-Strategy/Relative Value hedge fund strategies, Macro – Directional strategies, and Alternative Risk Premia strategies.

 

These strategies are relatively easy to invest into and provide well documented portfolio diversification benefits relative to other hedge fund type strategies.

Property   1.9% of the Fund is invested in Listed Property, 4.8% is invested in direct property.

 

Post-Match interviews

It is true, the only interview is with my keyboard, and the above is high level and rudimentary.

Nevertheless, on the surface the Aussies appear to have a more broadly diversified line up, which may play into their hands in tougher games e.g. global equity bear market.

There is certainly less of a reliance on listed equities to drive the performance of the Aussies.

Put another way, the Aussies might have a better line up to get them through a world cup campaign, able to hold up in different playing conditions (i.e. different market environments. The exception would be a strong global equity bull market, which would favour the Kiwis. Albeit the Aussie’s performance has been competitive over the last 10 years relative to the Kiwis – unlike the Wallabies!).

 

Therefore, the Aussie portfolio allocation will lead to a smoother and more consistent team performance.

 

Why the Difference

The difference in portfolio allocations can be for several reasons. I would like to highlight the following:

 

Investment Objectives

In many respects they both have similar objectives, to support future Government spending. They are both investing for future generations. The Kiwi specifically for future super payments and Aussies more so for the General Fund.

 

Return Objectives

Interestingly they have similar return objectives.

From 1 July 2017 the Aussie’s long-term benchmark return target has been CPI + 4% to 5% per annum. This has been lowered from previous years, reflecting a changed investment environment.

The Kiwi’s don’t appear to have a specific return target.

Nevertheless, the Kiwi Reference Portfolio, which they are currently reviewing, is expected to generate a return of Cash plus 2.7%.

The Reserve Bank of New Zealand (RBNZ) in a 2015 research paper estimated the long-term “neutral” 90-day interest rate is around 4.3%. Although this seems high given the current market environment, bear-in-mind it is a long-term estimate.

If we assume inflation is 2%, the mid-point of the RBNZ’s inflation target range of 1-3%, and a lower Cash rate, then Cash generates a 2% return over inflation.

Thus, the Kiwi objective is comparable to a CPI + 4.7% return.

 

Therefore, the return objectives are not too dissimilar between the two Teams, even if we make further conservative assumptions around the long-term neutral interest rate in New Zealand and its expected return above inflation – which I think will come down from its historical average.

If anything, the Kiwi’s return objective is more conservative than the Aussies, all else being equal, this would support a lower equity allocation relative to the Aussies, not a higher equity allocation as is the case.

 

It is interesting, for similar return objectives they have such a difference in equity exposure.

This is an issue of implementation.

The Aussies are seeking a broader source of returns through Private Equity, Alternative strategies, direct property, and unlisted infrastructure.  This will help them in different playing conditions – market environments.

 

Drawdown Requirements

There is a difference in when the funds will be drawn upon i.e. make payments to the Government.

In Australia, legislation permits drawdowns from the Future Fund from 1 July 2020. The Government announced in the 2017-18 budget that it will refrain from making withdrawals until at least 2026-27.

The Kiwis have a bit longer, from around 2035/36, the Government is expected to begin to withdraw money from the Fund to help pay for New Zealand superannuation. On current forecasts, a larger, permanent withdrawal period will commence in 2053/54.

 

Therefore, the Funds do have different maturity profiles and this can be a factor in determining the level of equity risk a portfolio may maintain.

 

One way of looking at this is that the Aussies are closer to “retirement”, there will no longer be deposits into the Fund and only capital withdrawals from 2026. Much like entering retirement.

Therefore, it would be prudent for them to have a lower equity allocation and higher level of portfolio diversification at this time, so there is a wider return source to draw upon.

The Kiwis have a bit longer until they enter retirement.

I would imagine that the Kiwis will move their portfolio closer to the current Aussies portfolio over time, as they “age” and get closer to the decumulation/drawdown phase (retirement), expected to commence around 2035 (16 years’ time).

The Kiwis will likely be considering this now, as they will want to reduce their sequencing risk, which is the risk of experiencing a major drawdown just before and just after entering the drawdown phase (retirement). I covered this in a previous Post, The Retirement Death Zone.

Likewise, they will not want to hold high levels of Equities once withdrawals commence (are in retirement).

Maintaining high levels of listed equities can significantly reduce the value of a portfolio that has regular withdrawals and there is a high level of market volatility. This is the case for Charities, Foundations, and Endowments.

