Evolution within the Wealth Management Industry, the death of the Policy Portfolio

There has been a profound shift in the savings and investment industry over the last 15-20 years.

Changes to accounting rules and regulations have resulted in a large number of corporates closing their defined benefit (DB) pension schemes.

This has resulted in a major shift globally away from DB schemes and to defined contribution (DC) schemes, such as KiwiSaver here in New Zealand.

 

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.

This has been likened to a “financial climate change” by the World Economic Forum.

Couple with an aging population, growing life expectations, and strains on Government sponsored pension/superannuation schemes there is an increasing need for well-designed retirement investment solution.

 

Overarching the above dynamics is the shortcomings of many financial products currently available.

Many Products currently do not provide a stable stream of income in retirement, or if they do, they lack flexibility.

As expressed by EDHEC Risk Institute robust investment solution need to display Flexicurity.

Flexicurity is the concept that individuals need both security and flexibility when approaching retirement investment decisions.

Annuities, although providing security, do not provide any potential upside. They can also be costly, represent an irreversible investment decision, and rarely are able to contribute to inheritance and endowment objectives.

Likewise, modern day investment products, from which there are many to choose from, provide flexibility yet not the security of replacement income in retirement. Often these Products focus solely on managing capital risk at the expense of the objective of generating replacement income in retirement.

Therefore, a flexicure retirement solution is one that provides greater flexibility than an annuity and increased security in generating appropriate levels of replacement income in retirement than many modern day investment products.

 

Retirement Goal

The most natural way to frame an investor’s retirement goal is in terms of how much lifetime replacement income they can afford in retirement.

The goal of most modern investment Products is to accumulate wealth, with the management of market volatility, where risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not provide a sufficient level of income in retirement.

This is a key learning from Australia as they near the end of the “accumulation” phase of their superannuation system. After a long period of accumulating capital a growing number of people are now entering retirement and “de-cumulating” their retirement savings.

A simple example of why there should be a greater focus on generating retirement income in the accumulation phase of saving for retirement is as follows:

A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $32k if they had remained invested in term deposits. That’s a big drop in income, and it will continue to fall as the Reserve Bank undertakes further interest rate reductions over the course of 2019.

This also does not take into account the erosion of buying power from inflation.

Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.

The central point, without a greater focus on generating Income in retirement during the accumulation phase there will likely be a higher level of variation of Income in retirement.

 

The concept of placing a greater focus on retirement income as the investment goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton  in this Posdcast with Steve Chen, of NewRetirement.

Professor Merton highlights that for retirement, income matters, and not the value of Accumulated Wealth.

He also argues that variability of retirement income is a better measure of risk rather than variability of capital.

More robust investment solutions are being developed to address these issues.

 

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

 

The death of the Policy Portfolio

Another important consideration is that investment practices and approaches are evolving. Modern Portfolio Theory (MPT), the bedrock of most current portfolios, was developed in the 1950s. It is no longer that modern!

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements can be made based on the ongoing academic and practitioner research into building more robust investment solutions.

The momentous shift is the move away from the old paradigm of the Policy Portfolio. The Policy Portfolio is the strategic asset allocation of a portfolio to several different asset classes deemed to be most appropriate for the investor.

It is a single Portfolio solution.

Over the last 15-20 years there has been several potential enhancements to the Policy Portfolio approach, including the move away from asset classes and greater focus on underlying “factors” that drive investment returns (Although a separate Post will be published on this development, an introduction to factor investing and its implementation have been covered in previous Posts).

This interview with Andrew Ang on Factor Investing might also be of interest.

 

The focus of this Post, and probably the most significant shift away from the old paradigm, is the realisation that investments should not be framed in terms of one all-encompassing Policy Portfolio, but instead in terms of two distinct reference Portfolios.

The two portfolios as expressed by EDHEC-Risk Institute and explained in the context of a wealth Management solution are:

  1. Liability-hedging portfolio, this is a portfolio of fixed interest securities, that seeks to match future income requirements of the individual in retirement
  2. Performance Seeking Portfolio, this is a portfolio that seeks growth in asset value.

The concept of two separate portfolios is not new, it dates back to finance studies in the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The idea of two portfolios was also recently endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.

 

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

Reasons for the death of Policy Portfolio include that there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.

Furthermore, Investors should be dynamic, they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Therefore, institutional investors are moving toward more liability driven investment solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.

The allocation between the two portfolios is seen as a dynamic process, which responds to the market environment and the changing likelihood of meeting investment goals.

 

Evolution of Wealth Management – the new Paradigm

These “institutional” investment approaches, liability driven investing, portfolio separation, and being more dynamic are finding their way into wealth management solutions.

Likewise, there is a growing acceptance the goal, as outlined above, is to focus on delivering income in retirement. Certainly a greater emphasis should be place on Retirement Income than previously.

Specifically, the goal is to meet with a high level of probability consumption goals in the first instance, and then aspirational goals, including healthcare, old age care and/or bequests.

