New Zealand Investment Strategy ideas

Investment strategies for the year(s) ahead – how to add value to a portfolio

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At this time of the year there are a plethora of economic and market forecasts for next year.  This Post is not one of them.

Outlined below are several investment strategies investors should consider in building more robust portfolios for the years ahead and to increase the odds of meeting their investment objectives.

These strategies directly address the current investment environment and the developing theme over 2020 that the traditional Balanced portfolio, of 60% equities and 40% fixed income, is facing several head winds, and likely to disappoint from a return perspective in the decade ahead.

A recent FT article captures this mood, titled: Investors wonder if the 60/40 portfolio has a future | Financial Times

In the article they make the following comment “The traditional 60/40 portfolio — the mix of equities and bonds that has been a mainstay of investment strategy for decades — is at risk of becoming obsolete as some investors predict years of underperformance by both its component parts.”

I first Posted about the potential demise of the Balanced Portfolio in 2019, see here, and again in early 2020, see here.   These Posts provide background as too why many investment professionals are questioning the likely robustness of the Balance Portfolio in the years ahead given the current investment environment.

In essence, there are two themes presented for the bleak outlook for the Balanced Portfolio.

The first is that fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest in these markets.

The second theme is that with interest rates at very low levels, there is doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.

For more on the low expected return environment, first Theme, see these Posts here and here.  This Post also outlines that although markets fell sharply in March 2020, forecast future returns remain disappointing.

The strategies discussed below address the second theme, the expected reduced effectiveness of fixed income to protect the Balance Portfolio at the time of severe sharemarket declines.

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

The strategies outlined below are “the more that can be done“, they aim to improve the risk and return outcomes for the Balance Portfolio in the years ahead.

For the record, I anticipate the global economy to continue to repair next year, experiencing above average growth fuelled by the roll out of the Covid-19 vaccines and underpinned by extraordinary low interest rates and generous government spending programs.  Global equities will continue to perform well in this environment, the US dollar will weaken further, commodity prices will move higher, value and emerging markets to outperform.

The Case for holding Government Bonds

Before looking at some of the strategies to improve on the Balance Portfolio, it goes without saying there is a role for equities in most portfolios.  The case for and against US equities are found here and here respectively.

There is also a role for holding Fixed Income securities, primarily government bonds.

This Post reviews some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It also brings some balance to present discussions around fixed income and the points within should be considered when determining portfolio allocations in the current market environment.

The central argument for holding government bonds within a portfolio: 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.

In a recent Financial Times article PIMCO argues the case for the 60/40 portfolio in equities and fixed income.   

In relation to fixed income they argue, that although “returns over the horizon may be harder to achieve, but bonds will still play a very important role in portfolios”.  The benefits being diversification and moderation of portfolio volatility.

However, they argue in relation to fixed income investors must target specific regions and parts of the yield curve (different maturity dates) to maximise return and diversification potential.

PIMCO see opportunities in high-quality assets such as mortgage-backed securities from US government agencies, areas of AA and AAA rated investment-grade corporate bonds, and emerging market debt that is currency hedged.

They conclude: “One answer for 60/40 portfolio investors is to divide fixed-income investments into two subcomponents — hedging and yield assets.”

Rethinking the “40” in the 60/40 Portfolio

This Post outlines a thinkadvisor.com article which provides a framework to consider potential investment ideas in the current extremely low interest rate environment, by examining the 40% fixed income allocation within the 60/40 Portfolio (Balanced Portfolio).

The basis of the article is that 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. This likely involves investing into a broader array of fixed income securities, dividend-paying equities, and alternatives, such as real assets and private credit.

The Role of Liquid Alternatives and Hedge Funds

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 next decade.

Not only will this help in increasing the odds of meeting investment objectives, but it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility, a role traditionally played by fixed income within a multi-asset portfolio.

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.

AQR has evaluated the effectiveness of diversifying investments during market drawdowns.

They recommend adding investments that make money on average and have a low correlation to equities i.e. liquid alternatives and hedge fund type strategies. 

AQR argue diversification should be true in both normal times and when most needed: during tough periods for equities.  Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, they tend to do worse on average over the longer term.

Alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and have higher returns.

Lastly, Portfolio diversification involves adding new “risks” to a portfolio, this can be hard to comprehend.  Diversification can be harder to achieve in practice than in theory.

This Post provides a full summary and access to the AQR article.

The case for Trend (momentum) Strategies

A sub-set of Alternatives and hedge funds is Trend/Momentum.

In this recent article MAN present the benefits of introducing Trend following strategies to the traditional Balanced Portfolio. Man note, “Another element that we believe can be of great help to bond-equity portfolios in the future is time-series momentum, or trend-following.”

Their analysis highlights that adding trend-following results in a significant improvement relation to the Balanced Portfolio, by improving returns, decreases volatility, and reducing the degree of losses when experienced (lower downside risk – drawdowns).

The case for Tail Risk Hedging

The expected reduced diversification benefits of fixed income in a Portfolio is a growing view among many investment professionals.

This presents a very important portfolio construction challenge to address, particularly for those portfolios with high allocations to fixed income.

There are many ways to approach this challenge,

This Post focuses on the case for Tail Risk Hedging.  It also outlines other approaches.

In my mind, investment strategies to address the current portfolio challenge need to be considered. The path taken is likely to be determined by individual circumstances.

Comparing a diversified approach versus Tail Risk Hedging

On this note, the complexity, and different approaches to providing portfolio protection, was highlighted by a twitter spat between Nassim Nicholas Taleb (Tail Risk Hedging) and Cliff Asness (broad Portfolio Diversification) from earlier in the year.

