Are Investment products meeting people’s needs over their working life?

A key finding by the Australian Productivity Commission is that “Well-designed life-cycle products can produce benefits greater than or equivalent to single-strategy balanced products, while better addressing sequencing risk for members.

There are also good prospects for further personalisation of life-cycle products that will better match them to diverse member needs, which would require funds to collect and use more information on their members.

Some current MySuper life-cycle products shift members into lower-risk assets too early in their working lives, which will not be in the interests of most members.”

 

This is one of many findings from of the 2018 Australian Productivity Commission Inquiry Report, Superannuation: Assessing Efficiency and Competitiveness.

Mysuper is a default option in Australia, similar to the Default Options by Kiwisaver providers in New Zealand and around the world.

 

The above findings are from the Section 4, Are Members needs being met, of the report (pg 238). This section, 4.3, Are products meeting people’s needs over their working life?, focuses on Life Cycle Funds. (Lifecycle Funds are often referred to as target-date funds in the United States, the United Kingdom, and other countries. They are popular in the US, accounting for 25% of their saving for retirement assets, and growing.)

Life cycle Funds, also referred to as Glide Path Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

 

Section 4.3 concludes “the Commission now recognises the value of well-designed MySuper life-cycle products, and the potentially significant gains that could arise from further personalisation.”

As covered in the report, they highlight that the poorer products currently on offer “requires some cleaning.”

 

Two areas of Section 4.3 are of interest to me.

 

The relative attractiveness of Lifecycle Funds

The report covers the varying views on Lifecycle Funds.

On this the Commission notes that the underperformance of some Lifecycle Funds does not “repudiate the principle of varying the management of risk as a person ages.”

Importantly, the “costs and benefits of life-cycle products depend on their design and on the characteristics of fund members (for example, the size of their balance).”

They note “the determinant of the variation between life-cycle products is the glide path from growth to defensive assets as the member ages”

“The lowest average retirement balances occur for life-cycle products with accelerated transitions to defensive assets as the member ages.”

 

As noted by several submissions, Lifecycle Funds can provide better outcomes if they maintain a higher growth allocation in the earlier years of saving for retirement. They also offer additional benefits in market downturns, particularly closer to retirement, they produce less poor outcomes than a standard single-strategy product, such as a Balanced Fund i.e. they manage sequencing risk better.

 

The criticism of Lifecycle Funds is often associated with poor design, as covered in this Post.

 

Increased Customisation of the Investment Solution

It is important to appreciate that not one investment product can meet all investor’s needs.  It does not make sense for a 29 year old and a 50 year to be in the same Default Fund.

This is an attractive feature of Lifecycle Fund offerings, they can be more tailored to the investor.

Specifically, they can be tailored for more than just age, such as Balance size, and this can in the majority of cases result in better outcomes for those saving for retirement. As outlined in this research article by Rice Warner.  Tailored investment solutions boost retirement savings outcomes.

 

On this point the Commission’s Report notes “There is significant scope for more personalised MySuper products”…

Specifically there is the scope to customise the investment strategy of Lifecycle Funds beyond age.

The report outlined a submission that observed that “… data and technology provide the opportunity for giant advancements in the design of personalised lifecycle strategies. Such strategies could account for: age, balance, contribution rate (which entails non-contribution due to career breaks etc), gender, expected returns, [and] risk.”

“Ultimately, individualised product design could also take into account other member characteristics, such as household assets, income from any partner and the potential capacity to extend a working life if there are adverse asset price shocks.”

 

The following two submissions in relation to Lifecycle Funds by David Bell and Aaron Minney are well worth reading for those wanting a greater understanding and appreciation of broader topics associated with Lifecycle Funds.

These submissions are also well worth reading by those interested in designing effective investment solutions for those saving for retirement.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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

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

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

Multifactor Lifecycle Funds:

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

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

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

 

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

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

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

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

 

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

 

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

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

 

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

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

 

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

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

 

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

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

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

 

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

 

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

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

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

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

 

 

Rice Warner – The benefits of Multifactor Lifecycle Funds

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

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

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

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

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

 

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

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

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

 

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

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

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

 

 

Rice Warner Analysis

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

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

Rice Warner considered:

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

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

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

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

 

Conclusions

Rice Warner Conclude:

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

 

Implications

Overall the results, aged 30:

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

 

For those aged 60

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

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

What too expect, navigating the current Bear Market

After reaching a historical high on 19th February the US sharemarket, as measured by the S&P 500 Index, recorded:

  • Its fastest correction from a peak, a fall of 10% but less than 19%, taking just 6 days; and
  • Its quickest period to fall into a Bear market, a fall of greater than 20%, 21 days.

