Robust Portfolios

Balanced Bear Market

/ Kiwi Investor / 1 Comment

A “Balanced Bear” is when both equities and bonds sell off together.

As a result, a Balanced Fund, 60% invested in the stockmarket (equities) and 40% invested in fixed income (bonds), has a larger than normally expected period of underperformance – a Balanced Fund Bear Market.

During these periods the diversification benefits of bonds relative to equities disappears.

As you will know, historically if the stock market is selling off sharply, money is moving into fixed income. This drives up the price of fixed income securities helping to partially offset the negative returns from the stock market.  A Balance Fund can come through these periods of equity market uncertainty relatively unscathed.

In a Balance Bear, equities are falling in value and fixed income is also falling in value given interest rates are rising (noting as interest rates rise the price, and therefore value, of a fixed income security falls).

This type of market environment was evident in early 2018 and was a prominent feature of the market volatility in early October 2018.

 

The thesis of the Balanced Bear has been promoted by Goldman Sachs and their equity analyst Christian Mueller-Glissmann raised the idea on CNBC in February of this year.

Goldman Sachs have written extensively on the Balance bear using historical US financial market data.

Importantly, a Balanced Fund is now into its longest period of outperformance, reflecting the very strong record run in US equities since 2009 and that interest rates, albeit they have risen from their June 2016 lows, are still at historical lows and have provided solid returns over the longer time frames.  The same can be said about New Zealand “Balanced Funds”.

 

The Anatomy of equity bear markets is well documented, not so for a Balanced Fund bear market.

In this regards Goldman Sachs (GS) has undertaken a wealth of analysis.

 

Requirements for a Balanced Bear – usually a Balance Bear requires a material economic growth or inflation shock.

In this regard, the largest Balance Fund declines over the last 100 years have been in or around US recessions (economic growth shock).

Nevertheless, Goldman Sachs also found that the Balance Fund can have long periods of low real returns (i.e. after inflation) without a recession e.g. mid 40s and late 70s. These periods are associated with accelerating inflation.

 

Naturally, equities dominate the risk within a Balanced Fund, therefore large equity market declines e.g. Black Monday 1987 are associated with periods of underperformance of Balanced Funds.

Not surprisingly, most of the largest Balanced Fund falls in value have been during US recessions, but not all e.g. 1994 Bond market bubble collapsing, stagflation of 1970 (low economic growth and high inflation), 1970’s oil shock.  It is worth noting that the 1987 sharemarket crash was not associated with a US recession.

 

Also of note, the stagflation periods of the 1970’’s and 80’s are periods in which there were large falls in both equities and bonds.

 

Bond market bears – are usually triggered by Central Banks, such as the US Federal Reserve, raising short term interest rates in response to strong growth and an overheating of the economy.  Bond market bears have been less common in modern history given the introduction of inflation targets anchoring inflation expectations.

 

Equity markets can absorb rising interest rates up to the point that higher interest rates are beginning to restrict economic activity. An unanticipated increase in interest rates is negative for sharemarkets and will lead to higher levels of volatility e.g. 1994 or recent tapper tantrum of May 2013.

 

As noted in previous blogs, most equity bear markets have been during recessions…but not all.

Goldman Sachs makes this point as well, noting the majority of 60/40 drawdowns of more than 10% have been due to equity bear markets, often around recessions. They note it is very seldom the case that equities deliver positive returns during a 60/40 drawdown (they estimate only in c.5% of cases).

With regards to recessions, Goldman Sachs note that there have been 22 recessions since 1900 and 22 S&P 500 bear markets. However, not every bear market automatically coincided with a recession in the last 100 years – out of the 22 since 1900, 15 were around a recession – 7 due to other factors.

 

Also, high equity valuations don’t signal a bear market. Nevertheless, they do signal below average returns over the medium to longer term. Albeit, sharemarket bear markets are not associated with low valuations!

 

Therefore, assessing the risk of a US recession is critical at this juncture.  As covered in a recent Post the “warning signs” of recession are not present currently based on a number of US Recession warning indicators.

 

Lastly, as also noted in a previous Post it is very difficult to predict bear markets and the costs of trying to time markets is very expensive.  The maintenance of a truly diversified portfolio and portfolio tilting will likely deliver superior return outcomes over the longer term.

