Balanced Fund Bear Market and the benefits of Rebalancing

Balanced Funds are on track to experience one of their largest monthly losses on record.

Although this largely reflects the sharp and historical declines in global sharemarkets, fixed income has also not provided the level of portfolio diversification witnessed in previous Bear markets.

In the US, the Balanced Portfolio (60% Shares and 40% Fixed Income) is experiencing declines similar to those during the Global Financial Crisis (GFC) and 1987.

In other parts of the world the declines in the Balance Portfolio are their worst since the   1960s.

As you will be well aware the level of volatility in equity markets has been at historical highs.

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%, 22 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 22 day plunge from 19th February’s historical high into a Bear market was half the time of the previous record set in 1929.

Volatility has also been historical to the upside, including near record highest daily positive returns and the most recent week was the best on record since the 1930s.

 

Volatility is likely to remain elevated for some time. The following is likely needed to be seen before there is a stabilisation of markets:

  • The Policy response from Governments and Central Banks is sufficient to prevent a deepening of the global recessions;
  • Coronavirus infection rates have peaked; and
  • Cheap valuations.

Although currently there are cheap valuations, this is not sufficient to stabilise markets. Nevertheless, for those with a longer term perspective selective and measured investments may well offer attractive opportunities.

Please seek professional investment advice before making any investment decision.

For those interested, my previous Post outlined one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

 

The Impact of Market Movements and Benefits of Rebalancing

My previous Post emphasised maintaining a disciplined investment approach.

Key among these is the consideration of continuing to rebalance an investment Portfolio.

Regular rebalancing of an investment portfolio adds value, this has been well documented by the research.  The importance and benefits of Rebalancing was covered in a previous Kiwi Investor Blog Post which may be of interest: The balancing act of the least liked investment activity.

Rebalancing is a key investment discipline of a professional investment manager. A benefit of having your money professionally managed.

Assuming sharemarkets have fallen 25%, and no return from Fixed Income, within a Balanced Portfolio (60% Shares and 40% Fixed Income) the Sharemarket allocation has fallen to 53% of the portfolio.

Therefore, portfolios are less risky currently relative to longer-term investment objectives. A disciplined investment approach would suggest a strategy to address this issue needs to be developed.

 

As an aside, within a New Zealand Balanced Portfolio, if no rebalancing had been undertaken the sharemarket component would have grown from 60% to 67% over the last three years, reflecting the New Zealand Sharemarket has outperformed New Zealand Fixed Income by 10.75% per year over the last three years.

This meant, without rebalancing, Portfolios were running higher risk relative to long-term investment objectives entering the current Bear Market.

Although regular rebalancing would have trimmed portfolio returns on the way up, it would also have reduced Portfolio risk when entering the Bear Market.

As mentioned, the research is compelling on the benefits of rebalancing, it requires investment discipline. In part this reflects the drag on performance from volatility. In simple terms, if markets fall by 25%, they need to return 33% to regain the value lost.

 

Investing in a Challenging Investment Environment

No doubt, you will discuss any current concerns you have with your Trusted Advisor.

In a previous Post I reflected on the tried and true while investing in a Challenging investment environment.

I have summarised below:

 

Seek “True” portfolio Diversification

The following is technical in nature and I will explain below.

A recent AllAboutAlpha article referenced a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

For the professional Investor this Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

 

We are currently experiencing a Black Swan, an unexpected event which has a major effect.

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits over the longer term and particularly at time of market crisis.

True portfolio diversification is achieved by investing in different risk factors (also referred to as premia) that drive the asset classes e.g. duration (movements in interest rates), economic growth, low volatility, value, and market momentums by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market risk (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative, and hedge fund risk premia. And of course, “true alpha” from active management, returns that cannot be explained by the risk exposures just outlined.

There has been a disaggregation of investment returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.

 

Therefore, seek true portfolio diversification this is the best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates to drive portfolio outcomes.  As the Deutsche Bank Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events e.g. Black Swans.

