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

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

What is Responsible Investing?

There was a good article recently in GoodReturns on Responsible Investing (RI).

 

If I was to be critical, I would disagree with the comment at the beginning of the article that starting with exclusions (or negative screening) is a good first step. (As the article explains exclusions or negative screening involves removing companies in a portfolio that are in bad/sin/egregious industries, for example, controversial weapons and tobacco.)

I would argue, that a good first step is to have a Responsible Investing Policy. And that this Policy includes incorporating Environmental, Social, and Governance (ESG) considerations into the investment process. The Policy may well lead to exclusions, or may even include excluding certain sectors such as tobacco.

A good RI policy would also include a level of engagement with underlying companies and the investment management industry on RI issues.

The consideration of ESG factors will broaden the understanding of a portfolio’s and security’s risks, which involves understanding predominately non-financial risks which may very well have a financial impact.

Nevertheless, having a ESG focus does not necessarily lead to exclusions, it may do, it may also temper the size of the allocation to a stock or sector.  As a better understanding of the risks can be incorporated into the investment decision making process. Likewise, the RI approach could result in a combination of exclusions and sizing of portfolio allocations.

The ongoing RI research may lead to a blanket exclusion of sectors, which would be reflected in the RI Policy. I’d suggest this is the maturing of the RI approach over time, not the beginning, nor the beginning of the end!

I’d also suggest as the level of exclusions increases this is more ethical or social responsible investing, which is a subset of Responsible Investing i.e. exclusions is not what “Responsible Investing” is all about. RI is a very broad church.

Lastly, I would also argue that ESG is already mainstream in many parts of the world, the Responsible Investment Association of Australasia (RIAA) was set up in 2002 and many institutional investors have been embracing ESG for over a decade, as have broker reports included ESG/sustainability scores on companies.

Albeit there is confusion on just what is RI. The comments to GoodReturns article reflect this.

 

There is also a growing body of evidence, which has been around for some time, that incorporating ESG considerations into the investment process leads to better-informed investment decisions.  As noted above, RI is a broad church and there are varying degrees of implementing RI.

Therefore, the criticism of RI around the fear of missing out and underperformance due to negative screens needs to be taken with a level of perspective.  Not all RI approaches are a like, and therefore impacts on likely performance outcomes can vary.

One should not be quick to criticise RI giving the variation in approaches.

The evidence is not clear cut.  The higher the level of negative screens and constraints on a portfolio the more likely it is to underperform.

Nevertheless, an appropriate RI approach can enhance returns, and certainly reduce portfolio risk.

 

Another criticism of RI is around fees. Fees just are not an issue in implementing a successful RI approach.

The NZ Super Fund is an example, they do have an appropriate fee budget to manage the Fund, which does not exclude them investing into higher fee investment strategies, e.g. hedge Fund strategies and Private Equity, yet they run a global best practice Responsible Investing approach. It would appear you can have both, appropriate fee level and an industry best practice RI approach.  They certainly believe this will result in better investment outcomes over the longer term and will have more to pay out to the Government from the Fund in the future.

To date they have a good performance record and would not appear to have been negatively impacted from their RI approach, which includes negative screens.

 

The research on exclusions is mixed and varied. Comments to the GoodReturn’s article refer to Cliff Asness from AQR and his blog post on ESG. I have a lot of respect for Asness and read his blog.

My understanding on his position is that negative screening and divesting bad stocks is “actually at odds with the very point of ESG investing”.

Asness argues, if removing “bad/sin” stocks from a portfolio does help, it is an action that should be taken anyway for the sake of higher returns.

Nevertheless, IMO, an ESG framework helps identify those stocks that would fail or underperform due to ESG factors, thus the value of ESG focussed investment approach.

Please note AQR has an ESG policy.

Asness is not arguing against ESG investing, he is arguing against placing constraints on a portfolio, in this context of negative screens.  Too many constraints and a portfolio will underperform in his opinion, not surprising given he is an active manager!