I provide a summary of this debate in Table format accessed in this Post, based on a Bloomberg article. 

Several learnings can be gained from their “discussion”.

Also covered the Post was 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”.

Hedge Funds vs Liquid Alternatives – both bring diversification benefits to a traditional portfolio say Vanguard

Vanguard recently concluded that investors should carefully consider liquid alternatives and hedge funds.

This is a very good article presenting the benefits Alternatives would bring to a Balanced Portfolio.

Their research highlighted that Hedge Funds and Liquid Alternatives both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest that liquid alternatives are often viable options for investors compared to hedge funds.

Although hedge funds and liquid alternatives deliver valuable portfolio diversification benefits, “it is crucial that investors assess funds on a standalone basis, as the benefits from any alternative investment allocation will be dictated by the specific strategy of the manager(s).”

The most important feature in gaining the benefits of hedge funds and liquid alternatives is manager selection.  Implementation is key.

Access to this research can be found here.

Private Equity Characteristics and benefits to a Portfolio

For those investors that can invest into illiquid investments, Private Equity (PE) is an option.

Portfolio analysis, also undertaken by Vanguard, demonstrates that PE can play a significant role in strategic, long-term, diversified portfolios.

PE is illiquid and so must be actively managed, introducing both illiquidity and manager specific risk to a multi-asset portfolio. Conventional asset allocation approaches often omit illiquidity and active risk dimensions from the risk-return trade-off. Therefore, these models do not reflect the unique aspects of PE and tend to over allocate to PE.

Vanguard addresses these issues: outlining four key reasons why the economic returns of private equity are different to those of public equities; highlighting the key risks that need to be accounted for when undertaking portfolio modelling including illiquid assets such as PE; and presenting the adjustments they make to portfolio modelling to address the illiquid features of PE and smoothed nature of historical returns.

This results in more realistic characteristics for PE that can be used for portfolio modelling purposes, reflected in the portfolio allocations generated in the article and the conclusion that PE can play a significant role in strategic, long-term, diversified portfolios.

A review of Vanguard’s analysis and their results can be found in this Post.

Real Assets Offer Real diversification benefits

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, Inflation-linked Bonds, Commodities, and Foreign Currencies offer real diversification benefits to a portfolio of just equities and fixed income.

The benefits of Real Assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation.

These are the conclusions of a recent study by PGIM.

PGIM provide a brief outline of the investment characteristics for several real assets. They then look at the sensitivity of the real assets to economic growth, inflation, equity markets, and fixed income.

They note there is wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds. These sensitivities vary over time and are best mitigated by holding a portfolio of real assets.

Therefore, PGIM construct and analyse three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection to reach their conclusions.

I provide a detailed summary of the PGIM Report in this Post.

Portfolio Tilts

Adding Emerging Markets and Value tilts to a Portfolio are potential areas to boost future investment returns in what is likely to be a low return environment over the next decade.

Value of Emerging Markets

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

The case for investing into emerging markets is well documented: a growing share of global economic activity in the years ahead and current attractive 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 is evident in market return forecasts.

Is a Value bias part of the answer in navigating today’s low interest rate environment

Value offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Value is exceptionally cheap, probably the cheapest it has ever been in history, based on several valuation measures and after making adjustments to market indices to try and prove otherwise, such as excluding all Technology, Media, and Telecom Stocks, excluding the largest stocks, and the most expensive stocks.

There is also little evidence to support the common criticisms of value, such as increased share repurchase activity, low interest rates, and rise of intangible assets.

This is not a popular view, and quite likely minority view, given the underperformance of value over the last ten years.

However, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next decade.

Please see my Disclosure Statement

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

Drivers of Unexpected Portfolio Return Outcomes – that should be controlled for.

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Six reasons could largely explain manager underperformance or the delivery of investment return outcomes different from what is expected.

Conversely, controlling for these “risks” might be the reason why a Manager is consistently adding value.

How a manager controls for the following risks should be considered as part of the due diligence process and in the construction of a multi-manager portfolio:

  1. Levels of uncompensated vs compensated risk
  2. Incidence of underlying portfolio holdings cancelling each other out
  3. Hidden portfolio risks resulting in unintended outcomes
  4. Conventional style-box investing, which leads to index-like performance with higher fees
  5. Over-diversification
  6. Possible attempts to “time” manager changes may prove costly.

The above six risks where identified by Northern Trust following the analysis of $200 billion of assets on more than 200 equity portfolios from 64 institutional investors around the world.  The results surprised many of the institutions involved. 

Northern Trust expressed the above risks as “six common drivers of unexpected Portfolio Results.”

These risks largely explained manager underperformance in single manager portfolios and also multi-manager portfolios.

The analysis highlights, in my opinion, that implementation and portfolio construction are fundamental to capturing value and in delivering excess returns. Although the investment theory and development of investment strategy are important, implementation and portfolio construction are fundamental.  This is an important area to focus on in undertaking manager/strategy due diligence.

To the point, implementation is vital in capturing the desired investment outcomes of any proposed investment strategy.  This is where a lot of value is added, primarily by not detracted value in implementing the desired strategy!

As Northern Trust emphasis, finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  Knowing how a manager, or strategy, interacts with the rest of your portfolio can have much more impact over time.

Institutions had nearly 2x more uncompensated vs compensated risk

Northern Trust found that portfolios which became “overcrowded” with uncompensated risks tended to underperform.

