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.

 

Optimal Private Equity Allocation

TIAA (Teachers Insurance and Annuity Associations of America Endowment & Philanthropic Services) has published a paper offering insights into the optimal way of building an allocation to Private Equity (PE).

“Private equity is an important part of institutional portfolios. It provides attractive opportunities for long-term investors to harvest the illiquidity premium over time and extract the value created by hands-on private equity managers.”

 

Private equity is by its nature is illiquid. This in turn makes rebalancing a challenge. That is why a PE allocation that is too large endangers the entire portfolio, especially in times of crisis when secondary markets seize up.

 

According to recent analysis by Prequin, the popularity and growth of PE, and other alternative investments, is expected to continue.

Furthermore, recent Cambridge Associates analysis on those Endowments and Foundations with the better long-term performance records had “one thing in common: a minimum allocation of 15% to private investments.

 

We all know, a robust portfolio is broadly diversified across different risks and returns. Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors, for which illiquidity is one factor.

In my mind, direct private investments, such as Private Equity, Direct Property, and Unlisted Infrastructure have a place in a genuinely diversified and robust Portfolio.

 

From this perspective, the TIAA paper is very useful as it considers how to build and maintain an allocation to PE within a well-diversified portfolio.  They assume building out the PE allocation over time to an equilibrium allocation.

The Paper provides valuable insights into the asset allocation process of what is a complicated asset to model given cash commitments (capital calls) are made overtime and there is uncertainty as to when invested capital will be returned (distributions). TIAA model for both of these variables, in a relatively conservative manner.

The TIAA Paper notes that investors have no control over the rate and timing of capital calls and distributions. Therefore, the paper focuses on two key variables Investors can control for: an annual commitment rate and the risk profile of the assets waiting to be invested in private equity assets i.e. where to invest the cash committed to PE but not yet called.

 

TIAA propose a robust process to determine an appropriate allocation to PE to ensure the allocation can be maintained and the benefits of PE are captured over time.

“Obtaining the benefits of an allocation to private equity, while also avoiding its inherent illiquidity pitfalls, can only occur through an effective, risk-based strategy for executing the build-out to the long-term equilibrium state.”

The goal of the paper is to develop a framework and a sound approach.

 

The results:

TIAA’s modelling suggests that a target allocation to private equity strategies in the range of 30% to 40% presents minimal liability and liquidity risks.

TIAA also suggest, that for long term investors, such as Endowments, capital awaiting investment in private equity should be invested in risk assets with higher expected returns, such as public equities (sharemarkets).

 

This level of allocation is probably high for most, and particularly KiwiSaver Funds.

Nevertheless, KiwiSaver Funds are underweight Private investments and Alternatives, particularly relative to the Superannuation industry in Australia.

Given the overall lack of allocation to private investments, including PE, Direct Property, and Unlisted Infrastructure, many KiwiSaver providers are most likely over estimating their liquidity needs to the detriment of investment performance over the longer term.

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

 

TIAA Analysis

With regards to the TIAA paper, they develop a simple three asset portfolio of Fixed Income, Public equities, and Private equities. TIAA use sophisticated modelling techniques looking at a number of variables, including:

  1. the annual commitment rate; and
  2. Risk profile of the assets waiting to be invested in private equity.

The annual commitment is defined as the new commitment to private equity every year as a percentage of last year’s total portfolio value.

“An annual commitment rate results in a long-term equilibrium percentage of the portfolio in private equity assets, as well as the portfolio’s corresponding unfunded commitment level. The unfunded commitment level is important from a risk perspective as it represents a nominal liability to fund future capital calls, regardless of the prevailing market environment at the time of capital calls.”

TIAA note that at low rates of annual commitment the equilibrium rate of PE is about twice the unfunded ratio. Therefore, a 6% annual commitment rate will result in a base case unfunded ratio of around 15%, and a PE allocation of around 30% at equilibrium.

For those wanting a brief overview of the methodology, All About Alpha provides a great summary.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in this report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

A well diversified and robust portfolio will be able to meet these motivations.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Changing the Conversation on Management Fees

Bloomberg report:

“BlackRock Inc. is tired of the conversation about costs. The world’s largest asset manager, which runs some of the cheapest investment products available, plans to place a greater focus on the quality of the engineering, construction and management of its funds going forward, …… “

“There’s too much emphasis purely on cost,” said Senra, ……….. “We don’t talk enough about quality. That’s not to say we’re not going to be competitive — we have to be competitive, this is a competitive industry — but I would move away from just a low-cost conversation.”

 

I agree, “too much emphasis purely on cost”, investment management fees, there should be a “greater focus on the quality of engineering, construction, and management”, and “we don’t talk enough about quality”.

 

Now don’t get me wrong, I think investment management fees are important.  I also think we should have a mature discussion about fees.  

The cheapest solution may not be the best, a race to bottom is not helpful.  And I’d say, not necessarily in the best interest of investors.