True diversification leads to a more robust portfolio.

 

Customised investment solution

Often the next bit of  advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from investment markets.

For example, level of income earned up to retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

Also look to financial planning options to see through difficult market conditions.

 

Think long-term

I think this is a given, and it needs to be balanced with your investment objectives as outlined above.

Try to see through market noise and volatility.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Remain disciplined.

 

There are a lot of Investment Behavioural issues to consider at this time to stop people making bad decisions, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwi Investor Blog is all about education, it does not provide investment advice nor promote any investment, and receives no financial benefits. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all-weather portfolio?

 

Stay safe and healthy.

 

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.

 

 

Why the Balanced Fund is expected to underperform

GMO concluded some time ago the time was right to consider moving away from the 60/40 Portfolio. Which is a “Balanced Portfolio” of 60% equities and 40% fixed income.

 

In a more recent note, GMO identify two key problems that lie ahead for the Balanced Portfolio, which are supportive of their conclusion. Which I think are problems facing all investors, but particularly for US and New Zealand investors.

 

First, stock and bond valuations are both extended, suggesting they will deliver less than they have historically.

As GMO point out, the math with fixed income (bonds) is straightforward. The 10-Year U.S. Treasuries yield is under 1% today. New Zealand’s yield is also near 1%.

Today’s yield is the best predicator of future returns.

Real returns, after inflation, will likely be negative over the next 10 years from fixed income.

In short, GMO highlight “It is more or less impossible for a bond index yielding roughly 2% to deliver the 5% nominal returns investors have become accustomed to over any period of time approaching or exceeding the index’s duration.”

 

GMO also highlight stockmarket valuations have risen. Recent market weakness provides some valuation relief, albeit, US valuations remain elevated relative to history.

 

GMO conclude, “the passive 60/40 portfolio will likely deliver disappointing returns. The low starting yield of a 60/40 portfolio represents the first problem we see ahead.”

 

The second issue identified by GMO is that risks within fixed income have risen, and not just from a valuation perspective.

As can be seen in the graph below, provided by GMO, duration is near its highest level in history. (Duration is the key measure of risk for a fixed income portfolio. It measures the sensitivity of a fixed income security’s price movements to changes in interest rates.)

Global duration

 

So, not only are interest rates at historical lows (low expected returns), but risk, as measured by duration, is amongst highest level in history.

 

This dynamic, low expected returns and heightened risk highlights the folly of an Index approach, similarly a set and forget approach in allocating to different asset classes. Similar dynamics also play out in sharemarket indices. Risks within markets vary over time.

Furthermore, the credit risk of many fixed income indices is also higher now than compared to the Global Financial Crisis. BBB and AA rated securities currently make up a greater proportion of the fixed income indices. Therefore, the credit quality of these indices has fallen over the last ten years, while the amount of corporate debt has grown. These dynamics need to be considered, preferably before the next credit crisis.

 

As GMO point out “Today, the sensitivity of a 60/40 portfolio to a change in yield is nearly as high as it has ever been. Both stocks and bonds are levered to future changes in discount and interest rates. Even a small amount of mean reversion upward in the aggregate yield of the 60/40 portfolio will be painful because there is less underlying yield to cushion any capital losses and those capital losses should be expected to be larger than normal for any change in yield given the high duration.”

 

Because of the higher duration and lower yields, smaller movements higher in interest rates will result in greater capital losses from fixed income securities compared to times when yields were higher. This is also the math.

At the same time, given the high valuation of sharemarkets, they are more susceptible to a movement higher in interest rates. Particularly those sectors of the equity market more sensitive to interest rate movements such as Listed Property.

Therefore, the historical diversification benefits from holding fixed income and equities are likely to less in the future.

