Disaggregation of Investment Returns

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

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

 

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

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.  The increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.  Alternative strategies are added so as to reduce overall portfolio volatility, resulting in a more attractive portfolio risk return profile.

The inclusion of alternative strategies can assist in providing greater probability in meeting investment objectives.

 

An understanding of the different return and risk outcomes can be gained by disaggregating investment returns.

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

  1. Market beta. Think equity market exposures to the NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).  Market Index funds provide market beta returns i.e. they track the returns of the market e.g. S&P 500 and NZX50
  2. Factor betas and Alternative hedge fund beta exposures.  Of the sources of investment returns these are a little more ambiguous and contentious than the others.  This mainly arises from use of terminology and number of investable factors that are rewarding.  My take is as follows, these betas fit between market betas and alpha.
    1. Factor Beta exposures.  These are the factor exposures for which I think there are a limited number.  The common factors include value, momentum, low volatility, size, quality/profitability, carry.  These were outlined in this blog and are often referred to as Smart beta – see diagram below.
    2. Alternative hedge fund betas.  Many hedge fund returns are sourced from well understood investment strategies.  Therefore, a large proportion of hedge fund returns can be explained by common hedge fund risk exposures, also known as hedge fund beta or alternative risk premia or risk premia.  Systematic, or rule based, investment strategies can be developed to capture a large portion of hedge fund returns that can be attributed to a hedge fund strategy (risk premia) e.g. long/short equity, managed futures, global macro, and arbitrage hedge fund strategies.  The alternative hedge fund betas do not capture the full hedge fund returns as a portion can be attributed to manager skill, which is not beta and more easily accessible, it is alpha.

 

Lastly, and number three, there is Alpha.  Alpha is what is left after beta.  It is manager skill.  Alpha is a risk adjusted measure. In this regard, a manager outperforming an index is not necessarily alpha.  The manager may have taken more risk than the index to generate the excess returns, they may have an exposure to one of the factor betas or hedge fund betas which could have been captured more cheaply to generate the excess return.  In short, what is often claimed as alpha is often explained by the factor and alternative hedge fund betas outlined above.  Albeit, there are some managers than can deliver true alpha.  Nevertheless, it is rare.

 

These broad sources of return are captured in the diagram below, provided in a recent hedge fund industry study produced by the AIMA (Alternative Investment Management Association).

Another key distinction, in the most beta and factor betas are captured by investing long (i.e. buying securities and holding) while alternative hedge fund betas are captured by going both long and short and generally being market neutral i.e. having a limited exposure to market betas e.g. equity market risk.

The framework above is also useful for a couple of other important investment considerations.  We can use this framework to determine:

  1. Appropriateness of the fees paid. Obviously for market beta low fees are paid e.g. index fund fees.  Fees increase for the factor betas and then again for the alternative hedge fund betas.  Lastly, higher fees are paid to obtain alpha, which is the hardest to produce.
  1. If a manager is adding value – this was touched on above. Can a manager’s outperformance, “alpha”, be explained by “beta” exposures, or it truly unique and can be put down to manager skill.

 

Lastly, and most importantly, to obtain a truly diversified portfolio, a robust portfolio should have exposures to the different return and risk sources outlined above.

Accessing the disaggregation of investment returns has come increasingly available due to advancements in technologies and the lowering of transaction costs.  It is also having a fundamental impact on the global funds management industry, including hedge funds.

Furthermore, the determination of institutional investors to pay appropriate fees for return sources has witnessed the development of investment strategies that appropriately match fees for sources of return and risk.

Happy investing.

 

Return aggregation

 

Please see my Disclosure Statement

 

Shortcomings of Target Date and Life Cycle Funds

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

They do this on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through human capital (salary and wages).  These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy.  This is a generalisation that does not take into consideration the individual circumstances of the investor nor market conditions.

Target Funds are becoming increasingly popular.  Particularly in situations where the Investor does not want or can afford investment advice.  The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice provided.

 

All good in theory, nevertheless, these “products” have some limitations in their design which are increasingly being highlighted.

No, it is not that they are moving investors into cash and fixed interest at a time of record low cash returns and over-valued fixed interest markets.  This is an issue, but a topic for another Blog.  Albeit this is touched on below from a slightly different angle.

 

Essentially, Target Date Funds have too main short comings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, level of income generated up retirement, or the investors risk profile, appetite for risk, or risk tolerance.
  • 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.
  1. Additionally, the glide path does not take into account current market conditions.
  • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.
  • Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:
    • Delays in the pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme market risk environments

 

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.

 

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.

As noted above, 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, both of which suggest that the optimal investment strategy should also display an element of dependence on the current state of the economy.

 

The optimal target date or life cycle 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 markets

 

All up, this requirements a more Liability Driven Investment approach, Goal Based Investing.

My first blog outlines the revolution required within the industry to Mass Customisations.

 

Please see my Disclosure Statement