 

There are many reasons why you might consider paying more for something.  In an investing context this could be for greater levels of true portfolio diversification to manage portfolio volatility and return outcomes, for example the model followed by US Endowment Funds which has been very successful.

 

I appreciate BlackRock is making comment in relation to gaining access to certain areas of the market that they believe will deliver greater return outcomes overtime. 

 

I think this is an interesting issue when framed in the context of Responsible Investing.  Particularly in relation to quality of data, portfolio construction, and portfolio management.   From a more broader perspective, it also  helps highlight issues beyond just a headline investment management fee.

 

The evidence is compelling, Environmental, Governance and Social (ESG) investing can be a clear win for companies.  It can also be a clear winner for investors, yet it is not easy to capture this value.

For a start the ESG data is not consistent across providers.  At the company level this creates a diversity of opinion amongst providers.  Several studies have highlighted the contrasting conclusions of ESG data providers. (See this article on ESG Scoring, sourced over LinkedIn and published by RBC GAM.) 

Studies highlight the low level of correlation between ESG data.  This can result from different weighting systems that generate an ESG score and that there is a level of subjectivity in determining the materiality of ESG input.

 

Let’s consider this from a New Zealand perspective.

As the recent RIAA Benchmark Report  highlights:

“When primary and secondary RI strategies are taken into account, the dominant responsible investment strategy is negative screening, which represents 44% of AUM. Where ESG integration was nominated as the primary strategy, it was usually paired with either corporate engagement and shareholder action, or negative screening, as secondary strategies.”

Negative Screening is the dominant Sustainable Investing approach in New Zealand, to move beyond this will take an increasing level of resources and time.

There is a lot more to RI than negative screening.  The implementation of negative screening is not straight forward i.e. coming up with the investment philosophy, approach, and framework takes time and consideration, trading on the exclusion list is relatively straight forward.

 

As the RIAA Report covers, there are seven broad RI strategies as detailed by the Global Sustainable Investment Alliance (GSIA) and applied in the Global Sustainable Investment Review 2018, which maps the growth and size of the global responsible investment market.

The Broad RI strategies are:

  1. ESG integration
  2. Corporate engagement and shareholder action
  3. Negative/exclusionary screening
  4. Norms-based screening
  5. Positive/best-in-class screening
  6. Sustainability-themed investing
  7.  Impact investing and community investing

 

Best practice RI involves the full spectrum of these strategies, negative screening, ESG integration, Best-in-class and impact investing, at the very least.  This includes corporate governance and shareholder action.

 

So how do New Zealand’s leading investment managers compare to best practice.  The RIAA report makes the following comment in relation to New Zealand managers:

“There’s a growing number of investment managers applying leading practice ESG integration, but the overall number remains small. Of the 25 investment managers assessed, just eight (32%) are applying a leading approach to ESG integration (score >80%). That said, the number of leading ESG integration practitioners has risen from four last year, with some employing other responsible investment strategies as their primary strategy.”

 

It is great to see ongoing progress.

To implement leading ESG integration practices, let alone capture the full value of the ESG factors, takes time and resources.  Those managers making this commitment are to be commended.  It takes a lot of hard work.

The market leading managers are applying a wide range of sustainable investing approaches and resources.  This comes at a cost.

 

Therefore, some thought must be given to quality of RI outcomes being delivered and are they in line with best practice and is there continuous improvement in place.  Do they meet customers expectations?

 

Accordingly, I agree, let’s change the conversation about investment management fees, there are a lot of issues to consider other than investment management fees alone.

There is a lot to consider in delivering robust outcomes to investors.

Happy investing.

 Please see my Disclosure Statement

 

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

Unscrambling the Sustainable Investing Return Puzzle

“The evidence is compelling: Sustainable investing can be a clear win for investors and for companies. However, many SRI fund managers, who have tended to use exclusionary screens, have historically struggled to capture this. We believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value. ESG best-in-class focussed funds should be able to capture superior risk-adjusted return if well executed.”

This is the key finding of a Deutsche Bank Group (DB) report published in 2012, Sustainable Investing, Establishing Long-Term Value and Performance

The DB report looked at more than 100 academic studies of sustainable investing around the world, and then closely examined and categorized 56 research papers, as well as 2 literature reviews and 4 meta studies.

To the point, they comment “… most importantly, “Environmental, Social and Governance” (ESG) factors are correlated with superior risk-adjusted returns at the securities level…..”

DB were surprised by the clarity of results. Which are as follows:

  • 100% of academic studies agree that companies with high ratings for Corporate Social Responsibility (CSR) and most importantly ESG factors have a lower cost of capital, for debt and equity. The market recognises them as having lower levels of risk.
  • 80% of studies show that companies with high ESG ratings exhibit market-based outperformance. The market is showing correlation between financial performance and what is perceived as the advantages of ESG strategies.
  • The single most important factor is Governance, Environment is next, closely followed by Social.