The S&P 500 entered Bear market territory on March 12th, when the market fell 9.5%, the largest daily drop since Black Monday in October 1987.

The 21 day plunge from 19th February’s historical high was half the time of the previous record set in 1929.

S&P500

Source: ETF.com

This follows the longest Bull market in history, which is a run up in the market without incurring a 20% or more fall in value. The last Bear market occurred in 2008 during the Global Financial Crisis (GFC).

The 11-year bull market grew in tandem with one of the longest economic expansions in US history, this too now looks under threat with a recession in the US now looking likely over the first half of 2020. Certainly, global recession appears most likely.

 

Global sharemarkets around the world have suffered similar declines, some have suffered greater declines, particularly across Europe.

Markets lost their complacency mid-late February on the spreading of the coronavirus from China to the rest of the world and after Chinese manufacturing data that was not only way below expectations but was also the worst on record.

A crash in the oil price, which slumped more than 30%, added to market anxieties.

 

Extreme Volatility

The recent period has been one of extreme market volatility, not just in sharemarkets, but currencies, fixed income, and commodity markets.

As the Table, courtesy of Bianco Research, below highlights, three of the five days in the week beginning 9th March are amongst the 20 biggest daily gains and losses.

After the 9.5% decline on 12th March, the market rebounded 9.3% the following day. The 7.6% decline on the 9th March was, to date, the 20th largest decline recorded by the S&P 500.

2020 is joining an infamous group of years, which include 1929, 1987, and 2008.

Extreme volatility

Where do we go from here?

Great question, and I wish I knew.

For guidance, this research paper by Goldman Sachs (GS) is helpful: Bear Essentials: a guide to navigating a bear market

To get a sense as to how much markets are likely to fall, and for how long, they look at the long-term history of the US sharemarket. They also categories Bear markets into three types, reflecting that Bear markets have different triggers and characteristics.

The three types as defined by GS are:

  • Structural bear market – triggered by structural imbalances and financial bubbles. Very often there is a ‘price’ shock such as deflation that follows.
  • Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in profits. They are a function of the economic cycle.
  • Event-driven bear markets – triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation).

They then plot US Bear Markets and Recoveries since the 1800s, as outlined in the following Table:

Historical US Bear markets

Source: Goldman Sachs

From this they can characterise the historical averages of the three types of Bear markets, as outlined at the bottom of the Table:

GS summarise:

  • Structural bear markets on average see falls of 57%, last 42 months and take 111 months to get back to starting point in nominal terms (134 months in real terms (after inflation)).
  • Cyclical bear markets on average see falls of 31%, last 27 months and take 50 months to get back to starting point in nominal terms (73 months in real terms).
  • Event-driven bear markets on average see falls of 29%, last 9 months and recover within 15 months in nominal terms (71 months in real terms).

 

In their opinion GS currently think we are in an Event-driven Bear market. Generally these Bear markets are less severe, but the speed of the fall in markets is quicker, as is the recover. However, as they note none of the previous Event-Driven Bear markets were triggered by the outbreak of a Virus, nor were interest rates so low at the start of the market decline.

Therefore, they conclude, a fall of between 20-25% can be expected, and the rebound will be swift.

This makes for an interest couple of quarters, in which the economic data and company profit announcements are sure to get worse, yet equity markets will likely look through this for evidence of a recovery in economic activity over the second half of this year.

 

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.

What does Portfolio Diversification look like?

What does a diversified portfolio look like?

This is answered by comparing a number of portfolios, as presented below.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.   Investors are compensated for being exposed to a range of different risks.

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

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.

 

This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.

The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).

To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.

 

Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe.  Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.

I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.