For more on this, see my previous Post, Could Buffett be wrong, which highlights the impact on portfolios when there are regular withdrawals and equity market volatility.

 

Team Philosophy

Differences in Investment Philosophy could account for differences in portfolio allocations. Nevertheless, there does not appear to be any measurable difference in Philosophy.

 

Resources and fee budgets

This is probably the most contentious factor. Fund size, team resources, and fee budgets can influence portfolio allocations. Those with a limited fee budget will find it challenging to diversify equity risk.

I am not saying this is an issue for the Kiwis, I would only be speculating. The Aussies have a good size budget based on their recent annual report.

Let’s hope it is not a factor for the Kiwis, an appropriate investment management fee budget will be required for them to satisfactorily meet their objectives and exceed expectations – as any good sports team know.

This is an aged old industry issue. My Post on Investment Fees and Investing like US Endowments covers my thoughts on the fee budget debate.

 

Happy investing.

Please see my Disclosure Statement

 

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

Reported death of the 60/40 Portfolio

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

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

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

All three firms have similar reasons:

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

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

 

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

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

 

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

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

 

What to do?

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

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

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

 

 

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

For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

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

 

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

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

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

 

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

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

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

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

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

 

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

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

 

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

 

Happy investing.

Please see my Disclosure Statement

 

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

Charitable Foundation Investing, with Endowments

It is vitally important that Foundations, Endowments, and Charities have customised investment programs to better support their very long-term goals.

Not only is a customised investment program important in meeting their investment objectives, such a robust process will also help them in attracting new donors.

This Post reviews a paper written by Cambridge Associates on how community foundations can develop customized investment programs to better support their long-term goals.

The key to success is to have exposure to a truly diversified range of investment risks and returns.  A more diversified portfolio is recommended which has better risk and return outcome than a portfolio solely reliant on Equities and Fixed Income.

A high listed equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.

The point is that Foundations, Charities, and Endowments can increase their overall diversification and this will provide stronger return expectations. They need to play to their strengths, which includes their longevity.

 

As Cambridge note in their paper “One of the most important roles of a community foundation is to steward philanthropic assets well. A thoughtful and disciplined investment approach increases the probability of generating higher portfolio returns and amplifies the foundation’s philanthropic impact.”

“Each Foundation has a unique focus on the needs and priorities of its particular community, which translates into a particular mix of assets under management.”

Implementing a successful investment program requires a customized approach that considers all the philanthropic funds under management, their role in supporting philanthropy and programs, and how they come together in the aggregate.

 

Cambridge argue that an investment strategy that employs the endowment model can differentiate a foundation in a vast landscape of options available to donors. i.e. they are likely to attract more donors.

The Endowment Model of investing can deliver on investment and stewardship goals, but the approach requires a deep understanding of risk, liquidity, and investable assets, and may not be the appropriate strategy for all assets under management.

The endowment model is anchored to four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

 

Therefore, given “that each organization brings a unique combination of circumstances, the development of the optimal investment program starts with an enterprise review. This provides a deeper understanding of a foundation’s assets, fundraising flows, and the role the investment assets play in supporting the mission. These factors frame the portfolio’s risk and liquidity, which are then reflected in investment policy and implemented in portfolio construction.”

To illustrate a more robust investment approach, Cambridge provide an illustrated example by creating a representative community foundation with $500 million in assets under management.

 

As you know, Foundations, University Endowments, and Charities deliver a range of philanthropic, programmatic, and investment services.

Community foundations lead and serve their local community, fundraise, and deliver programs. Like private foundations, they identify grant-making opportunities and support charitable causes with grants and program-related investments.

 

Tailored investment solution

“Once truly short-term philanthropy has been set aside, community foundations often find that the aggregate portfolio of funds is aligned with a long-term investment strategy, because spending is matched by fundraising. This provides a level of stability for investment assets and indicates that liquidity requirements do not constrain investment policy. The foundation’s portfolio is in an advantageous position where spending needs are matched or exceeded by inflows of new funds, so the investment portfolio can take on more illiquidity to achieve return objectives.”

 

An individual can be characterised in a simply fashion, future liabilities of desired spending in retirement need to be “matched” by investment assets. This is the basis of Liability Driven Investing for Banks and Insurance companies and Goals-Based Investing for the individual.  Such an approach is appropriate for a Charity, Foundation, and Endowment.

