The most read Kiwi Investor Blog Posts in 2020 have been relevant to the current environment facing investors. They have also focused on building more robust portfolios.
The ultra-low interest rate environment and sobering low return forecasts present a bleak outlook for the Traditional Balanced Portfolio (60% Equities and 40% Fixed Income.) This outlook for the Balanced Portfolio was a developing theme in 2020, which gained greater prominence as the year progressed.
In essence, there are two themes that present a challenge for the Traditional Balanced Portfolio in the years ahead:
That fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest too heavily in these markets; and
With interest rates at very low levels, there is increasing doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.
My highest read Posts address the second theme above.
The Balance Portfolio has served investors well in recent years. Although equities and fixed income still have a role to play in the future, there is more that can be done.
The most read Kiwi Investor Blog Posts outline strategies that are “more that can be done”.
I have no doubt investors are going to have to look for alternative sources of returns and new asset classes outside equities and fixed income over the years ahead. In addition, investors will need to prepare for a period of higher inflation.
Not only will this help in increasing the odds of meeting investment return objectives; it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility.
The best way to manage periods of severe sharemarket declines, as experienced in the first quarter of 2020, is to have a diversified portfolio. It is impossible to time these episodes.
Arguably the most prudent course of action for an investor to pursue in the years ahead is to take advantage of modern investment strategies that deliver portfolio diversification benefits and to employ more advanced portfolio construction techniques. Both of which have been successfully implemented by large institutional investors for many years.
From my perspective, maintaining an array of diversification strategies is preferred, investors should diversify their diversifiers.
The most read Kiwi Investor Blog Posts in 2020 were:
Those in the Retirement Risk Zone would benefit most from targeted investment advice.
The Retirement Risk Zone is the 10-year period before and after retirement (assumed to retire at age 65 years).
It is the 20-year period when the greatest amount of retirement savings is in play, and subsequently, risk is at its highest. It is a very important period for retirement planning.
The Retirement Risk Zone is the worst possible time to experience a large negative return. How much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of that loss.
Therefore, the value of good advice and a well-constructed portfolio aligned with one’s investment objectives is of most value during the Retirement Risk Zone.
Impact on timing of market losses
If a large loss occurs during the Retirement Risk Zone it will result in less money in retirement and raise longevity risk (the risk of running out of money in retirement).
The risk that the order of investment returns is unfavourable is referred to as sequencing risk.
Sequencing risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement.
Once an investor needs to take capital or income from a portfolio volatility of equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.
It is untrue to say that volatility does not matter for the long term when cashflows are involved. For further discussion on this issue see this Post, Could Buffett be wrong?
The portfolio size effect and sequencing risk have a direct relationship to longevity risk.
For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.
One-way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.
Materiality of Market Volatility in Retirement Risk Zone
Research by Griffith University finds “that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“
Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.
They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”
This is consistent with other international studies.
Managing Sequencing Risk
Sequencing risk is largely a retirement planning issue. Albeit a robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk.
Two key areas from an investment perspective to focus on in managing sequencing risk include:
The Retirement Goal is Income
The OECD’s Core Principles of Private Pension Regulation emphasis that the objective is to generate retirement income. This is different to the focus on accumulated value. A key learning from the Australian Superannuation industry is that there has been too greater focus on the size of the accumulated balance and that the purpose of superannuation should be about income in retirement.
An important point to consider, without a greater focus on generating income in retirement during the accumulation phase the variation of income in retirement will likely be higher.
Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.
This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable and secure level of income in retirement.
This is aligned with a Goals Based Investment approach.
A greater focus on reducing downside risk in a portfolio (Capital Preservation)
This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.
A robust portfolio must display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.
This may include the inclusion of alternative investments, tail risk hedging, and low volatility equities may also be option.
The current ultra-low interest rate environment presents a challenging environment for preserving portfolio capital, historically the role of Fixed Income. Further discussion on this issue can be found in this Post, which includes a discussion on Tail Risk Hedging.
This article in smstrusteenews highlights the growing issue of capital preservation within the Australian Self-Managed Super Fund (SMSF) space given the current investment environment.
Meanwhile, this article from Forbes is on managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.
Many argue that sequencing risk can be managed by Product use alone.
My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing. Longevity annuities could be used to complement the Goals-Based approach, to manage longevity risk.
This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.
For a more technical read please see the following papers:
The case for a greater focus on generating retirement income is provided in this Post, summarising an article by Nobel Laureate Professor Robert Merton. He argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.
Canada’s largest Pension Funds plan to increase their investments into emerging markets over the following years. Asia, particularly India and China, are set to benefit.