 

GMO conclude “While investors have become conditioned to believe that a 60/40 portfolio delivers consistently strong returns, history shows this has not always been the case and the twin problems weighing on such a construction today suggest robust returns are unlikely going forward. Due to elevated valuations (low yields) and extended durations of both stocks and bonds, it is possible that in a future downturn investors will not receive the diversification they expect from their bond portfolio. Stocks and bonds have risen together and could certainly fall in unison as well.”

 

Although recent market events may have delayed this moment, they have not derailed the underlying dynamics within a Balanced Portfolio which will see it struggling to meet investor’s expectations over the next decade.  The risks identify above remain.

 

The Balanced Portfolio is riskier than many appreciate. I covered this in a previous Post. It is not uncommon for the Balanced Portfolio to have a lost decade of returns and losses of up to 30% over a twelve-month period.

 

Possible Solution

To address the threats to the Balanced Portfolio identified above GMO suggest the inclusion of Liquid Alternatives across multi-asset portfolios.

Such strategies provided portfolio diversification, importantly they have very little duration risk within them, a risk both equities and fixed income are exposed too.

GMO articulate the benefits of such strategies as follows: “Liquid Alternatives can provide diversifying and uncorrelated returns. While Alternatives should not be expected to keep up with robust equity markets, they can help shield large drawdowns given their lower equity beta exposure.”

Liquid alternatives largely generate their return outcomes independently from the returns generated by equity markets (beta) and fixed income market (duration). Thus they provide exposure to different risk and return outcomes from equities and fixed income.

GMO conclude “Liquid alternatives improve the robustness of our multi-asset portfolios by helping to protect against the problems that today’s low yields and high durations present.”

 

The benefits of such strategies has been evident over the last few weeks, helping to diversify portfolios from the sharp fall in global sharemarkets as a result of the spreading of the coronavirus.

 

To finish, I would add to the GMO commentary that well diversified portfolios should also have an exposure to Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.  These assets offer real diversification benefits relative to equities and fixed income, and to Balanced Portfolio in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

I covered the investment characteristics and  benefits of Real Assets to a Balanced Portfolio in different economic environments in a recent Post.

 

Happy investing.

 

Please read my Disclosure Statement

 

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

 

Small Foundations, Charities, investing like large Endowment Funds – a developing trend

The Orange County Community Foundation (OCCF) runs its $400m investments portfolio like a multi-billion-dollar endowment.

They have adopted an investment strategy that is more active than passive, emphasizes alternative investments like hedge funds and private equity, and targets geographies and asset classes not typically found in community foundation portfolios in the US.

The result is a portfolio that looks like that of an endowment more than twice the size of OCCF.

According to a recent Institutional Investor article OCCF are not alone in taking such an approach amongst the smaller Foundations found in the US.

The Institutional Investor article emphasises that not all Foundations and Charities can look like Yale and consider the Endowment Fund model.

Having said that, smaller Funds can take the learnings from the larger Endowments and should look to access a more diverse range of investment strategies.

 

Size should not be an impediment to investing with great managers and implementing more advanced and diversified investment strategies.

 

As the article also highlights, many Foundations and Charities have a long-term endowment. Often when you take a closer look at the Foundations and Charities endowments and cashflows they have a profile that is well suited to an endowment model.

 

They key benefits of the Endowment model include less risk being taken and the implementation of a more diversified investment strategy, delivering a more stable return profile.

 

This is attractive to donors.

According to the article, OCCF’s “investment performance over the past four-and-a-half years has encouraged more contributions from donors — and this increase in donations, combined with the above-benchmark returns, has enabled the foundation to pay out more grants and scholarships without sacrificing growth.”

 

What did OCCF do?

After a review of the OCCF’s investments their asset consultant, Cambridge Associates, helped them develop a new investment strategy allocation plan that was more diversified and contained higher exposures to alternative investments.

Cambridge Associations determined that OCCF had large enough long-term pools and high enough donations coming in to support more illiquid investments in the private markets.

 

What changed?

