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.

The opportunity and role of active management

RBC Global Asset Management provides a strong case for the opportunity of active management and its role within a truly diversified portfolio.

As they note, there are considerable opportunities within markets for active managers to turn into reliable excess returns.

RBC’s analysis highlights that a large proportion of active share price movements, up to 75%, cannot be explained by market factors.

This is a large opportunity set for active managers. An opportunity set that is found to remain reasonably consistent over time.

The scale of the opportunity as demonstrated by RBC, if successfully captured, provides a potential source of excess returns and a true portfolio diversifier – which is a return outcome largely sourced from company/stock specific risks.

Nevertheless, active managers do need to evolve from historical practices and processes. From this perspective, the paper also provides great insights into the evaluation of a modern day active manager.

With regards to the success of active management, the Conventional Wisdom toward active management is changing. Specifically, the conventional wisdom is too negative on the value of active management.

The RBC article is well worth reading.

 

RBC emphasis “An active manager’s task is to capitalise on the fact that the market or index return is an average, and to use analysis and skill to identify those stocks that produce an above-average return and to avoid those that don’t.”

 

To capture the opportunity identified by RBC, they believe active managers need to find a way to turn share price movements into reliable excess returns.

To do this they believe that active managers must get two things right:

  1. Alpha generation: devise means of explaining and predicting the share price movements that are not explained by factors.
  2. Alpha capture: devise means of efficiently capturing alpha and turning it into reliable portfolio excess returns.

The RBC paper provides a lengthy discussion on what it likely takes to achieve this, including analysing the unique features associated with each business, including ESG factors, taking an active ownership role, and maintaining a long-term perspective.

Each company (security) has a unique performance history, which cannot all be explained by broad market factors.  Financial outcomes are partly dependent on management teams, brand, location, reputation, non-financial factors, and Culture. Analysis needs to be undertaken on the unique factors associated with each business.

Furthermore, accounting data is a poor measure of business value, there are extra financial factors, Governance, employee engagement, Health and Safety, ESG etc etc

 

RBC conclude “that the critical skill for stock pickers is understanding and evaluating extra-financial factors as well as assessing their impact on financial returns. Skill and expertise need to be developed to assess nuanced factors such as corporate culture, employee engagement, customer satisfaction, the business’s social licence to operate, maintenance and safety procedures, R&D effectiveness, brand and reputation, and these will vary from industry to industry and will also shift over time.”

See the article for fuller discussion on their perspective and type of analysis required by a modern day active manager.

 

Portfolio construction is also key, the size of portfolio positions matters.

Equity investments can be held in fractional holdings so it is possible to construct an almost infinite number of portfolios from a relatively modest number of securities.

Different combinations of securities will create portfolios with different factor exposures.   Which will cause variation in portfolio returns.

Therefore, Portfolio construction becomes the framework within which portfolio managers can assess the trade-off between “two often conflicting objectives: maximising exposure to their best investments vs. minimising exposure to unintended factor returns.“

 

My personal view is that many managers under estimate the value added from a solid portfolio construction approach, often it distracts value from a sound stock selection process.

 

One final point, the paper provides a good account of how active management has been disrupted by technology and the information revolution – computing power and access to company information. This has resulted in the rise of passive investing and factor-based investing. This has driven down fees.

The active management industry has changed dramatically, and active management has had to evolve. This is touched on within the Article.

Therefore, the Article provides insight from the perspective of manager selection and a potential lens with which to consider in evaluating modern day active managers.

 

The Role of Active management within a portfolio

From a Kiwi Investor Blog perspective, the active management described by RBC in the Paper “seeks to generate outperformance from stock-specific risk that lies outside the realms of factors. This is a different alpha source, hence it creates a return stream that is not correlated to factor returns.”, highlights the role active management can play within a truly diversified and robust portfolio.

Consistent with RBC, active managers can co-exist with passive and factor based strategies. Active management has a role to play within a Portfolio.

Why? Investors seek to access a wide range of investment risks and returns, seeking true portfolio diversification.

The source of risks and returns from active management that seeks to outperform from stock specific risks is a true portfolio diversifier, if done successfully.

This is consistent with many Posts on Kiwi Investor Blog around the disaggregation of investment returns.

Understanding the disaggregation of investment returns can assist in building a truly diversified and robust portfolio.

It can also help determine the appropriateness of fees being paid and if a manager is adding value.

 

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk and return sources.  See earlier post More Asset Classes Does not Equal More Diversification.

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.  For example, the increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.