 

The study shows quite clearly that ESG factors matter at the security level, with consistent evidence of better financial performance.

The key for investors and fund managers is the ability to identify and capture these factors. This is a key issue as it comes down to the ESG scoring approach (whether active or index based) implemented, level and definition of portfolio exclusions.

It comes down to how ESG is integrated into the investment process.

 

Unscrambling Fund performance

A common perception is that Sustainable Investing is hard to define and provides mixed results – there is no really clear evidence it leads to a superior risk-adjusted return.

A key conclusion from DB is that “Sustainable investing has been too closely associated for too long with the performance of SRI Funds. These funds are not only an extremely broad category (i.e. in terms of investment mandate), but historically were based more exclusionary (or negative) – as opposed to positive best-in-class-screening.”

DB note that the Academic studies have not been aggregated and classified into appropriate categories, but have been mixed together, thus providing mixed results.

DB: “ By “unscrambling” them – as we do in this paper – a clearer picture emerges.”

 

“Socially Responsible Investing (SRI) in the academic literature have tended to rely on exclusionary screens – show SRI adds little upside, although it does not underperform either. Exclusion, in many senses, is essentially a value-based or ethical consideration for investors.”

With regards to the SRI Funds, the results are mixed, largely support they do not underperform, and there is no significant difference in performance.   Neutral to mixed results.

These results are limited to the review of SRI Funds only, they did not look at categories of ESG Funds.

 

DB found that ESG factors are correlated to superior performance at the security level, as highlighted above.

The real issue is how Managers are attempting to capture the superior performance from ESG factors at the security level in their portfolios.

Therefore, implementation and the approach taken to integrate ESG into the investment process is key in capturing the excess returns available from Sustainable investing as identified by the DB.

 

Increasingly, positive ESG investing, commonly referred to best-in-class, approach is being employed.

Best-in-class is an investment approach that focuses on companies that have historically performed better than their peers within a particular industry or sector on measures of environmental, social, and corporate governance issues. This typically involves positive or negative screening or portfolio tilting.

Best-in-class compares to exclusion, also called negative screening, where companies involved in certain “controversial” activities, such as tobacco or weapons are removed or excluded from an investor’s portfolio.

Best practice includes exclusions, ESG integration with a focus on best-in-class, and Impact investing, the full array of Sustainable Investing.

Crucially it requires an understanding of how to integrate ESG criteria in to the investment process, so as to capture the full value of the ESG factors.

 

Summary

DB note that the analysis on SRI performance goes a long way towards explaining why the concept of sustainable investing has taken so long to gain acceptance, it has been too closely associated for too long with the SRI fund manager results, which is a very broad category and has historically been based on exclusions, as opposed to a best-in-class screening.

They note that ESG investing, by contrast takes a best-in-class approach. DB have analysed the various categories within the universe of sustainable investing, they confidently say that the ESG approach, at an analytical level, works for investors and companies (in terms of lower cost of capital).

“It is now a question of ESG best-in-class funds capturing the available returns.” This is a key point.

So while Sustainable investing is the term use to refer to all form of investment, DB believe using ESG factors in a best-in-class approach is emerging as the key investment methodology. It is worth noting this was forecast in 2012 and is coming into fruition now.

DB note: “Investors should seek out investment managers who understand the ESG advantages and can leverage the information arbitrage that exists in the studies we examined. Sustainable Investing can pay dividends, but it requires managers who have internalised this information into their investment process and can also create appropriate strategies to help capture the upside that undoubtedly exists in this approach.”

Or put another way: “In effect, the conclusion is that there are superior risk-adjusted returns for investors, but managers need to take the right approach toward sustainable investing in order to capture these. For corporations, these are important results but the implication of lower cost of debt and equity capital must surely make this a key issue for any CFO, not just the CEO and Sustainability Officer.”

As an aside, this has implications in relation to the fee debate and manager selection. This will be covered in a future Post.

 

Another Comprehensive Study

A more recent study, ESG and financial Performance: aggregated evidence from more than 200 empirical studies, published in 2015 came up with similar conclusions.

They too found clear evidence in support of ESG investing. Their central conclusions was: “the orientation toward long term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors……..”

As  mentioned, implementation is key. Therefore, when selecting an index provider or/and active manager, their integration of ESG factors into the investment process and strategy is very important, as also highlighted by the DB study.

The full conclusion of the 2015 study:

“Through a second-level review of 60 review studies – including both, vote-count studies and meta-analyses – on the ESG–CFP relation, we are able to combine more than 3700 study results from more than 2200 unique primary studies. Based on this sample, we clearly find evidence for the business case for ESG investing. This finding contrasts with the common perception among investors. The contrary perception of investors may be biased due to findings of portfolio studies, which exhibit, on average, a neutral/mixed ESG–CFP performance relation. It is important to be aware that the results of these (to date about 150 studies) are overlaid by various systematic and idiosyncratic risks in portfolios and, in the case of mutual funds, by implementation costs. Still more than 2100 other – in particular company-focused – empiric studies suggest a positive ESG relation. ESG outperformance opportunities exist in many areas of the market. In particular, we find that this holds true for North America, Emerging Markets, and in non-equity asset classes. Our results propose that capital markets so far demonstrate no consistent learning effects regarding the ESG–CFP relation: Since the mid-1990s, the positive correlation patterns in primary studies have been stable over time.