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

 

It is a good time to reflect on the diversification of your portfolio at this time in the market cycle. As Goldman Sachs note, both equities and bonds appear expensive relative to the last 100 years.

In a Balanced Bear scenario there are very few places to hide.

  

Happy investing.

 

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

 

Please see my Disclosure Statement

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

/ Kiwi Investor / 3 Comments

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

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

 

What is the dominant purpose of ETF usage?

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

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

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

 

What are the future growth drivers?

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

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

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

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

 

How do investors select ETFs?

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

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

 

A section I found more interesting:

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

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

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

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

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

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

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

 

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

 

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

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

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

 

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

 

Future Developments

What are investor expectations for further development of ETF products?

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

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

 

Fixed Income and Alternatives

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

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

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

  

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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

/ Kiwi Investor / 1 Comment

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

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

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

This seems timely given current market volatility.

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

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

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

 

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

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

 

What is the answer?

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

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

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

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

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

 

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

 

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

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

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

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

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

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

 

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

 

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

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

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

No argument there as far as I am concerned.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

For those with a real focus on retirement income solutions

/ Kiwi Investor / 1 Comment

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

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

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

 

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

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

 

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

 

Happy investing.

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

 

Please see my Disclosure Statement

 

Is variability of retirement income a better measure of risk rather than variability of capital?

/ Kiwi Investor / 9 Comments

This is the second Post on why a greater focus should be placed on generating a level of Income in retirement as an investment goal. The first Post outlines why income matters as an investment goal.

This Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

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

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

 

To set the scene Merton discusses the difference between the high and low in longer term interest rates in the United States in the last 10 years, if you retired … with a given pot of money, if you retired and you got an income of a hundred, whatever that means, at the peak of interest rates, when they’re high, you get a hundred. At the trough, at the low end of interest rate, the same amount of money, you’d only get 74.

As he says, in other words your income will be 26% lower. “Think about that, 26% less of income, that’s a big hit especially for working middle class people but for any of us.”

 

You may well argue, that the last 10 years was an extraordinary period of time and corresponding fall in interest rates. Which would be correct.

Nevertheless, this does not detract from the point being made, how can we determine if a pot of money is enough to retire on? This can only be known by focusing on income generated from that pot of money.

Importantly, if you don’t monitor this risk, generating a stable level of income in retirement, you cannot manage it. And I would argue, such a focus will lead to you making better informed investment decisions that will likely result in a more stable and secure income in retirement.

This could well mean that as interest rates rise, you need a smaller pot and don’t need to take on as much risk as thought to support your life style in retirement.

 

Back to Merton, he uses another example, and highlights a number of times, the industry focuses on the wrong metric, the value of the pot (accumulated value).

If the value of the pot rises, we are happy, if the value declines, ‘you’re frowning’!

But, that’s not reality and in most cases it is not telling how you are going to go in retirement because you really want to know what income you are going to get in retirement.

Therefore, you should not be worried about the value of your pot, but what income the pot can generate in retirement.

That is the goal, and we should measure ourselves relative to that goal.

 

Defining risk around the risk of not being able to achieve income

Merton uses the following thought piece:

You’re 62, you’ve done well in your retirement account and I say to you, “Hey, you’ve got enough money to basically lock in your goal. I can buy you inflation protect, US Treasuries with funding that will take care of you throughout retirement guaranteed full faith and credit, the government protected for inflation at this level income, that’s your goal. Then I say, “You do want to increase your goal?” You said, “No, I’m happy with that, that’s my lifestyle. If I have some extra money, I’ll do something with it but basically, I’m happy with that. That’s what I want to live on and the safety and security, that is what matters to me.”

As Merton argues, in this situation the rationale thing to do would be to implement such an investment strategy. (This is Liability Driven Investing, or Goal Based Investing. Such investment approaches can be implemented now. Such approaches are aligned with how Insurance Companies and some Pension Funds implement.)

Such strategies as outlined above will closely match a desired level of income (subject to availability of appropriate securities – which is an area Government Policy could help in securing better retirement outcomes).

Under such an investment strategy retirement income is safe and largely predicable – reflecting the use of Government securities that are linked to inflation.