Therefore, the investment solution should be designed to meet investment goals, as opposed to purely focusing on market risks as a whole, as is the case with the Policy Portfolio.

 

Goal-Based Investing

This new paradigm has led to Goal-Based investing (GBI) for individuals. Under GBI the focus is on meeting investor’s goals, much like liability-driven investing (LDI) is for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  1. Disaggregation of investor preferences into a hierarchical list of goals, with a key distinction between essential and aspirational goals, and the mapping of these groups to hedging portfolios possessing corresponding risk characteristics (Liability Hedging Portfolio).
  2. On the other hand it involves an efficient dynamic allocation to these dedicated hedging portfolios and a common performance seeking portfolio.

 

GBI is consistent with two portfolio approach, fund separation, liability driven investing, and undertaking a dynamic investment approach.

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

The objective of this Portfolio is to secure with some certainty future income requirements. It is typically made up of longer dated high quality fixed income securities, including inflation linked securities.

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

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

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

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals. It will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

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

 

Industry Challenge

The Industry challenge, as so eloquently defined by EDHEC Risk, as a means to address the Pension Crisis as outlined at the beginning of this Post:

“investment managers must focus on the launch of meaningful mass-customized retirement solutions with a focus on generating replacement income in retirement, as opposed to keeping busy with launching financial products ill-suited to the problem at hand”

“……..The true challenge is indeed to find a way to provide a large number of individual investors with meaningful dedicated investment solutions.”

 

As expressed above, saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

Mass-production of Products, rather than Mass-Customisation of Investment Solutions, has been around for many years with the introduction of Unit Trusts/Mutual Funds, and more recently Exchange Traded Funds (ETFs).

Mass-production, and MPT, down play the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

Although the Growth Portfolio would be the same for all investors, the Liability Hedge Portfolio requires a greater level of customisation, it needs to be more “custom-made”.

 

Conclusion

Encouragingly, the limitation of “one size fits all” approach has been known for some time. The investment techniques and approaches are available now to better customise investment solutions.

The challenge, is scalability, and the good news is advancements have been made in this area as well.

This is leading to changes within funds management organisations involving the greater use of technology and new and improved risk management techniques.  New skills sets have been developed.

The important point is that the knowledge is available now and it is expected that such investment solutions will be a growing presence on the investment landscape.

This will lead to better investment outcomes for many and have a very real social benefit.

 

The inspiration for this Post comes from EDHEC Risks short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Balance Funds are not on Target for Default KiwiSaver Investors

Personally I am not convinced with the suggestion of moving KiwiSaver Default Fund Investors into a Balance Fund is the right solution, as was recently promoted in a Stuff article.

It is certainly a bit of a stretch to claim it is a radical idea. Nor is it really something materially different, it is a variation on a current theme – what equity allocation should be targeted.

 

The Balance Fund solution would result in a higher equity allocation, which in theory, and observed in practice over the longer term, will “likely” result in higher savings account balances. This is not guaranteed of course.

On this basis, a higher allocation is more likely to be appropriate for some Default Fund investors but not all. Conceivably it may be more appropriate for more than is currently the case.

Albeit, it is far from an ideal solution.

As noted in the article, it would not be appropriate for those saving for a house deposit, a high equity allocation is not appropriate in this situation. Therefore, there is still a need to provide advice as suggested. Unfortunately, whether it is a Conservative or Balance Fund a level of advice will be required.

A higher equity allocation may not necessarily result in a better outcome for KiwiSaver investors, what happens if an investor switches out of the higher equity weighted fund just after a major market correction as they cannot tolerate the higher level of market volatility. It may take years to get back to their starting position. Over the longer term, they may have been better off sticking with a more Conservative Fund. This is a real risk given a lack of advice around KiwiSaver.

This is also a real risk currently given both the New Zealand and US sharemarket have not had a major correction in over 10 years and both are currently on one of their best performance periods in history.

A higher level of volatility may result in pressure on the Government to switch back to a more conservative portfolio at a later date. A variation on the above individual situation which would likely occur at exactly the wrong time to make such a change in an equity allocation.

 

A more robust investment solution is required.

 

A possible Solution?

Perhaps the solution, and some may argue a more radical and materially different approach, is to introduce Target Date Funds as the Default Fund KiwiSaver solution.

Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement. Administratively it is more complex for the Providers, as many different Funds are required, as is a higher level of oversight.

Target Date Funds adjust the equity allocation on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through salary and wages. These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy. This is a generalisation and does not take into consideration the individual circumstances of the investor nor market conditions.

Target Date Funds are becoming increasingly popular overseas e.g. the US and Australia. Particularly in situations where the Investor does not want or cannot afford investment advice. The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice is provided.

 

All good in theory, nevertheless, these products have some limitations in their design which is increasingly being highlighted.