 Based on this exhaustive review effort, our main conclusion is: the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors. A key area for future research is to better understand the interaction of different ESG criteria in portfolios and the relevance of specific ESG sub-criteria for CFP. These insights will shed further light on the ESG determinants for long-term positive performance impacts.”

 

Happy investing.

 

Please see my Disclosure Statement

 

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

 

Could Buffett be wrong?

As has been widely reported Warren Buffett frequently comments on the benefits of investing in low-cost index funds.

He’s reportedly instructed the trustee of his estate to invest in index funds. “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund,” he noted in the Berkshire Hathaway’s 2013 annual letter to shareholders.

 

Not that I want to disagree with Buffett, I have enormous respect for him, incorporate many of his investment insights and philosophies into my own investment approaches. Albeit, I think he might be wrong on this account.

And this is not to say Index Funds do not have a part to play in a portfolio, nor that investment fees are not important. They are. I do think more portfolios should be invested along the lines of Endowments. Broad diversification is the key.

 

Following Buffett could be the right advice for a young person starting out with many years until retirement.  Such an investor would need to weather the volatility of being largely invested in equities, which is no mean achievement when equity markets can suffer falls of over 40%. A high equity strategy can become horribly undone.

Nevertheless, as one gets closer to retirement and is in retirement Buffett’s strategy is unsuitable.

Similarly Buffett’s strategy is not appropriate for a Pension Fund or Endowment. These Funds are in a similar position to those in retirement. Meanwhile, the equity allocation should be reduced as one gets closer to retirement.

The short comings of a higher equity allocation was highlighted in a recent article  by Charles E.F. Millard, who is a consultant to AQR Capital Management, LLC.

 

Once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.

The key point that Millard makes is that Pension Funds and Endowments are required to make periodic payment obligations. So do those in retirement, they either draw capital or income from the portfolio to sustain a desired standard of living.

 

Ultimately, it the drawing of an income or the payments by Endowments that consume most of the investment returns. “This is why assets don’t just mushroom over time.”

As Millard explains, “each year endowments usually pay out at least 5% of their holdings, and the institutions they support tend to count on those funds. That changes the situation an awful lot.”

Let’s look at the math. Millard explains”

and assume that each year the endowment pays out 5% of its assets. In that case, starting at $1 million, the endowment would not have the $5.3 billion Buffett imagines. Rather, after having paid out almost $145 million along the way, the endowment would have less than $150 million remaining”

Still a great result, but far from the billions assumed by Buffett.

It is also worth noting that a Pension’s obligation (liability) can continue to grow as employees retire and live longer. The Pension Fund has no ability to reduce its payouts and must manage this risk.

 

This is where market volatility comes into play, particularly drawdowns – a large fall in the value of the market.

“In a prolonged stock market drawdown, those growing benefit payments will consume a larger share of the shrunken plan assets.  So, they can’t take too much solace in long-run optimism when in the intermediate run they’re already paying out much of their capital.”

 

This is a key point. You can’t take comfort in the long-term returns from equities when you are running out of money!

Equity markets do fall in value and this is why institutions with meaningful annual pay-out obligations are not invested only in equities.

 

No argument that equities will not outperform over the longer term, this is highly likely. Yet this observation fails to recognise the volatility inherent in equities.

Millard:

“Over Buffett’s 77 years investing, the endowment CIO would see fund assets decline in 23 out of 77 years (when equity returns didn’t cover the 5% distribution), and in the average bad year, the fund would shrink by -12%. But at least an endowment may be able to reduce its spending; a pension fund can’t, so in a bad year, the fraction of pension assets that must be paid out increases substantially. This is why most institutional investors subscribe to a concept that Buffett seems to hate – diversification. He’s said it’s “a protection against ignorance.” We think it is more a protection against hubris.”

Diversification is key.

“It is worth noting that Institutions do not seek to maximize potential long-term returns, without regard to risks. They often seek to maximize the likelihood that they can meet their payout obligations. They seek to be reliable payers of those obligations. And in the case of pensions, they also seek to make it possible for the employer to have somewhat predictable and affordable contribution obligations. A portfolio of stocks alone doesn’t do that. That’s why asset class diversification is a bedrock principle of modern investing.

 

In short, institutional investors have different goals and obligations to Buffett.

For those in retirement, their goals and obligations are more closely aligned with the Pension Fund and Endowment, than Buffett and Berkshire Hathaway. Those closer to retirement need to make sure that market volatility does not impact them and their ability to sustain the standard of level they wish to maintain in retirement.