Risk needs to be taken to outperform.  Nevertheless, some risks are compensated for over the longer term and others are not.  Norther Trust outlines that some styles are not compensated for over the longer term, e.g. low quality.  They also include currency, and some countries and sectors have also not historically compensated for the risk taken.

From my own experience, managers who control for some of these risks, tend to outperform, primarily because intended risks, such as company specific risks or compensated styles, end up driving investment outcomes.

Norther Trust found a high level of uncompensated risk across all institutional investment segments, including Super Funds, Endowments, Insurance, Corporate Pensions, and Family Offices.

They conclude: “The result of uncompensated risks comprising nearly 50% of total portfolio active risk was generally benchmark-like returns or underperformance.  While sometimes these risks were taken intentionally, we found that many institutions were surprised when they saw the actual numbers.”

Underlying portfolio holdings cancelled each other out – and hurt performance

This risk particularly impacts multi-manager portfolios.

The cancellation effect occurs when managers within a portfolio take opposing positions that offsets each other e.g. one manager goes overweight a stock another manager is underweight, a manager might have a growth bias which offsets a manager with a value bias.

As Northern Trust note, on a standalone basis many managers individually offer high active risk, once combined with other managers a lot of this active risk is cancelled out.

This needs to be considered in the construction of a multi-manager portfolio. 

Northern Trust conclude: “Our analysis uncovered a shocking amount of this cancellation effect.  Nearly 50% of manager active risk was lost.  Capturing just 50% of targeted active risk, while paying 100% of the manager fees, effectively translates into paying 2x more for each realized basis point of active risk than originally thought.”

Hidden Portfolio risks cause unintended outcomes

Northern Trust found that style tilts contributed 29% of active risk on average.  However, other bets where often introduced into a portfolio unintentionally and led to “unpredictable portfolio outcomes.”

Although some styles are a consistent source of excess returns over time, it was unintended style risks that negatively impacted portfolio performance.

Often, these unintended style risks are included when trying to capture a known rewarded risk e.g. value comes with common unintended style risk exposures of low quality and low momentum.

This means meaningful style exposure is lost.

They conclude: “Our research uncovered that 55% of the portfolios had material style conflicts – caused by the cancellation effect – that introduced exposures different from the managers stated objective.  This introduction of conflicting and unintended style exposures left many portfolios with no material exposure to their intended style tilts.”

Conventional style investing led to index like performance with higher fees

This is probably self-evident to many, particularly given the above research conclusions.

Northern Trust found that those portfolios based on conventional style analysis, and those of a core-satellite approach, tended to suffer more from the cancellation effect.

The “style box” approach portfolio was more likely to have managers who took opposing views or two managers where hired to generate an exposure one manager alone could achieve.

As a result, “conventional style investing, whether intentional or not, created a mix of managers that closely mimicked the benchmark and left little chance to outperform.”

Over-diversification diluted performance

The Northern Trust research highlights than “hiring too many managers or building equity portfolios with thousand of securities took a significant toll on performance.”

Obviously, adding managers and combination of strategies can reduce overall portfolio risk, Northern Trust research showed that often the risks reduced where different to what was intended.

Norther Trust conclude: “While there are many approaches to generating excess returns, our research suggests that a greater focus on eliminating uncompensated risks is a critical first step toward potentially increasing a portfolio’s ability to outperform.”

Possible attempts to “time” manager changes may prove costly

Do not chase manager performance.  The Northern Trust research highlighted that historically poor active management performance had resulted in lower allocations to active managers in the following year.  When performance was better, a higher allocation to active managers resulted.

As they conclude: “Finding a manager that consistently delivers on their investment objectives is certainly important, but it should not be the only area of focus.  As evidenced through the preceding discoveries of this report, knowing how a manager will interact with the rest of your portfolio can ultimately be much more impactful over time.”

Access to the Northern Trust Risk Report can be found here.

Please read my Disclosure Statement

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

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

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

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

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

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

Increasing allocations to Emerging Markets

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

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

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

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

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

The Attraction of Emerging Markets

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

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

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

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

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

Lastly, the valuations within emerging market sharemarkets are attractive. 

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

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

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

GMO Annual Real Returns over 7 years

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

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

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

Please read my Disclosure Statement

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

Is a value bias part of the answer in navigating today’s low interest rates?

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The Value Factor (value) offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Exploring an array of different investment strategies and questioning the role of bonds in a portfolio are key to building a robust portfolio in the current low interest rate environment.

There will also be a need to be more dynamic and flexible to take advantage of market opportunities as they arise.

From this perspective, a value tilt within a portfolio is one investment strategy to consider in potentially boosting future investment returns.

The attraction of Value

Evidence supporting a value tilt within a robust portfolio is compelling, albeit opinion is split.

Nevertheless, longer-term, the “Rotating into Value stocks offers substantial upside in terms of return versus the broad market” according to GMO.

GMO presents the case for a value tilt to navigate today’s low interest rates in their Second Quarter 2020 Letter, which includes two insightful articles, one by Ben Inker and another by Matt Kadnar. 

Value is at cheapest relative to the broader market since 1999, based on GMO’s analysis.  Value is in the top decile of attractiveness around the world, as highlighted in the following figure.

Spread of Value for MSCI Regional Value Factors (GMO)

As of 6/30/2020 | Source: MSCI, Worldscope, GMO

Is Value Investing Dead

As mentioned, the opinion on value is split.

A research paper by AQR earlier in the year addressed the key criticisms of value, Is (Systematic) Value Investing Dead?

For a shorter read on the case for value Cliff Asness, of AQR, Blog Post of the same title is worth reading.

AQR’s analysis is consistent with GMO’s, as highlighted in the Graph and Table below.