WTW Model Reference Portfolio Typical US Advisor
Domestic Cash 2.0%
Domestic Fixed Interest 13.0% 15.0% 28.0%
Global Fixed Interest 15.0%
Domestic Equities 15.0% 25.0% 35.0%
International Equities 20.0% 40.0% 12.0%
Emerging Markets 5.0% 5.0% 4.0%
Listed Property 3.0%
Global Property 3.0%
Listed Infrastructure 3.0%
Alternative Beta 8.0%
Hedge Funds 7.0% 8.0%
Private Equity 8.0% 4.0%
Unlisted Infrastructure 5.0%
Alternative Credit 8.0%
US High Yield 4.0%
Commodities / Real Estate 4.0%
Emerging Markets Bonds 1.0%
100.0% 100.0% 100.0%
Broad Asset Classes
Cash and Fixed Income 15.0% 30.0% 28.0%
Listed Equity 49.0% 70.0% 51.0%
Non Traditional 36.0% 0.0% 21.0%
100.0% 100.0% 100.0%

Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta

The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.

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

From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.

 

If a picture tells a thousand words, the Tables above speak volumes.

The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.

 

It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).

Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set 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.”

Globally allocations to alternatives are set to grow, as outlined in this Post.

 

The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.

Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments.  As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).

 

Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.

The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.

Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.

Although investors can experience strong performance, they can also experience very weak performance.

 

Comparison Return Analysis

Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.

By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.

It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.

 

The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.

 

Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%

 

A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.  They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?

Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.

For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.

 

Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.

As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are 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, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

The Retirement Planning Death Zone

The retirement risk zone (also known as the ‘conversion’ phase) is commonly defined as the final 10 years of working life (the ‘accumulation’ phase) and the first 10 years of retirement (the pay-out phase or decumulation).

This period is right before and right after you retire.

Importantly, it is this 20 year period when the greatest amount of retirement savings is in play and, subsequently, risk is at its highest.

 

This can be thought of along the lines of the death zone when climbing Mt Everest. The risky time is the final ascent, clambering over the Hillary Step, on the way to the summit of Mt Everest. However, once at the summit risks remain on the decent and until below the death zone when the ability to breathe becomes easier.

The summit in terms of retirement savings is generally reached at age 65, this is when the amount saved will be the “peak” in savings accumulated. It is here when accumulated wealth is at its largest.  Albeit, from an investment perspective, risks remain heightened over the first 10 years of the pay-out/decumulation phase.

 

The Retirement Risk Zone, the 10 years either side of retirement, is the worst possible time to experience a large negative return given this is when the greatness amount of money is at stake. Risks to portfolios are heightened at this stage.

It is a very important period for retirement planning.

 

During the Retirement Risk Zone two factors can potentially combine to have a detrimental impact on the standard of living in retirement:

  1. The portfolio size effect (what you do when the largest amount of your money is at risk matters); and
  2. the problem of sequencing risk (how much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of the loss, again, especially during the Retirement Risk Zone).

 

To explain, sequencing risk, is the risk that the order of investment returns are unfavourable, resulting in less money for retirement.

Sequencing risk impacts pre-and post-retirement i.e. the retirement risk zone.

 

Cashflows, investments in and withdrawals out of the retirement savings plan, add another dimension to sequencing risk.

Sequencing Risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement. This impacts on longevity risk.

This is where Warren Buffet could be wrong in recommending people maintain high equity allocations for the longer term. As noted in my previous Post, Could Buffet be Wrong? “once an investor needs to take capital or income from a portfolio volatility of the equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives”. This is sequencing risk at play for those planning for retirement. This is also why many US Endowments do not hold large equity allocations.

It is untrue to say that volatility does not matter for the long term when cashflows are involved.

A brief explanation of interplay between the timing of returns and cashflows is provided below.

 

Longevity Risk

The portfolio size effect and sequencing risk have a direct relationship to longevity risk.

For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.

Or put another way, longevity risk is the likelihood that superannuation savings will be depleted prior to satisfying the lifetime financial needs of the dependents of those savings.

One way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.

 

The point to take away: the size of your portfolio, order in which returns are experienced, and timing of cashflows into and out of the retirement savings account have an impact on accumulated wealth and ultimately standard of living in retirement.

The basic conclusions. First, it is better to suffer negative returns early in the accumulation phase.

Secondly, it is better to suffer negative returns later in retirement.

