The psychology of Portfolio Diversification

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.

Please see my Disclosure Statement

 

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

 

 

 

Tailored Investment solutions boost superannuation outcomes – Lifecycle Funds outperform Balanced Funds

A greater level of customisation leads to better investment outcomes for investors.

For example, Multifactor Lifecycle Funds that focus on age and size of account balances are best placed to last the distance as we live for longer in retirement, compared to a Balanced Fund and Lifecycle Funds that focus on age alone.

Multifactor Lifecycle Funds:

  1. Generate higher expected lifetime income relative to a Balanced Fund (70% equities and 30% Fixed Income and Cash); and
  2. Outperform a Balanced Fund over 90% of the time based on a numerous number of different market and economic scenarios.

These are the key findings of the Rice Warner’s research paper: Lifecycle Design – To and Through Retirement.

Lifecycle Funds, also referred to as Glide Path Funds, Target Date Funds, or Lifestages Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor approaches retirement.

 

Rice Warner found that somebody aged 30 with an opening balance of $26,000 and invested in a Multifactor Lifecycle Fund had a 91.8% chance of outperforming a Balanced Fund by the time of retirement at age 63.

Their research also found that by investing in a Multifactor Lifecycle Fund the expected retirement income is up to 35% higher than that expected from a Balanced Fund (Source: Australian AFR The product that can boost super by 35pc).

For somebody aged 60 with an account balance of $118,300, a Multifactor Lifecycle Fund had a 72.4 per cent chance of outperforming a Balanced Fund.

Lastly, Second Generation Lifecycle Funds, which reduce their growth allocation later, outperformed a Balanced Fund 91.2% of the time. A Multifactor Lifecycle Fund outperforms a Second Generation Lifecycle Fund 84.6% of the time.

 

A key conclusion from the Rice Warner research is that Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to enhance outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

 

They achieve this by adopting a more growth-oriented stance while an investor has a long investment horizon and shifting to defensive assets when the investor’s investment horizon grows short.

Importantly, an individual’s investment horizon is a function of not only age but also the size of their superannuation account. This is an important concept, the rationale is provided in the section below – The Benefits of a Multifactor Lifecycle Fund.

 

A summary of the Rice Warner analysis is provided below, along with key Conclusions and Implications for those aged 30 and 60.

A copy of the Rice Warner analysis can be found here.

 

To my mind, there is going to be an increased customisation of investment solutions available for those saving for retirement that will consider factors beyond age e.g. account size, salary, and assets outside of Super.  Some are available already.

Technology will enable this, Microsoft and BlackRock are well advanced in collaborating, BlackRock and Microsoft want to make retirement investing as easy as ordering an Uber.

 

In relation to Lifecycle Funds, they are subject to wide spread criticism.

Some of this criticism is warranted, nevertheless, often the criticism is the result of the poor design of the Fund itself, rather than concept of a Lifecycle Fund itself. This is highlighted in the Rice Warner research, where the first Generation of Lifecycle Funds de-risk to early.

I covered the criticism of Lifecycle Funds in a previous Post, in the defence of Lifecycle Funds.

 

Lifecycle Funds can be improved upon. For example a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

In my opinion, all investments strategies would benefit from a greater focus on tangible investment goals, this will lead to a more robust investment solution.

A Goals based investing approach is more robust than the application of “rule of thumbs”, such as the 4% rule and adjusting the growth allocation based purely as a function of age.

Goals based investing approaches provide a better framework in which to assess the risk of not meeting your retirement goals.

Greater levels of customisation are required, which is more relevant in the current investment environment.

 

 

Rice Warner – The benefits of Multifactor Lifecycle Funds

Investment literature indicates that an investor’s investment horizon is a key determinant of an appropriate investment strategy.

The consequence of longer investment horizons allows an investor to take on more risk because even if there is a severe market decline there is time to recover the losses.

Furthermore, and an important observation, Rice Warner’s analysis suggests that as we enter retirement investment horizon is a function of age and size of the superannuation account balance.

A retiree with a larger account balance has in effect a longer investment horizon. They are in a better position to weather any market volatility.

This reflects, that those with a small account size typically withdraw a greater proportion of their total assets each year, indicative of largely fixed minimum cost of living, resulting in a shorter investment horizon.

 

A very big implication of this analysis is that an investor’s investment horizon is “not bounded by the date that they choose to retire (though this point is relevant). This is as a member is likely to hold a substantial proportion of their superannuation well into the retirement phase, unless their balance is low.”

“One consequence of this is that investment strategies which consider this retirement investment horizon may deliver better outcomes for members – both to and through retirement. This is because as a member’s account balance grows, sequencing risk becomes less relevant allowing higher allocations to growth assets.”

For those wanting a better understanding of sequencing risk, please see my earlier Post.

 

Rice Warner conclude, Lifecycle strategies that use factors in addition to age, such as superannuation account balance size, provide the ability to better tailor a portfolio to provide enhanced outcomes for those saving for retirement. Therefore, they often outperform other investment strategies.

Thus, the title of their research Paper, Lifecycle Design – To and Through Retirement, more often than not investors should still hold a relatively high allocation to growth assets in retirement.  They should be held to the day of retirement and throughout retirement.

The research clearly supports this, a higher growth asset allocations should be held to and through retirement.  In my mind this is going to be an increasingly topically issue given the current market environment.

 

 

Rice Warner Analysis

Rice Warner considered several investment strategies applied to various hypothetical members throughout their lifetime.

They assess the distribution of outcomes of the investment strategies to establish whether adjustments can be made to provide members with better outcomes overtime.

Rice Warner considered:

  1. Balanced Strategy which adopts a fixed 70% allocation to Growth assets.
  2. High Growth strategy which adopts a fixed 85% allocation to Growth assets.
  3. First-generation Lifecycle (Lifecycle 1 (Age)) with a focus on defensive assets and de-risking at young ages.
  4. Second-generation Lifecycle (Lifecycle 2 (Age)) with a focus on growth assets and de-risking at older ages.
  5. Multi-dimensional Lifecycle (Lifecycle (Age and Balance)) which adopts a high allocation to growth assets unless a member is at an advanced age and has a low balance.

Six member profiles selected to capture low, moderate, and high wealth members at ages 30 and 60.

Rice Warner then considered the distribution of expected lifetime income under a range of investment scenarios using a stochastic model.

This allowed for a comparison of the income provided to members under each strategy in a range of investment situations for comparative purposes.

 

Conclusions

Rice Warner Conclude:

  • Investment horizon is a critical driver in setting an appropriate investment strategy. Investment strategies should take into consideration a range of investment horizon, both before and after retirement.
  • Adopting high allocations to growth assets is not inherently a poor strategy, even in cases where members are approaching retirement. These portfolios will typically provide:
    • Improved outcomes in cases where members are young, or investment performance is strong;
    • Marginally weaker outcomes where members are older and investment performance is weak.
  • Second-generation Lifecycle investment strategies (focused on growth assets and late de-risking) will typically outperform first generation strategies (which are focused on defensive assets and de-risking when a member is young).
  • Growth-oriented constant strategies will typically outperform First-generation Lifecycle strategies, except where investment performance is poor.
  • Designing Lifecycle strategies that use further factors in addition to age (such as balance) provide the ability to better tailor a portfolio to provide enhanced outcomes by:
    • Adopting a more growth-oriented stance while a member has a long investment horizon.
    • Shifting to defensive assets when a member’s investment horizon grows short.