Essentially, and from a very broad view, investment returns can be disaggregated in to the following three parts:

  1. Market beta. Think equity market exposure NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).
  2. Factor and Alternative hedge fund beta exposures.  See the Disaggregation of Investment Returns Post for a fuller discussion.
  3. Alpha. Alpha is what is left after beta and factors. It is the manager skill to capture the stock specific risks as outlined in RBC paper. Alpha is a risk adjusted return source.

 

With regards to the success of active management, the Conventional Wisdom toward active management is changing, as highlighted in this Post. The linked article in this Post is the most read from Kiwi Investor Blog.

The article undertakes a review of the most recent academic literature on active equity management and concludes by challenging the conventional wisdom of active management, “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.

 

Finally, the disaggregation of investment returns busts opens the active vs passive debate, the debate has moved on. It is no longer an emotive black vs white debate, risk and return sources come in many different shades. A truly diversified portfolio has as many different risk and return exposure as possible. It is from poor portfolio construction that portfolios fail.  The value is in implementation of a truly diversified portfolio.

 

It is evident that New Zealand portfolios need to become more diversified and that Kiwi Saver Investors are missing out.

 

 

Happy investing.

Please read my Disclosure Statement

 

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

New Zealand Super Fund vs the Australian Future Fund

The analysis below compares the variation in portfolio allocations between the Sovereign Wealth Funds of New Zealand and Australia, the New Zealand (NZ) Super Fund (Kiwis) and Australian Future Fund (Aussies).

Many of the insights are relevant for those saving for retirement or are in retirement.

A light-hearted approach is taken.

 

A previous Post, What Does Diversification Look Like compared Australian Superannuation Funds to the KiwiSaver universe, the Aussies won easily, with more diverse portfolio allocations.

However, this comparison is amongst the top echelon of the nation’s investment funds, a Test match of portfolio diversification comparisons, sovereign wealth fund vs sovereign wealth fund, the All Blacks vs the Wallabies, the Black Cap vs the Baggy Green, the Silver Ferns vs the Diamonds ………………

Let’s gets stuck into the Test Match Statistics.

 

Test Match in Play

 

NZS

Future Fund

Kiwi vs Aussie Difference

Int’l Equities

56.0%

18.5%

37.5%

Emerging Markets

11.0%

10.0%

Domestic Equities

4.0%

7.0%

Fixed Income

9.0%

9.0%

Alternatives
Infrastructure & Timberland

7.0%

7.5%

-0.5%

Property

2.0%

6.7%

-4.7%

PE

5.0%

15.8%

-10.8%

Alternatives 13.5%

-13.5%

Rural

1.0%

Private Mkts

3.0%

Public Mkts

2.0%

Cash

11.9%

100%

100%

           
High Level Allocations          
Equities

71.0%

35.5%

35.5%

Fixed Income

9.0%

9.0%

0.0%

Cash

11.9%

-11.9%

Alternatives

20.0%

43.5%

-23.5%

100%

100%

 

High Level Match Coverage:

  • The Kiwis are highly reliant on International Equities to drive performance – let’s hope they don’t get injured.
  • The Aussies currently have a higher allocation to Cash – are they holding something in reserve
  • The Aussies, with a higher Alternative allocation, on the surface, and looking at the detail below, have a more broadly diversified line up – depth to come off the bench
  • The Aussies have a much higher allocation to Private Equity,15.8 vs 5% – might have something to do with their schooling
  • Interestingly both have a similar allocation to Emerging Market Equities ~10% – both are willing to be adventurous

 

The standout is the difference in the international equities exposures, the Kiwis have a ~37% higher allocation, the majority of this difference is invested into Private Equity (+~10%), Property (+~4.7%), and Alternatives (+~13%) by the Aussies.

 

As for the detail

  New Zealand Australia
Infrastructure & Timberlands

Of the total 7%, 5% is in Timberlands, the Kiwis have 1% invested in NZ rural land and farms

Of the 7.5%, 1.7% is invested in listed infrastructure equities, 3.4% is invested in Australian assets, 2% is invested offshore. An array of infrastructure assets is invested in.
Alternatives Not sure how this is categorised by the Kiwis (Public Markets?), they have 2% invested in Natural Catastrophe Reinsurance and Life Settlements.

 

The Kiwis also have allocations to Merger Arbitrage.

The Aussies have 13.5% invested into Multi-Strategy/Relative Value hedge fund strategies, Macro – Directional strategies, and Alternative Risk Premia strategies.

 

These strategies are relatively easy to invest into and provide well documented portfolio diversification benefits relative to other hedge fund type strategies.

Property   1.9% of the Fund is invested in Listed Property, 4.8% is invested in direct property.