 

Materiality of Sequencing Risk

In short, the research finds that the sequence of returns materially impacts peak accumulated wealth (terminal wealth) and heightens the probability of running out of money in retirement (longevity risk).  The research backs up the two conclusions above.

The Griffith University research paper mentioned below “finds that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“

Terminal wealth is “peak” accumulated savings in our Mt Everest example above.

Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.

They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”

This is consistent with other international studies.

 

For those wanting a more technical read please see the papers that have been drawn upon for this Post:

  1. Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
  2. Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife

 

Managing Sequencing Risk

The combination of the portfolio size effect, sequencing risk, and longevity risk combine to form a trinity of investment issues that need to be managed inside the Retirement Risk Zone.

Mitigation of sequencing risk is critical across the retirement risk zone.

Sequencing risk is largely a retirement planning issue. Albeit a more robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk:

  1. A greater focus on generating retirement income earlier

In my mind, a greater focus should be placed on positioning retirement portfolios for generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement.

This is achieved by using asset-liability matching techniques as recommended by the OECD. This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable level of income in retirement.

The investment knowledge is available now to achieve this and these techniques can improve the outcomes of Target Date Funds.

This is also consistent with the OECD’s Core Principles of Private Pension Regulation that emphasised that the objective is to generate retirement income.

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, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.

 

I have highlighted the OECD recommendations in a previous Post.

 

2. A greater focus on reducing downside risk in a portfolio

This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.

From this perspective Target Date Funds would be an appropriate default option for KiwiSaver, as I have previously outlined.

A more robust portfolio must also display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.

This includes the inclusion of alternative investments. Portfolios should be built more like US endowments as I outlined in a previous Post.

An allocation to Alternatives have also been shown to improve the investment outcomes of Target Date Funds.

The inclusion of low volatility equities may also be option.

 

The article from Forbes is of interest in managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.

Many argue that sequencing risk can be managed by Product use alone.

 

My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing, and is therefore using asset-liability matching type strategies.  I would complement the Goals-Based approach with longevity annuities so as to manage longevity risk.   This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

 

Sequencing risk is currently a growing and present danger given it has been a long time since both the US and New Zealand sharemarkets have incurred a major fall in value. Hopefully, sequencing risk is getting some consideration in investment decisions being made today.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Background – Understanding Impact of returns and Cashflows

It is hard to believe, but two investors might both experience “average” returns of 8 per cent over a 20-year period and yet have materially different balances due to sequencing risk.

The 20-year periods would occur at different times, yet the “average” return is the same.

Nevertheless, the sequence of returns to generate an “average” return over the 20 year periods can result in different accumulated wealth.

This reflects there is a difference between time weighted returns and dollar invested returns. The time weighted return assumes you held the same investment over the time period. A dollar weighted return takes into consideration that money goes in and comes out of a savings account and each dollar earns a different return given the period it is invested for.  Dollar weighted returns impact on accumulated wealth.

Although the sequence of returns is crucial, so too are the timing of Cashflows into (deposits) and out (withdrawals) of a savings account.

To appreciate this, it is important to understand the impact of market volatility, it is hard to recover a dollar lost from a negative market movement. For example, if your portfolio falls in value by 40%, it’s takes a 67% return to recover your loses e.g. you have $100, this falls in value by 40%, wealth falls to $60, to get back to $100, the portfolio must recover 67%.

When there are cashflows not every dollar will experience the same return e.g. a dollar withdrawn after a 50% fall will miss out on any subsequent recovery in market prices, which can take up to six to ten years.

Therefore, the introduction of cashflows can also result in different outcomes for investors. This is why the pulling of funds out of markets following a large fall (draw-down) early in the accumulation phase can have a detrimental impact on accumulated wealth at the time of retirement.

The sequence of returns and cashflows matters during both the accumulation of retirement savings and in retirement.

During accumulation cashflows are going into the savings account and the account balance is growing. Therefore, each dollar invested has a different investment return.

In retirement, cashflows coming out of the portfolio will gradually reduce the capital base, therefore, investors will be better off if returns are stronger at the start of retirement, as the account balance will be larger and growing, meaning cashflows out will not reduce the capital base as much when returns are poorer in the earlier years of retirement.

For those wanting a more technical explanation, along with some great charts and graphs, this article by Challanger will be of real value.