The Graph below measures the Price-to-Book spread of the whole US sharemarket from December 1967 to March 2020.

This spread was at the 100th percentile versus 50+ years of history on the 31 March 2020 i.e. value is at it cheapest based on 50 years of data.

Price-to-Book Spread (AQR)

Asness’s Blog Post highlights “expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive.” (March 2020).

It is the same story when looking at different measures of value for the US sharemarket, as highlighted in the Table below.

Value is at its cheapest on many measures (AQR)

‘Don’t ask the barber whether you need a haircut’

This quote by Warren Buffett springs to mind when considering the analysis from GMO and AQR, both being value orientated investors.  As Asness states, AQR has a horse in the race.

However, as outlined in his Post, he undertakes the same analysis as above and controls for, just to name a few:

  • Excluding all Technology, Media, and Telcom Stocks
  • Excluding the largest stocks
  • Excluding the most expensive stocks
  • Industry bets
  • Industry neutrality
  • Quality of company

Analysis is also undertaken using other measures of value, Price-Sales, P/E, using trailing and forecast earnings (these are in addition to Price-Book).

The attraction of value remains based on different measures of value and when making the adjustments to market indices as outlined above.

Asness argues value is exceptionally cheap, probably the cheapest it has ever been in history (March 2020).

The AQR analysis shows this is not because of an outdated price-to-book nor because of the dominance of highly expensive mega-cap stocks.  Investors are paying more than usual for stocks they love versus the ones they hate.  There is a very large mispricing.

The AQR research paper mentioned above, looked at the common criticisms of value, such as:

  1. increased share repurchase activity;
  2. the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems;
  3. the changing nature of monetary policy and the potential impact of lower interest rates; and
  4. value measures are too simple to work.

 Across each criticism they find little evidence to support them.

Are we there yet?

We do not know when and how the valuation gap will be closed. 

Nevertheless, the evidence is compelling in favour of maintaining a value tilt within a portfolio, and certainly now is not the time to give up on value.

This is not a widely popular view, and quite likely a minority view, given the underperformance of value over the last ten years.  As clearly demonstrated in the Graph below provided by Top Down Charts.

However, from an investment management perspective, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next ten years.

It is too early to give up on value, news of its death are greatly exaggerated, on this, Asness makes the following point, value is “a strategy that’s “worked” through the 1920s – when a lot of stocks were railroads, steel, and steamship companies – through the Great Depression, WWII, the 1950s – which included some small technological changes like rural electrification, the space race and all the technology that it spanned – the internet age (remember these same stories for why value was broken back in 1999-2000?)………. Value certainly doesn’t depend on technological advancement being stagnant! But in a time when it’s failed for quite a while (again, that just happens sometimes even if it’s as good as we realistically think it is), it’s natural and proper that all the old questions get asked again. Is now different?”

I don’t think so.

Please see my Disclosure Statement

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

The reality is that asset allocations can only do so much

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It is estimated US public pension plans would need to leverage a Balance Portfolio of 60% equities and 40% fixed income by 47% to achieve their 7.25% actuarial return target in the years ahead. 

Such is the challenge facing all investors in the current low interest rate environment.

Investors face some very tough decisions in the future and may be forced to consider significant asset allocation shifts.  Increasing the tolerance for risk and illiquidity are likely actions required to boost future investment returns.

Investors are going to have consider something different, from a return perspective, buying bonds is not going to cut it.  Likely actions may include considering substitutes to fixed income to provide portfolio stability and some diversification during periods of equity market weakness.

The reality is that asset allocation decisions can only do so much.

These are the key conclusions from an article written by Rob Croce, PhD, of Mellon and Aaron Filbeck, that recently appeared in AllAboutAlpha.

The article covers three potential solutions for investors to consider in boosting future investment returns.

Meeting the Pension Fund Challenge

The above conclusions are determined in the context of the challenge facing US public pension plans.

On average US pension plans currently have target returns assumptions of 7.25% on average, this is down from 8% in 2000.

In the year 2000, US 10-year government bond interest rates were 6%.  Therefore there “was little headwind to meeting return objectives”….

However, with the dramatic fall in interest rates over the last 20 years, the “gap” between long-term interest rates and return assumptions has widened materially.  This is highlighted in Figure 1 below, from the article. 

The gap is currently around 6%, compared to 2% in 2000!

Figure 1: Difference Between Average Plan Actuarial Return Assumption and 10-Year US Treasury Yield

Source: NASRA, Bloomberg, CAIA calculations

What have US pension plans done over the last 20 years as the return gap has widened:

  • Reduced their allocations to fixed income;
  • Allocated more to equities; and
  • Allocated more to alternatives.

“ According to Public Plans Data, from 2001 to 2009, the average pension allocation to alternative investments increased from 8.7% to 15.7%, which only accelerated after the Global Financial Crisis (GFC). Over the next decade, allocations to alternatives nearly doubled, reaching nearly 27% by the end of 2019.”

The increased allocation to Equities and Alternatives at the expense of fixed income is highlighted in the following Figure also provided in the article.

Figure 2: Average Allocations for the 73 Largest State-Sponsored Pension Funds

Source: Pew Research. Data as of 2016

At the same time US pension plans remain underfunded. 

The challenge facing US pension plans has been known for some time, the article notes, “In general, pension trustees seem to be faced with two potential solutions – take on more (or differentiated) risks or improve funding statuses through higher taxation or slashing benefits.”

How big is the Pension Fund Return Challenge?

The article analyses potential solutions to “filling the gap” between current interest rates and the assumed target rate of return for US pension funds.