 

Foundation Example

After undertaking a review of their representative Foundation, Cambridge note the foundation has a substantial level of non-endowed funds, those funds behave like long-term capital because of strong fundraising that replenishes fund levels each year. The foundation can thus grow assets and offer donors a risk-appropriate, competitive return on their philanthropic funds. “Optimizing the endowment investment offering further distinguishes the foundation from competitors.”

Given these endowment characteristics Cambridge argue the foundation can have a greater emphasis on less liquid investments such as private investments.

The point is that the Foundation can increase its overall diversification and this will provide stronger return expectations. Foundations, Charities, and Endowments need to play to their strengths.

 

With such an approach the Foundation is more likely to preserve its purchasing power and grow market value over time.

A more diversified portfolio is recommended which has better risk and return outcome than a portfolio solely reliant on Equities and Fixed Income.

As would be expected by any asset consultant extensive portfolio modelling has been undertaken to understand the resilience and robustness of the portfolio under different market conditions.

As would also be expected a more robust portfolio translates into greater performance over the long term, often with similar if not better protection in poor market conditions i.e. down markets.

 

Likewise, with an increased allocation to illiquid assets, stress testing of different liquidity scenarios is undertaken to gain an understanding of the recommended portfolio’s ability to support annual foundation operations, programs, and grant-making.

Scenario analysis includes the foundation deciding to maintain its level of grant-making to help grantees weather financial challenges, despite the fact that the effective spending rate will exceed its policy target, and the scenario were the Foundation cuts the fundraising achievement level in half, reducing the rate in which new capital is added to the portfolio.

Cambridge conclude ”To evaluate whether the recommended investment portfolio is a good fit, the foundation’s staff, investment committee, and board need to assess whether they are comfortable with the potential portfolio losses and levels of spending presented by a stress scenario. They will also need to consider whether the foundation will maintain grant funding (as modelled) or even grow grant funding in an economic downturn. While an investment policy’s focus is long term, it needs to be able to withstand difficult short-term periods.”

 

 

I have written a number of blogs on the risk of having high equity weightings and the benefits of true portfolio diversification.

A high equity allocation is detrimental to a portfolios that have regular cashflows i.e. Endowments, Charities, and Foundations. This was covered in a previous Post, Could Buffet be wrong? This Post highlights the devastating impacts listed equity market volatility has on a portfolio such as an Endowment/Charity/Foundation which need to provide regular income and to periodically draw on capital.

For those wanting a short history on the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest. Current investment portfolios should reflect key learnings from previous market meltdowns.

My last Post, What Does a Diversified Portfolio Look Like? May also be of interest. This Post highlights that a diversified portfolio has a number of risk and return exposures and is not overly reliant on listed equities to generate investment outcomes.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

What does Portfolio Diversification look like?

What does a diversified portfolio look like?

This is answered by comparing a number of portfolios, as presented below.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.   Investors are compensated for being exposed to a range of different risks.

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

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.

 

This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.

The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).

To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.

 

Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe.  Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.

I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.

WTW Model Reference Portfolio Typical US Advisor
Domestic Cash 2.0%
Domestic Fixed Interest 13.0% 15.0% 28.0%
Global Fixed Interest 15.0%
Domestic Equities 15.0% 25.0% 35.0%
International Equities 20.0% 40.0% 12.0%
Emerging Markets 5.0% 5.0% 4.0%
Listed Property 3.0%
Global Property 3.0%
Listed Infrastructure 3.0%
Alternative Beta 8.0%
Hedge Funds 7.0% 8.0%
Private Equity 8.0% 4.0%
Unlisted Infrastructure 5.0%
Alternative Credit 8.0%
US High Yield 4.0%
Commodities / Real Estate 4.0%
Emerging Markets Bonds 1.0%
100.0% 100.0% 100.0%
Broad Asset Classes
Cash and Fixed Income 15.0% 30.0% 28.0%
Listed Equity 49.0% 70.0% 51.0%
Non Traditional 36.0% 0.0% 21.0%
100.0% 100.0% 100.0%

Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta

The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.

Allocations to broad asset classes KiwiSaver Aussie Pension Funds
Cash and Fixed Interest (bonds) 49 31
Equities 48 47
Other / non-traditional assets 1 22

From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.

 

If a picture tells a thousand words, the Tables above speak volumes.

The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.

 

It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).

Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

Globally allocations to alternatives are set to grow, as outlined in this Post.

 

The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.

Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments.  As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).

 

Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.

The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.

Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.

Although investors can experience strong performance, they can also experience very weak performance.

 

Comparison Return Analysis

Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.

By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.

It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.

 

The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.