Essentially, Target Date Funds have two main short comings:

  1. They are not customised to an individual’s circumstances e.g. they do not take into consideration future income requirements, likely endowments, level of income generated up to retirement, or risk profile.
    • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  2. Additionally, the equity allocation glide path does not take into account current market conditions.
    • Risky assets have historically shown mean reversion i.e. asset returns eventually return back toward the mean or average return
    • Therefore, linear glide paths, as employed by most Target Date Funds, do not exploit mean reversion in assets prices which may require:
      • Delays in pace of transitioning from risky assets (equities) to safer assets (cash and fixed income);
      • Stepping off the glide path given extreme market risk environments

The failure to not make revisions to asset allocations due to market conditions is inconsistent with academic prescriptions and common sense, both suggest that the optimal strategy should display an element of dependence on the current state of the economy.

The optimal Target Date Fund asset allocation should be goal based and multi-period:

    • It requires customisation by goals, of human capital, and risk preferences
    • Some mechanism to exploit the possibility of mean reversion within markets

 

To achieve this the Investment Solution requires a more Liability Driven Investment approach: Goals Based Investing.

Furthermore, central to improving investment outcomes, particularly most current Target Date Funds and eliminating the need for an annuity in the earlier years of retirement, is designing a more suitable investment solution in relation to the conservative allocation (e.g. cash and fixed income) within a Target Date Fund.

From this perspective, the conservative allocations within a Target Date Fund are risky when it comes to generating a secure and stable level of replacement income in retirement. These risks are not widely understood nor managed appropriately.

The conservative allocations within most Target Date Funds can be improved by matching future cashflow and income requirements. While also focusing on reducing the risk of inflation eroding the purchasing power of future income.

This requires moving away from current market based shorter term investment portfolios and implementing a more customised investment solution.

The investment approach to do this is readily available now and is based on the concept of Liability Driven Investing applied by Insurance companies, called Goal Based Investing for investment retirement solutions. #Goalbasedinvesting

 

Many of the overseas Target Date Funds address the shortcomings outlined above, including the management of the equities allocation over the life cycle subject to market conditions.

This is relevant to improving the likely outcome for many in retirement. This knowledge is helping make finance more useful again, in providing very real welfare benefits to society. #MakeFinanceUsefulAgain

 

As we know, holding high Cash holdings at retirement is risky, if not scandalous.

We need to be weary of rules of thumb, such as the level of equity allocation based on age and the 4% rule (which has been found to be insufficient in most markets globally).

We also need to be weary of what we wish for and instead should actively seek more robust investment solutions that focus on meeting Clients investment objectives.

 

This requires a Goals Based Investment approach and an investment solution that displays “flexicurity”. This is an investment solution that provides greater flexibility than an annuity and increased security in generating appropriate levels replacement income in retirement than many modern day investment products.

This is not a radical concept, as discussed above the investment frameworks, techniques, and approaches are currently available to achieve better investment outcomes for Default KiwiSaver investors.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

One Year Anniversary

Kiwi Investor Blog is one year old.

My top three articles for the year would be:

Investment Fees and Investing like an Endowment – Part 2

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

 

A Robust Framework for generating Retirement Income

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

 

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

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

 

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

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

 

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

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

Flexicure is my word of 2018.

 

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Best Portfolio Does Not Mean Optimal Portfolio

The best portfolio is not necessarily the optimal portfolio.

As this thought-provoking article by Joachim Klement, CFA, highlights, “In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given investor. Or to recall a quote variously attributed to Albert Einstein, Yogi Berra, and Richard Feynman, among others: “In theory, there is no difference between theory and practice, while in practice there is.””

The article highlights the shortcomings of a portfolio optimisation approach. No surprises there!

Nevertheless, a key point made in the article is that many people in a Trustee or Fiduciary role see the portfolio optimisation process as a black-box exercise which is full of assumptions.

If true, this can be a challenge, particularly for those presenting the results and “the client never understands how these assumptions lead to the proposed allocation”.

I am sure this occurs to varying degrees and as a result there is a real risk that there is not a good understanding of the purpose of each investment allocation within the portfolio.

This often leads to the most pertinent point made in the article:

“But since clients do not grasp the purpose of each investment in the context of the overall portfolio, they are more likely to give up on the portfolio, or parts of it, in times of trouble. As a result, the best portfolio is not the optimal portfolio, but rather the one that the client can stick with through the market’s ups and downs. This means reframing the role of different asset classes or funds relative to the investor’s goals and sophistication rather than to volatility and return.”

 

Exactly. Reframing the role of the different asset classes can be achieved by taking the discussion away from the largely two-dimensional world of an optimal portfolio, market risk and return, and focusing instead on how the allocations will help meet a client’s investment goals over time.

Therefore, we can move beyond the Markowitz portfolio (the basis of Modern Portfolio and the “Optimal” Portfolio).  This is not to diminish the Markowitz optimal portfolio and the benefits of diversification, the closest thing to a free lunch in investing. Markowitz also placed a number on risk through the variance of returns.