The foundation, which had a 2 percent allocation to private equity in 2015, now has 8 percent of its investable assets committed to private equity investments, with the eventual goal of scaling the asset class to 20 percent of the total portfolio.

Other changes included adopting a 10 percent target for real assets and 15 percent allocation to hedge funds.

OCCF has also started making co-investments — deals that are usually reserved for limited partners that can put up much larger amounts of capital.

The adoption of a more diversified portfolio not only make sense on a longer-term basis, but also given where we are in the current economic and market cycle.

 

The adoption of a more diversified portfolio not only makes sense on a longer-term basis, but also given where we are in the current economic and market cycle.

This is relevant in the current investment environment, the chorus of expected low returns over the years ahead has reached a crescendo and many are recommending moving away from the traditional Balanced Portfolio of equities and fixed income only.

 

The value is in implementation and sourcing the appropriate investment strategies.

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Real Assets offer real diversification benefits

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income.

They offer real diversification benefits to a Balanced portfolio (60% equities and 40% fixed income) in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. PGIM is one of the largest asset managers in the world, managing over US$1 trillion in assets, and can trace its heritage to Prudential Financial in 1875.

 

The comprehensive analysis undertaken by PGIM outlines the role Real Assets can play in an Investment Portfolio.

Initially they identify and provided a brief outline of the investment characteristics for a number of real assets (see detail below).

The analysis primarily focuses on the sensitivities of real assets to both macroeconomic variables (e.g. economic growth and inflation) and traditional financial markets (e.g., equities and fixed income returns). This analysis is undertaken for each of real assets identified.

Pertinent points of the analysis:

  • There is a wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds.
  • These sensitivities vary over time.
  • The time varying nature of these sensitivities can be mitigated by holding a portfolio of real assets or actively managing the real assets exposures.

 

An important observation from the perspective of portfolio diversification, equities and fixed income have different sensitivities to inflation and growth than many of the real assets.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

Inflation

Sensitivity

Accessibility Data Availability & Quality Specific Risks Sector Difference
Real Estate Core

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

PGIM then constructed three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection, by including some of the real assets identified above.

While the real asset portfolios’ macro-economic and financial market sensitivities still varied over time they were more stable than holding individual real assets.

Furthermore, across various economic environments, the three strategies displayed lower risk (lower volatility of returns) compared to equities.

PGIM then showed how these strategies performed in different economic environments: ideal, overheating, stagflation and stagnation.

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

Ideal Overheating Muddled Stagflation Stagnation
Inflation &/ Growth Low & High High & High Median/Median High & Low Low & Low
Diversification

Y

Y

Y

Y

Y

Inflation-Protection

Y

Y Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y

Y

Fixed Income

Y

Scenario frequency

8.9%

11.4%

53.9%

10.2%

15.8%

 

The PGIM analysis concludes that an allocation to real assets can improve the investment outcomes for a traditional portfolio dominated by equities and fixed income. These benefits are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation, cost of living adjustments.

This conclusion comes as no surprise given the demonstrated diversification benefits as outlined within the Report.

 

I provide more detail below by summarising the various sections of the PGIM Report.

The sections include:

    • The Real assets universe and their investment characteristics
    • Real Assets sensitivity to Macro-economic and financial market exposures
    • Real Asset Diversification Benefits relative to equities and fixed income
    • Analysis of Real Asset Strategy Portfolios
    • Diversification Benefits of the three Real Asset Portfolios, sensitivities to equities, fixed income, economic growth, and inflation.
    • Benefits of Real Asset Strategies in Investment Portfolios

 

Access to the PGIM Report is provided below.

 

The Real Assets Universe and their investment characteristics

PGIM identify the following real assets: Farmland, Timberland, Infrastructure, private equity and debt, Natural Resources, private and public equity, Real Estate, Private Equity, Core, Value-add, opportunistic, private debt, REITS, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold.

The PGIM paper provides a brief description of each real asset, including sources of return drivers and key investment attributes.