The first approach uses risk premia-based analysis, focusing on the amount of return that can be generated over and above holding just risk-free short-term US Government bonds.

Starting with a traditional Balanced Portfolio, 60% domestic stocks and 40% U.S. 10-year bonds, the analysis seeks to determine how much risk would need to be taken to reach the 7.25% return target. Assuming historical return premia, but with the current level of interest rates.

In relation to return assumptions, the Article notes “Since 1928, stocks have outperformed the risk free asset by 6.2% at 20% volatility and 10-year U.S. government bonds have outperformed the risk-free asset by 1.5%, for Sharpe ratios of 0.3 and 0.2, respectively. For cash, we have decided to use its current near-zero return, rather than its 3.3% average return during that period.”

The results, “there is effectively no unlevered portfolio of stocks and bonds that can reliably deliver many investors’ 7.25% target return over time. Because of the nature of the problem, the solution will likely force pension investors to consider taking on leverage.”

This reflects the low interest rate environment, returns on equities will be lower on an absolute return basis.  Although equities are still expected to earn a “premium” above cash, the absolute return will be lower given the cash rate is so low (0%). The 6% equity premium is earnt on 0%, not the average 3.3% cash rate since 1928. 

The article estimates, for the Balance Portfolio to achieve the 7.25% return objective it would need to be levered by 47%.  This would increase the Portfolio’s volatility to 17.75% from 12%.

As they note, this is not a sustainable solution.  Nevertheless, it provides an indication of how much more risk needs to be taken to achieve the 7.25% return target in the current low interest rate environment.

Therefore, the article highlights the return challenge all investors face.  The leveraging of portfolios is not going to be a viable option for most investors.

The Potential Role of Alternatives

The article looks at two “hypothetical alternative allocations as potential solutions for U.S. pension funds to hit their 7.25% return, one illiquid and the other liquid.”

  1. Private Equity (illiquid).
  2. Hedge Funds or Diversified Assets (liquid)

Their analysis seeks to achieve the return outcome of 7.25% with less volatility than the levered Balance Portfolio above of 17.75% with an allocation to Private Equity and Liquid Alternatives separately.

Based on their analysis, and assumptions, they conclude the inclusion of Private Equity and Liquid Alterative strategies could help in reaching the 7.25% return assumption.

They note that Private Equity and Liquid Alternatives are “two examples provide different solutions for the same problem”.

The article also notes that there are many strategies that do not make sense e.g. anything that takes them further from their return target for the sake of diversification or anything illiquid with an expected return below their target portfolio return.

Key insights

The article wraps up with some key insights, including “buying bonds isn’t going to cut it from a return target perspective today,”…..

They also demonstrated that to meet return targets US pension plans are going to have consider something different.  “And while each pension fund is different, risk tolerance and liquidity needs will need to be managed.”

“We think that the current, low yield environment could potentially open institutions up to the idea of using low-risk liquid absolute return strategies as substitutes for fixed income investments. We believe they will increasingly look for investments that provide portfolio stability values and some diversification during risk-off environments, similar to that of traditional fixed income, but potentially provide the return of fixed income two decades ago.”

Reading this article made me think of the following John Maynard Keynes quotes:

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”

“When my information changes, I alter my conclusions. What do you do, sir?”

“It is better to be roughly right than precisely wrong.”

Please see my Disclosure Statement

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

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

/ Kiwi Investor / 4 Comments

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

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

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

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

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

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

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

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

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

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

Implementation of the Modern-Day Wealth Management Investment Solution

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

Modern-day investment solutions have two specific investment portfolios:  

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

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

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

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

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

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

The death of the Policy Portfolio

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

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

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

It is a single Portfolio solution.

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

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

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

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

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

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

Reasons for the death of Policy Portfolio include:

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

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

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

Evolution of Wealth Management – Implementation of the new Paradigm

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

As explained by EDHEC Risk Goal-Based Investing involves:

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

GBI is consistent with the two portfolios approach, fund separation, LDI, and undertaking a dynamic investment approach.

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

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

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

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

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

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

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

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

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

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

Please see my Disclosure Statement

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

The Case for holding Government Bonds and fixed income

/ Kiwi Investor / 3 Comments

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

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

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

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

Why you can’t afford not to own government bonds

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

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

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

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

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

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

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

Return expectations

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

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

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

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

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

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

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

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

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

Happy investing.

Please see my Disclosure Statement

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

Asset Allocations decisions for the conundrum of inflation or deflation?

/ Kiwi Investor / 2 Comments

One of the key questions facing investors at the moment is whether inflation or deflation represents the bigger risk in the coming years.

Now more than ever, given the likely economic environment in the years ahead, investors need to consider all their options when building a portfolio for their future.  This may mean a number of things, including: increasing diversification, investing in new or different markets, being active, and flexible to take advantage of unique opportunities as they arise.

Those portfolios overly reliant on traditional markets, such as equities and fixed income in particular, run the risk of failing to meet to their investment objectives over the next ten years.

Conundrum Facing Investors

A recent article by Alan Dunne, Managing Director, Abbey Capital, The Inflation-Deflation debate and its Implications for Asset Allocation, which recently appeared in AllAboutAlpha.com, clearly outlines the conundrum currently facing investors.

As the article highlights, one of the “key questions facing investors at the moment is whether inflation or deflation represents the bigger risk for the coming years. Economists are split on this….”

Following a detailed analysis of the current and likely future economic environment and potential influences on inflation or deflation (which is well worth reading) the article covers the Implications for Asset Allocations.