Nevertheless, variance of return may not be an appropriate measure of risk. Other measures of volatility can be used, just as more sophisticated portfolio optimisation approaches can be implemented. Neither of which would address the key issues of the article as outlined above. In fact, they may compound the issues, particularly the black-box nature of the process.

Other measures of risk should be considered, the most important risk being failure to meet one’s investment objectives.

If your investment goal is to optimise risk and return the “optimal” portfolio is likely to be the “best” portfolio. Albeit, I am not sure this is the primary objective for most individuals and companies. For example, other investment objectives may include liquidity, income/cashflow generation, endowments. (I also don’t think the most optimal equities portfolio is the best portfolio, there are other risks to consider e.g. liquidity and concentration risk which would mean moving away from the optimal portfolio.)

There are personal and aspiration risks to take into consideration e.g. ability to weather large loses. There could be investment goals with different time periods – the optimal portfolio is generally for a single period, not multi-periods.

This is not to say don’t use an optimisation approach, it is a good starting point. Albeit, the portfolio allocation will likely need to be adjusted to take into consideration a wider set of investment objectives, risk tolerances, and behavioural factors. I would have thought this is standard practice.

 

Expanding the discussion with the client will help identify a more robust portfolio and increase the understanding of the role of each allocation within the Portfolio.

In effect, a more customising investment solution will be generated, rather than a mass-produced product.

As noted in the article, reframing the role of different asset classes within a portfolio relative to the investor’s goals and the sophistication of the client rather than to volatility and return will likely result in better outcomes for clients.

Such an approach is consistent with Liability Driven Investment (LDI), where the liabilities are matched with predictable cashflows and the excess capital is invested in a growth/return seeking portfolio, which would include the likes of equities.

Such an approach is also consistent with a Goal Based Investing approach for individuals.

It is also more consistent with a behavioural bias approach.

 

As the paper concludes:

“In my experience, such behavioral approaches to portfolio construction work much better in practice than black box “optimal portfolios.”

“Consultants, portfolio managers, and wealth managers who take their fiduciary duty seriously should seriously consider ditching their “optimal portfolios” in favor of these theoretically less optimal but practically more robust solutions.”

“Because you are not acting in the client’s best interest if you build them a portfolio that they won’t stick with over the long term.”

 

The above would resonate with most investment professionals I know, yet strangely it does not appear to be “conventional” wisdom. Perhaps ditch is to stronger a word, too provocative.

It would be hard to argue with implementing a more practical and robust solutions aligned with a wider set of investment objectives is not in the best interest of clients, particularly if they are able to stay with the investment strategy over the longer term.

 

Referenced in the article is the work undertaken by Ashvin Chhabra, Beyond Markowitz. This work is well worth reading. Essentially he frames the investor’s risks as being:

  • Personal Risk – e.g. the risk of not losing too much that would impact on life style, this supports the safety first type portfolio
  • Market Risk – e.g. risk within the investment
  • Aspirational risk – e.g. taking risks to achieve a higher standard of living

 

This would is a great framework for a Wealth Management / Financial Planning process. Of note, market risk is only one component.

Lastly, the concept of a single Optimal Portfolio is far from the likely solution under this framework.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

The Regret Proof Portfolio

Based on analysis involving the input of Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.

Insurance companies regularly implement a two-portfolio approach as part of their Liability Driven Investment (LDI) program: a liability matching portfolio and a return seeking portfolio.

It is also consistent with a Goal Based Investing approach for an individual: Goal-hedging portfolio and a performance seeking portfolio. #EDHEC

Although there is much more to it than outlined by the article below, I find it interesting the solution of two portfolios came from the angle of behavioural economics.

I also think it is an interesting concept given recent market volatility, but also for the longer-term.

 

Background Discussion

Kahneman, discussed the idea of a “regret-proof policy” at a recent Morningstar Investment Conference in Chicago.

“The idea that we had was to develop what we called a ‘regret-proof policy,’” Kahneman explained. “Even when things go badly, they are not going to rush to change their mind or change and to start over,”.

According to Kahneman, the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are “really not the same.”

In developing a “regret-proof policy” or “regret minimization” Portfolio allows advisors to bring up “things that people may not be thinking of, including the possibility of regret, including the possibility of them wanting to change their mind, which is a bad idea generally.”

 

In developing a regret proof portfolio, they asked people to imagine various scenarios, generally bad scenarios, and asked at what point do you want to bail out or change your mind.

Kahneman, noted that most people — even the very wealthy people — are extremely loss averse.

“There is a limit to how much money they’re willing to put at risk,” Kahneman said. “You ask, ‘How much fortune are you willing to lose?’ Quite frequently you get something on the order of 10%.”

 

Investment Solution

The investment solution is for people to “have two portfolios — one is the risky portfolio and one is a much safer portfolio,” Kahneman explained. The two portfolios are managed separately, and people get results on each of the portfolios separately.

“That was a way that we thought we could help people be comfortable with the amount of risk that they are taking,” he said.