 

Implications

Overall the results, aged 30:

  • High Growth strategies can provide significant scope for outperformance with minimal risk of underperformance relative to a Balanced Fund due to the members’ long investment horizon.
  • First-generation Lifecycle strategies will typically underperform each of the other strategies considered except where investment outcomes are poor for a protracted period. This underperformance is a result of the defensive allocation of these strategies being compounded over the member’s long investment horizon.
  • Second-generation Lifecycle can mitigate the risk faced by the members over their lifetime, albeit at the cost of a reduced expected return on their portfolio relative to a portfolio with a higher constant allocation to growth assets.
  • Lifecycle strategies which adjust based on multiple factors are able to manage the risk and return trade-off inherent to investments in a more effective way than single strategies or Lifecycle strategies only based on age. This is a result of the increased tailoring allowing the portfolio to adopt a more aggressive stance when members are young and thereby accumulate a high balance and extend their investment horizon further. This leads to this portfolio often outperforming the other strategies considered.

 

For those aged 60

  • High Growth strategies can provide significant outperformance in strong investment conditions. This comes at the cost of a modest level of underperformance in a poor investment scenario (a reduction in total lifetime income for members ranging between 2% and 5% relative to a Balanced fund).
  • First-generation Lifecycle strategies will underperform in neutral or strong market conditions due to their lack of growth assets. In cases where investment performance is poor these strategies outperform the other strategies considered particularly for those with low levels of wealth (due to their short investment horizons).
  • Two-dimensional Lifecycles provide enhanced risk management (but not necessarily better expected performance) by providing:
    • Protection for members who are vulnerable to sequencing risk with short investment horizons (low and moderate wealth profiles) by adopting a Balanced stance.
    • High allocations to growth for members whose investment horizon is long (high wealth profiles).

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Forecasted investment returns remain disappointing – despite recent market movements

Long-term expected returns from global sharemarkets have not materially changed despite recent sharemarket declines.

The longer term outlook for fixed income returns has deteriorated materially.

There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.

This should prompt some introspection as to the robustness of current portfolios.

From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.

A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term.

By way of example, the expected long-term return from a traditional Balanced Portfolio, of 60% Equities and 40% Fixed Income, is going to be very challenging.

Arguably, the environment for the Balanced Portfolio has worsened, given return forecasts for fixed income and that they are not expected to provide the same level of portfolio diversification as displayed historically.

The strong performance of fixed income is a key contributing factor to the success of the Balanced Fund over the last 20 years. This portfolio plank has been severely weakened.

 

Asset Class expected forecasted Returns

A clue to future expected returns is outlined in the following Table generated by GMO, which they update on a regular basis.

The Table presents GMO’s 7-Year Asset Class Real Return Forecasts (after inflation of around 2%), as at 31 March 2020.

GMO 7-YEAR ASSET CLASS REAL RETURN FORECASTSGMO 7-Year Asset Class Real Return Forecasts March 2020

 

An indication of the impact of recent market performance on future market forecasts can be gained by comparing current asset class forecast returns to those undertaken previously.

The following Table compares GMO’s 7-Year Asset Class Real Returns as 31 March 2020 to those published for 31 December 2019.

The first column provides the 7-Year return forecasts updated as at 31 March 2020. These are compared to GMO’s return forecast at the beginning of the year.

The last column in the Table below outlines the change in asset class forecasted returns over the quarter.

31-Mar-20

31-Dec-19

Change

US Large

-1.5%

-4.9%

3.4%

US Small

1.4%

-2.2%

3.6%

International Equities

1.9%

-0.8%

2.7%

Emerging Markets

4.9%

3.5%

1.4%

US Fixed Income

-3.8%

-1.8%

-2.0%

International Fixed Income Hedged

-4.3%

-3.5%

-0.8%

Emerging Market Debt

3.0%

-0.6%

3.6%

US Cash

-0.2%

0.2%

-0.4%

       
US Balanced (60% Equities / 40% Fixed Income)

-2.4%

-3.7%

1.2%

International Balanced

-0.6%

-1.9%

1.3%

The following observations can be made from the Table above:

  • Although the return outcomes for equities have improved, they remain low, under 2% p.a. after inflation;
  • Emerging markets equities offer the most value amongst global sharemarkets, generally returns outside of the US are more attractive;
  • Expected returns from developed market fixed income markets have deteriorated, particularly for the US;
  • The expected outlook for Emerging Market debt has improved materially over the last three months; and
  • The return outlook for the Balanced Fund remains disappointing despite an improvement.

 

Impact of recent market movements on expected returns

The degree to which forecast sharemarket returns have increased may disappoint, particular given the extreme levels of market volatility experienced over the first quarter of 2020.

This in part reflects that global sharemarkets as a group “only” fell 11.5% over the first three months of the year. It probably felt like more.

Furthermore, although declining sharemarkets now translates to higher expected returns in the future, it is not a one for one relationship.

 

The relationship between current market performance and the impact on forecast returns is well captured by a recent Research Affiliates article.

As they note “When a market corrects dramatically, say, 30%, long-term expected returns do not rise by the same 30%.”

They illustrate this point using the US market (S&P 500 Index).

 

Research Affiliates estimate that a 30% pullback (drawdown) in the US sharemarket implies an increase in expected return of 1.7% a year for the next decade.

This is based on their assumptions for average real earnings per share over a rolling 10-year period for US companies and their estimate of fair value for the US sharemarket over the longer term. For an estimation of fair value they apply a cyclically adjusted price-to-earnings (CAPE) ratio.

The return estimate is based on the level and valuation of the US sharemarket on the 19th February, when the US market reached a historical high level (Peak).

The interrelationship between current market value, expected earnings, and the estimate of longer term value and their impact on expected returns is captured in the following diagram.

Based on market valuation, as measured by CAPE on 19th February 2020, the right-hand side displays the estimated change in expected returns from a decline in the US sharemarket from the peak in February e.g. a 30% drop in the S&P 500 Index from the Peak translates to a 1.7% change in Expected Return from valuation (change in CAPE).

The central point remains, a drop in the sharemarket today translates into higher expected returns.

Research Affiliates CAPE and Expected Return Estimates at Different Market Prices

The diagram above also captures the changing valuation of the market, as measured by CAPE, to a decline in the US sharemarket, as outlined on the left-hand side.

 

Research Affiliates long-term expected returns for a wide range of markets can be found on their homepage.

 

Caution in using Longer-term market forecasts

Forecasting the expected return for sharemarkets is extremely tricky, to say the least, with the likely variation in potential outcomes very widely dispersed.

Forecasting fixed income returns has a higher level of certainty.  The current level of interest rates provides a good indication of future returns. Given the dramatic fall in interest rates over the last three months, the expected returns from fixed income has deteriorated.

 

Nevertheless, caution should be taken when considering longer-term market forecasts.

This is emphasised in the Research Affiliates article, their “expected return forecasts also come with a warning label: Long-term expected returns, unto themselves, are not sufficient for short-term decision making. Ignoring this warning will most likely lead to impaired wealth.