Interesting, Asness contends that the desired outcome from negative screening will lower the level of investment returns achieved by the sin stocks given their cost of capital will rise. Thus the “Virtuous” negative screening investor will achieve their desired outcome: less investment within the sin/bad sectors by those companies. Asness argues that the Virtuous investor will achieve this but incur lower levels of returns themselves. The price of being Virtuous.

Not to pick an argument with Asness, as I’d surely lose, those companies that focus on managing ESG risks may have a lower cost of capital relative to their industry peers, and therefore make higher returns on investments. Thus positive ESG screening results in higher returns, the additional benefits of incorporating ESG considerations into the investment process. I’d certainly see this playing out in the resource sector.

 

Interestingly the recently released RIAA annual benchmark report noted “a lack of awareness and advice among retail investors…., and… Financial advisers…. (but the) truth is in some pockets of the advisor community, they’ve been slow to understand what this is all about and often somewhat dismissive about clients’ interests in ethical and responsible investing. There are a lot of deeply entrenched myths that still pervade that space, ……………… there’s still a perception that there’s a performance cost, this latest research shows responsible investment funds have performed consistently over time. ”

RIAA saw “ESG integration as having a positive impact on performance and the historical question marks that hung over the relative performance of responsible investment funds were starting to lift.’

Therefore, you can still have an ESG approach without negative screening.  Of course, you can also have varying levels of negative screening and maintain an ESG approach.

All up though, there is growing body of evidence that incorporating ESG considerations into the investment process leads to better-informed investment decisions.  The performance impact from negative screening is more contentious and motives to implement negative screens more varied.

 

I argue strongly, incorporating ESG into the investment process and maintaining a robust and evolving RI policy will result in better investment outcomes over time.

 

 

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

“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

Is the 4% rule dead? – Approaches to Generating Retirement Income

The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

Bill Bengen developed this rule in 1994.

There have been numerous other studies since and the rule has gained wide acceptance.

Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.

Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?

 

The 4% rule has been challenged in a recent article by Wade Pfau.

Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.

Pfau concluded:

  • the 4% real withdrawal rule has simply not been safe;
  • even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
  • a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.

 

At a minimum, investment outcomes can be improved from:

  • Increasing levels of portfolio diversification e.g. the use of alternatives;
  • A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
  • An appropriate rebalancing strategy.

 

Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”

 

The most insightful observation

In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”

I say this given the sharp reduction in equities by many Target Date Funds and many Target Date Funds have limitations, see a recent post and another I posted earlier in the year.

 

More robust and innovative retirement solutions are required

We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.

Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.

These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.

The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.

 

EDHEC-Risk Institute

From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.

EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

 

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.

 

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.

Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.

 

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.

Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Alternatives Investments will improve the investment outcomes of Target-Date Funds

Including alternative investments in Target-Date Funds (TDF) will improve their investment outcomes.

This is the conclusion of a recently published research report by the Center for Retirement Initiatives at Georgetown University’s McCourt School of Public Policy, developed in conjunction with Willis Tower Watson.   The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes

The study concludes the use of alternative investment strategies “can improve expected retirement income and mitigate loss in downside scenarios.”

 

Many TDF are over exposed to equity risk, they are not truly diversified.

The above study notes that TDF need to increase their diversification away from equities and fixed interest that dominate their portfolios.  In short, TDF need to broaden their diversification to allow access to alternative return drivers.

This is seen as very important, “even more important step is improving the performance of the underlying investments. The use of alternatives in DB (Define Benefit) plans is an investment practice that should be considered in today’s DC (Define Contribution) plans, specifically in TDFs”

The article outlines the growing popularity of TDF and therefore the opportunity that is available to build better portfolios and improve investment outcomes for clients.

 

The study compared TDF’s comprising of only equities, bonds, and cash.  To this traditional portfolio they added individual allocations to Private Equity, Unlisted Property, and Hedge Funds separately.