 

Nevertheless, while Income is stable, the value of the portfolio of fixed interest securities is not stable.

As interest rates rise, the price of bonds, fixed interest securities such as Government Bonds, fall.

However the Income from the bond does not change.

Using Merton’s example:

“Income is absolutely stable in a bond. Its value will fluctuate with interest rate. If interest rates, especially long-term bonds, which is what you would need for retirement, if the interest rates go up and let’s say your bonds go from 100 to 85 and I send you or put it on your account that your account has gone down 15% and you’re 62, you see that, you’ll go berserk. You’re going to say, “You told me you’re being safe for me and I’ve lost 15% of my retirement.”

“In fact, that’s not correct statement. Your retirement is defined by how much income you get for life. That hasn’t changed. The value of that has, that example is the problem at the core. It’s misinformation because we show them the wrong number”.

As Merton notes, investors get happy when the value of their portfolio goes up, but they are not actually better off if interest rates have fallen (meaning the price of a bond goes up).

Under this scenario buying new bonds will mean a lower level of income in the future.

This highlights that we focus on volatility of a capital as risk, the changing value in the pot of money, rather than volatility of future income.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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

/ Kiwi Investor / 11 Comments

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

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

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

The rationale for the focus on income is provided below.

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Shocked to see the State of the Asset Management industry

/ Kiwi Investor / Leave a comment

“The asset management industry is at the crossroads of enjoying rising markets and growing pools of capital to manage, and navigating significant disruption, changes and pressures from all sides. Taking the right path and making the right choices to adapt, evolve and transform will distinguish winners from losers.”

That is the thoughts of KPMG following the publication of report in to State of the Asset Management Industry

KPMG have identified three game changes that they believe are “fundamentally changing the landscape for this industry. How the asset and wealth management firms respond to these will likely determine their success in the next 5 -10 years.”

KPMG identify three main Game Changers:

  1. ETFs
  2. China
  3. Responsible Investing

 

Responsible Investing

The focus on Responsible Investing (RI) was interesting and a little concerning.

KMPG notes the global asset management has a lower level of trust than the banks and insurers. This is a big issue for the industry.

Therefore KMPG calls for the industry to “truly embrace responsible investment and embed Environmental, Social and Governance criteria into the investment process”

KMPG see this as an important part in restoring trust within the industry. They encourage the “industry to be much more wholehearted and convincing in embracing responsible investment and embedding ESG factors into the investment process.”

“The next generation of retail, pension fund and institutional investors want to see their capital being used to create an impact and contribute to a better world”.

 

Of course Responsible Investment and ESG are not new. The Responsible Investment Association of Australia (RIAA) was set up in 2002. Australia has likely lead the rest of the world in this respect.

Therefore, a key issue is that Asset Managers, and Asset Owners, can clearly demonstrate to clients and regulators they are doing what they say they are doing, a point noted by KPMG. A more convincing approach is required.

 

The other two changes are well understood, ETFs and China.

ETFs

KPMG note:

  • Exchange Traded Fund (ETF) assets are already bigger than hedge funds and index tracker funds, and are expected to overtake mutual funds within the next 10 years. Currently the global ETF market is at US$5 trillion and is expected to more than double in the next 5 years.
  • There are rapidly growing markets where ETFs are the vehicle of choice. They fit well with digital technology used by Roboadvisers. They work well as efficient building blocks for asset allocation solutions and model portfolios in the wealth management industry and in the increasingly important self-directed market.
  • Wealth Managers are increasing their use of ETFs. Areas of growth include smart beta, while active ETFs are increasing in popularity

KMPG sum it up: “The traditional asset management industry is at an inflection point. Regulatory scrutiny around value for money and transparency, disruptive D2C technology and new investor preferences, necessitate that firms adapt and innovate if they are to flourish in the new order.

 

China

Pretty simple, “KPMG expects the industry to grow at a double digit rate, year on year, over the next 15 years.”

“In 1998, six Fund Management Companies (FMCs) managed US$1.27 billion, while today 132 firms manage US$2.0 trillion of funds. KPMG forecast USD$5.6 trillion of assets under management in China by 2025, which would make it the second-largest asset management market in the world.”

 

It is certainly a challenging environment for which industry leaders need to be aware.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Reports of the death of Diversification are greatly exaggerated.