Ten-year return forecasts offer valuable guidance to a buy-and-hold investor about the return they are likely to earn over the next decade. They provide no information, however, about when to buy or sell and do not identify a market top or bottom.”

 

Challenging Investment Environment

From a risk management perspective an assessment should be undertaken to determine if current portfolio allocations are appropriate in meeting client investment objectives over the longer term.

A set and forget strategy does not look appropriate at this time. Serious thought should be given to where expected returns are going to come from over the medium to longer term

There is no doubt the investment environment is going to be challenging, not just in the months ahead, over the medium to longer term as well.

 

This should prompt some introspection as to the robustness of current portfolios.

For example, the low expected return environment led GMO to declare earlier in the year it is time to move away from the Balanced Portfolio. The Balanced Portfolio is riskier than many people think.

The low expected return environment and reduced portfolio diversification benefits of fixed income is why the Balanced Fund is expected to underperform.

 

It is also partly driving institutional investors to develop more robust portfolios by investing outside of the traditional asset classes of equities and fixed income by increasing their allocations to alternative investments.

As highlighted by a recent CAIA survey investments into alternatives, such as private equity, real assets, and liquid alternatives, are set to grow over the next five years, becoming a bigger proportion of the global investment universe.

 

Research by AQR highlights that diversifying outside of the traditional asset is the best way to manage through severe sharemarket declines. Furthermore, diversification should work in good and bad times

 

For those interested, posts on the optimal private equity allocation and characteristics and portfolio benefits of real assets may be of interest.  Real assets offer real portfolio diversification benefits, particularly in different economic environments.

My Post Investing in a Challenging Investment Environment outlines suggested changes to current investment approaches that could be considered.

 

Good luck, stay healthy and safe.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

Sharemarket crashes – what works best in minimising losses, market timing or diversification?

The best way to manage periods of severe sharemarket declines, as recently experienced, is to have a diversified portfolio, it is impossible to time these episodes.

A 2018 paper by AQR evaluated the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

They analysed the potential benefits and costs of shifting away from equities, including into investments that are diversifying (i.e. are lowly correlated to equities) and investments that provide a market hedge (i.e. expected to outperform in bad times).

To diversify a portfolio AQR recommends adding return sources that make money on average and have a low correlation to equities i.e. their returns are largely independent of the performance of sharemarkets.

They argue that diversification should be true both in normal times and when most needed: during tough periods for equities.

Furthermore, as AQR emphasis, “diversification is not the same thing as a hedge.” Although “hedges”, e.g. Gold, may 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.

Therefore, alternative investments 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.

 

The analysis highlights that the funding source can matter just as much as the new diversifying investment. Funding from equities reduces drawdown losses, however, longer term returns are on average lower when compared to funding the allocation proportionally from the 60/40 equity/fixed income split.

 

Portfolio diversification is harder to achieve in practice than in theory. It involves adding new “risks” to a portfolio. Risks that have their own return profile largely independent of other investment strategies within a Portfolio.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

Any new lowly correlated investment should be vigorously assessed and well understood before added to a portfolio.

The success of which largely rests with manager selection.

 

A summary of the AQR analysis is provided below, first, the following section discusses the challenges and characteristics of achieving portfolio diversification.

 

The challenges and characteristics of Portfolio Diversification

AQR advocate that diversification is a better solution to mitigating the pain of severe sharemarket falls than trying to time markets.

Specifically, they recommend adding return sources that make money on average and have a low correlation to equities.

 

Lowly correlated assets can be tremendously valuable additions to a portfolio.

Lowly correlated means returns that are not influenced by the other risks in the portfolio e.g. hedge funds and liquid alternative strategy returns are largely driven by factors other than sharemarket and fixed income returns.

Therefore, although diversifying strategies can lose money in large sharemarket drawdowns, this does not mean they are not portfolio diversifiers. The point being, is that on “average” they do not suffer when equities do.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

In contrast, a hedge is something you would expect to do better than average exactly when other parts of the portfolio are suffering. Although this sounds attractive, hedges come with a cost. This is discussed further below.

 

Adding diversifying strategies to any portfolio means adding new risks.

The diversifying strategies will have their own risk and return profile and will suffer periods of underperformance – like any investment.

Therefore, as AQR note, implementing and maintaining portfolio diversification is harder in practice than in theory.

Portfolio diversification in effect results in adding new risks to a portfolio to make it less risky.  Somewhat of a paradox.

This can be challenging for some to implement, particularly if they only view the risk of an investment in isolation and not the benefits it brings to the total portfolio.

Furthermore, adding more asset classes does not equal more diversification, as outlined in this Post.

 

Background

Most portfolios are dominated by sharemarket risk. Even a seemingly diversified balanced portfolio of 60% equities and 40% fixed income is dominated by equity risk, since equities tend to be a much higher-risk asset class. Although equities have had high average returns historically, they are subject to major drawdowns such that the overall “balanced” portfolio will suffer too.   The Balance Portfolio is riskier than many appreciated, as outlined in this Post.

 

A major sharemarket drawdown is characterised as a cumulative fall in value of 20% or more. Recent examples include the first quarter of 2020, the Global Financial Crisis (2008/09) and Tech Bust (1999/2000). Based on the AQR analysis of almost 100 year of data, drawdowns worse than 20% have happened 11 times since 1926 — a little over once per decade on average. The average peak-to-trough has been -33%, and on average it took 27 months to get back to pre-drawdown levels (assuming investors stayed invested throughout – there is considerable research that indicates they don’t stay the course and earn less than market returns over the investment cycle).

 

AQR’s analysis highlights that using market valuations as a signal to time market drawdowns has not always been fruitful. Market valuations has rarely been a good signal to tactically change a portfolio to avoid a market drawdowns.

However, it is worth noting AQR are not against the concept of small tactical tilts within portfolios based on value or other signals such as momentum, best expressed as “if market timing is a sin, we have advocated to “sin a little””.

Nevertheless, market timing is not a “panacea” for large sharemarket drawdowns.

 

Diversification Benefits

The AQR analysis highlights that diversification outside of equities and fixed income can benefit portfolios, for example the inclusion of Style strategies (long/short risk premium across several different asset classes) and Trend following. Both of which are found to be lowly correlated to equities and provide comparable returns over market cycles.

Interestingly, the benefits of diversification vary from where the source of funds is taken to invest into the diversifying strategies.

AQR look at the impact on the portfolio of making an allocation from a 60/40 portfolio to the diversifying strategies. They consider two approaches:

  1. Funding the allocation all equities; and
  2. Funding from a combination of equities and fixed income, at a 60/40 ratio.

They evaluate a 10% allocation from the funding source to the new investments and consider both the impact on returns during equity drawdowns as well as the impact on returns on average over the entire 1926–2017 period.

The analysis highlights that the funding source can matter just as much as the new diversifying investment.

Funding from equities reduces the drawdown losses, however there is a trade-off, longer term returns are on average lower when compared to funding the allocation proportionally to the 60/40 equity / fixed income split.

When allocating to other traditional asset classes as a means of diversification e.g. Cash and Fixed Income, there is also a trade-off between a lower portfolio drawdown and lower average returns over time.

 

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

 

The Cost of Hedging

As noted above Hedging is different to adding diversifying strategies to a portfolio.