In effect this places a barrier between the money that the client wants to protect and the money the client is willing to take risk on.

Kahneman added that one of the portfolios will always be doing better than market — either the safer one or the risky one.

“[That] gives some people sense of accomplishment there,” he said. “But mainly it’s this idea of using risk to the level you’re comfortable. That turns out to not be a lot, even for very wealthy people.”

 

I would note a few important points:

  1. The allocation between the safe and return seeking portfolio should not be determined by risk profile and age alone. By way of example, the allocation should be based primarily on investment goals and the client’s other assets/source of income.
  2. The allocation over time between the two portfolios should not be changed based on a naïve glide path.
  3. There is an ability to tactically allocate between the two portfolios. This should be done to take advantage of market conditions and within a framework of increasing the probability of meeting a Client’s investment objectives / goals.
  4. The “safer portfolio” should look more like an annuity. This means it should be invested along the lines that it will likely meet an individual’s cashflow / income replacement objectives in retirement e.g. a portfolio of cash is not a safe portfolio in the context of delivering sufficient replacement income in retirement.

 

Robust investment solutions, particularly those designed as retirement solutions need to display Flexicurity.   They need to provide security in generating sufficient replacement income in retirement and yet offer flexibility in meeting other investment objectives e.g. bequests.  They also need to be cost effective.

The concepts and approaches outlined above need to be considered and implemented in any modern-day investment solution that assists clients in achieving their investment goals.

Such consideration will assist in reducing the risk of clients adjusting their investment strategies at inappropriate times because of regret and the increased fear that comes with market volatility.

Being more goal focussed, rather than return focused, will help in getting investors through the ups and downs of market cycles. A two-portfolio investment approach may well assist in this regard as well.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Future trends in ETFs are rather daunting. Are you prepared?

The recent survey by EDHEC-Risk Institute (EDHEC) of European professional investors into their practices, perceptions and future plans for investing into Exchange Trade Funds (ETF) is of interest and well worth reading.

The survey gathered information from 163 European investment professionals. Respondents to the survey were high-ranking professionals within their respective organisations, representing firms with large assets under management (36% of respondents represent firms with assets under management exceeding €10bn). Respondents to the survey are from the United Kingdom, European Union, Switzerland, and a small sample from other countries outside the European Union.

 

What is the dominant purpose of ETF usage?

The survey results clearly indicate that the current usage of ETFs is dominated by a truly passive investment approach. “Despite the possibilities that ETFs offer – due to their liquidity – for implementing tactical changes, they are mainly used for long-term exposure.”

Gaining broad market exposure remains the main focus of ETF users – 71% of respondents use ETFs to gain broad market exposure, versus 45% who use ETFs to obtain specific sub-segment exposure (sector, style).

“In line with this expression of conservatism in their use of ETFs, which is mainly focused on traditional passive management, it can also be noted that investors are largely satisfied by ETFs in traditional asset classes but more reserved about ETFs for alternative asset classes”

 

What are the future growth drivers?

The European ETF market has seen tremendous growth over the past decade or so. At the end of December 2017, the assets under management (AUM) within the 1,610 ETFs constituting the European industry stood at $762bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2017).

“A remarkable finding from our survey is that a high percentage of investors (50%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates.”

Why? lowering investment cost is the primary driver behind investors’ future adoption of ETFs for 86% of respondents in 2018 (which is an increase from 70% in 2014).

Interestingly, EDHEC find investors are not only planning to increase their ETF allocation to replace active managers (70% of respondents in 2018), but are also seeking to replace other passive investing products through ETFs (45% of respondents in 2018).

 

How do investors select ETFs?

Cost and quality of replication. Both of which are more easy to identify from a quantitative perspective.

EDHEC argue” Given that the key decision criteria are more product-specific and are actually “hard” measurable criteria, while “soft” criteria that may be more provider-specific have less importance, competition for offering the best products can be expected to remain strong in the ETF market. This implies that it will be difficult to build barriers of entry for existing providers unless they are related to hurdles associated with an ability to offer products with low cost and high replication quality.”

 

A section I found more interesting:

What are the Key Objectives Driving the Use of Smart Beta and Factor Investing Strategies?

EDHEC find that “the quest for outperformance is the main driver of interest in smart beta and factor investing. In fact, 73% of respondents agree that smart beta and factor investing indices offers significant potential for outperformance”

The most important motivation behind adopting such strategies is to improve performance.

Interestingly they find that the actual implementation of such strategies is still at an early stage

EDHEC found that among those respondents who have made investments in smart beta and factor investing strategies, these investments typically made up only a small fraction of portfolio holdings.

“More than four-fifths of respondents (83%) invest less than 20% of their total investments in smart beta and factor investing strategies and only 11% of respondents invest more than 40% of their total investments in smart beta and factor investing strategies”

As they say, ”It is perhaps surprising that almost a decade after the influential report on Norway’s Sovereign Wealth Fund (see Ang, Goetzmann and Schaefer, 2009), which emphasised the benefits of factor investing for investors, adoption of such an approach remains partial at best.