/ Kiwi Investor / 2 Comments

Is Portfolio Diversification dead?

One could think so given the extraordinary performance of equities over the last five to six years and the absence of a significant market correction.

The US equity market is likely to record its longest running bull market in August of this year, which is the longest period of time without a 20% or more fall in value.  The equity market correction in February/March of this year ended a record period of historically low volatility for US equities, having experienced their longest period in history without a 5% or greater fall in value.

 

This is a theme picked up by Joe Wiggins in a recent post on his Blog site, Behavioural Investment, titled “The Death of Diversification”.

Wiggins proposes that the success of equities over the last few years could be used by some to argue as evidence of the failure of portfolio diversification.  Furthermore, such has been the superior performance of equities that some could argue “prudent diversification” is no longer important.

The benign environment could well lead some to believe this, reflecting there has been “scant reward” for holding other assets.  Diversification has come at a “cost”.

Of course such a worldly view, if held, is rubbish.

Wiggins does not hold these views.  He does however indicate it is hard in this environment to argue for the benefits of diversification.

Nevertheless the benefits of portfolio diversification still exist.

It is not a time to become complacent, nor suffer from FOMO (Fare of missing out).

 

Building robust and truly diversified portfolios will never go out of fashion.

This is well summed up in Wiggins’s post:

“The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.

 

Well said.

I like the turn of phrase: as forecast-free as possible.

In my opinion, a portfolio still needs to be dynamically managed and tilted to reflect extreme valuations and a shifting economic environment, the focus should be on factors rather than asset classes.

Invest like an Endowment, seek true diversification and always remember the long-term benefits of diversification.  The portfolio should be constructed to meet an investor’s objectives “through a range of potential outcomes”.

There would appear to be a diverse range of likely economic and market outcomes currently.

Robust portfolios are positioned for a range of outcomes and “forecast-free as possible”.

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

 

I’ll leave the final comment from a great post from Wiggins:

“At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles.  Take the long-term view and remain diversified”

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Index Funds buy high and sell low…….

/ Kiwi Investor / 2 Comments

We know this.  This is related to an earlier post on the Limitations of Passive Index Investing.

 

A recent Research Affiliates article has looked into the cost of buying high and selling low by market indices and Index Funds.

Research Affiliates highlight that stocks added to market weighted indices are “routinely priced at a substantial premium to market valuation multiples (i.e., buying high), while discretionary deletions (excepting removals related to mergers, acquisitions, and other corporate actions) are routinely of deep-discount value stocks (i.e., selling low). In fact, additions tend to be priced at valuation multiples—using a blend of price-to-earnings (P/E), price-to-cash-flow (P/CF), price-to-book (P/B), price-to-sales (P/S), and (if available) price-to-dividends (P/D) ratios—that average over three times as expensive as those of deletions. This helps explain why from October 1989 through December 2017, the performance of additions lagged discretionary deletions by an average of over 2,200 basis points (bps) in the 12 months following the addition or deletion. Once investors recognize this buy-high/sell-low dynamic, they can avail themselves of some surprisingly simple ways to earn above-market returns”.

 

Obviously Index Fund providers understand this and may adjust their trading activities around additions and deletions from an index to minimise trading costs and impacts on performance.

A passive index solution is not passive, they are actively managed.

 

Nevertheless, there are costs around market index changes over time.  These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns.

Given Index Funds look to closely match market index returns (low tracking error) they incur these costs.

Based on the Research Affiliates analysis if Index Funds were to tolerate a higher level of tracking error they would add value above the index they are tracking by avoiding the longer term costs of market index changes.  This is achieved largely by delaying changes to their portfolios.

Some serious thought needs to be given when appointing a passive index provider.

 

What are these costs?

The costs reflect that a stock outperforms over the period from the date it is announced it will be included in a market index until the effective date (when it is added to the market index).

Similarly, stocks removed from the market index underperform the market from the date of the announcement until effective date.

Research Affiliates estimates that additions outperform the market by 5.23% on average over the period between announcement date and effective date.

They also estimate that deletions underperformed the market by 4.29% on average over the period from announcement date to the day they are removed from the market index.