Hedges may include assets such as Gold, defensive strategies – which hedge against market falls, and Put Option strategies.

The AQR analysis found that over the past 30 years the defensive strategies provided positive returns on average during sharemarket drawdowns and almost no periods with meaningful negative performance.

This is attractive for investors who are purely focused on lessening the negative impacts of sharemarket drawdowns.

However, there is a trade-off – “the strategies that are more defensively orientated tend to have lower average returns.”

The cost of avoiding the sharemarket drawdown is lower portfolio performance over time.

 

AQR Conclude

AQR conclude “As with everything in investing, there is no perfect solution to addressing the risk of large equity market drawdowns. However, we find using nearly a century of data that diversification is probably (still) investors’ best bet. This is not to say that diversification is easy.”

“Investors should analyze the return and correlation profiles of their diversifying investments to prepare themselves for the range of outcomes that they should expect during drawdowns and also over the long term.”

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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

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

Their research highlighted that they 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 who value the regulatory protections, ease of access, and lower costs they provide”, when 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.

This reflects the wide dispersion of returns and investment approaches within the categories of hedge fund and liquid alternatives.

 

The Vanguard Report undertakes an extensive analysis and comparison of the performance and characteristics of hedge funds and liquid alternatives.

The comparison of hedge funds and liquid alternative is particularly useful to those new to the subject.

For the more technically advanced, there is an in-depth performance analysis comparing the drivers of performance between hedge funds and liquid alternative strategies. Vanguard ran a seven-factor model and a customised regression model to identify the drivers of returns.

 

Benefits of Hedge Funds and Liquid Alternatives

Vanguard’s analysis highlights that hedge funds and liquid alternatives provide diversification benefits to a traditional portfolio of equities and fixed income. As noted above, capturing these benefits is heavily reliant on manager selection.

It is important to note that the diversification benefits of the different hedge funds and liquid alternatives strategy types vary over time, they have time varying sensitivity to equity markets and fixed income.

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

 

Blending Alternative investment strategies can smooth the ride

Vanguard note that an additional layer of portfolio diversification can be attained by combining different hedge funds and alternative strategies.

Vanguard’s analysis suggested global macro (including managed futures) and the market neutral strategies are the best diversifiers when combined with other hedge fund and liquid alternative strategies.

Their research highlighted that combining multi-strategy hedge fund and liquid alternatives with a few other strategy types provided additional portfolio diversification benefits.

Again they highlight the importance of undertaking fund-by-fund basis analysis to better capture these diversification benefits – i.e. manager selection is important

 

Framework for Manager Selection

Vanguard suggest a framework for manager selection

  1. Identify your investment objective for including hedge funds and liquid alternatives. Investors have an array of objectives, which may include return enhancement, portfolio diversification and risk reduction, and inflation protection.
  2. Before selecting a manager determine a suitable strategy type(s). This is undertaken in consideration of investment objective(s) and any constraints. This could take into consideration risk and fee budgets, tolerance for level of leverage, and operational implementation issues. Ideally you would want to identify a number of strategy types so as to gain the diversification benefits from having a blended investment solution.
  3. Undertake manager selection within the strategy types. Undertake research as to the benefits of a particular manager and their ability to consistently deliver return outcomes consistent with the overarching investment objectives within the strategy type.
  4. Maintain a policy of regular review and monitoring of the manager and strategies in meeting desired investment objectives.

 

Liquid Alternatives are often the Prudent Option

The report highlights that investors will place varying degrees of value on the relative benefits of hedge funds and liquid alternatives.

Vanguard note that liquid alternatives may provide valuable portfolio construction benefits for investors who are not interested in undertaking the additional due diligence required for, or paying the costs associated with, investing in hedge funds.

They conclude that liquid alternatives maybe a viable option. Compared to hedge funds liquid alternative often have:

  • Lower fee structure that are easier to understand;
  • Greater transparency of underlying holdings; and
  • Greater liquidity i.e. easier access to getting your money back.

 

Performance Comparison

The Vanguard analysis reveals that hedge funds have performed better than liquid alternatives. They have also performed better on a risk adjusted basis.

However, the dispersion of returns between hedge fund managers is greater.

Vanguard undertook extensive performance analysis of hedge funds and liquid alternative returns, using factor analysis. Vanguard ran a seven-factor model and a customised regression model.

This analysis highlighted that liquid alternatives have more consistent factor exposures than hedge funds. Their returns are driven more by market factors such as value, momentum, low volatility, credit, quality, and liquidity.

Different factors drove the returns of different liquid alternative strategies – thus the diversification benefits of combining different strategy types.

Conversely, hedge funds are driven more by manager skill, returns are less sensitive to market factor returns.

 

To Conclude

Liquid alternatives provide an exposure to more “generic” hedge fund strategies – “hedge fund beta” exposures that have been found to be relatively stable over time. The market sensitivities vary across the different strategy types.

Investing in hedge funds, provides access to more unique return sources (alpha). Albeit this is harder to identify. Therefore, manager selection is even more important, given the larger dispersion of returns amongst hedge fund strategies and managers.

However, both the hedge fund alpha and the liquid alternative beta can provide diversification benefits to a traditional portfolio. Therefore, both can play a role in a portfolio.

Individual preferences and constraints will largely drive allocations to each.

Appropriate due diligence and focus on returns after fees will increase the likelihood of capturing the portfolio diversification benefits.

Manager selection is key.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Why the Balanced Fund is expected to underperform

GMO concluded some time ago the time was right to consider moving away from the 60/40 Portfolio. Which is a “Balanced Portfolio” of 60% equities and 40% fixed income.

 

In a more recent note, GMO identify two key problems that lie ahead for the Balanced Portfolio, which are supportive of their conclusion. Which I think are problems facing all investors, but particularly for US and New Zealand investors.

 

First, stock and bond valuations are both extended, suggesting they will deliver less than they have historically.

As GMO point out, the math with fixed income (bonds) is straightforward. The 10-Year U.S. Treasuries yield is under 1% today. New Zealand’s yield is also near 1%.

Today’s yield is the best predicator of future returns.

Real returns, after inflation, will likely be negative over the next 10 years from fixed income.

In short, GMO highlight “It is more or less impossible for a bond index yielding roughly 2% to deliver the 5% nominal returns investors have become accustomed to over any period of time approaching or exceeding the index’s duration.”

 

GMO also highlight stockmarket valuations have risen. Recent market weakness provides some valuation relief, albeit, US valuations remain elevated relative to history.

 

GMO conclude, “the passive 60/40 portfolio will likely deliver disappointing returns. The low starting yield of a 60/40 portfolio represents the first problem we see ahead.”

 

The second issue identified by GMO is that risks within fixed income have risen, and not just from a valuation perspective.

As can be seen in the graph below, provided by GMO, duration is near its highest level in history. (Duration is the key measure of risk for a fixed income portfolio. It measures the sensitivity of a fixed income security’s price movements to changes in interest rates.)

Global duration

 

So, not only are interest rates at historical lows (low expected returns), but risk, as measured by duration, is amongst highest level in history.

 

This dynamic, low expected returns and heightened risk highlights the folly of an Index approach, similarly a set and forget approach in allocating to different asset classes. Similar dynamics also play out in sharemarket indices. Risks within markets vary over time.