 

Happy investing.

Please see my Disclosure Statement

 

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

The balancing act of the least liked investment activity

A recent Research Affiliates article on rebalancing noted: “Regularly rebalancing a portfolio to its target asset mix is necessary to maintain desired risk exposure over the portfolio’s lifetime. But getting investors to do it is another matter entirely—many would rather sit in rush-hour traffic! “

“A systematic rebalancing approach can be effective in keeping investors on the road of timely rebalancing, headed toward their destination of achieving their financial goals and improving long-term risk-adjusted returns.”

Research Affiliates are referencing a Wells Fargo/ Gallup Survey, based on this survey “31% of investors would opt to spend an hour stuck in traffic rather than spend that time rebalancing their portfolios. Why would we subject ourselves to gridlock instead of performing a simple task such as rebalancing a portfolio?

 

I can’t understand why rebalancing of an investment portfolio is one of least liked investment activity, it adds value to a portfolio overtime, is a simple risk management exercise, and is easy to implement.

It is important to regularly rebalance a Portfolio so that it continues to be invested as intended to be.

 

A recent article in Plansponsor highlighted the importance of rebalancing. This article also noted the reluctance of investors to rebalance their portfolio.

As the article noted, once an appropriate asset allocation (investment strategy) has been determined, based on achieving certain investment goals, the portfolio needs to be regularly rebalanced to remain aligned with these goals.

By not rebalancing, risks within the Portfolio will develop that may not be consistent with achieving desired investment goals. As expressed in the article “Participants need to make sure the risk they want to take is actually the risk they are taking,” …………..“Certain asset classes can become over- or under-weight over time.”

Based on research undertaken by BCA Research and presented in the article “Rebalancing is definitely recommended for all investors, perhaps more so for retirement plan participants than others, as they are more likely to be concerned with capital preservation than capital appreciation.”

The following observation is also made “While a portfolio that is not rebalanced will have a greater allocation to equities during a bull market and, therefore, outperform a rebalanced portfolio, all rebalanced portfolios outperformed an unbalanced portfolio during periods leading up to market corrections and recessions,” Hanafy says, citing a BCA Research study which looked at three main rebalancing scenarios of a simple 60/40 portfolio since 1973.

The potential risks outlined above is very relevant for New Zealand and USA investors currently given the great run in the respective sharemarkets over the last 10 years.

When was last time your investment fiduciary rebalanced your investment portfolio?

 

Rebalancing becomes more important as you get closer to retirement and once in retirement:

“There are two main components to retirement plans: returns and the risk you take,” …… “When you do not rebalance your portfolio, a participant could inadvertently take on too much risk, which would expose them to a market correction. This is important because, statistically, as participants reach age 40 to 45, how much risk they take on is far more important than how much they save. When you are young, the most important thing is how much you save.”

Rebalancing Policy

As the article notes, you can systematically set up a Portfolio rebalancing approach based on time e.g. rebalance the portfolio every Quarter, six-months or yearly intervals.

It is not difficult!

Alternatively, investment ranges could be set up which trigger a rebalancing of the portfolio e.g. +/- 3% of a target portfolio allocation.

Higher level issues to consider when developing a rebalancing policy include:

  • Cost, the more regularly the portfolio is rebalanced the higher the cost on the portfolio and the drag on performance. This especially needs to be considered where less liquid markets are involved;
  • Tax may also be a consideration;
  • The volatility of the asset involved;
  • Rebalancing Policy allows for market momentum. This is about letting the winners run and not buying into falling markets too soon. To be clear this is not about market timing. For example, it could include a mechanism such as not rebalancing all the way back to target when trimming market exposures.

 

My preference is to use rebalancing ranges and develop an approach that takes into consideration the above higher level issues. As with many activities in investing, trade-offs will need to be made, this requires judgement.

 

As noted above, it appears that rebalancing is an un-liked investment activity, if not an over looked and underappreciated investment activity. This seems crazy to me as there is plenty of evidence that a rebalancing policy can add value to a naïve monitoring and “wait and see” approach.

I think the key point is to have a documented Rebalancing Policy and be disciplined in implementing the Policy.

 

This also means that those implementing the Rebalancing Policy have the correct systems in place to efficiently carry out the Portfolio rebalancing so as to minimise transaction costs involved.

Be sure, that those responsible for your investment portfolio can efficiently and easily rebalance your portfolio. Importantly, make sure the rebalancing process is not a big expense on your portfolio e.g. trading commissions and the crossing of market spreads (e.g. difference between buy and sell price), and how close to the “market price” are the trades being undertaken?

These are all hidden costs to the unsuspecting.

 

A couple of last points:

  • It was noted in the recent Kiwi Investor Blog on Behaviour Finance that rebalancing of the portfolio was an import tool in the kit in helping to reduce the negative impact on our decision making from behavioural bias. It is difficult to implement a rebalancing policy when markets are behaving badly, discipline is required.
  • The automatic rebalancing nature of Target Date Funds is an attractive feature of these investment solutions.