The increased exposures are expected to be achieved by increasing portfolio target allocations to emerging markets, partnering on new deals, and boosting staff with expertise to the area.
The expected growth in the share of global economic activity in the years ahead and current attractive sharemarket valuations underpin the case for considering a higher weighting to emerging markets within portfolios. Particularly considering the low interest rate environment and stretched valuation of the US sharemarket. This dynamic is very evident in the market return forecasts provided below.
Additionally, emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.
As outlined in the P&I article, the Ontario Teachers’ Pension Plan (C$201.4 billion) is investing significantly into emerging markets, particularly Asia. Their exposure to emerging markets fluctuates between 10% and 20% of the total Portfolio.
The Fund’s investments across the emerging markets includes fixed income, infrastructure, and public and private equities. They plan to double the number of investment staff in Asia over the next few years, they already have an office in Hong Kong.
The Canada Pension Plan Investment Board (CPPIB) (C$400.6 billion) anticipates up to one-third of their fund to be invested in emerging markets by 2025.
CPPIB sees opportunities in both equity and debt. Investments in India are expected to grow, along with China.
The Attraction of Emerging Markets
The case for investing into emerging markets is well documented: rising share of global economic activity, under-representation in global market indices, and currently very attractive sharemarket valuations.
Although the current global economic and pandemic uncertainty provides pause for concern, the longer-term prospects for emerging market are encouraging.
From the P&I article “CPPIB estimates the share of global gross domestic product represented by emerging markets will reach 47% by 2025 and surpass the GDP of developed economies by 2029”.
Based on the expected growth outlook CPPIB “feel there are attractive returns available over the long term to those investors who take the time to study the characteristics and fundamentals of these markets and are able to identify trends and opportunities in those markets,”…..
CPPIB also highlight the benefit of diversification into different geographies and asset classes for the Fund.
Lastly, the valuations within emerging market sharemarkets are attractive.
This is highlighted in the following Table from GMO, which provides their latest (Sept 2020) Forecasts Annual Real Returns over the next 7 years (after inflation).
As can be seen, emerging market is one of only two asset classes that provides a positive return forecast. Emerging market value offers the prospect of the highest returns over the next 7 years. As GMO highlight, the forecasts are subject to numerous assumptions, risks and uncertainties. Actual results may differ from those forecasted.
Nevertheless, GMO provided the following brief commentary in this LinkedIn Post “From an absolute perspective, broad markets in the US are frighteningly bad; non-US developed markets, however, are not as bad, but that is faint praise, as our official forecast for this basket is also in negative territory. “Safe” bond forecasts are not much better. With yields this low, the very foundational justification for holding bonds — as providers of income and/or as anti-correlated money makers when equities decline — has been shaken to its core. The traditional 60/40 portfolio, consisting of heavy doses of US and International stocks and Government Bonds, is poised for a miserable and prolonged period.”
GMO Annual Real Returns over 7 years
In February 2020, GMO advised that it was time to move away from the Balanced Portfolio, as outlined in this Kiwi Investor Blog Post. GMO provide a historical performance of the traditional Balanced Portfolio (60% equities and 40% fixed income). Overall, the Balanced Fund is riskier than people think.
In the LinkedIn Post mentioned above, GMO comment that “Our Asset Allocation team believes this is the best opportunity set we’ve seen since 1999 in terms of looking as different as possible from a traditional benchmarked portfolio.” Where the traditional benchmarked portfolio is the Balanced Portfolio of 60% equities and 40% fixed income.
Why the Balanced Portfolio is expected to underperform and potential solutions to enhancing future portfolio returns is covered in this Post.
The case for holding Government Bonds is all about certainty. The question isn’t why would you own bonds but, in the current environment, why wouldn’t you own bonds to deliver certainty in such uncertain times?
This is the central argument for holding government bonds within a portfolio. The case for holding government bonds is well presented in a recent article by Darren Langer, from Nikko Asset Management, Why you can’t afford not to own government bonds.
As he argues, government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.
The article examines some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It is well worth reading.
Why you can’t afford not to own government bonds
The argument against holding government bonds are based on expectations of higher interest rates, higher inflation, and current extremely low yields.
As argued in the article, although these are all very valid reasons for not holding government bonds, they all require a world economy that is growing strongly. This is far from the case currently.
They key point being made here, in my opinion, is that the future is unknown, and there are numerous likely economic and market outcomes.
Therefore, investors need to consider an array of likely scenarios and test their assumptions of what is “likely” to happen. For example, what is the ‘normal’ level of interest rates? Are they likely to return to normal levels when the experience since the Global Financial Crisis has been a slow grind to zero?