A total return different of 9.52%!  (this analysis was undertaken over the period October 1989 to December 2017)

 

Research Affiliates also estimate that over one-third of the performance differential takes place on the day the Index makes the changes (e.g. adds the new stocks and makes the deletions).

 

As Research Affiliates says, the additions win big before they are added to the market index and deletions lose big before they’re dropped out.

 

Furthermore, once a stock is added to a market index, on average it underperforms the market over the next twelve months.

Likewise, a stock deleted from the market index will on average outperform the market over the next 12 months.

 

There is value to be added around market index changes and more broadly the rebalancing policy of an investment portfolio.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is Sector exclusion Lazy? Responsible Investing

/ Kiwi Investor / Leave a comment

I have some sympathy with the view that excluding sectors is lazy.

Doing so alone does not make one a Responsible Investor (RI), more an ethical investor.

Nevertheless, excluding sectors (negative screening) could be part of an Investor’s RI approach.

 

This post is in response to a recent GoodReturns article, Sector exclusions lazy CIO says.

 

In my mind, RI can be thought of as a continuum, at one end is do nothing, non RI, and at the other end is ethical investing, which would include a number of exclusions depending on ethical positions.  In between are different shades of RI.  RI is a broad church.

For most institutional Investor’s their RI approach centres around the United Nations supported Principles of Responsible Investing (PRI).  PRI has six principles, see below.

 

Whatever the “Responsible Investing” approach it should be based on a documented policy, preferably approved by the Board.  The policy would provide RI philosophy, approach, and guidelines e.g. the exclusion of sectors based on a investment research position or set of values.

I think the approach to RI should be addressing the PRI’s six principles.

 

With regards to impact on performance.  I’d see RI as having the ability to add value, certainly improve risk-adjusted returns.  There is increasingly more evidence suggesting this, particularly at the stock selection level for equities and bonds.

Likewise, heading down the road of excluding a large number of sectors will increase variability of returns relative to broad market indices (that is the math).  Nevertheless, I’d argue this is ethical investing, not RI.  Perhaps the two will come closer together over time.  That will need a growing consensus of what sectors are acceptable and what are not i.e. tobacco has wide acceptance as being excluded currently.

 

RI to me is much more about risk management.  Environment, Social, and Governance (ESG) factors can impact on the long term financial outcomes of a company and a broader portfolio.  Well researched ESG positions will improve risk-adjusted performance.  Such a research driven approach may result in the exclusion of some sectors.  It may also result in making investment decisions a non-RI approach would not consider e.g. impact investing or reducing a portfolio’s carbon exposure given changing government regulations and taxes.  I have a preference that the ESG approach focuses more on a portfolio’s financial impacts, rather than ethics.  Albeit, RI should be set within a sound philosophy and values framework.

The ESG factors should be integrated into the investment process, through selection and monitoring of investments.

Therefore, the consideration of ESG factors will help improve long term risk-adjusted returns, provide better insights into the risk of companies and potentially wider portfolio risk exposures, not just listed equities but unlisted assets such as infrastructure and property.  ESG assists in considering portfolio risks more broadly.  RI can make for more robust portfolios.

RI also includes engagement, with companies and the industry.  It is proactive, e.g. proxy voting and engagement with companies.  RI is a lot more than just excluding an equity market sector.  From this perspective, an investment manager can do more good through engagement than just excluded particular sectors.  They can make a conscious and research based decision not to invest in a company with the consideration of ESG factors.

RI is consistent with being a long term investor and stewardship.  In this regard, RI is as much about sustainable investing.

And that highlights a problem, there is so much terminology in our industry, particularly within this space.  This leads to inconsistency in meaning across the industry, which is reflected within the media e.g. Ethical Investing and Social Responsible Investing are often described as “RI”, which is not really true, at best it is at the far end of the RI continuum and based more on values than financial impacts, it is a subset of RI at best.

 

As an aside, one of the best books I have read on sustainable investing is, Sustainable Investing for Institutional Investors, by Mirjam Staub-Bisang.  I am interviewed in one of the chapters (no I don’t get any royalties) along with Amanda McCluskey, chpt 16.  Both are wonderful people.

 

 

Happy investing.

 

 

Please see my Disclosure Statement

 

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

 

 

PRI Principles:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.