 

To conclude, as Research Affiliates sums up:

  1. Systemic rebalancing raises the likelihood of improving longer-term risk-adjusted investment returns
  2. The benefits of rebalancing result from opportunistically capitalising on human behavioural tendencies and long-horizon mean reversion in asset class prices.
  3. Investors who “institutionalise contrarian investment behaviour” by relying on a systematic rebalancing approach increase their odds of reaping the rewards of rebalancing.

 

It is not hard to do.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Recessions, inverted yield curves, and Sharemarket returns

Fears of economic recession, particularly in the US, peaked over the final three months of 2018.

Nevertheless, talk of economic recession has now faded into the background after the US Federal Reserve hit the pause button to further interest rate increases in January of 2019. The Fed is not expected to raise interest rates again in 2019.

This is not to say that a recession will not occur, it will at some stage, just as night follows day. The economic/business cycle has not been conquered.

Nevertheless, the timing of the next recession is unknown. Take Australia for example, their last recession was over 28 years ago. New Zealand is over 9 years since their last recession.

With regards to the US, in July of this year the US economy will enter its longest period in history without incurring a recession. Their economy remains on a sound footing: interest rates remain low, the US consumer is confident, businesses are investing, the Government is increasing spending, and forward looking indicators of economic activity remain positive. Lastly, housing activity is likely to pick up over the second half of 2019.

 

What is a Recession?

A recession is defined as at least two consecutive quarters of declining economic growth. The US National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real gross domestic product (GDP), real income, employment, industrial production and wholesale-retail sales.”

 

A recent article by the Capital Group: Preparing for the next recession: 9 things you need to know provides a good overview of the ins-and-outs of economic recession.

 

The good news, as Capital highlight, recessions generally aren’t very long.

Capital undertook analysis of 10 US economic cycles since 1950. This analysis showed that recessions have lasted between eight and 18 months, with the average spanning about 11 months. Unfortunately New Zealand’s history is a little more chequered than the US.

Investors with a long-term investment horizon, should expect to experience a number recession over their investment horizon and therefore look through the full economic cycle. Fortunately, for most of us, we spend more time in economic expansion than in recession.

Capital note, “over the last 65 years, the U.S. has been in an official recession less than 15% of all months.”

The following graph highlights the average length, total growth, and returns from the average stock market return over the average recession and economic expansion.

Notably, “equity returns can even be positive over the full length of a contraction, since some of the strongest stock rallies have occurred during the late stages of a recession.”

The human cost of economic recession is provided in the form of jobs lost and this should not be forgotten.

 

Economic cycles Capital.jpg

 

From a sharemarket perspective, a bear market, defined as a 20% or more fall in value, usually overlaps with recessions.

Share markets tend to lead the economic cycle, given they are forward looking. Sharemarkets on average peak six months prior to the onset of a recession. They continue to fall during the early stages of a recession.

The recovery in sharemarkets often takes hold while the economy is still in recession (economic growth is still contracting).

The initial bounce in sharemarkets is often a period of strong performance and occurs before there is any hard evidence of a pickup in economic activity.

The following graph presents the above sequencing and overlapping nature of sharemarket returns and recessions.

Sharemarket returns and recession cycles.png

 

Having said all that, stock markets are not good predictors of economic recession i.e. a sharp fall in global sharemarket does not mean there will be an onset of global economic recession.

This is captured by the well know quote from Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

 

Sharemarket Returns and Inverted Yield Curves

There has been a lot of discussion over the last twelve months about the implications of an inverted US yield curve. (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months). A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Parts of the US yield curve are currently inverted, and this inversion has increased over recent days.

The significance of this is that prior to the last 7 US recessions the yield curve has inverted prior each time. An inverted yield curve has by and large been a good predictor of recession.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

The following analysis undertaken by Wellington Management looks at the performance of the US sharemarket in relation to yield curves inversions.

The period of analysis is from the 1950s at which time the US Federal Reserve gained full, independent control over interest rates from the US Treasury. As Wellington note, “it was after this transition that the yield curve became an effective tool for gauging the impact of monetary policy on the economy and the prospect of a recession.”

Wellington present the following analysis and the Table below:

  • “As shown in the third column (of Table below), the S&P 500 peaked ahead of a yield-curve inversion only twice (1959 and 1973).
  • “The median time between inversion and peak equity returns was 17 months, and in several cases the market peaked almost two years or more after inversion.”
  • “Aggregate equity returns post-inversion have been partly dependent on the length of time between the initial inversion and the start of the recession.”
  • “Since returns tend to be negative right around the time a recession begins, the instances in which there was a shorter period between the initial inversion and the start of the recession were more likely to have a negative return.”

 

Just like there is a period of time between economic recession and an inverted yield curve, the sharemarket often peaks after the yield curves inverts.

Sharemarket returns and inverted yield curves.png

 

Back to the Capital article, for it also runs through a number of other recession related questions.