Personally, although inflation is not an issue now, I do think we should be preparing portfolios for a period of higher inflation, as I outline here. Albeit, this does not negate the role of fixed income in a portfolio.
The article argues that current conditions appear to be different and given this it is not unrealistic to expect that inflation and interest rates are likely to remain low for many years and significantly lower than the past 30 years.
In an uncertain world, government bonds provide certainty. Given multiple economic and market scenarios to consider, maintaining an allocation to government bonds in a genuinely diverse and robust portfolio does not appear unreasonable on this basis.
Investors should be prepared for lower rates of returns across all assets classes, not just fixed income.
A likely scenario is that governments and central banks will target an environment of stable and low interest rates for a prolonged period.
In this type of environment, government bonds have the potential to provide a reasonable return with some certainty. The article argues, the benefits to owning bonds under these conditions are two-fold:
A positively sloped yield curve in a market where yields are at or near their ceiling levels. Investors can move out the curve (i.e. by buying longer maturity bonds) to pick up higher coupon income without taking on more risk.
Investors can, over time, ride a position down the positively-sloped yield curve (i.e. over time the bond will gain in value from the passing of time because shorter rates are lower than longer rates). This is often described as roll-down return.
The article concludes, that although fixed income may lose money during times of strong economic growth, rising interest rates, and higher inflation, these losses can be offset by the gains on riskier assets in a portfolio. Losses on fixed income are small compared to potential losses on other asset classes and are generally recovered more quickly.
No one would suggest a 100% allocation to government bonds is a balanced investment strategy; likewise, not having an allocation to bonds should also be considered unbalanced.
“But a known return in an uncertain world, where returns on all asset classes are likely to be lower than the past, might just be a good thing to have in a portfolio.”
The article on the case for government bonds helps bring some balance to the discussion around fixed income and the points within should be considered when determining portfolio investment strategies in the current environment.
A key investment concept is volatility drag. Volatility drag provides a framework for considering the trade-off between the “cost” and “benefit” of reducing portfolio volatility.
The volatility of your portfolio matters. Reducing portfolio volatility helps deliver higher compound returns over the longer-term. This leads to a greater accumulation of wealth over time.
When introducing volatility reduction strategies into a Portfolio a cost benefit analysis should be undertaken.
The cost of reducing portfolio volatility cannot be considered in isolation.
The importance of volatility and its impact on an investment portfolio is captured in a recent article by Aberdeen Standard Investment (ASI), The long-term benefits of finding the right hedging strategy.
The ASI article is summarised below. Access to article via LinkedIn is here.
It is widely accept that avoiding large market losses and reducing portfolio volatility is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, an ongoing and uninterrupted endowment, or meeting Pension liabilities.
Understanding Volatility Drag
Volatility Drag is a key concept from the paper: if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”
The main disconnect some investors have is they look at returns over a discrete period, such as a year, or the simple average return over two years (zero in the case above).
Instead, investors should focus on the realised compound rate. The compound annualised return in the above example is -13.97% versus simple average return of zero.
ASI make the following point: “The compound (geometric) rate of return will only equal the arithmetic average rate of return if volatility is zero. As soon as you introduce volatility to the return series, the geometric IRR will start falling, relative to the average return.”
This is a key concept to understand. Volatility reduces compounded returns over time, therefore it impacts on accumulated wealth. The focus should be on the actual return investors receive, rather than discrete period returns. Most investment professionals understand this.
Cashflows, into and out of a Portfolio, also impact on actual returns and therefore accumulated wealth. This is why a 100% equities portfolio is unlikely to be appropriate for the vast majority of investors. The short comings of a high equity allocations is outlined in one of my previous Posts: Could Buffett be wrong?
In the article ASI offers a thought experiment to make their point, a choice between two hypothetical investments:
Investment A, has an average annual return of 1% with 5% volatility.
Investment B, has twice the average return (2%) but with four times the volatility (20%).
An investor with a long term horizon might allocate to the higher expected return investment and not worry about the higher levels of volatility. The view could be taken because you have a longer term investment horizon more risk can be taken to be rewarded with higher returns.
In the article ASI provides simulated track records of the two investments over 50 years (the graph is well worth looking at).
As would be expected, Investment B with the 20% volatility has a much wider range of possible paths than the lower-volatility Investment A.
What is most interesting “despite having double the average annual return, the more volatile strategy generally underperforms over the long term.”
This is evident in the Table below from the ASI article, based on simulated investment returns:
Average Annual Return
Standard Deviation of Annual Returns
Average total return after 50 years
Average realised internal rate of return (IRR)
Note, how the IRR is lower than the average annual return e.g. Investment A, IRR is 0.88% versus average annual return of 1.0%. As noted above, they are only the same if volatility is zero.