 

Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%

 

A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.  They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?

Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.

For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.

 

Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.

As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Global Economic and market outlook

For those looking for a balanced, rational, and insightful view of the global economy and outlook for financial markets, this article is worth reading.

 

I don’t normally post economic views on Kiwi Investor Blog as they are readily available. The quality of these views can also often be questioned.

It is also easier to find articles of doom and gloom, as they are more often promoted by the mainstream media, they attract more headlines.

 

This interview with Peter Berezin, of BCA, is the exception to the rule.

BCA’s Chief Global Strategist, Berezin, is not worried about the current weakness of the global industrial sector. If anything, he expects the global economy is going to see a revival in growth over the next few quarters.

As the article outlines “Falling interest rates and the service sector which is cooling but still expanding give Berezin grounds for optimism. He considers the trade dispute to be the greatest risk. But he believes that both the US and China have an interest in reaching a deal before the next US presidential elections.”

“Berezin prefers equities to bonds. In the longer term, he expects painful losses for the latter because central banks underestimate inflation risks……..”

I’ll quickly summarise Berezin’s thoughts below, nevertheless, the article is well worth reading so as to form your own view and to be informed.

In summary Berezin made the following comments and observations:

  • He does not see the global economy heading for a recessions, as noted above if anything, he expects the global economy is going to see a revival in growth over the next few quarters. Financial conditions have eased significantly over the last six months largely due to the decline in government bond yields. Historically, easier financial conditions tended to translate into faster growth.
  • Provided that the trade war doesn’t heat up significantly, the global manufacturing sector is going to rebound later this year. That’s going to drive global growth higher.
  • He does not see any glaring imbalances in the US or globally that gives concern to a recession, noting the private sector globally is a net saver.
  • The trade dispute between the US and China is the biggest risk to his view. China is stimulating their economy.
  • He believes both parties have an incentive to cool things down – Trump so it does not do damage to the economy and his election changes. China – likewise so not to damage their economy, also they don’t like the prospect of negotiating trade if Trump does win the election and also if he doesn’t win the election – the Democrats are likely to be tougher on trade than Trump.

 

The above provides a taste, the article also covers the outlook for oil, inflation, and risk of regulatory impact on the large US technology companies.

 

What should investors do?

Berezin recommends investors to overweight equities relative to government bonds over the next 12 months. “Stocks are not particularly cheap, but they are certainly not very expensive either. The MSCI All Country World Index is trading at around 15.5 times forward earnings which is not too bad. Outside the US, stocks are trading at close to 13.5 forward earnings which is actually pretty cheap.”

Looking forward, his preferred regions are away from the US and towards the emerging markets and Europe.  This is subject to a pickup in the global economy.

In relation to Fixed Income (bonds), he sees “an environment in which government bond yields are rising”. This is a negative environment for bonds (as yields rise, bond prices fall).

 

It is worth noting that 2019 is turning out to be good year for investors, particularly those invested in a “Balanced Portfolio”, 60% Equities and 40% Fixed Income. Global equities have returned around 18% since 31 December 2018, likewise returns on New Zealand and Global Bonds have been around 8-10%. This follows a very hard year in 2018 in which to generate investment returns, with the possible exception of New Zealand equities.

Returns on a one year basis include sharp declines in global equity markets over the final three months of 2018. These negative returns will start to “unwind” out of annual returns so long as equity markets remain at current levels.

 

Happy investing.

Please read my Disclosure Statement

 

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

Kiwi Wealth caught in an active storm

We need to change the conversation on investment management fees.

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

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

Kiwi Wealth make the following comment in the introduction:

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

 

I can’t disagree with that.

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

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

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

 

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

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

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

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

 

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

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

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

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

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

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

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

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

 

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

 

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

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

 

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

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

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

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

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

 

Happy investing.

Please see my Disclosure Statement

 

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

A short history of Portfolio Diversification

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

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

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

 

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

 

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

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

 

Standing on the Shoulders of Giants

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

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

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

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

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

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

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

Increased Diversification of the 60:40 Portfolio

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

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

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

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

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

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

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

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

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

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

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

 

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

Pioneering Portfolio Management – the Yale Endowment Model

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

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

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

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

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

Learnings from Norway

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

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

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

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

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

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

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

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

Innovation and pressure on Investment Management Fees

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

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

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

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

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

True Portfolio Diversification

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

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

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

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

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

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

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

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

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

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

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

Future Direction of Diversification

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

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

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

 

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

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

 

Happy investing.

Please see my Disclosure Statement

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