Furthermore, the credit risk of many fixed income indices is also higher now than compared to the Global Financial Crisis. BBB and AA rated securities currently make up a greater proportion of the fixed income indices. Therefore, the credit quality of these indices has fallen over the last ten years, while the amount of corporate debt has grown. These dynamics need to be considered, preferably before the next credit crisis.

 

As GMO point out “Today, the sensitivity of a 60/40 portfolio to a change in yield is nearly as high as it has ever been. Both stocks and bonds are levered to future changes in discount and interest rates. Even a small amount of mean reversion upward in the aggregate yield of the 60/40 portfolio will be painful because there is less underlying yield to cushion any capital losses and those capital losses should be expected to be larger than normal for any change in yield given the high duration.”

 

Because of the higher duration and lower yields, smaller movements higher in interest rates will result in greater capital losses from fixed income securities compared to times when yields were higher. This is also the math.

At the same time, given the high valuation of sharemarkets, they are more susceptible to a movement higher in interest rates. Particularly those sectors of the equity market more sensitive to interest rate movements such as Listed Property.

Therefore, the historical diversification benefits from holding fixed income and equities are likely to less in the future.

 

GMO conclude “While investors have become conditioned to believe that a 60/40 portfolio delivers consistently strong returns, history shows this has not always been the case and the twin problems weighing on such a construction today suggest robust returns are unlikely going forward. Due to elevated valuations (low yields) and extended durations of both stocks and bonds, it is possible that in a future downturn investors will not receive the diversification they expect from their bond portfolio. Stocks and bonds have risen together and could certainly fall in unison as well.”

 

Although recent market events may have delayed this moment, they have not derailed the underlying dynamics within a Balanced Portfolio which will see it struggling to meet investor’s expectations over the next decade.  The risks identify above remain.

 

The Balanced Portfolio is riskier than many appreciate. I covered this in a previous Post. It is not uncommon for the Balanced Portfolio to have a lost decade of returns and losses of up to 30% over a twelve-month period.

 

Possible Solution

To address the threats to the Balanced Portfolio identified above GMO suggest the inclusion of Liquid Alternatives across multi-asset portfolios.

Such strategies provided portfolio diversification, importantly they have very little duration risk within them, a risk both equities and fixed income are exposed too.

GMO articulate the benefits of such strategies as follows: “Liquid Alternatives can provide diversifying and uncorrelated returns. While Alternatives should not be expected to keep up with robust equity markets, they can help shield large drawdowns given their lower equity beta exposure.”

Liquid alternatives largely generate their return outcomes independently from the returns generated by equity markets (beta) and fixed income market (duration). Thus they provide exposure to different risk and return outcomes from equities and fixed income.

GMO conclude “Liquid alternatives improve the robustness of our multi-asset portfolios by helping to protect against the problems that today’s low yields and high durations present.”

 

The benefits of such strategies has been evident over the last few weeks, helping to diversify portfolios from the sharp fall in global sharemarkets as a result of the spreading of the coronavirus.

 

To finish, I would add to the GMO commentary that well diversified portfolios should also have an exposure to Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.  These assets offer real diversification benefits relative to equities and fixed income, and to Balanced Portfolio in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

I covered the investment characteristics and  benefits of Real Assets to a Balanced Portfolio in different economic environments in a recent Post.

 

Happy investing.

 

Please read my Disclosure Statement

 

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

 

Real Assets offer real diversification benefits

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.

They offer real diversification benefits to a Balanced portfolio (60% equities and 40% 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. PGIM is one of the largest asset managers in the world, managing over US$1 trillion in assets, and can trace its heritage to Prudential Financial in 1875.

 

The comprehensive analysis undertaken by PGIM outlines the role Real Assets can play in an Investment Portfolio.

Initially they identify and provided a brief outline of the investment characteristics for a number of real assets (see detail below).

The analysis primarily focuses on the sensitivities of real assets to both macroeconomic variables (e.g. economic growth and inflation) and traditional financial markets (e.g., equities and fixed income returns). This analysis is undertaken for each of real assets identified.

Pertinent points of the analysis:

  • There is a wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds.
  • These sensitivities vary over time.
  • The time varying nature of these sensitivities can be mitigated by holding a portfolio of real assets or actively managing the real assets exposures.

 

An important observation from the perspective of portfolio diversification, equities and fixed income have different sensitivities to inflation and growth than many of the real assets.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

Inflation

Sensitivity

Accessibility Data Availability & Quality Specific Risks Sector Difference
Real Estate Core

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

PGIM then constructed three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection, by including some of the real assets identified above.

While the real asset portfolios’ macro-economic and financial market sensitivities still varied over time they were more stable than holding individual real assets.

Furthermore, across various economic environments, the three strategies displayed lower risk (lower volatility of returns) compared to equities.

PGIM then showed how these strategies performed in different economic environments: ideal, overheating, stagflation and stagnation.

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

Ideal Overheating Muddled Stagflation Stagnation
Inflation &/ Growth Low & High High & High Median/Median High & Low Low & Low
Diversification

Y

Y

Y

Y

Y

Inflation-Protection

Y

Y Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y

Y

Fixed Income

Y

Scenario frequency

8.9%

11.4%

53.9%

10.2%

15.8%

 

The PGIM analysis concludes that an allocation to real assets can improve the investment outcomes for a traditional portfolio dominated by equities and fixed income. These benefits are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation, cost of living adjustments.

This conclusion comes as no surprise given the demonstrated diversification benefits as outlined within the Report.

 

I provide more detail below by summarising the various sections of the PGIM Report.

The sections include:

    • The Real assets universe and their investment characteristics
    • Real Assets sensitivity to Macro-economic and financial market exposures
    • Real Asset Diversification Benefits relative to equities and fixed income
    • Analysis of Real Asset Strategy Portfolios
    • Diversification Benefits of the three Real Asset Portfolios, sensitivities to equities, fixed income, economic growth, and inflation.
    • Benefits of Real Asset Strategies in Investment Portfolios

 

Access to the PGIM Report is provided below.

 

The Real Assets Universe and their investment characteristics

PGIM identify the following real assets: Farmland, Timberland, Infrastructure, private equity and debt, Natural Resources, private and public equity, Real Estate, Private Equity, Core, Value-add, opportunistic, private debt, REITS, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.

The PGIM paper provides a brief description of each real asset, including sources of return drivers and key investment attributes.

Investment return characteristics of the real assets over the period January 1996 – June 2017 are provided.  I have reproduced for some of the real assets in the following Table.

Asset

Annual p.a. returns

Risk annual volatility

Sharpe Ratio

Real Estate Core

8.3%

11.0%

0.55

Real Estate Debt

6.3%

4.8%

0.85

REIT

10.7%

19.8%

0.43

Natural Resources

15.9%

23.8%

0.58

Energy Equity

9.0%

19.7%

0.35

Infrastructure

4.0%

12.7%

0.14

MLP

12.6%

26.2%

0.39

Timberland

7.3%

6.9%

0.74

Farmland

12.2%

7.3%

1.37

TIPS

5.2%

6.0%

0.50

Commodity

-0.9%

28.2%

-0.11

Gold

5.6%

16.2%

0.21

Currency

-1.2%

8.5%

-0.40

US Cash

2.2%

2.2%

US 10 yr Treasury

5.2%

8.6%

0.35

US Equity (S&P 500)

8.6%

18.3%

0.35

 

Sensitivity to Macro-economic and financial market exposures

PGIM reviewed the sensitivity of Real Assets to several macro-economic variables over the period 1996-2017 and subperiods 1996-2007 and 2008-2017:

Inflation and growth

PGIM found an unstable return sensitivity profile to inflation and growth i.e. variation in return outcomes to different inflation and economic growth periods.