The performance drag, or “cost”, is due to volatility.
Implications and recognising the importance of volatility
The concept of Volatility Drag provides a framework for considering the trade-off between the “cost” and benefit of reducing portfolio volatility.
The ASI article presents this specifically in relation to the benefits of portfolio hedges, as part of a risk mitigation strategy, and their costs with the following points:
The annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
Putting on exposures with flat or even negative expected returns can still increase your total portfolio return over time if they lower your volatility profile sufficiently.
It is meaningless, therefore, to look at the costs of hedges in isolation.
These points are relevant when considering introducing any volatility reduction strategies into an Investment Portfolio i.e. not just in relation to tail risk hedging. A cost benefit analysis should be undertaken, investment costs cannot be considered in isolation.
As ASI note, investors need to consider the overall portfolio impact of introducing new investment strategies, specifically the impact on the downside volatility of a portfolio is critical.
There are a number of ways of reducing portfolios volatility as outlined below, including the risk mitigation strategies of the ASI article.
The key point is that the volatility of your portfolio matters. Reducing portfolio volatility helps in delivering better compound returns over the longer-term.
Therefore, exploring ways to reduce portfolio volatility is important.
ASI outline the expectation that volatility is likely to pick up in the years ahead, “especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.”
They also make the following pertinent comment, “Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility.”
ASI also note that investors have access to a wide range of tools and strategies to manage volatility. This is particularly relevant in relation to the risk mitigation hedging strategies that manage downside volatility and are the focus of the ASI article.
Therefore, a modern day portfolio will implement several strategies and approaches to reduce portfolio volatility, primarily as a means to generate higher compound returns over time. This is evident when looking at industry leading sovereign wealth funds, pension funds, superannuation funds, endowments, and foundations around the world.
Strategies and Approaches to reducing Portfolio Volatility
There are a number of strategies and approaches to reducing portfolio volatility, Kiwi Investor Blog has recently covered the following:
Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation. Thus reducing portfolio volatility and enhancing long-term accumulated returns.
Investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk.
Investing into a broader array of fixed income securities, dividend-paying equities, and alternatives such as real assets and private credit is likely required.
Investors will need to build more diversified portfolios.
These are key conclusions from a recent article written by Tony Rodriquez, of Nuveen, Rethinking the ‘40’ in 60/40 Portfolios, which appeared recently in thinkadvisor.com.
The 60/40 Portfolio being 60% equities and 40% fixed income, the Balanced Portfolio. The ‘40’ is the Balanced Portfolio’s 40% allocation to fixed income.
In my mind, the most value will be added in implementation of investment strategies and manager selection.
In addition, the opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.
The value of good investment advice at this juncture will be invaluable.
Putting It All Together
The thinkadvisor.com article provides the following Table.
This Table is useful in considering potential investment ideas. Actions taken will depend on the individual’s circumstances, including investment objectives, and risk tolerance.
The Table provides a framework across three dimensions to consider how to tackle the current investment challenge of very low interest rates.
Those dimensions are:
The trade-off between level of income generated and risk tolerance (measured by portfolio volatility), e.g. lower income and reduced equity risk
“How to do it” in meeting the trade-off identified above e.g. increase credit and equity exposures to seek higher income
“Where to find it”, types of investments to implement How to do it e.g. active core fixed income, real assets (e.g. infrastructure and real estate), higher yielding credit assets.
Current Investment Environment
These insights reflect the current investment environment of extremely low interest rates.
More specifically the article starts with the following comments: “For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.”
Tony calls for action, “With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?”
This would be a worthy discussion for Investment Advisers and Consultants to have with their clients.
Returns from fixed income are relatively predictable, unlike equity market returns. Current fixed income yields are the best predictor of future returns. With global government bond yields around zero and global investment grade credit providing not much more, a return of greater than 1% p.a. from traditional global bond markets over the next 10 years is unlikely.
Fixed income returns over the next 10 years are highly likely to be below the rate of inflation. Therefore, the risk of the erosion of purchasing power from fixed income is very high. This is a portfolio risk that needs to be managed.
Although forecasted returns from equities are also low compared to history, they are higher than those expected from traditional fixed income markets.
What should Investors do?
The article provides some specific guidance in relation to fixed income investments and a view on the outlook for the global economy.
The key point from the article, in my mind, is that for investors to meet the current investment challenges over the next decade they are going to need a more broadly diversified portfolio than the traditional 60/40 portfolio.
I also think it is going to require greater levels of active management.