 

Not surprisingly, those that use factor strategies, the use of them is not related to factor timing and more to extracting the long term premia from the factors.

 

In relation to fixed interest, “17% of the whole sample of respondents already use smart beta and factor investing for fixed-income. Some 80% of this sub-sample of respondents invest less than 20% of their total investment in smart beta and factor investing for fixed-income.”

It appears that respondents show a significant interest for smart beta and factor investing for fixed-income. The interest appears to be there, but likelihood of implementation not so much.

Interestingly, from responses “it thus appears that investors are doubtful that research on factor investing in fixed-income is sufficiently mature at this stage. Given the strong interest in such strategies indicated by investors, furthering research in fixed-income factor investing is a promising venture for the industry.”

 

The survey looked into a number of other areas, for example do investors have the necessary information to evaluate smart beta and factor investing strategies? What requirements do investors have about smart beta and factor investing strategy factors?

 

Future Developments

What are investor expectations for further development of ETF products?

The following areas where identified as potential are of further ETF product development:

  • Ethical/Socially Responsible Investing (SRI) ETFs,
  • emerging market equity ETFs and emerging market bond ETFs,
  • ETF indices based on smart beta and on multi-factor indices, EDHEC note that more than two-fifths of the respondents want further developments in at least one of the categories related to smart beta equity or factor indices. “This shows that the development of ETFs based on advanced forms of equity indices is now by far the highest priority for respondents.”……… “We also note that additional demand for ETFs based on smart bond indices is not so far behind”…..

 

Fixed Income and Alternatives

The survey results indicate that respondents desire further development in the area of fixed income and alternative asset classes.

Also there is an increased interest in integration of ESG in smart beta and factor investing, and strategies in alternative asset classes.

“So, there is still a lack of products when it comes to asset classes other than equity, and this lack is particularly critical for the fixed-income asset class, which is largely used by investors.”… “It is likely that the development of new products corresponding to these demands may lead to an even wider adoption of smart beta and factor investing solutions.”

  

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Trustees should be aware of the shocking cost of timing markets and what is the best solution

Cambridge Associates recently published a research report concluding it does not pay to be out of the market.

” Investors who take money out of the market too early stand to “risk substantial underperformance,”

Cambridge advised investors concerned about the length of the current bull market not to bail out of equity markets earlier than necessary in an attempt to avoid exposure to downturns.

This seems timely given current market volatility.

As the article notes, it is hard to time markets “because trying to time re-entry to get back into the markets at lower levels leads to substantially lower long-term returns, the researchers found. For example, the report showed that being out of the market for just the two best quarters since the turn of the last century cut cumulative real returns on U.K. equities by more than 50 percent.”

“That effect is even more profound in the United States, where sitting out the best two quarters cut cumulative real returns by more than two thirds, according to the report.”

“While no investor should be ignoring valuations, becoming too focused on timing an exit has substantial risks,” said Alex Koriath, head of Cambridge’s European pensions practice, in a statement accompanying the research. “The best periods for returns tend to be very concentrated, meaning that exiting at the wrong time could drag down cumulative returns significantly.”

 

This is a pertinent issue given the US sharemarket is into its longest bull market run in history. Also, of interest, historically on average, markets perform very strongly over the final stages of a bull market run. Lastly, bull markets tend to, more often than not, end six-twelve months prior to a recession. Noting, this is not always the case. Albeit, the consensus is not forecasting a recession in the US for some time. It appears, the probability of a US recession in the next couple of years is low.

The key forward looking indicators, such as shape of the yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US. Please see my earlier posts History of Sharemarket corrections – An Anatomy of equity market corrections

 

What is the answer?

It is difficult to time markets. AQR came to a similar conclusion in a recent article. AQR argue the best form of defence is a truly diversified portfolio. I agree and this is a core focus of this Blog.

As we know equity markets have drawdowns, declines in value of over 20%. In the recent AQR article they estimate that there have been 11 episodes of 20% plus drawdowns since 1926, a little over once every 10 years! Bearing in mind the last major drawdown was in 2008 – 09.

The average peak to trough has been -33% and on average it has taken 27 months to get back to the pre-drawdown levels.

As AQR note, we cannot consistently forecast and avoid these severe down markets. In my mind, conceptually these drawdowns are the risk of investing in equities. With that risk, comes higher returns over the longer term relative to investing in other assets.

At the very least we can try and reduce our exposure by strategically tilting portfolios, as AQR says, “if market timing is a sin, we have advocated to “sin a little””.

 

I agree with the Cambridge Associates article to never be out of the market completely and with AQR to strategically tilting the portfolio. These tilts should primarily be based on value, be subject to a disciplined research process, and focused more on risk reduction rather than chasing returns. This approach provides the opportunity to add value over the medium to longer term.