Investment return characteristics of the real assets over the period January 1996 – June 2017 are provided.  I have reproduced for some of the real assets in the following Table.

Asset

Annual p.a. returns

Risk annual volatility

Sharpe Ratio

Real Estate Core

8.3%

11.0%

0.55

Real Estate Debt

6.3%

4.8%

0.85

REIT

10.7%

19.8%

0.43

Natural Resources

15.9%

23.8%

0.58

Energy Equity

9.0%

19.7%

0.35

Infrastructure

4.0%

12.7%

0.14

MLP

12.6%

26.2%

0.39

Timberland

7.3%

6.9%

0.74

Farmland

12.2%

7.3%

1.37

TIPS

5.2%

6.0%

0.50

Commodity

-0.9%

28.2%

-0.11

Gold

5.6%

16.2%

0.21

Currency

-1.2%

8.5%

-0.40

US Cash

2.2%

2.2%

US 10 yr Treasury

5.2%

8.6%

0.35

US Equity (S&P 500)

8.6%

18.3%

0.35

 

Sensitivity to Macro-economic and financial market exposures

PGIM reviewed the sensitivity of Real Assets to several macro-economic variables over the period 1996-2017 and subperiods 1996-2007 and 2008-2017:

Inflation and growth

PGIM found an unstable return sensitivity profile to inflation and growth i.e. variation in return outcomes to different inflation and economic growth periods.

Of note, and an important observation from the perspective of portfolio diversification, equites and fixed income have different sensitivities to inflation and growth than many of the real assets.

Inflation Protection

PGIM found that many real assets had large positive sensitivities to inflation.

They found that commodity, currency, energy equity, gold, infrastructure, TIPS and natural resource real assets provided inflation protection, not only for the full period but generally (except for gold and currency) for both subperiods as well.

Stagnation Protection

Equities have a high sensitivity to economic growth, cash a low sensitivity.

Farmland, gold, real estate debt, TIPS, and currency had insignificant sensitivity to economic growth. Their sensitivity to growth surprises were also low and statistically insignificant i.e. their return outcomes are largely independent of economic growth.

The growth surprise sensitivity for farmland was negative and statistically significant.

PGIM define a real asset as offering “stagnation protection” if its full-period estimated growth and growth surprise sensitivity were approximately equal to or less than the corresponding growth sensitivity for cash.

Therefore, farmland, currency, gold, real estate debt, and TIPS provided stagnation protection for the full period and often for both subperiods.

 

A summary of the sensitivity to economic growth and inflation, along with some specific investment characteristics, for some of the different real assets is provided in the Table below.

Asset

Growth

Sensitivity

Inflation

Sensitivity

Accessibility Data Availability & Quality Specific Risks

Sector Difference

Real Estate Core

mid

mid high high mid

mid

Real Estate Debt

low

low mid low low

mid

Natural Resources

high

high mid mid high

high

Infrastructure

mid

mid mid low mid

mid

Timberland

mid

mid mid mid high

mid

Farmland (annual crops)

mid

high mid mid mid

mid

Farmland (permanent crops)

low

mid low mid high

high

TIPS

low

high high high low

low

Commodity

high

high high high low

high

Gold

low

high high high low

low

Currency

low

mid high high mid

Mid

 

Real Asset Diversification Benefits relative to equities and fixed income

The different sensitivities of real assets to economic and inflation outcomes, on an absolute basis and relative to equities and fixed income, highlights the potential diversification benefits they could bring to a traditional portfolio of just equities and fixed income.

This is confirmed by the analysis undertaken by PGIM looking into the diversification benefits of real assets relative to equities and fixed income.

 

Diversifying Real Assets

Based on their criteria of sensitivity to equities and fixed income over the performance periods, PGIM found that currency, farmland, gold, natural resource, real estate, and timberland as diversifying real assets.

Not providing meaningful diversification benefits relative to equities was energy equity, listed property, and real estate.