This will involve a rethink of the ‘40’ fixed income allocation. Specifically, the focus will be on generating higher returns and that fixed income is likely to provide less protection to a Balanced Portfolio at times of sharemarket declines than has been experienced historically.
Ultimately, a broader view of the 60/40 Portfolio’s construction will need to be undertaken.
This is likely to require thinking outside of the fixed income universe and implementing a more robust and truly diversified portfolio.
Implementation will be key, including strategy and manager selection.
There will still be a role for fixed income within a Portfolio, particularly duration. Depending on individual circumstances, higher yielding securities, emerging market debt, and active management of the entire fixed income universe, including duration, is something to consider. More of an absolute return focus may need to be contemplated.
Outside of fixed income, thought should be given to thinking broadly in implementing a more robust and truly diversified portfolio.
Kiwi Investor Blog has highlighted the following areas in previous Posts as a means to diversify a portfolio and address the current investment challenge:
Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.
There have been a number of articles over recent months calling into question the robustness of the Balanced Portfolio of 60% Equities / 40% Fixed Income going forward. I have covered this issue in previous Posts, here and here.
Why the Balanced Portfolio is expected to underperform is outlined in this Post.
Lastly, also relevant to the above discussion, please see this Post on preparing Portfolios for higher levels of inflation.
Call to Action
In appealing to Tony’s call for action, there has probably never been a more important time in realising the value of good investment advice and honest conversations of investment objectives and portfolio allocations.
Perhaps it is time to push against some outdated conventions, seek new investments and asset classes.
The opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.
The value of good investment advice at this juncture will be invaluable.
For a perspective on the current market environment this podcast by Goldman Sachs may be of interest.
In the podcast, Goldman Sachs discuss their asset allocation strategy in the current environment, noting both fixed income and equities look expensive, this points to lower returns and higher risks for a Balanced Portfolio. They anticipate an environment of below average returns and above average volatility.
Those saving for retirement face the reality that fixed income may no longer serve as an effective portfolio diversifier and source of meaningful returns.
In future fixed income is unlikely to provide the same level of offset in a portfolio as has transpired historically when the inevitable sharp decline in sharemarkets occur – which tend to happen more often than anticipated.
The expected reduced diversification benefit of fixed income is a growing view among many investment professionals. In addition, forecast returns from fixed income, and cash, are extremely low. Both are likely to deliver returns around, if not below, the rate of inflation over the next 5 – 10 years.
Notwithstanding this, there is still a role for fixed income within a portfolio.
However, there is still a very important portfolio construction issue to address. It is a major challenge for retirement savings portfolios, particularly those portfolios with high allocations to cash and fixed income.
In effect, this challenge is about exploring alternatives to traditional portfolio diversification, as expressed by the Balanced Portfolio of 60% Equities / 40% Fixed Income. I have covered this issue in previous Posts, here and here.
Outdated Investment Strategy
There are many ways to approach the current challenge, which investment committees, Trustees, and Plan Sponsors world-wide must surely be considering, at the very least analysing and reviewing, and hopefully addressing.
One way to approach this issue, and the focus of this Post, is Tail Risk Hedging. (I comment on other approaches below.)
The article is written by Ron Lagnado, who is a director at Universa Investments. Universa Investments is an investment management firm that specialises in risk mitigation e.g. tail risk hedging.
The article makes several interesting observations and lays out the case for Tail Risk Hedging in the context of the underfunding of US Pension Plans. Albeit, there are other situations in which the consideration of Tail Risk Hedging would also be applicable.
The framework for Equity Tail Risk Hedging, recognises “that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns.”
By way of positioning, the article argues that a reduction in Portfolio volatility leads to better investment outcomes overtime, as measured by the Compound Annual Growth Return (CAGR). There is validity to this argument, the reduction in portfolio volatility is paramount to successful investment outcomes over the longer-term.
The traditional Balance Portfolio, 60/40 mix of equities and fixed income, is supposed to mitigate the effects of extreme market volatility and deliver on return expectations.
Nevertheless, it is argued in the article that the Balanced Portfolio “limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance.”
In other words, “It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.”
The article provides some evidence of this, highlighting that “large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points.”
Essentially, the argument is made that the Balanced Portfolio has not delivered on its promise historically and is an outdated strategy, particularly considering the current market environment and the outlook for investment returns.
Meeting the Challenge – Tail Risk Hedging
The article calls for the consideration of different approaches to the traditional Balance Portfolio. Naturally, they call for Tail Risk Hedging.
In effect, the strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge (protection of large equity loses).
It is argued that this will result in a higher CAGR over the longer term given a higher allocation to equities and without the drag on performance from fixed income.