 

Post-Match interviews

It is true, the only interview is with my keyboard, and the above is high level and rudimentary.

Nevertheless, on the surface the Aussies appear to have a more broadly diversified line up, which may play into their hands in tougher games e.g. global equity bear market.

There is certainly less of a reliance on listed equities to drive the performance of the Aussies.

Put another way, the Aussies might have a better line up to get them through a world cup campaign, able to hold up in different playing conditions (i.e. different market environments. The exception would be a strong global equity bull market, which would favour the Kiwis. Albeit the Aussie’s performance has been competitive over the last 10 years relative to the Kiwis – unlike the Wallabies!).

 

Therefore, the Aussie portfolio allocation will lead to a smoother and more consistent team performance.

 

Why the Difference

The difference in portfolio allocations can be for several reasons. I would like to highlight the following:

 

Investment Objectives

In many respects they both have similar objectives, to support future Government spending. They are both investing for future generations. The Kiwi specifically for future super payments and Aussies more so for the General Fund.

 

Return Objectives

Interestingly they have similar return objectives.

From 1 July 2017 the Aussie’s long-term benchmark return target has been CPI + 4% to 5% per annum. This has been lowered from previous years, reflecting a changed investment environment.

The Kiwi’s don’t appear to have a specific return target.

Nevertheless, the Kiwi Reference Portfolio, which they are currently reviewing, is expected to generate a return of Cash plus 2.7%.

The Reserve Bank of New Zealand (RBNZ) in a 2015 research paper estimated the long-term “neutral” 90-day interest rate is around 4.3%. Although this seems high given the current market environment, bear-in-mind it is a long-term estimate.

If we assume inflation is 2%, the mid-point of the RBNZ’s inflation target range of 1-3%, and a lower Cash rate, then Cash generates a 2% return over inflation.

Thus, the Kiwi objective is comparable to a CPI + 4.7% return.

 

Therefore, the return objectives are not too dissimilar between the two Teams, even if we make further conservative assumptions around the long-term neutral interest rate in New Zealand and its expected return above inflation – which I think will come down from its historical average.

If anything, the Kiwi’s return objective is more conservative than the Aussies, all else being equal, this would support a lower equity allocation relative to the Aussies, not a higher equity allocation as is the case.

 

It is interesting, for similar return objectives they have such a difference in equity exposure.

This is an issue of implementation.

The Aussies are seeking a broader source of returns through Private Equity, Alternative strategies, direct property, and unlisted infrastructure.  This will help them in different playing conditions – market environments.

 

Drawdown Requirements

There is a difference in when the funds will be drawn upon i.e. make payments to the Government.

In Australia, legislation permits drawdowns from the Future Fund from 1 July 2020. The Government announced in the 2017-18 budget that it will refrain from making withdrawals until at least 2026-27.

The Kiwis have a bit longer, from around 2035/36, the Government is expected to begin to withdraw money from the Fund to help pay for New Zealand superannuation. On current forecasts, a larger, permanent withdrawal period will commence in 2053/54.

 

Therefore, the Funds do have different maturity profiles and this can be a factor in determining the level of equity risk a portfolio may maintain.

 

One way of looking at this is that the Aussies are closer to “retirement”, there will no longer be deposits into the Fund and only capital withdrawals from 2026. Much like entering retirement.

Therefore, it would be prudent for them to have a lower equity allocation and higher level of portfolio diversification at this time, so there is a wider return source to draw upon.

The Kiwis have a bit longer until they enter retirement.

I would imagine that the Kiwis will move their portfolio closer to the current Aussies portfolio over time, as they “age” and get closer to the decumulation/drawdown phase (retirement), expected to commence around 2035 (16 years’ time).

The Kiwis will likely be considering this now, as they will want to reduce their sequencing risk, which is the risk of experiencing a major drawdown just before and just after entering the drawdown phase (retirement). I covered this in a previous Post, The Retirement Death Zone.

Likewise, they will not want to hold high levels of Equities once withdrawals commence (are in retirement).

Maintaining high levels of listed equities can significantly reduce the value of a portfolio that has regular withdrawals and there is a high level of market volatility. This is the case for Charities, Foundations, and Endowments.

For more on this, see my previous Post, Could Buffett be wrong, which highlights the impact on portfolios when there are regular withdrawals and equity market volatility.

 

Team Philosophy

Differences in Investment Philosophy could account for differences in portfolio allocations. Nevertheless, there does not appear to be any measurable difference in Philosophy.