The study first looked at outcomes of adding these alternative strategies in isolation to the Traditional Portfolio, and then when all are added to the Portfolio all together.

When adding the alternatives in isolation to a traditional equities and fixed interest portfolio they concluded that investment outcomes for TDF were improved by:

  • Increasing the amount of income that can be generated in retirement from the portfolio;
  • Increase the probability of maintaining positive assets after 30 years of retirement spending;
  • Delivering higher expected returns; and
  • Reducing downside risk, particularly reduce the negative impact of a negative market at time of retirement (reducing sequencing risk)

 

Therefore, investment outcomes for Target-Date Funds can be improved with greater levels of diversification (as can any portfolio which only invests in equities, bonds, and cash).

Investment outcomes were improved with any one of the alternative strategies implemented in isolation.

 

The study then looked at TDF when all the alternative strategies were added to the Traditional Portfolio.

As they note “previous examples look attractive in isolation, we now turn to considering how these strategies contribute to a diversified implementation that includes allocations to all these assets. Not only do these alternative asset classes provide diversification or differentiated return drivers relative to equities and fixed income, but they also provide attractive cross-correlation benefits when viewed in combination with each other (meaning they outperform and underperform at different times from one another).”

 

Importantly, portfolios were constructed to be of similar risk along the glide path, the increased diversification of adding alternative provides risk benefits over time.

A higher allocation to return seeking assets is able to be maintained over time given the diversification benefits of adding alternatives to the TDF.

Again investment outcome were improved upon compared to a Traditional Portfolio of Equities and Fixed Interest, higher retirement income (+17%) and improved downside risk outcomes (+11%)

 

Importantly, they noted:  “One straightforward way to mitigate downside risk is to shift more equities into fixed income, though that approach would materially lower expected returns and adversely impact participants who intended to utilize the funds as a source for income throughout retirement.  Additionally, shifting from equities to core fixed income lessens equity risk but increases other risks such as interest rate and inflation. Instead, participants may be better off by further diversifying their portfolios.”

 

Notably they comment that this is part of an overall plan to improve retirement income outcomes:

“In order to improve retirement income outcomes, plan sponsors must pull all of the levers at their disposal across their organizations. While a number of enhancements have been made with investment vehicles …., plan design…….., and communications, DC plans still lag behind other large investment pools in the use of alternative asset classes. There is a reason why alternative assets are used more often in other investment pools: They can improve investment efficiency and the net-of-fee value proposition.”

 

Implementation Considerations

The paper covers a number of implementation issues, such as Governance, liquidity, and fees.

Their comments of fees hits the mark:

“To include the potential benefits of alternatives in TDFs, plan sponsors need to be comfortable increasing total fund fees, which can be accomplished through a prudent process focused on enhancing potential outcomes for participants. The fee compression in TDFs has come at the expense of the potential increased returns, lower volatility and portfolio efficiency alternatives could provide.”

Think about after fee outcomes.

 

Concluding remarks

Overall the outcomes from this Study are hardly surprising.  The use of alternatives has been shown to improve the investment outcomes of other investment portfolios and are widely used e.g. endowments, Insurance Companies, Super (Pension) Funds, and as mentioned Defined Benefit Funds.

The Study notes “As of 2016, the largest corporate pension plans in the Fortune 1000 (assets greater than $2.1 billion) held average allocations of 4.2 percent to hedge funds, 3.4 percent to private equity, 3.0 percent to real estate and 3.6 percent to “other” asset classes.” And “public pensions allocate even more to alternative investments (approximately 25 percent), according to the National Association of State Retirement Administrators.”

This is not to take anything away from the Study, it is great analysis, enhances our understanding of TDF, and is well worth reading.

 

Lastly, investment outcomes for Target-Date Funds can also be enhanced with the more active management of the glide path strategy.  This may include delaying the pace of transitioning from risky assets (which would include alternatives!) to safer assets or stepping off the glide path given extreme risk environments.