The Tail Risk Hedge strategy is implemented via an options strategy.
As they note, there is no free lunch with this strategy, an “options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns.”
This is the inverse to some investment strategies, which provide incremental gains over extended periods and then short sharp losses. There is indeed no free lunch.
The article concludes, “diversification for its own sake is not a strategy for success.”
I would have to disagree. True portfolio diversification is the closest thing to a free lunch in Portfolio Management.
However, this does not discount the use of Tail Risk Hedging.
The implementation of any investment strategy needs to be consistent with client’s investment philosophy, objectives, fee budgets, ability to implement, and risk appetite, including the level of comfort with strategies employed.
Broad portfolio diversification versus Tail Risk Hedging has been an area of hot debate recently. It is good to take in and consider a wide range of views.
The debate between providing portfolio protection (Tail Risk Hedging vs greater Portfolio Diversification) hit colossal proportions earlier in the year with a twitter spat between Nassim Nicholas Taleb, author of Black Swan and involved in Universa Investments, and Cliff Asness, a pioneer in quant investing and founder of AQR.
I provide a summary of their contrasting perspectives to portfolio protection as outlined in a Bloomberg article in this Post. There are certainly some important learnings and insights in contrasting their different approaches.
The Post also covered a PIMCO article, Hedging for Different Market Environments.
A key point from the PIMCO article is that not one strategy can be effective in all market environments. This is an important observation.
Therefore, maintaining an array of diversification strategies is preferred, PIMCO suggest “investors should diversify their diversifiers”.
They provide the following Table, which outlines an array of “Portfolio Protection” strategies.
In Short, and in general, Asness is supportive of correlation based like hedging strategies (Trend and Alternative Risk Premia) and Taleb the Direct Hedging approach.
From the Table above we can see in what type of market environment each “hedging” strategy is Most Effective and Least Effective.
For balance, more on the AQR perspective can be found here.
You could say I have a foot in both camps and are pleased I do not have a twitter account, as I would likely be in the firing line from both Asness and Taleb!
I think we can all agree that fixed income is going to be less of a portfolio diversifier in future and produce lower returns in the future relative to the last 10-20 years.
This is an investment portfolio challenge that must be addressed.
We should also agree that avoiding large market losses is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, ongoing and uninterrupted endowment, or meeting future Pension liabilities.
In my mind, staying still is not going to work over the next 5-10 years and the issues raised by the Institutional Investor.com article do need to be addressed. The path taken is likely to be determined by individual circumstances.
Missing the sharemarket’s five best days in 2020 would have led to a 30% loss compared to doing nothing.
The 2020 covid-19 sharemarket crash provides a timely example of the difficulty and cost of trying to time markets.
The volatility from global sharemarkets has been extreme this year, nevertheless, the best thing would had been to sit back and enjoy the ride, as is often the case.
By way of example, the US S&P 500 sharemarket index reached a historical high on 19th February 2020. The market then fell into bear market territory (a decline of 20% or more) in record time, taking just 16 trading days, beating the previous record of 44 days set in 1929.
After falling 33% from the 19th February high global equity markets bounced back strongly over the following weeks, recording their best 50-day advance.
The benchmark dropped more than 5% on five days, four of which occurred in March. The same month also accounted for four of the five biggest gains.
Within the sharp bounce from the 23rd March lows, the US sharemarkets had two 9% single-day increases. Putting this into perspective, this is about equal to an average expected yearly return within one day!
For all the volatility, the US markets are nearly flat for the period since early February.
A recent Bloomberg article provides a good account of the cost of trying to time markets.
The Bloomberg article provides “One stark statistic highlighting the risk focuses on the penalty an investor incurs by sitting out the biggest single-day gains. Without the best five, for instance, a tepid 2020 becomes a horrendous one: a loss of 30%.”
As highlighted in the Bloomberg article, we all want to be active, we may even panic and sit on the side line, the key point is often the decision to get out can be made easily, however, the decision to get back in is a lot harder.
The cost of being wrong can be high.
Furthermore, there are better ways to manage market volatility, even as extreme as we have encountered this year.
For those interested, the following Kiwi Investor Blog Posts are relevant:
Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or a lasting endowment.
The complexity and different approaches to providing portfolio protection has been highlighted by a recent twitter spat between Nassim Nicholas Taleb and Cliff Asness.
The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.
I provide a summary of this debate in Table format in this Post.
Also covered in this Post is an article by PIMCO on Hedging for Different Market Scenarios. This provides another perspective and a summary of different strategies and their trade-offs in different market environments.
Not every type of risk-mitigating strategy can be expected to work in every type of market environment.