Of interest are:

What economic indicators can warn of a recession?

  • Capital outline some generally reliable signals worth watching closely, such as an inverted yield curve, corporate profits, unemployment, and leading economic indices.
  • Importantly it is appropriate to look at and consider several different economic indicators.

 

What Causes Recessions?

  • There are many reasons for a recession, chief amongst them are rising interest rates, particularly by Central Banks such as the US Federal Reserve and Reserve Bank of New Zealand, imbalances within an economy e.g. excess housing prices, high debt levels
  • Every economic cycle is unique, but anything that impacts on corporate profits or consumer spending, such as rising unemployment, are factors to consider.

 

Just remember is it notoriously difficult to predict economic recession and they are normally the result of a number of factors that have a cascading effect leading to an economic downturn.

 

The following Kiwi Investor Blog Posts maybe of interest to those wanting a better understanding of inverted yield curves, leading economic indicators, and historical performance of equity market corrections.

Recession predictability of inverted yield curves and other economic indicators to considered:

 

Analysis of Sharemarket corrections and market declines

 

Lastly the Capital article provides some suggestions as to how to position your portfolio for a recession. I think it is exceedingly difficult to finesse a portfolio in the expectations of a recession.

From my perspective, the following is most critical:

  • Maintain a long-term perspective;
  • Implement a balanced and broadly diversified portfolio. Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration (movements in interest rate), economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks;
  • Know you risk tolerance: what level of volatility in capital are you prepared to handle without changing your mind;
  • Understand your risk capacity: the amount of risk you need to take in order to reach your financial goals;
  • Implement a goals-based investment approach, where success is measured on how you are tracking relative to your investment goals, rather than market index performances; and
  • Always maintain a high quality portfolio, with plenty of liquidity, and limit the level of turnover across the portfolio e.g. amount of trading (buying and selling)

 

A good advisor should be able to help you with the above and see you through bouts of sharemarket volatility, including a recession environment.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

cropped-title-picture-enhanced.jpg

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, a robust portfolio is broadly diversified across different risks and returns.

Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

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

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative, and hedge fund risk premia. And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above. There has been a disaggregation of investment returns.

Not all of these risk exposures can be accessed cheaply.

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

 

Growing importance of ESG within the Alternatives sector

The growing importance of ESG within the Alternatives sector is one of the key themes from the JP Morgan Alts Survey March 2019.  This survey provides some fascinating detail on the state of the Global Alternatives industry, including Private Equity, Real Estate, Infrastructure and Hedge Funds.

Some of the other highlights from the survey include:

  • Diversified benefits – correlation matrix
  • Strategy and manager selection is vitally important – dispersion of manager returns
  • Detailed analysis of the varying Alternative categories e.g. hedge funds and real estate, including drivers of returns

 

As noted in previous Posts, Kiwisaver Funds are underweight Alternatives relative to the rest of the world, an alternatives allocation would be beneficial for Target Date Funds, and US Endowment have provided superior long term returns after fees due their successful allocations to Alternatives.

 

The benefits of Alternatives have been well documented and they are set to continue to become a larger part of Client portfolios over time as outlined by the recently published Prequin Global Alternatives Report.

 

Therefore, not surprisingly, according to JP Morgan, “Institutional investors are flocking to hedge funds this year, even after a turbulent 2018 marked by poor performance and market volatility.”

The demand for hedged funds is driven by the search for market-beating returns and diversification.

They found that about a third of respondents plan to boost allocations, up from 15 percent in 2018. Just 13 percent expect a decrease while 55 percent said they plan to maintain current allocations.

As a recent Bloomberg article highlighted, the hedge fund industry took its biggest annual loss last year since 2011, declining 4.8 percent on a fund-weighted basis, according to Hedge Fund Research Inc. Managers were hurt by volatility that trampled markets, and hedge funds saw $33.5 billion in outflows.

JPMorgan polled 227 investors with about $706 billion in hedge fund assets for its annual Institutional Investor Survey.

 

For those new to Alternatives, a recent Investment News article provides some wonderful insights into the benefits of Alternatives and implementation challenges with clients.

With regards to the benefits of Alternatives, comments by Dick Pfister, founder and president of AlphaCore Capital, a firm that allocates between 15% and 30% of client assets to alternative investments, are worth highlighting.

“We look at some alternatives as diversifiers,” he said. “But we will also look at other alternatives as ways to capture chunks of up markets.”

The article notes the “message that investors, advisers and allocators like Mr. Pfister understand is that the big picture perspective rarely looks good for alternative investments, which is why those who dwell on broad category averages often get stopped at the gate.”

The article continues “Making the case for alternatives, which are generally designed to neutralize market beta and enhance alternative alpha, is never easy when market beta is robust in the form of a bullish stock market.”

“That is the reality of allocating to alternative investments. To benefit from the diversifying factors, investors and advisers must appreciate that losing less than the market can often mean gaining less than the market.”