Inflation or Deflation: Implications for Asset Allocations

The article makes the following observations as far as asset class performance in different inflation environments, based on historical observations:

  • Deflation like in the 1930s, is negative for equities but positive for Bonds.
  • If inflation picks ups, or even stagflation, that would be negative for real returns on financial assets and real assets may be favoured.

They conclude: “the current uncertainty highlights the importance of holding diversified portfolios, with exposure to a range of traditional and alternative assets and strategies with the potential to deliver returns in different market environments.”

Current Environment

Abbey Capital anticipate greater co-ordination of policy between governments (fiscal policy) and central banks (monetary policy). 

As they note, “many economists draw a parallel between the current scenario and the substantial increase in government debt during World War II. One of the consequences of higher debt levels is that we may see pressure on central banks to maintain interest rates at low levels and maintain asset purchases to ensure higher bond issuance is not disruptive for bond markets i.e. coordination of monetary and fiscal policies.”

I think this will be the case.  The Bank of Japan has maintained a direct yield curve control policy for some time and the Reserve Bank of Australia has implemented a similar policy recently.  Direct yield curve control is where the central bank will target an interest rate level for the likes of the 3-year government bond.

In the environment after World War II debt levels were brought back to more manageable levels by keeping interest rates low (a process known as financial repression).

From a government policy perspective, financial repression reduces the real value of debt over time.  It is the most palatable of a number of options.

Financial repression is potentially negative for government bonds

With interest rates so low, and likely to remain low for some time given policies of financial repression the real return (after inflation) on many fixed income instruments and cash could be negative.

A higher level of inflation not only reduces the real return on bonds but potentially also reduces the diversification benefits of holding bonds in a portfolio with equities.

The diversification benefits of bonds in the traditional 60 / 40 equity-bond portfolio (Balanced Portfolio) has been a strong tail wind over the last 20 years.

The more recent low correlation between bonds and equities is evident in the Chart below, which was presented in the article.

The Chart also highlights that the relation of low correlation between equities and bonds, which benefits a Balanced Portfolio, has not always been present.

As can be seen in the Chart, in the 1980s, when inflation was a greater concern, inflation surprises were negative for both bonds and equities, they became positively correlated.

What should investors do?

“Investors are therefore left with the challenge of finding alternatives for government bonds, ideally with a low or negative correlation to equities and protection against possible inflation.”

The article runs through some possible investment solutions and approaches to meet the likely challenges ahead.  I have outlined some of them below.

I think duration (interest rate risk) and credit can still play a role within a broad and truly diversified portfolio.  Within credit this would likely involve expanding the universe to include the likes of high yield, securitised loans, private debt, inflation protections securities, and emerging market debt as examples.

The key and most important point is that a robust portfolio will be less reliant on tradition asset classes, traditional asset class betas, to drive investment return outcomes.  This is likely to be vitally important in the years ahead.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios.  Not only within asset classes, such as the fixed income example provided above, but across the portfolio to include the likes of real assets and liquid alternatives.

Real assets

Abbey Capital comment that “Real assets such as property and infrastructure should provide protection against higher inflation for long-term investors but may not be attractive for investors valuing liquidity.”

Although the maintenance of portfolio liquidity is important, Real assets can play an important role within a robust portfolio.

For the different types of real assets, their investment characteristics, and likely performance and sensitivity to different economic environments, including economic growth, inflation, inflation protection, stagflation, and stagnation please see the Kiwi Investor Blog Post, Real Assets Offer Real Diversification.  The extensive analysis has been undertake by PGIM.  

Liquid Alternatives

Abbey Capital provide a brief discussion on liquid alternatives with a focus on managed futures.  Not surprisingly given their pedigree.

They provide the following Table which highlights the benefit of liquid alternatives and hedge funds at time of significant sharemarket declines (drawdowns).

Concluding Remarks

Being a managed futures manager, it is natural to be cautious of Abbey Capitals concluding remarks, being reminded of the Warren Buffet quote, “Never ask a barber if you need a haircut.”

Nevertheless, the Abbey Capital’s economic analysis and investment recommendations are consistent with a growing chorus, all singing from a similar song sheet. (Perhaps we could call this a “Barbers Quartet”!)

Without having an axe to grind, and in all seriousness, I have covered similar analysis and comments in previous Posts, the conclusions of which have a high degree of validity and should be considered, if not a purely from portfolio risk management perspective so as to understand any gaps in current portfolios for a number of likely economic environments.

The key and most important point is that robust portfolios will be less reliant on traditional asset classes, traditional asset class betas, to drive investment return outcomes.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios

Therefore, it is hard to disagree with one of the concluding remarks by Abbey Capital “To account for the competing requirements in a portfolio of returns, low correlation to equities, liquidity and possible inflation protection, investors may need to build robust portfolios with a broader mix of assets and strategies.”

Other Reading

For those interested, previous Kiwi Investor Blog posts of relevance to the Abbey Capital article include:

Preparing your Portfolio for a period of Higher Inflation, this is the Post of most relevance to the current Post, and covers a recent Man article which undertook an analysis of the current economic environment and historical episodes of inflation and deflation.

Man conclude that although inflation is not an immediate threat, the likelihood of a period of higher inflation is likely in the future, and the time to prepare for this is now.  Man recommends several investment strategies they think will outperform in a higher inflation environment.

Protecting your portfolio from different market environments – including tail risk hedging debate, compares the contrasting approaches of broad portfolio diversification and tail risk hedging to manage through difficult market environments. 

It also includes analysis by PIMCO, where it is suggested to “diversify your diversifiers”.