Investment outcomes for clients can also be improved if more client information is used over and above age to determine an investment glide paths e.g. changes in salary leading to a higher expected standard of living.  This is where technology can have a massive impact on the industry.

Many TDF have their limitations, particularly they have no goal and the glide path is based solely on age.

The experience in retirement is changing, we are living longer, more robust retirement solutions are needed.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is All-Passive Really the Best Thing for Target-Date Funds?

A recent AB article highlights the limitation of some Target-Date Funds (Life Cycle Funds).

AB propose:

“With market returns expected to be lower going forward, target-date funds that invest in passively managed underlying components are at risk of underdelivering. We think diversifying beyond traditional asset classes and tapping alpha opportunities with a multi-manager structure can increase the chances of success. “

 

I would argue more broadly, despite the market outlook, any passive portfolio that only invests into the traditional markets of equities, bonds, and cash are not well diversified for a range of possible economic and market outcomes. They are further at risk if they take a set and forget approach to the overarching strategic asset class positioning of the fund i.e. these short-comings are not limited to passively managed Target-Date Funds.

 

In short, AB argue that the outlook for traditional markets (beta) is challenging. As a result, this environment pose:

“major headwinds to target-date funds as they work to provide the growth participants need. Target-date funds that invest only in traditional asset classes, such as large-cap equities and core bonds through indices, face limitations in their glide path designs. This can make it a struggle for target-date funds to meet participants’ needs in anything but a high-return, low-risk market environment. And in terms of environments, that ship has likely sailed for now.”

Further: “A lower-beta landscape challenges a popular line of thinking that says investing in funds with the lowest fees will ensure compliance with plan sponsors’ fiduciary responsibilities. Low fees aren’t the end all and be all. For one thing, focusing too much on fees could cause sponsors to overlook other factors in retirement investing that also have fiduciary implications.”

The bold is mine.

 

My Opinion and solution

Increase the diversification of the Target-Date Fund and more actively manage the glide path of the strategy.

There could well be a blend of active and passive strategies.

Quite obviously increasing true portfolio diversification is paramount to building robust portfolios and increasing the likelihood of achieving investment objectives.

The prospect of a low returning environment only reinforces this position.

As mentioned in my last post, Reports of the death of Diversification are greatly exaggerated, also see my post Invest more like an Endowment, which also touches on the fee debate, investors should seek true portfolio 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 are “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.

 

Limitations of Target Date Funds

The AB article touches on the limitations of most Target-Date Funds, weather the underlying asset classes are actively or Index (passively) managed.

Essentially, most Target-Date Funds have two main short comings:

  • They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration by way of example future income requirements or likely endowments, level of income earned to retirement, or investor’s risk profile.

They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.

  • The glide path does not take into account current market conditions.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

      • Delays in pace of transitioning from risky assets to safer assets
      • May require step off the glide path given extreme risk environments

Most Target-Date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, which both suggest that the optimal strategy should also display an element of dependence on the current state of the economy.

 

Therefore, there is the risk that some Target-Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income. See A more Robust Retirement Income Solution is needed.

Target-Date Funds (Life Cycle Funds) focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.   The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk. A better solution is required.

 

The optimal Target-Date fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within market

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Why Low-Cost Index Investing Is Not Necessarily Low Risk

The US equity market has become more concentrated and not for the first time in history.

Current market concentration has been compared to 1999.

The market observations in this short article are consistent with the recently published Research by Research Affiliates, which I covered in a recent post, Buy High and Sell Low with Index Funds.

 

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.

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

How long will the record US equities bull market run continue for?

An interesting view from JP Morgan.

The US Equity market is within a month of recording its longest ever bull market.  Many are expecting it to continue well into 2019.  The US economy will reaches its longest period of economic expansion in modern history July 2019.

History of Sharemarket corrections – An Anatomy of equity market corrections

 

JP Morgan view.

www.bloomberg.com/news/articles/2018-07-19/jpmorgan-says-record-breaking-bull-market-could-run-until-2020

 

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…….

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