 

Resources and fee budgets

This is probably the most contentious factor. Fund size, team resources, and fee budgets can influence portfolio allocations. Those with a limited fee budget will find it challenging to diversify equity risk.

I am not saying this is an issue for the Kiwis, I would only be speculating. The Aussies have a good size budget based on their recent annual report.

Let’s hope it is not a factor for the Kiwis, an appropriate investment management fee budget will be required for them to satisfactorily meet their objectives and exceed expectations – as any good sports team know.

This is an aged old industry issue. My Post on Investment Fees and Investing like US Endowments covers my thoughts on the fee budget debate.

 

Happy investing.

Please see my Disclosure Statement

 

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

A short history of Portfolio Diversification

Advancements in technology and new knowledge have made it easier to diversify portfolios and manage investment management fees. Greater clarity over sources of returns have placed downward pressure on active manager’s fees.  True sources of portfolio diversification can command a higher fee and are worth considering.

Is your portfolio managed as if it is the 1980s? the 1990s? Does it include any of the key learnings from the Tech Bubble crash of 2000 and the market meltdown of the Global Financial Crisis (GFC or Great Recession)?

Finally, is your portfolio positioned for future trends in portfolio management?

 

Below I provide a short history of the evolution of portfolio diversification. The evolution of portfolio diversification is interesting and can be referenced to determine how advanced your portfolio is.

 

The framework, idea, and some of the material comes from a very well written article by Aberdeen Standard Investments (ASI).

Unless stated otherwise, the opinions and comments below are mine.

 

Standing on the Shoulders of Giants

Nobel Laureate and pioneer of investment theory Harry Markowitz’s 1952 paper “Portfolio Selection” provided the foundations for Modern Portfolio Theory (MPT).

Markowitz’s analysis provided the mathematical underpinnings for portfolio optimisation.

The key contribution of Markowitz was the quantification of portfolio “risk”. Portfolio Risk was measured by the variation in investment returns – standard deviation of returns.

Markowitz’s paper led to the concept of an “optimal portfolio”, a framework in which both risk and returns are considered. Optimal portfolios offer the maximum expected return for a defined level of risk.

The benefits of diversification were clear to see. Diversification reduces risk without sacrificing returns.

As the ASI article noted: Markowitz called diversification “the only free lunch in finance”.

MPT led to the establishment of the 60:40 portfolio, a portfolio of 60% equities and 40% fixed income.

Increased Diversification of the 60:40 Portfolio

The 60:40 portfolio dominated for a long period time. This portfolio was also largely domestically orientated i.e. the concept of investing internationally was not widely practiced in the 1960 – 70s, even early 1980s.

The next phase in portfolio diversification largely focused on increasing the level of diversification within the equity and fixed income components of 60:40 Portfolio.

As outlined in the ASI paper, four trends combined to drive a broadening of investments in 1980s and 90s:

  • deregulation of financial markets
  • rapid growth in emerging markets
  • financial innovation
  • academic ‘discoveries’.

Deregulation played a major role, particularly the ending of fixed currency exchange rates and the relaxing of capital controls. This enabled an increased level of investing internationally.

This also coincided with the discovery of the “emerging markets”, leading to an increased allocation to emerging market equities and fixed income securities.

Financial innovation resulted in the development of several new financial instruments, including mortgage-backed securities, high-yield bonds (formally called Junk Bonds), and leverage loans.

The use of derivatives also grew rapidly following the establishment of Option Pricing Theory.

Other academic discoveries led to style investing, such as value and growth, and the rise of investing into smaller companies to add value and increase diversification.  Style investing has been superseded by factor investing, which is discussed further below.

ASI conclude, that at the end 1990’s portfolio diversification could be characterised as including:

  • domestic and international equities
  • value and growth stocks
  • large-cap and small-cap stocks
  • developed and emerging markets
  • government, mortgage and corporate fixed income securities.

 

Fundamentally, this is still a portfolio of equities and bonds. Nevertheless, compared to the domestic two-asset class 60:40 Portfolio of the 1960 – 70s it offered more diversification and weathered the severe market declines of tech bubble burst in 2000 and GFC better.

Pioneering Portfolio Management – the Yale Endowment Model

The 2000’s witnessed the emergence of the “Endowment Model”. This followed a period of strong performance and evidence of their diversification benefits during the tech bubble burst of 1999-2000.

The Endowment model has been characterised as being based on four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets e.g. property.

The endowment model was pioneered by David Swensen at Yale University. Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.

For more on diversification approach adopted by Endowments and Sovereign Wealth Funds please see my previous Post Investment Fees and Investing like and Endowment – Part 2.