Of note, and an important observation from the perspective of portfolio diversification, equites and fixed income have different sensitivities to inflation and growth than many of the real assets.

Inflation Protection

PGIM found that many real assets had large positive sensitivities to inflation.

They found that commodity, currency, energy equity, gold, infrastructure, TIPS and natural resource real assets provided inflation protection, not only for the full period but generally (except for gold and currency) for both subperiods as well.

Stagnation Protection

Equities have a high sensitivity to economic growth, cash a low sensitivity.

Farmland, gold, real estate debt, TIPS, and currency had insignificant sensitivity to economic growth. Their sensitivity to growth surprises were also low and statistically insignificant i.e. their return outcomes are largely independent of economic growth.

The growth surprise sensitivity for farmland was negative and statistically significant.

PGIM define a real asset as offering “stagnation protection” if its full-period estimated growth and growth surprise sensitivity were approximately equal to or less than the corresponding growth sensitivity for cash.

Therefore, farmland, currency, gold, real estate debt, and TIPS provided stagnation protection for the full period and often for both subperiods.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

Inflation

Sensitivity

Accessibility Data Availability & Quality Specific Risks

Sector Difference

Real Estate Core

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low

mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

Real Asset Diversification Benefits relative to equities and fixed income

The different sensitivities of real assets to economic and inflation outcomes, on an absolute basis and relative to equities and fixed income, highlights the potential diversification benefits they could bring to a traditional portfolio of just equities and fixed income.

This is confirmed by the analysis undertaken by PGIM looking into the diversification benefits of real assets relative to equities and fixed income.

 

Diversifying Real Assets

Based on their criteria of sensitivity to equities and fixed income over the performance periods, PGIM found that currency, farmland, gold, natural resource, real estate, and timberland as diversifying real assets.

Not providing meaningful diversification benefits relative to equities was energy equity, listed property, and real estate.

Likewise, real estate debt and TIPS provided little diversification benefits relative to fixed income.

Although PGIM found diversification benefits from infrastructure, real estate debt and TIPS, they also found periods of time when there was limited diversification benefits relative to equities and fixed income.

 

Analysis of Real Asset Strategy Portfolios

PGIM used equal weights to the real assets to construct three Real Asset Strategy Portfolios. Each portfolio is a mix of public and private real assets.

A description of the three real asset Portfolios is provided below.

 

Diversification (80% private assets):

  • This portfolio is expected to have performance that has a low level of sensitivity with a traditional 60/40 Portfolio.
  • This ensures there will be diversification benefits regardless of the market cycle.
  • The Diversified Portfolio is made up of 20% Farmland, 20% Gold, 20% Natural Resource, 20% Real Estate, 20% Timberland

 

Inflation-Protection (33% private assets)

  • This strategy is designed to have better returns when inflation and inflation surprises are higher.
  • It is a strategy for investors with inflation-linked liabilities or a concern about overheating (high inflation and high growth) and stagflation (high inflation and low growth) economic scenarios.
  • Therefore, it includes real assets that have significant and positive exposure to both the inflation level and inflation surprise
  • The Inflation-Protection portfolio is made up of 17% Commodity, 17% Energy Equity, 17% Gold, 17% Infrastructure, 17% Natural Resource, 17% TIPS

 

Stagnation-Protection (50% private assets)

  • The Stagnation-Protection strategy portfolio is expected to perform better than cash in economic environments with below average growth.
  • This is a strategy for investors concerned about stagnation (low inflation and low growth) scenarios.
  • Included in this portfolio are real assets that have a sensitivity to both the real economic growth level and growth surprise that is lower than corresponding sensitivities for cash:
  • The Stagnation-Protection portfolio is made up of 25% Farmland, 25% Gold, 25% Real Estate Debt, and 25% TIPS.

 

Return Outcomes

PGIM measured the performance characteristic of these portfolios from January 1996 to December 2017. Including the sub-periods identified above.

The Diversification strategy produced the highest return (10.4%), with moderate risk (8.6%), and outperformed the 60/40 Portfolio (60% equities and 40% fixed income portfolio).

The Stagnation-Protection strategy offered similar absolute performance as the 60/40 portfolio, but due to its lower volatility produced much better risk-adjusted performance.

The Inflation-Protection strategy underperformed the 60/40 portfolio but generated slightly better risk adjusted returns. The Inflation-Protection strategy had the highest volatility of all three real asset strategies due to holdings of commodity and natural resource which have higher volatilities than stocks.

 

Diversification Benefits of the three Real Asset Portfolios

Sensitivity to Equities and Fixed Income

PGIM also found that the three Real Asset Portfolio strategies had low sensitivities to Equities.

The Inflation-Protection strategy tended to have the highest sensitivity to equities, while the Stagnation-Protection strategy had the lowest.

PGIM note the Stagnation-Protection portfolio had much lower sensitivity to equities than the 60/40 portfolio.

 

Relative to Fixed Income, the three strategies had on average a low and statistically insignificant sensitivity to Fixed Income. However, it was a game of two halves, all three strategies had negative sensitivity to Fixed Income in the first sub-period but positive sensitivity in the second sub-period.

 

Sensitivity to Economic variables

Economic Growth

The Inflation-Protection and Diversification strategies showed positive sensitivity to economic growth in both the full period and the second sub-period.

In contrast, the Stagnation-Protection strategy had negative sensitivity to economic growth for the full period, although not statistically significant.

While the Stagnation-Protection strategy had positive and statistically significant exposure to economic growth in the second sub-period, it was still the lowest growth exposure of all three real asset portfolio strategies.

Importantly, all three strategies display lower economic growth exposure relative to equities, this suggests they may provide investors protection at times of economic downturn (especially Stagnation-Protection and Diversification).

 

As PGIM note “To highlight the potential benefit, the Stagnation-Protection strategy offered positive exposure to inflation and negative exposure to growth, the opposite exposures for the 60/40 portfolio.”

 

Inflation Sensitivity

All three strategies had positive and significant sensitivity to inflation for the full period.

As was desired, the Inflation Protection strategy displayed the highest and statistically significant inflation sensitivity in both the full period and in both sub-periods “suggesting the strategy may provide inflation protection going forward. Notably, the Inflation-Protection strategy had much higher inflation sensitivity than stocks, bonds or the 60/40 portfolio.”

The Stagnation-Protection strategy had the lowest sensitivity to inflation.

 

Further in-depth analysis was undertaken into how the strategies would perform in different economic environments.

This analysis found:

  • All three real asset strategies perform well when inflation is high.
  • During stagflation the three strategies all have higher average returns than stocks or bonds.
  • In overheating environments stocks do well but the Diversification and Inflation-Protection strategies do even better.
  • Performance across the three real asset strategies diverges when inflation is low.
  • During periods of stagnation (low inflation/low growth) bonds do well, but so do the Stagnation-Protection and Diversification strategies.