Therefore, maintaining an array of diversification strategies is preferred “investors should diversify their diversifiers”.
Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or an ongoing and uninterrupted endowment.
The complexity and different approaches to providing portfolio protection (tail-risk hedging) has been highlighted by a recent twitter spat between Nassim Nicholas Taleb, author of Black Swan, and Cliff Asness, a pioneer in quant investing.
PIMCO provide a brief summary of different strategies and their trade-offs in diversifying a Portfolio.
They outline four approaches to diversify the risk from investing in sharemarkets (equity risk).
In addition to tail risk hedging, the subject of the twitter spat above between Taleb and Asness, and outlined below, PIMCO consider three other strategies to increase portfolio diversification: Long-term Fixed Income securities (Bonds), managed futures, and alternative risk premia.
PIMCO provide the following Graph to illustrate the effectiveness of the different “hedging” strategies varies by market scenario.
As PIMCO note “it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.”
As they emphasise “not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.”
A brief description of the diversifying strategies is provided below:
Long Bonds – holding long term (duration) high quality government bonds (e.g. US and NZ 10-year or long Government Bonds) have been effective when there are sudden declines in sharemarkets. They are less effective when interest rates are rising. (Although not covered in the PIMCO article, there are some questions as to their effectiveness in the future given extremely low interest rates currently.)
Managed Futures, or trend following strategies, have historically performed well when markets trend i.e. there is are consistent drawn-out decline in sharemarkets e.g. tech market bust of 2000-2001. These strategies work less well when markets are very volatile, short sharp movements up and down.
Alternative risk premia strategies have the potential to add value to a portfolio when sharemarkets are non-trending. Although they generally provide a return outcome independent of broad market movements they struggle to provide effective portfolio diversification benefits when there are major market disruptions. Alternative risk premia is an extension of Factor investing.
Tail risk hedging, is often explained as providing a higher degree of reliability at time of significant market declines, this is often at the expense of short-term returns i.e. there is a cost for market protection.
A key point from the PIMCO article is that not one strategy can be effective in all market environments.
Therefore, maintaining an array of diversification strategies is preferred “investors should “diversify their diversifiers””.
It is well accepted you cannot time markets and the best means to protect portfolios from large market declines is via a well-diversified portfolio, as outlined in this Kiwi Investor Blog Post found here, which coincidentally covers an AQR paper. (The business Cliff Asness is a Founding Partner.)
A summary of the key differences in perspectives and approaches between Taleb and Asness as outlined in Aaron Brown’s Bloomberg’s article, Taleb-Asness Black Swan Spat Is a Teaching Moment.
Defining a tail event
Asness refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index.
Research by AQR shows that steep declines that last three months or less do little or no damage to 10-year returns.
It is the long periods of mediocre returns, particularly three years or longer, that damages longer term performance.
Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. (Black Swan)
Therefore, he is scathing of strategies designed to do well in past disasters, or based on models about likely future scenarios.
The emphasis is not only on surviving the tail event but to design portfolios that have the highest probability of generating acceptable long-term returns. These portfolios will give an unpleasant experience during bad times.
Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. Cash provides a more pleasant outcome and greater options at times of a crisis.
Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.
AQR strategies usually involve leverage and unlimited-loss derivatives.
Taleb believes this approach just adds new risks to a portfolio. The potential downsides are greater than the upside.
AQR responds that Taleb’s preferred approaches are expensive that they don’t reduce risk.
Also, the more successful the strategy, the more expensive it becomes to implement, that you give up your gains over time e.g. put options on stocks
Taleb argues he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk.
Asness argues that investors often adopt Taleb’s like strategies after a severe market decline. Therefore, they pay the high premiums as outlined above. Eventually, they get tire of the paying the premiums during the good times, exit the strategy, and therefore miss the payout on the next crash.
Taleb emphasises the bad decisions investors make during a market crisis/panic, in contrast to AQR’s emphasis on bad decisions people make after the market crisis.
Long-term expected returns from global sharemarkets have not materially changed despite recent sharemarket declines.
The longer term outlook for fixed income returns has deteriorated materially.
There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.
This should prompt some introspection as to the robustness of current portfolios.
From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.
A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term.
By way of example, the expected long-term return from a traditional Balanced Portfolio, of 60% Equities and 40% Fixed Income, is going to be very challenging.
Arguably, the environment for the Balanced Portfolio has worsened, given return forecasts for fixed income and that they are not expected to provide the same level of portfolio diversification as displayed historically.
The strong performance of fixed income is a key contributing factor to the success of the Balanced Fund over the last 20 years. This portfolio plank has been severely weakened.