Learnings from Norway

The extreme severity the GFC tested all portfolios, including the Endowment Model.

The dislocation in markets muted the benefits of diversification from alternative investments and left many questioning the actual level of diversification within their portfolio.

In 2009 this disappointment prompted the Norwegian Government Pension fund to commission a study to investigate their returns during the GFC.

The study was undertaken by three prominent professors, Andrew Ang (Columbia Business School), William Goetzmann (Yale University) and Stephen Schaefer (London Business School). The paper is well worth reading.

This study went on to influence portfolio diversification considerations and captures some major learnings from the GFC. The study brought factor investing into greater prominence.

Factors are the underlying drivers of investment returns.  The Nordic study recommended that factor related returns should take centre stage in an investment process.

As a result, the Norwegians rethought about how they structured their portfolios. Other countries have followed, incorporating factor investing into their asset allocations.

Please see my previous Post on Factor Investing and this interview with Andrew Ang, one of the authors of Nordic study, for further details.

Innovation and pressure on Investment Management Fees

The period since the GFC has yielded an increasing level of innovation. This innovation has been driven in part by factor investing, technology advancements, pressure on reducing investment management fees, and increased demand to access more liquid alternative investment strategies to further diversify portfolios.

The disaggregation of investment turns has provided a new lens in which to view portfolio diversification. With technology advancements and the rise of factor investing returns from within markets have been isolated. Broadly speaking, investment returns can be attributed to: market exposures (beta e.g. sharemarkets); underlying factors (e.g. value and momentum); hedge fund strategy returns (e.g. relative value and merger arbitrage); and returns purely attributable to manager skill (called alpha, what is left if the previous sources cannot explain all the return outcome). For a fuller discussion please see my earlier Post on Disaggregation of Investment Returns.

These trends have resulted in the proliferation of ETFs and the downward pressure on investment management fees. The active manager has been squeezed, with investors only wanting to pay fees relative to the source of return i.e. very very low fees for beta and higher fees for alpha.

These developments have also resulted in the rise of liquid alternatives. Returns once attributed to hedge funds can now be more easily accessed, from a cost and liquid perspective.

Increasingly these strategies are available in an Exchange Trade Fund (ETF) structure.

True Portfolio Diversification

Consequently, there is a now a greater ability to significantly diversify the portfolios of the 1980s and 1990s and take on the learnings from GFC and 2000 Tech bubble.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or listed liquid infrastructure to a multi-asset portfolio that includes global equities.   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.

True diversification involves taking the learnings from the endowment model and the Norwegian Government Pension Fund study.

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.  This Post highlights that more asset classes does not equal more diversification may also be of interest.

Goal Based Investing and the extinction of the 60:40 Portfolio

Advancements in technology have helped investors understand the different dimensions of risk better and move away from the sole risk measure of MPT (standard deviation of returns).

Likewise, there has been a growing appreciation that failure to meet your investment objectives is the greatest investment risk.

More advanced portfolio construction approaches such as Liability Driven Investing (LDI) have been embraced.

Goal-Based Investing for the individual is based on the concepts of LDI.

The move toward Goal-Based Investing completely upturns portfolio construction, likely resulting in the extinction of the 60:40 Portfolio.

This paradigm shift within the industry is best captured by analysis undertaken by EDHEC Risk Institute.  I covered the most relevant EDHEC article in more depth recently for those wanting more information. This Post outlines future trends in Wealth Management.

Future Direction of Diversification

The ASI article finishes by discussing several trends they believe are reshaping portfolio construction. Some of these trends have been discussed on Kiwiinvestorblog.

I would like to highlight the following trends identified by ASI:

  1. Investors continue to shift from traditional to alternative assets, see the recent Prequin Post.
  2. Investors are increasingly integrating environmental, social and governance (ESG) analysis into their decision-making process.
  3. Opportunities to invest in emerging markets are increasing.
  4. Individuals have to take more responsibility for their financial futures. This is known as the Financial Climate Change.

 

As ASI conclude “If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.”

I would also add, and it is worth reflecting upon, although the benefits of diversification are without question, Modern Portfolio Theory of the 1950s can hardly be considered modern.

 

Happy investing.

Please see my Disclosure Statement

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

Low Return Environment Forecasted

Many commentators highlight the likelihood of a low return environment over the next 5 -10 years or more.

Even looking through the shorter-term challenges of the current market environment as highlighted in a recent Post, many publicly available forecasts underline the potential for a low return environment over the longer term.

The most often referenced longer-term return forecasts are the GMO 7 Year Asset Class Forecast.