 

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

Ideal

Overheating Muddled Stagflation

Stagnation

Inflation &/ Growth

Low & High

High & High Median/Median High & Low

Low & Low

Diversification

Y

Y Y Y

Y

Inflation-Protection Y Y

Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y Y
Fixed Income

Y

Scenario frequency

8.9%

11.4% 53.9% 10.2%

15.8%

 

Diversification Benefits of Real Asset Strategies in Pension Plans

The last section of the PGIM report seeks to determine if an allocation to real assets will improve the outcomes for US Pension Funds. PGIM note that this research can be applied to portfolios in other countries.

It should come as no surprise, given the results of the in-depth analysis undertaken by PGIM above, that an allocation to Real Assets improves the investment outcomes to a portfolio dominated by equities and fixed income.

By way of example, even a 10% allocation to a real asset strategy, depending on the investment objective, can lead to a noticeable improvement in both the final funded ratio and the risk of being further under-funded (i.e., surplus risk) of a Defined Benefit plan.  Resulting from lower levels of portfolio volatility.

In high inflation environments an allocation to real assets improves the outcomes Pension Plan, especially those with liabilities tied to inflation (cost of living adjustments).

Likewise, in low growth environments they found an allocation to real asset strategies made a big difference.

It is similar across different environments, stagflation and stagnation protection.

To conclude, the PGIM Portfolio analysis highlighted that a real asset allocation can help Defined Benefit providers improve outcomes in different economic environments of concern, like stagflation and stagnation, improving either surplus risk or the average funded ratio.

 

Access to the PGIM Report

 

Happy investing.

Please read my Disclosure Statement

 

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

 

Time to move away from the Balanced Portfolio. They are riskier than you think.

GMO, a US based value investor, has concluded “now is the time to be moving away from 60/40” Portfolio.  Which is a Balanced Portfolio consisting of 60% US equities and 40% US fixed income.

Being a “contrarian investor”, recent market returns and GMO’s outlook for future market returns are driving their conclusions.

I covered their 7-year forecasts in an earlier Post. GMO provide a brief summary of their medium term returns in the recently published article: Now is the Time to be Contrarian

 

The GMO article makes the following key observations to back up their contrarian call:

  • The last time they saw such a wide “spread” in expected returns between a traditional 60/40 portfolio and a non-traditional one was back in the late 1990s, this was just prior to the Tech bubble bursting.
  • The traditional 60/40 portfolio went on to have a “Lost Decade” in the 2000s making essentially no money, in real terms, for ten years. Starting in late 1999, the 60/40 portfolio delivered a cumulative real return over the next ten years of -3.9%.

 

As outlined in the GMO chart below, Lost Decades for a Balanced Portfolio have happened with alarming and surprising frequency, all preceded by expensive stocks or expensive bonds.

GMO note that both US equities and fixed income are expensive today. As observed by the high CAPE and negative real yield at the bottom of the Chart.

They are of course not alone with this observation, as highlighted by a recent CFA Institute article. I summarised this article in the Post: Past Decade of strong returns are unlikely to be repeated.

lost-decades_12-31-19

 

 

The Balance Portfolio is riskier than you think.

The GMO chart is consistent with the analysis undertaken by Deutsche Bank in 2012, Rethinking Portfolio Construction and Risk Management.

This analysis highlights that the Balanced Portfolio is risker than many think. This is quite evident in the following Table. The Performance period is from 1900 – 2010.

Real Returns

(after inflation)

Compound Annual Return per annum 3.8%
Volatility (standard deviation of returns) 9.8%
Maximum Drawdown (peak to bottom) -66%
% up years 67%
Best Year 51%
Worst Year -31%
% time negative returns over 10 years 22%

The Deutsche Bank analysis highlights:

  • The, 60/40 Portfolio has generated negative real returns over a rolling 10 year period for almost a quarter of the time (22%).
  • In the worst year the Portfolio lost 31%.
  • On an annual basis, real negative returns occur 1 in three years, and returns worse than -10% 1 in every six years
  • Equities dominate risk of a 60/40 Portfolio, accounting for over 90% of the risk in most countries.

 

The 4% average return, comes with volatility, much higher than people appreciate, as outlined in the Table above. The losses (drawdowns) can be large and lengthy.

This is evident the following Table of Decade returns, which line up with the GMO Chart above.

Decade Per annum return
1900s 6.3%
1910s -4.7%
1920s 12.7%
1930s -2.3%
1940s 1.1%
1950s 9.1%
1960s 4.5%
1970s -0.3%
1980s 11.7%
1990s 11.7%
2000s 0.5%

 

We know the 2010s was a great decade for the Balanced Portfolio.  A 10 year period in which the US sharemarket did not experience a bear market (a decline of 20% or more). This is the first time in history this has occurred.

Interestingly, Deutsche Bank highlight the 1920s and 1950s where post war gains, while the 1980s and 1990s were wind-full gains.

The best 4 decades returned 11.3% p.a. and the 7 others 0.7% p.a.

 

As outlined in my last Post, the case for diversifying away from traditional equity and fixed income is arguably stronger than ever before.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Why is the Multi-Asset Portfolio so Popular?

The rise of the Multi-Asset Portfolio can be traced back to the Global Financial Crisis (GFC) in 2008, when many investors “grew disenchanted with the long-time investment mantra that equities were the one true way to wealth. That smug bromide rang hollow when the financial crisis slashed many stock portfolios in half”, according to recent Chief Investment Office (CIO) article, How Multi-Asset Investing Became So Popular.

Following the GFC, the mantra became diversify your holdings. As a result, Multi-Asset Portfolios, which combine equities, fixed income, and an array of other assets, gained greater prominence.

Multi-Asset Portfolios grew more popular on promises of greater capital preservation and sometimes the delivery of superior returns.

As CIO note, the increased prominence of the Multi-Asset Portfolio can be attributed to David Swensen, Yale’s investment chief since 1986. Yale has generated an impressive performance record by investing outside of just equities and fixed income. Their portfolio has included high allocations to private equity, real estate, and other non-traditional assets. (For more on the success of the Endowment model and the fee debate please see this Post.)

 

The CIO article also noted that Multi-Asset Portfolios are most prominent among target-date funds (TDFs), which have become the default offering among 401(k) plans (e.g. US superannuation schemes such as KiwiSaver in New Zealand).

“TDFs have grown five-fold since the financial crisis, reaching $1.09 trillion in 2018, a Morningstar report concluded, with an estimated $40 billion added last year.”

 

The Concept: Absolute returns and better risk management

The Multi-Asset Portfolio is based on the concept of absolute returns, where the focus is on generating a more targeted and less volatile investment return outcome. There is a greater focus on risk management relative to that undertaken within a traditional portfolio. The intensity and sophistication of risk management employed depends on the type of absolute return strategy.

The absolute return universe is very broad, ranging from Multi-Asset Portfolios to those with a much greater focus on absolute returns such as the plethora of Hedge Fund strategies, including Risk Parity as discussed in the CIO article.

This contrasts with the traditional balanced fund, which are generally less diversified, portfolio risk is dominated by the equity exposures, and returns are much more subject to the vagaries of investment markets. The management of risk is more focused on relative returns i.e. how performance goes relative to a market benchmark, rather than returns relative to an absolute return outcome.