 

Nevertheless, by far a better solution is to truly diversify and build a robust portfolio. This is core to adding value, portfolio tilting is a complementary means of adding value over the medium to long term relative to truly diversifying the portfolio.

True diversification in this sense is to add investment strategies that are lowly correlated with equities, while at the same time are expected to make money over time. Specifically, they help to mitigate the drawdowns of equities. For example, adding listed property and listed infrastructure to an equity portfolio is not providing true portfolio diversification.

In this sense truly “alternative” investment strategies need to be considered e.g. Alternative Risk premia and hedge fund type strategies. Private equity and unlisted assets are also diversifiers.

Again conceptually, there is a cost to diversifying. However, it is the closest thing in finance to a free lunch from a risk/return perspective i.e. true portfolio diversification results a more efficient portfolio. Most of the diversifying investment strategies have lower returns to equities. There are costs to diversification whether using an options strategy, holding cash, or investing in alternative investment strategies as a means to reduce sharp drawdowns in portfolios.

Nevertheless, a more diversified portfolio is a more robust portfolio, and offers a better risk return outcome.

Also, very few investor’s objectives require to be 100% invested in equities. For most investors a 100% allocation to equities is too volatile for them, which raises the risk that investors act suboptimal during periods of market drawdowns and heightened levels of market volatility i.e. sell at the bottom of the market

 

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

As AQR note, diversification is not the same thing as a hedge. Uncorrelated means returns are influenced by other risks. They have different return drivers.

From this perspective, it is also worth noting that adding diversifying strategies to any portfolio means adding new risks. The diversifiers will have their own periods of underperformance, hopefully this will be at a different times to when other assets in the portfolio are also underperforming. Albeit, just because they have periods of underperformance does not mean they are not portfolio diversifiers.

AQR perform a series of model portfolios which highlight the benefits of adding truly diversifying strategies to a traditional portfolio of equities and fixed interest.

No argument there as far as I am concerned.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

For those with a real focus on retirement income solutions

Great to see EDHEC pick up on my recent post on Target Date Funds (Life Cycle Funds).  Monkey Claw – be careful what you wish for.

I have considerable appreciation for EDHEC’s approach to applying goal-based investing principles to the retirement problem.  This makes a lot of sense given my insurance (liability backing) investing background.

Their focus on the need for more robust retirement solutions based on Goal Based Investing is so critical.

 

EDHEC’s and the thoughts of Professor Robert Merton, as outlined in my previous Posts of focusing on income and the volatility of income, are important concepts that will have an immediate and lasting contribution and impact on the ongoing shape of retirement solutions.

As EDHEC outlines, we need investment solutions that provide the certainty of Annuities but with more flexibility.  This is the industry challenge.  

 

EDHEC’s and Merton’s work, analysis, and insights have an important and fundamental contribution to the building of more robust retirement solutions that should be considered by anyone working in this area.

 

Happy investing.

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

 

Please see my Disclosure Statement

 

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

I have written previously about the short comings of Target Date Funds (TDF). They would certainly benefit from the inclusion of Alternative investment strategies.

Nevertheless, this is not to dismiss them. TDF have some notable advantages e.g. they have an inbuilt advice model. TDF automatically de-risk the portfolio with the age of the investor by down weighting the equity allocation and increasing the allocation to cash and fixed interest. This is attractive to those who are unable to afford investment advice or are not interested in seeking investment advice.

Nevertheless, it is important to understand their short comings given their growing dominance international. (According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.”

Locally, TDF have also been raised as a possible addition to the KiwiSaver landscape as a Default Fund option. They are very much part of the investment landscape in Australia.

 

In my mind TDF don’t address the inherit weaknesses of current investment products that overly simplify the retirement investment solution by focusing on:

  • Accumulated wealth as the primary goal; and a
  • Formulaic (prescribed) approach of adjusting allocations to equities over the period up to retirement based on age.

 

TDF may not be the investment solution that addresses key retirement issues, just as Annuities are also not the solution.   Arguably, TDF don’t have an investment objective.

A more goal orientated investment approach is required.

Improvements in the investment solution and a more robust portfolio can be developed by engaging in a more goal orientated investment approach that:

  • Has a focus on the generation of retirement income as an investment goal; and
  • Employs a more sophisticated cash and fixed interest solution that generates a more stable level of retirement income (much like insurance companies employ to meet future liabilities (insurance claims).

 

The investment knowledge is available now to implement these investment solution enhancements.

This new approach will bring more rigor to the investment strategy and a move away from rules of thumbs such as the 4% Rule and adjusting the equity allocation based on age alone.

 

At the centre of a more robust approach is the focussing on the generation of retirement income.

Accumulated wealth is important, you can say you are rich with a million-dollar investment portfolio.

However, this million-dollars does not tell you the standard of living you may be able to support in retirement. Some may well say a very good one! And that may well depend on whether you live in Auckland or Gore.

How about the volatility of income in retirement?