As at 31 July 2019 they estimated the real returns (returns after 2.2% inflation) for the following asset classes as follows:

Share Markets

Annual Real Return Forecasts

US Large Capitalised Shares

-3.7%

International Shares

0.6%

Emerging Markets

5.3%

   
Fixed Income Markets  
US Fixed Income

-1.7%

International Fixed Income Hedged

-3.7%

Emerging Debt

0.7%

US Cash

0.2%

 

As GMO highlight, these are forward looking returns based on their reasonable beliefs and they are no guarantee of future performance.

Actual results may differ materially from those anticipated in forward looking statements.

 

The variation in sequence of returns is an additional consideration e.g. global sharemarkets could continue to move higher and then fall sharply to generate a 0.6% annual return over the next seven years. Or they could do the reverse, fall sharply within the next year and then float higher over the next 6 years to generate the 0.6% return.

 

The sequencing of returns is important for those in the retirement death zone, see my previous Post on the riskiest time of saving for and being in retirement.

 

Looking at the return forecasts the following observations can be made:

  • Within equity markets Emerging Markets are offering more value and US equities the least; and
  • The return expectations for Fixed Income are very dire, particularly for those developed markets outside of the US.

 

For comparison purposes, the long-term return of US equities is 6.5%.

 

The Fixed Income returns reflect that more than $US15 trillion of fixed income securities across Europe and Japan are trading on a negative yield.

Based on some measures, interest rates are at their lowest level in 5,000 years!

 

GMO is not alone with such longer-term market forecasts, those from Research Affiliates and State Street are provided below. They all have different methodologies and approaches to calculating their forecasts. Notably, they are all pointed in a similar direction.

 

This analysis highlights that outstanding returns have been delivered over the last 10 years, particularly if you are invested in the US and New Zealand sharemarkets and have had longer dated interest rate exposures.

The Balance Portfolio (60% Equities and 40%) has benefited from this environment.

The last 10 years have been amongst the best for a New Zealand investor invested in a Balanced Portfolio, if they had managed to stay fully invested during that time.

The New Zealand sharemarket has returned 13.3% over the last 10 years and New Zealand Government Bonds 5.9%. Therefore, a Balanced Fund has returned 10.3% over the last decade!

Global Equites have returned 10.0%, led higher by the US sharemarket, and Global Bonds 4.3% over the last 10 years. Globally, the Balanced Portfolio has benefited from the 35 year long decline in interest rates.

 

Therefore, the forecast returns are pretty frightening from a Balanced Fund perspective. Certainly, returns are not likely to be as strong over the next ten years as they have been over the last decade.

This calls into question the level diversification of a Balanced Fund of only equities and fixed income.

This issue can be considered from two angles, the need to increase the level of diversification within a Balanced Portfolio and the effectiveness of fixed income in providing diversification benefits to a Balanced Portfolio given historically low interest rates.

On the first issue, although a lack of true portfolio diversification has not disadvantaged investors greatly over the last 5-10 years, the potential to earn other sources of returns from true portfolio diversification may be of more value over the next 10 years. It is certainly a risk that should be considered and managed.

With regards the effectiveness of fixed income in diversify sharemarket risk in the future, this dynamic is best captured by the following insightful observation by Louis Grave: investors are hedging overvalued growth stocks with overvalued bonds.

What he is saying, is that given current valuations in the US of both the sharemarket and fixed income a Balanced Portfolio no longer has the degree of diversification it once had.

Of course, interest rates could fall further, and provide some offset from a falling sharemarket, as they have historically. Nevertheless, the effectiveness and extent of this offset is limited given historically low interest rates.

Most importantly, given current valuations, there is the scenario where both fixed income and sharemarkets underperform at the same time. This would be like the stagflation environment of 1970, where inflation is rising, and economic growth is muted.  This is a scenario worth considering.

In my mind the biggest risks to portfolios are in longer term fixed income securities or “bond proxies”, such as slow-growth and dividend-oriented investments.  Listed Property and infrastructure securities would fall into this definition.

It is quite likely that those looking for diversification benefits from listed property, global and domestic, and listed infrastructure, are likely to be disappointed. As they would had been during the Global Financial Crisis. They only provide limited portfolio diversification benefits, not true portfolio diversification.

 

The expected low returns environment throws up a lot of issues to consider:

  • True Portfolio diversification. Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.   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.

 

  • Consistent with the above, there is a growing evolution within the Wealth Management Industry, a paradigm shift which is resulting in the death of the Policy Portfolio (i.e. Balanced Portfolio).

 

  • The growing risks with traditional market indices and index funds, as highlighted by the low return forecasts.