“There’s always something to complain about when you have a diversified portfolio,” said Hans-Christian Winkler, a financial planner at Claraphi Advisory Network, where client portfolios have between 20% and 30% allocated to alternatives.

“A diversified portfolio will never outperform the market, but in times like the last quarter of 2018, when we saw the market down 20% from the high, our portfolios with alternatives were down 5%,” he added. “By using alternatives, you are spreading out your risk and making your investment portfolio a lot less bond-market- and stock-market-dependent.”

 

These are key points, they highlight the benefits but also the challenges when it comes to positioning Alternatives with clients and stakeholders e.g. Trustees, Investment Committees.

Alternatives “underperform” on a relative basis when equity and bond markets perform strongly.  This can have some challenges with Clients, the article is well worth reading from this perspective, as it provides insights into how a number of Advisors are positioning Alternatives with their Clients.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Risk Measure of Wealth Management

Risk is not the volatility of your investment portfolio, or volatility of returns, risk is determined by your investment goals.

This is the view of Nobel laureate Professor Robert Merton. Such an assessment of risk also underpins many Goals-Based wealth management solutions.

More robust investment solutions are developed when the focus on risk moves beyond variations of returns and volatility of capital. The key risk is failure to meet your investment objectives.

 

The finance industry, many financial advisors and academics express risk as the variation in returns and capital, as measured by the standard deviation of returns, or variance.

Nevertheless, clients often see risk as the likelihood of not attaining their investment goals.

The traditional financial planning approach is to understand client’s goals, then ask questions to determine risk tolerance, which then leads to advising a client to adopt a portfolio that has a mean expected return and standard deviation corresponding to the Client’s risk appetite.  Standard deviation of returns, variation in capital, becomes the measure of risk.

 

Nevertheless, a different discussion with clients on their goals will likely result in a different investment solution. It will also improve the relationship between the Client and the Advisor.

Such a discussion will lead to more individualised advice and a better understanding of the choices being made. Clients will be in a better place to understand the impacts of their choices and the probability of achieving their goals. It will be more explicit to them in making trade-offs between playing it safe and taking risks to achieve their investment goals.

A goals based approach provides a more intuitive, transparent, and understandable planning approach.

Ultimately it leads to a more robust portfolio for the Client where information from the goals-based discussion can be mapped to a specific range of portfolios.

It is also a dynamic process, where portfolios can be updated and changed on new discussions and information. The process can adapt for multiple-goals over multiple time periods.

This is in stark contrast to the single period single objective, static portfolio traditionally implemented based on risk appetite.

There is also a strong foundation in Behaviour Economics supporting the Goals-Based investment approach.

 

I have covered Merton’s view in previous Posts, so please don’t accuse me of confirmation bias!

Merton’s views on risk is also well presented in a 2016 i3 Invest article in Australia, Risk is determined by Investment goal.

“Risk is not simply expressed as the volatility of your invested assets, but is determined by your ultimate goal, according to Nobel laureate Robert Merton.”

 

The i3 article provides an example on how your goal determines to a large degree what your risk-free asset is.

The goal provides a starting point for determining:

  • how far removed you are from achieving your objectives; and
  • importantly, how much risk you need to take to have a chance of meeting these objectives.

 

“If you had as your goal to pay your (Australian dollar) tax bill in a year from now, then what is the safe asset for you?”

“It would be an Australian dollar, one year, zero coupon, Australian Treasury Bill that matures in one year. That would be the sure thing.”

 

As the i3 article mentions Merton has criticised the idea that superannuation is a pot of money, instead of a basis for generating an income stream.

Merton argues that there should be greater focus on generating replacement income in retirement and we need to stop looking at account balances and variations in account balances. Instead, we should focus on the income that can potentially be generated in retirement from the investment portfolio, pot of money.

 

This is not a radical idea, this is looking at the system in the same way as Defined Benefit Funds did, the “old” style funds before the now “modern” defined contributions fund (where the individual takes on all the investment risk).  Defined contributions funds focus on the size of the pot.  The size of the superannuation pot (Kiwisaver account balance) does not necessarily tell you the standard of living that can be supported in retirement.  This is Merton’s critical point.

 

A greater focus on income is aligned with goals-based investment approach.

As Merton’s explains, if we accept we should focus on income, targeting sufficient replacement income in retirement, the development of a comprehensive income product in retirement is not difficult. He concludes, “This doesn’t require the smartest scientist in Australia to solve this problem. We know how to do it, we just need to go out and do it,”.

 

As noted above I have previously Posted on Merton’s retirement income views. The material from these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Professor Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.

 

For those wanting a greater understanding of Merton’s views and rationale please see:

  1. What matters for retirement is income not the value of Accumulated Wealth
  2. Is variability of retirement income a better measure of risk rather than variability of capital? – What matters for retirement is income not the value of Accumulated Wealth

 

Happy investing.

 

Please see my Disclosure Statement

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