Likewise, real estate debt and TIPS provided little diversification benefits relative to fixed income.

Although PGIM found diversification benefits from infrastructure, real estate debt and TIPS, they also found periods of time when there was limited diversification benefits relative to equities and fixed income.

 

Analysis of Real Asset Strategy Portfolios

PGIM used equal weights to the real assets to construct three Real Asset Strategy Portfolios. Each portfolio is a mix of public and private real assets.

A description of the three real asset Portfolios is provided below.

 

Diversification (80% private assets):

  • This portfolio is expected to have performance that has a low level of sensitivity with a traditional 60/40 Portfolio.
  • This ensures there will be diversification benefits regardless of the market cycle.
  • The Diversified Portfolio is made up of 20% Farmland, 20% Gold, 20% Natural Resource, 20% Real Estate, 20% Timberland

 

Inflation-Protection (33% private assets)

  • This strategy is designed to have better returns when inflation and inflation surprises are higher.
  • It is a strategy for investors with inflation-linked liabilities or a concern about overheating (high inflation and high growth) and stagflation (high inflation and low growth) economic scenarios.
  • Therefore, it includes real assets that have significant and positive exposure to both the inflation level and inflation surprise
  • The Inflation-Protection portfolio is made up of 17% Commodity, 17% Energy Equity, 17% Gold, 17% Infrastructure, 17% Natural Resource, 17% TIPS

 

Stagnation-Protection (50% private assets)

  • The Stagnation-Protection strategy portfolio is expected to perform better than cash in economic environments with below average growth.
  • This is a strategy for investors concerned about stagnation (low inflation and low growth) scenarios.
  • Included in this portfolio are real assets that have a sensitivity to both the real economic growth level and growth surprise that is lower than corresponding sensitivities for cash:
  • The Stagnation-Protection portfolio is made up of 25% Farmland, 25% Gold, 25% Real Estate Debt, and 25% TIPS.

 

Return Outcomes

PGIM measured the performance characteristic of these portfolios from January 1996 to December 2017. Including the sub-periods identified above.

The Diversification strategy produced the highest return (10.4%), with moderate risk (8.6%), and outperformed the 60/40 Portfolio (60% equities and 40% fixed income portfolio).

The Stagnation-Protection strategy offered similar absolute performance as the 60/40 portfolio, but due to its lower volatility produced much better risk-adjusted performance.

The Inflation-Protection strategy underperformed the 60/40 portfolio but generated slightly better risk adjusted returns. The Inflation-Protection strategy had the highest volatility of all three real asset strategies due to holdings of commodity and natural resource which have higher volatilities than stocks.

 

Diversification Benefits of the three Real Asset Portfolios

Sensitivity to Equities and Fixed Income

PGIM also found that the three Real Asset Portfolio strategies had low sensitivities to Equities.

The Inflation-Protection strategy tended to have the highest sensitivity to equities, while the Stagnation-Protection strategy had the lowest.

PGIM note the Stagnation-Protection portfolio had much lower sensitivity to equities than the 60/40 portfolio.

 

Relative to Fixed Income, the three strategies had on average a low and statistically insignificant sensitivity to Fixed Income. However, it was a game of two halves, all three strategies had negative sensitivity to Fixed Income in the first sub-period but positive sensitivity in the second sub-period.

 

Sensitivity to Economic variables

Economic Growth

The Inflation-Protection and Diversification strategies showed positive sensitivity to economic growth in both the full period and the second sub-period.

In contrast, the Stagnation-Protection strategy had negative sensitivity to economic growth for the full period, although not statistically significant.

While the Stagnation-Protection strategy had positive and statistically significant exposure to economic growth in the second sub-period, it was still the lowest growth exposure of all three real asset portfolio strategies.

Importantly, all three strategies display lower economic growth exposure relative to equities, this suggests they may provide investors protection at times of economic downturn (especially Stagnation-Protection and Diversification).