Lastly, Sharemarket crashes – what works best in minimising losses, market timing or diversification, covers a research article by AQR, which concludes the best way to manage periods of severe sharemarket decline is to have a diversified portfolio, it is impossible to time these episodes.  AQR evaluates the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

Happy investing.

Please see my Disclosure Statement

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

Preparing your Portfolio for a period of higher inflation

/ Kiwi Investor / 7 Comments

Although inflation is not a threat currently the case for a period of higher than average inflation can be easily made.

From an investment perspective:

  1. A period of high inflation is the most challenging period for traditional assets e.g. equities and Fixed Income;
  2. Before the inflation period, as we move from the current period of deflation there is a period of reflation, during which things will feel okay for a while; and
  3. During the higher inflation period the leadership of investment returns are likely to change.

These are some of the key insights from a recent Man article, Inflation Regime Roadmap.

Following an extensive review of previous inflation/deflationary episodes Man clearly articulate the case for a period of higher inflation is ahead.

As Man note the timing of moving to a higher inflation environment is uncertain.

As outlined below, they provide a check list of factors to monitor in anticipation of higher inflation.

Nevertheless, although the timing of a higher inflation environment is uncertain, Man argue the need for preparation is not and should commence now.

Investors need to be assessing the robust of their portfolios for a higher than average inflation environment now.

Man identify several strategies they expect will outperform during a period of higher inflation.

Investment Implications

The level and direction of inflation is important.

This is evident in the diagram below, which Man refer to as the Fire and Ice Framework.

The performance of investment strategies differs depending on the inflation environment.

As can be seen in the diagram, the traditional assets of equities and bonds (fixed income securities) have on average performed poorly in the inflation periods (Fire).

Also, of note is that the benefits of Bonds in providing portfolio diversification benefits are diminished during these periods, as signified by the positive stock-bond correlation relationship.

As Man note, and evident in the diagram above, the path to inflation is via reflation, so things will feel good for a while.

Importantly, there will be a regime change, those investment strategies that have flourished over the last 10 years are likely to struggle in the decade ahead.

The expected new winners in a higher inflation environment are succinctly captured in the following diagram.

As can been seen in the Table above, Man argue new investment strategies are needed within portfolios.

These include:

  • Alternative risk premia and long-short (L/S) type strategies, rather than traditional market exposures (long only, L/O) of equities and fixed income which are likely to generate real negative returns (See Fire and Ice Framework).
  • Real Assets, such inflation-linked bonds, precious metals, commodities, and real estate.

Man also expect leadership within equity markets to change toward value and away from growth and quality. Those companies with Pricing Power are also expected to benefit.

Several pitfalls to introducing the new strategies to a portfolio are outlined in the article.

Time for Preparation is now

As mentioned the timing of a transition to a higher inflation environment is uncertain. Certainly markets are not pricing one in now.

Nevertheless, the preparation for such an environment is now. Man highlight:

  • the likelihood of an inflationary regime is much higher than it has been in recent times;
  • the investment implications of this new regime would be so large that all the things that have worked are at risk of stopping to work; and
  • given that markets are not priced for higher inflation at all, the market inflationary regime may well start well before inflation actually kicks in, given the starting point.

Man believe investors have some time to prepare for the regime shift. Nevertheless, those preparations should start now.

In addition, Man provide a check list to monitor to determine progress toward a higher than average inflation environment.

Inflation Check List to Monitor

The paper undertakes a thorough review of different inflation regimes and the drivers of them. The review and analysis on inflation makes up a large share of the report and is well worth reviewing.

Man identify five significant regime changes to support their analysis:

  1. Hoover’s Depression and Roosevelt’s New Deal (Deflation to Reflation)
  2. WW2-1951 Debt Work-down (Inflation to Disinflation).
  3. The Twin Oil Shocks of the 1970s (Inflation).
  4. Paul Volcker (Disinflation).
  5. The Global Financial Crisis (Deflation to Reflation and back again).

As noted in the list above, we are currently in a deflationary environment (again) – Thanks to the Coronavirus Pandemic.

Man expect the deflationary forces over the last decade are likely to fade in the years ahead. As a result inflation is likely to pick up. Central banks are also likely to allow an overshoot relative to inflation targets. Their independence could also be at risk.

They argue the current deflationary status quo is unsustainable, high debt levels leading to underinvestment in product assets resulting in lower levels of spare capacity and rising levels of inequality around the world will lead to policy responses by both governments and central banks that will result in a period of higher than average inflation.

They provide a checklist of factors to monitor, which includes:

  1. Inflation Momentum, which is broadly neutral currently
  2. Measures of inflation in the pipeline, which are currently deflationary
  3. Economic slack, which is large and heavily deflationary at present
  4. Labour market tightness, which is loose and heavily deflationary presently
  5. Wage inflation, currently neutral to inflationary
  6. Inflation Expectations, sending mixed signals at this time

Man conclude their dashboard is more deflationary than inflationary. They also believe this could change quite rapidly if demand picks up faster than expected.

Concluding Remarks

Man’s view on the outlook for inflation are not alone, a number of other organisations hold similar views.

Although inflation is not a problem now, it is highly likely to become of a greater concern to investors than recent history.

This will likely lead to a change in investment return leadership. Those investment strategies that have worked well over the last 10 years are unlikely to work so well in the decade ahead. Man propose some they think will perform better in such an environment, there are likely others.

A review of current portfolio holdings should be undertaken to determine the robustness to a different inflation regime. This is a key point.

The performance of real assets in different economic environments was covered in a previous Post, Real Assets offer real diversification benefits, this Post covered analysis undertaken by PGIM.