 

  • Increased innovation within Exchange Traded Funds as investors seek to diversify their traditional market exposures.

 

I plan to write more on the last two points in future Posts.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Research Affiliates – 10 Year Forecast Real (After Inflation)

Share Markets

Real Return Forecasts

US Large Capitalised Shares

0.7%

International Shares

3.2%

Emerging Markets

7.7%

   
Fixed Income Markets  
US Fixed Income

-0.8%

International Fixed Income Hedged

-0.5%

Emerging Debt

4.2%

US Cash

-0.3%

 

State Street also provides:

  • They are more optimistic in relation to developed market sharemarket, with Emerging Markets outperforming developed markets, Global Listed Property underperforms both developed and emerging market equities
  • They see very low returns from Global Fixed Income.

KiwiSaver Investors are missing out

This is a great article by Stuff outlining the KiwiSaver risk ladder, rung by rung.

However, what struck me is that there is a rung missing on the KiwiSaver ladder.

That rung being the lack of exposure to non-traditional investments, such as Alternatives, including liquid alternatives, hedge funds, and investments into Direct Property and unlisted infrastructure.

 

Based on the Stuff article, there is just 1% within all of the KiwiSaver Funds invested outside of Cash, Fixed Interest (bonds), and Equities (the traditional asset classes).

We don’t have to look far to see how much of anomaly this.

By way of comparison, the Australian Pension Fund Industry, which is the fourth largest Pension market in the world, invests 22.0% into non-traditional assets.

As can be seen in the Table below, Australian Pension Funds, which manages A$2.9 trillion, invests 22.0% into non-traditional assets, meanwhile KiwiSaver has 1% invested outside of the traditional assets. (KiwiSaver Total Assets are just over $50 billion).

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

 

As recently reported by Bloomberg, allocations to non-traditional assets is expected to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

 

The increased allocations to Alternative is a global trend, which is not just in response to current market conditions.

As outlined in a previous Post, Preqin a specialist global researcher of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world, expect Alternatives to make up a larger share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018). This is an issue from the perspective of capacity and ability to deliver superior returns – manager selection will be critical.

 

Globally the trend toward increasing allocations to non-traditional assets has been in play for some time. As one of my first Posts notes, the case for adding alternatives to a traditional portfolio is strong.

This Post highlights that the movement toward Alternatives and non-traditional assets is not revolutionary nor radical, it is seen globally as evolutionary, a natural progression toward building more robust Portfolios that can better weather sharp falls in global sharemarkets.

 

Being more specific about Alternatives, Prequin note 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

 

Therefore, motives to investing in alternatives range from enhancing returns (Private Equity) and reducing risk through better diversification (Hedge Funds) and hedging against inflation (infrastructure and real estate (property), high exposures to non-traditional assets have benefited Endowments and foundations for many years.

 

I have Posted extensively on the benefits of Alternatives, for example highlighting research they would benefit Target Date Funds and the benefits of Alternatives more generally.

 

So the Question needs to be asked, why do KiwiSaver Funds not invest more into non-traditional assets? Particularly, when globally the trend is to invest in such assets is well established and further growth is expected, while the benefits are well documented.

 

Therefore, KiwiSaver Investors are potentially missing out.  Their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

Fintech’s Colossal Solution – Uber Moment? Microsoft and BlackRock team up

BlackRock and Microsoft are building a platform that will help people develop better saving and investment habits through more regular engagement with their retirement assets.

This initiative was announced in December 2018 and the Wall Street Journal (WSJ) noted at the time:

“The firms plan to develop a technology platform that will provide digital financial-planning tools and new BlackRock funds offering guaranteed retirement income to employees through their workplace saving plans.”

 

This is close to the Uber moment for the Wealth Management industry: technology platform providing retirement planning tools and direct access to new generation Investment Solutions.

 

BlackRock, the world’s largest money manager, according to WSJ “wants to shape the technology plumbing that connects it to different parts of the financial ecosystem handling workers’ retirement money.”  And for Microsoft, who needs no introduction, “an investment platform built with its technology could bring in new revenue as it looks to become a bigger cloud-computing player.”

 

BlackRock and Microsoft have made progress since December and FinancialPlanning.com provided further details in July 2019:

“The technology giant and the asset manager overseeing 15 million Americans’ 401(k) portfolios are developing an app and desktop tool aimed at narrowing the widening gap between what workers will need in retirement and how much they’re saving.”  (401 (k) is like KiwiSaver)

BlackRock and Microsoft are looking to reimage America’s path toward achieving greater financial security in retirement by bringing together BlackRock’s investment capabilities and Microsoft’s technology strength.