By way of example, prior to the Global Financial Crisis (GFC) a New Zealand investor could get 7-8% on cash at the bank, lets say $70k in income on your million dollar investment.

Current term deposit rates are around 3.5%, that’s a 50% fall in income!! And interest rates have been at these levels for some time and if the Reserve Bank of New Zealand is right they will continue to remain at these levels for some time.

 

Of course, these issues are not the concern of the ultra-wealthy. They are nevertheless vitally important for the less wealthy. They could have a detrimental impact on the standard of living in retirement for many people.

Furthermore, with an income focus, as interest rates rise (they will some day!) more informed investment decisions can be made and importantly investment strategies can be undertaken to help minimise the volatility of income in retirement.

 

Therefore, we should not just focus on the generation of retirement income as the investment goal but also consider how we can manage the volatility of income in retirement. As I say, the knowledge to do this is already available.

 

I have recently written a Post on why focus on Income and one on why focus on the volatility of Income.

 

This FT article on the short comings of TDF may be of interest.

 

The article highlights the risk to the industry.

 

The following section of the FT article is most relevant to the discussion above:

…….. “This underscores the importance of crafting investment products that generate sustained income for retirees, says Lionel Martellini, a professor at Edhec currently seconded to Princeton.

Prof Martellini says the key shortcoming with target date funds the group has identified is the fact that the bond allocation, intended to be the safe portion of the portfolio, is often risky. This risk hinges on the fact that bond portfolios offer — but do not guarantee — income, according to the researchers.

The fixed income allocation should look more like an annuity, Prof Martellini says, a financial product that pays a steady stream of income to the holder. But it must avoid the pitfalls of annuities, namely a lack of flexibility that means they cannot be passed on to a next of kin, for example.

“That’s what we’re talking about — a bond portfolio that is a good proxy for the cash flow that people need. Such a simple move will add a large benefit to how much replacement income you can generate,” Prof Martellini says. Critics say target date funds fail to achieve this because their fixed income portfolios are composed of short-term bonds that are beholden to market risks and do not take into account retirees’ different income expectations.” ………………..

 

The final comments are consistent with the point made above with having a more sophisticated cash and fixed interest investment solution.

 

Happy investing.

 

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

Please see my Disclosure Statement

What matters for Retirement is Income not the value of Accumulated Wealth

This is the first of two Posts on why a greater focus should be placed on generating a level of income in retirement as an investment goal.

This Post outlines why income matters as an investment goal and the second Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

A greater focus on income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.

The rationale for the focus on income is provided below.

The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length, full of great conversation about retirement income, and well worth listening to.

 

During the Podcast discussion on why the focus should be on income and not accumulated wealth a definition of the standard of living in retirement needed to be determined.

From this perspective, Merton argues a standard of living in retirement is better defined as an amount of income, not a pot of money (accumulated wealth).

He argues the focus on income is consistent with what the Government provides you in retirement, a level of income. It is also much like a Defined Benefit where a level of income is provided and not a pot of money.

Also, the concept of income is easier to understand. You can see how rich I am with X amount of capital, but when converted to income that can be generated from that capital one can quickly see that the amount of capital may not be sufficient to support a desired standard of living in retirement. This is a key point.

Merton makes a strong case income is what matters in retirement and not how big your pot of money is.

As he says, people say, “If I have enough money, I’ll get the income. It will be fine.”

This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

Merton provides an example: twelve years ago in the US, if you had a million dollars you could generate $50k in interest, three years ago you could get a tenth of 1%, an income of $1k per million.

You’ve lost 98% of your income. As Merton says, what would you do if I lost 98% of your wealth!

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

Merton is more direct with the following: “Let’s be clear the goal, the purpose for retirement. Not for the silly other things but for retirement is a stream of income sufficient to sustain a standard living and that standard of living is measured by income.”

“Just knowing the amount of money you have doesn’t tell you how you can live. That’s the message and we have to get that clear both so that savers and people in plans are trying to figure out how they’re doing. We need to tell them the amount they can buy as an indicator of how close to where they are.”

What Merton is saying here, is we should let people know what level of income can be generated from their pot of money. This provides a better measure and insight as to how they are placed for retirement.

Further to this point, volatility of accumulated wealth is not a good measure of how well we are doing.

More importantly, we should focus on the volatility of expected income in retirement, not current volatility of capital. This is covered in the next Post – What matters for retirement is income not the value of Accumulated Wealth – Focus on likely variability of Income not variability of Capital

For the time being: “What matters for retirement is income not the value of the pot of money” Merton.

The investment knowledge is currently available to design investment solutions that can better meet client’s income requirements in retirement to support the standard of living they wish to attain. It will result in the implementation of different investment strategies based in Liability Driven Investing (Goal Based Investing). A more Robust Retirement Income Solution is required.

The benefit being, there will be an increased likelihood that investment outcomes are more consistent with Client’s retirement objectives.

 

Happy investing.

 

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

 

Please see my Disclosure Statement