A Multi-Asset Portfolio generally has more of an absolute return focus than a Traditional Portfolio. It achieves this by having a more truly diversified portfolio, moving beyond the traditional Balanced Portfolio (60% equities and 40% Fixed Income), to incorporate a greater array of different investment strategies and risk management approaches within the portfolio.

As the CIO article comments, “There’s a strong argument for Swensen-like multi-asset funds that range beyond stocks and bonds, adding solid helpings of commodities, real estate and all kinds of other asset classes. With such an array, the thinking goes, you’re best protected when recessions thunder in.”

 

Return Expectations

The CIO article made the following observation, Multi-Assets Portfolios are “expected to return 4.5% annually through 2024, according to Casey Quirk, an arm of Deloitte Consulting. That isn’t a daunting growth rate, but the figure should have a decent chance of holding steady, while public markets lurch around, especially in the next recession.”

To put this into perspective, a recent CFA Institute article estimated that a Balanced Portfolio will return 3.1% over the next 10 years.

It is highly likely we are heading into a “Low Return Environment”.

 

As a result, a different investment approach to that which has been successful over the last 20-30 years is likely needed to invest successfully in what is expected to be a Challenging Investment Environment.

As the CIO article notes, “But multi-asset now goes far beyond the simple stock-bond duality, which seems insufficient to deliver the best diversification. The most salient problem with the basic pairing nowadays is that bonds are paying low interest rates. Their ability to score capital gains is limited because rates don’t have much left to fall before they hit zero. “These don’t work as well as they used to,” observed Deepak Puri, CIO Americas for Deutsche Bank Wealth Management.”

 

I fear the lessons from the GFC and 2000 Tech Bubble are fading from the collective memory, as equity markets reach historical highs and investors chase income from within equity-income sectors of the sharemarket.

In addition, more advanced portfolio management approaches have been developed over the last 20 – 30 years.

It would seem crazy that these learnings are not reflected in modern day investment portfolios. In a previous Post: A Short History of Portfolio Diversification, it is not hard to see how the Multi-Asset Portfolio has developed over time and is preferred by many large institutional investors.

Meanwhile, this Post: What Portfolio Diversification looks like, compares a range of investment portfolios, including the KiwiSaver universe, to emphasis what a Multi-Asset Portfolio does look like.

 

Growth in Multi-Asset Portfolios to continue

Increasingly the Multi-Asset Portfolios are taking market share from traditional portfolios.

Institutional investors are increasingly adopting a more absolute return investing approach. This has witnessed an increased allocation, and growth in Funds Under Management, in underlying strategies, “such as private equity, hedge funds, real estate, natural resources, and other strategies whose assets aren’t publicly traded.”

 

An underlying theme of the CIO article is the Death of the Balance Portfolio, which I covered in a previous Post.

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, as noted above, more advanced approaches can be implemented. For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

 

Concluding Remarks

The current market environment, of low expected returns, might quicken the evolution in portfolio construction toward greater adoption of Multi-Asset Portfolios and a more absolute return focus.

Therefore, the value is in implementation, identifying the suitable underlying investment strategies to construct a truly diversified portfolio, within an appropriate fee budget.

Wealth management practices need to be suitably aligned with this value adding activity.

 

Happy investing.

Please read my Disclosure Statement

 

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

Target Date Funds – 25 Years of US Learnings

Launched in 1994, target-date funds now boast assets of more than $2 trillion in the US, according to a recent Wealth Management.com article, Target-Date Funds Aging Gracefully

The article concludes: “Naturally it is difficult to foresee how target date funds will evolve over coming decades, as the list of potential innovations is endless, but one thing is certain: the benefits target-date funds present both to plan participants and sponsors ensure they will play a dominant role in building comfortable retirements for years to come.”

The growth Target-Date Funds (TDF) has significantly changed the Defined Contribution (DC), superannuation, industry in the US.

TDF are also referred to as Life Stages or Life Cycle strategies.

 

Since their launch in 1994 TDF have become to dominate DC plans. According to the Wealth Management.com article total assets in TDF mutual funds alone have grown from about $278 million at the end of 1994 to more than $1.2 trillion in the second quarter of 2019.

Considering other investments, it is estimated that $2 trillion or about 25% of total DC assets today are invested TDF.

 

Why the Growth?

The growth in TDF can be attributed to their appeal to those saving for retirement (Participants) and those offering investment solutions e.g. Sponsors such KiwiSaver Providers.

For the Participant, TDF remove the “burden of creating an asset allocation strategy and choosing the investments through which they would execute it.” Participants do not need to make complicated investment decisions.

For Sponsors, they can “streamline their investment offering (reducing complexity and administrative costs), while meeting their fiduciary responsibility to participants.”

Also, and of particular interest given New Zealand is currently reviewing the Default option for KiwiSaver, TDF have also experienced a significant boost from the enactment of the Pension Protection Act (PPA) in 2006.

As noted by the Wealth Management.com article “The PPA relieved plan sponsors from fiduciary responsibility for investment outcomes if they provided a suitable Qualified Default Investment Alternative (QDIA), such as TDFs, to anyone auto-enrolled in their plans. The combination of auto enrollment and safe harbor relief for plan sponsors paved the way for the wide adoption of TDFs.”

 

Future Growth and Innovation

The growth of funds invested into TDF is expected to grow, primarily from the ongoing innovation of the vehicle.

It is likely that the TDF will evolve into the key investment vehicle over the complete lifecycle of an investor, not only by accumulating capital for retirement (Defined Contribution Fund) but also helping generate a stable and secure income once in retirement (Defined Benefit Fund).

A recent enhancement to TDF is the addition of Guaranteed-income options. These Funds convert into a personalised investment plan for those seeking the security of a guaranteed income for life.

TDF offering guaranteed income are available now in the US, but they have not been widely embraced by either participants or plan sponsors. They do face a higher fee hurdle to be adopted. Albeit, the Wealth Management.com article notes “TDFs offering guaranteed income are likely to gain traction in the DC space. Participants contemplating decades in retirement naturally have concerns about outliving their savings, and guaranteed-income TDFs address that anxiety.”

 

The innovation and focus of these Funds is consistent with the framework proposed by EDHEC Risk Institute, as I outlined in the Post: A more Robust Investment Solution

They are also consistent with the Next Generation of Retirement solutions promoted by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012. I summarise Professor Merton’s Paper in this Post: Designing a new Retirement System, which is the most read Kiwi Investor Blog Post.

 

Such considerations will greatly increase the efficiency of TDF.

These solutions are about making Finance great Again (Flexicurity in Retirement Income Solutions – making finance great again)

 

New Zealand Perspective

TDF would make more sense as a Default KiwiSaver solution, and stack up better relative to a Balanced Fund option (Balanced Funds not the Solution for Default Kiwi Saver Investors).

Lastly, the criticism of TDF is often due to poor design (In Defence of Target Date Funds).

An example is a large Kiwi Saver provider promoting a 65+ Life Stages Fund which is 100% investment in Cash. This is scandalous as outlined in this research by Dimensional, this research is summarised in the Post High Cash holdings a scandalous investment for someone in retirement.

 

 

Happy investing.

Please read my Disclosure Statement

 

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