Happy investing.

Please see my Disclosure Statement

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

The psychology of Portfolio Diversification

/ Kiwi Investor / 3 Comments

In a well-diversified portfolio, when one asset class is performing extremely well (like global equity markets), the diversified portfolio is unlikely to keep pace.

In these instances, the investor is likely to regret that they had reduced their exposure to that asset class in favour of greater portfolio diversification.

This is a key characteristic of having a well-diversified portfolio. On many occasions, some part of the portfolio will be “underperforming” (particularly relative to the asset class that is performing strongly).

Nevertheless, stay the course, over any given period, diversification will have won or lost but as that period gets longer diversification is more and more likely to win.

True diversification comes from introducing new risks into a portfolio. This can appear counter-intuitive. These new risks have their own risk and return profile that is largely independent of other investment strategies within the Portfolio. These new risks will perform well in some market environments and poorly in others.

Nevertheless, overtime the sum is greater than the parts.

 

The majority of the above insights are from a recent Willis Tower Watson (WTW) article on Diversification, Keep Calm and Diversify.

The article provides a clear and precise account of portfolio diversification.  It is a great resource for those new to the topic and for those more familiar.

 

WTW conclude with the view “that true diversification is the best way to achieve strong risk adjusted returns and that portfolios with these characteristics will fare better than equities and diversified growth funds with high exposures to traditional asset classes in the years to come.”

 

Playing with our minds – Recent History

As the WTW article highlights the last ten-twenty years has been very unusual for both equity and bond markets have delivered excellent returns.

This is illustrated in the following chart they provide, the last two rolling 10-year periods have been periods of exceptional performance for a Balanced Portfolio (60%/40% equity/fixed income portfolio).

WTW Balance Fund Performance

 

WTW made the following observations:

  • The last ten years has tested the patience of investors when it comes to diversification;
  • For those running truly diversified portfolios, this may be the worst time to change approach (the death of portfolio diversification is greatly exaggerated);
  • Diversification offers ‘insurance’ against getting it wrong e.g. market timing; and
  • Diversification has a positive return outcome, unlike most insurance.

 

WTW are not alone on their view of diversification, for example a AQR article from 2018 highlighted that diversification was the best way to manage periods of severe sharemarket declines, as recently experienced.  I covered this paper in a recent Post: Sharemarket crashes – what works best in minimising losses, market timing or diversification.

 

WTW also note that it is difficult to believe that the next 10-year period will look like the period that has just gone.

There is no doubt we are in for a challenging investment environment based on many forecasted investment returns.

 

What is diversification?

WTW believe investors will be better served going forwards by building robust portfolios that exploit a range of return drivers such that no single risk dominates performance. (In a Balanced Portfolio of 60% equities, equities account for over 90% of portfolio risk.)

They argue true portfolio diversification is achieved by investing in a range of strategies that have low and varying levels of sensitivity (correlation) to traditional asset classes and in some instances have none at all.

Other sources of return, and risks, include investing in investment strategies with low levels of liquidity, accessing manager skill e.g. active returns above a market benchmark are a source of return diversification, and diversifying strategies that access return sources independent of traditional equity and fixed income returns. These strategies are also lowly correlated to traditional market returns.

 

Sources of Portfolio Diversification

Hedge Funds and Liquid Alternatives

Hedge Funds and Liquid Alternatives are an example of diversifying strategies mentioned above. As outlined in this Post, covering a paper by Vanguard, they both bring diversifying benefits to a traditional portfolio.

Access to the Vanguard paper can be found here.

 

It is worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity and fixed income markets.

Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Private Markets

TWT also note there are opportunities within Private Markets to increase portfolio diversification.

There will be increasing opportunities in Private markets because fewer companies are choosing to list and there are greater restrictions on the banking sector’s ability to lend.

This is consistent with key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The factors mentioned above, along with the low interest rate environment, the expected shortfall in superannuation accounts to meet future retirement obligations, and the maturing of emerging markets are expected to drive the growth in alternative investments over the decade ahead.

A copy of the CAIA report can be found here. I covered the report in a recent Post: CAIA Survey Results – The attraction of Alternative Investments and future trends.

 

TWT expect to see increasing opportunities across private markets, including a “range from investments in the acquisition, development, and operation of natural resources, infrastructure and real estate assets, fast-growing companies in overlooked parts of capital markets, and innovative early-stage ventures that can benefit from long-term megatrends.”

Continuing the theme of lending where the banks cannot, they also see the opportunity for increasing portfolios with allocations to Private Debt.

WTW provided the following graph, source data from Preqin

WTW Private Market Performance

 

Real Assets

In addition to Hedge Funds, Liquid Alternatives, and Private markets (debt and equity), Real Assets are worthy of special mention.

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. The PGIM report on Real Assets can be found here. I provided a summary of their analysis in this Post: Real Assets offer real diversification benefits.

 

Conclusion

To diversify a portfolio it is recommended to add risk and return sources that make money on average and have a low correlation to equities.

Diversification should be true both in normal times and when most needed: during tough periods for sharemarkets.

Diversification is not the same thing as a hedge. Although “hedges” make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term. Think of this as the cost of “insurance”.

Therefore, alternatives investments, as outlined above, are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

Importantly, investing in more and more traditional asset classes does not equal more diversification e.g. listed property.  As outlined in this Post.

 

As outlined above, we want to invest in a combination of lowly correlated asset classes, where returns are largely independent of each other. A combination of investment strategies that have largely different risk and return drivers.

 

Good luck, stay healthy and safe.

 

Happy investing.

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