Asset Class expected forecasted Returns
A clue to future expected returns is outlined in the following Table generated by GMO, which they update on a regular basis.
The Table presents GMO’s 7-Year Asset Class Real Return Forecasts (after inflation of around 2%), as at 31 March 2020.
GMO 7-YEAR ASSET CLASS REAL RETURN FORECASTS
An indication of the impact of recent market performance on future market forecasts can be gained by comparing current asset class forecast returns to those undertaken previously.
The following Table compares GMO’s 7-Year Asset Class Real Returns as 31 March 2020 to those published for 31 December 2019.
The first column provides the 7-Year return forecasts updated as at 31 March 2020. These are compared to GMO’s return forecast at the beginning of the year.
The last column in the Table below outlines the change in asset class forecasted returns over the quarter.
US Fixed Income
International Fixed Income Hedged
Emerging Market Debt
US Balanced (60% Equities / 40% Fixed Income)
The following observations can be made from the Table above:
Although the return outcomes for equities have improved, they remain low, under 2% p.a. after inflation;
Emerging markets equities offer the most value amongst global sharemarkets, generally returns outside of the US are more attractive;
Expected returns from developed market fixed income markets have deteriorated, particularly for the US;
The expected outlook for Emerging Market debt has improved materially over the last three months; and
The return outlook for the Balanced Fund remains disappointing despite an improvement.
Impact of recent market movements on expected returns
The degree to which forecast sharemarket returns have increased may disappoint, particular given the extreme levels of market volatility experienced over the first quarter of 2020.
This in part reflects that global sharemarkets as a group “only” fell 11.5% over the first three months of the year. It probably felt like more.
Furthermore, although declining sharemarkets now translates to higher expected returns in the future, it is not a one for one relationship.
The relationship between current market performance and the impact on forecast returns is well captured by a recent Research Affiliates article.
As they note “When a market corrects dramatically, say, 30%, long-term expected returns do not rise by the same 30%.”
They illustrate this point using the US market (S&P 500 Index).
Research Affiliates estimate that a 30% pullback (drawdown) in the US sharemarket implies an increase in expected return of 1.7% a year for the next decade.
This is based on their assumptions for average real earnings per share over a rolling 10-year period for US companies and their estimate of fair value for the US sharemarket over the longer term. For an estimation of fair value they apply a cyclically adjusted price-to-earnings (CAPE) ratio.
The return estimate is based on the level and valuation of the US sharemarket on the 19th February, when the US market reached a historical high level (Peak).
The interrelationship between current market value, expected earnings, and the estimate of longer term value and their impact on expected returns is captured in the following diagram.
Based on market valuation, as measured by CAPE on 19th February 2020, the right-hand side displays the estimated change in expected returns from a decline in the US sharemarket from the peak in February e.g. a 30% drop in the S&P 500 Index from the Peak translates to a 1.7% change in Expected Return from valuation (change in CAPE).
The central point remains, a drop in the sharemarket today translates into higher expected returns.
The diagram above also captures the changing valuation of the market, as measured by CAPE, to a decline in the US sharemarket, as outlined on the left-hand side.
Research Affiliates long-term expected returns for a wide range of markets can be found on their homepage.
Caution in using Longer-term market forecasts
Forecasting the expected return for sharemarkets is extremely tricky, to say the least, with the likely variation in potential outcomes very widely dispersed.
Forecasting fixed income returns has a higher level of certainty. The current level of interest rates provides a good indication of future returns. Given the dramatic fall in interest rates over the last three months, the expected returns from fixed income has deteriorated.
Nevertheless, caution should be taken when considering longer-term market forecasts.
This is emphasised in the Research Affiliates article, their “expected return forecasts also come with a warning label: Long-term expected returns, unto themselves, are not sufficient for short-term decision making. Ignoring this warning will most likely lead to impaired wealth.
Ten-year return forecasts offer valuable guidance to a buy-and-hold investor about the return they are likely to earn over the next decade. They provide no information, however, about when to buy or sell and do not identify a market top or bottom.”
Challenging Investment Environment
From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.
A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term
There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.
This should prompt some introspection as to the robustness of current portfolios.
It is also partly driving institutional investors to develop more robust portfolios by investing outside of the traditional asset classes of equities and fixed income by increasing their allocations to alternative investments.
As highlighted by a recent CAIA survey investments into alternatives, such as private equity, real assets, and liquid alternatives, are set to grow over the next five years, becoming a bigger proportion of the global investment universe.
Research by AQR highlights that diversifying outside of the traditional asset is the best way to manage through severe sharemarket declines. Furthermore, diversification should work in good and bad times