Together, they are exploring the next generation of investment solutions to help more people make better decisions as they work toward their financial goals in retirement.

Taking advantage of Microsoft’s technologies and BlackRock’s investment products, the companies are aiming to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.

The firms will begin rolling out their tool later this year.

By all accounts, this is going to be a powerful platform.  I’d imagine some of the tools will be like the BlackRock CoRI Index, which estimates the level of lifetime retirement from current savings.

 

Lifetime Income Focus – Next Generation of Investment Products

From an investment perspective the retirement tool will include guaranteed retirement income planning.

As part of the rollout Microsoft and BlackRock are designing methods of showing workers how much extra contributions today could end up netting them in retirement.  The intended result is that employees “have a clearer picture of how their contributions today will translate to long-term retirement income”.

BlackRock intends to offer the platform in connection with next generation investment products that it will design and manage. The new products from BlackRock will seek to provide a lifetime of income in retirement.

 

Therefore, BlackRock will be offering more sophisticated products than widely available now.  These Funds will seek to provide guaranteed income streams to participants as they get older, an element not common in 401(k) (like KiwiSaver) and other retirement plans.

The funds will be like Target Date Funds, a blend of investments that get more conservative as investors head into retirement. However, the funds BlackRock wants to roll out will also increase their concentration in financial instruments that provide regular payouts as participants reach retirement.  This is a massive enhancement.

As an aside, Target Date Funds would be a good option as the Default Fund for KiwiSaver.

 

Importantly, the focus is on providing an income stream in retirement.  There is a strong argument this should be the primary investment goal and not the targeting of a lump sum at time of retirement. What matters in retirement is income.

The OECD encourages the retirement objective to be the generation of income in retirement and for there to be coherency between the accumulation and pay-out phase of retirement.

Currently most investment products are poorly positioned to meet these objectives.

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

Therefore, volatility of income in retirement is a good risk measure.

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.

 

More specifically, the focus on retirement income and use of more advanced portfolio construction techniques as liability-driven investing overcomes one of the main criticisms of Target Date Funds.  Particularly, Target Date Funds should have a greater focus on generating income in retirement.  This means the fixed income allocation should act more like an annuity so that is pays a steady stream of income to the investor once they reach retirement.

The investment knowledge is available to achieve this.

 

Accordingly, BlackRock’s solutions appear to be more aligned with Goals-Based Investing and will be a more robust Retirement Income Solution than those available now.

There is a real need for these new generation investment solutions as many of the current financial products have shortcomings in meeting future customer needs, particularly the delivery of a stable and secure level of retirement income.

It is also important to note that there is a paradigm shift underway within the wealth management industry in relation to the development of new and improved investment solutions.

The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions to meet a growing savings crisis.

 

Defining Social Challenge – Addressing the Savings Crisis with Technology

As BlackRock outlined when making the initial announcement in December 2018:

Retirement systems worldwide are under stress and providing financial security to retirees has become one of the most defining societal challenges of our time,” said Laurence Fink, chairman and chief executive of BlackRock.

BlackRock has a tremendous responsibility to help solve this challenge, and we recognise the need to act now. Working with Microsoft will enable us to build a powerful solution for millions of hardworking Americans.”

There has been a major shift globally away from Defined Benefit (DB) schemes to Defined Contribution (DC).

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 “financial climate change” by the World Economic Forum

In America, millions are struggling to achieve their financial goals in retirement.  BlackRock and Microsoft are aiming to narrow the “gap” between what workers will need in retirement and how much they are saving.  This gap is estimated to be expanding by $3 trillion each year!

Therefore, there is a very real need to help people who are struggling with the difficult task of saving, investing, and turning this into a retirement income.

In BlackRock and Microsoft’s view the “shift in responsibility, from corporations to individuals, combined with ever increasing life-spans, has created a need to reimagine a new approach to securing a sound financial future in retirement – one that is powered by innovative investment solutions and the most advanced, trusted and cutting-edge technologies.”

“Technology is already revolutionizing entire industries and the way people interact with everything from health care to education and transportation. And yet, retirement solutions of today have been slow to keep pace. Taking advantage of Microsoft’s cutting-edge technologies and innovative investment products from BlackRock, the companies aim to make it easier for people to both save for retirement and achieve the lifetime income they need through their employers’ workplace savings plan.”

 

Thus, the need for new innovative investment solutions and technology platforms.

This is close to the Uber moment for the Wealth Management industry.

 

Happy investing.

Please see my Disclosure Statement

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