 

As PGIM note “To highlight the potential benefit, the Stagnation-Protection strategy offered positive exposure to inflation and negative exposure to growth, the opposite exposures for the 60/40 portfolio.”

 

Inflation Sensitivity

All three strategies had positive and significant sensitivity to inflation for the full period.

As was desired, the Inflation Protection strategy displayed the highest and statistically significant inflation sensitivity in both the full period and in both sub-periods “suggesting the strategy may provide inflation protection going forward. Notably, the Inflation-Protection strategy had much higher inflation sensitivity than stocks, bonds or the 60/40 portfolio.”

The Stagnation-Protection strategy had the lowest sensitivity to inflation.

 

Further in-depth analysis was undertaken into how the strategies would perform in different economic environments.

This analysis found:

  • All three real asset strategies perform well when inflation is high.
  • During stagflation the three strategies all have higher average returns than stocks or bonds.
  • In overheating environments stocks do well but the Diversification and Inflation-Protection strategies do even better.
  • Performance across the three real asset strategies diverges when inflation is low.
  • During periods of stagnation (low inflation/low growth) bonds do well, but so do the Stagnation-Protection and Diversification strategies.

 

The following Table outlines what Real Asset Strategy Portfolio performs best in different inflation and economic growth environments, compared to Equities and Fixed Income. The frequency of the different likely economic environments is also provided.

Portfolio Strategy

Ideal

Overheating Muddled Stagflation

Stagnation

Inflation &/ Growth

Low & High

High & High Median/Median High & Low

Low & Low

Diversification

Y

Y Y Y

Y

Inflation-Protection Y Y

Y

Stagnation Protection

Y

Y

Y

Equities

Y

Y Y
Fixed Income

Y

Scenario frequency

8.9%

11.4% 53.9% 10.2%

15.8%

 

Diversification Benefits of Real Asset Strategies in Pension Plans

The last section of the PGIM report seeks to determine if an allocation to real assets will improve the outcomes for US Pension Funds. PGIM note that this research can be applied to portfolios in other countries.

It should come as no surprise, given the results of the in-depth analysis undertaken by PGIM above, that an allocation to Real Assets improves the investment outcomes to a portfolio dominated by equities and fixed income.

By way of example, even a 10% allocation to a real asset strategy, depending on the investment objective, can lead to a noticeable improvement in both the final funded ratio and the risk of being further under-funded (i.e., surplus risk) of a Defined Benefit plan.  Resulting from lower levels of portfolio volatility.

In high inflation environments an allocation to real assets improves the outcomes Pension Plan, especially those with liabilities tied to inflation (cost of living adjustments).

Likewise, in low growth environments they found an allocation to real asset strategies made a big difference.

It is similar across different environments, stagflation and stagnation protection.

To conclude, the PGIM Portfolio analysis highlighted that a real asset allocation can help Defined Benefit providers improve outcomes in different economic environments of concern, like stagflation and stagnation, improving either surplus risk or the average funded ratio.

 

Access to the PGIM Report

 

Happy investing.

Please read my Disclosure Statement

 

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

 

Time to move away from the Balanced Portfolio. They are riskier than you think.

GMO, a US based value investor, has concluded “now is the time to be moving away from 60/40” Portfolio.  Which is a Balanced Portfolio consisting of 60% US equities and 40% US fixed income.

Being a “contrarian investor”, recent market returns and GMO’s outlook for future market returns are driving their conclusions.

I covered their 7-year forecasts in an earlier Post. GMO provide a brief summary of their medium term returns in the recently published article: Now is the Time to be Contrarian

 

The GMO article makes the following key observations to back up their contrarian call:

  • The last time they saw such a wide “spread” in expected returns between a traditional 60/40 portfolio and a non-traditional one was back in the late 1990s, this was just prior to the Tech bubble bursting.
  • The traditional 60/40 portfolio went on to have a “Lost Decade” in the 2000s making essentially no money, in real terms, for ten years. Starting in late 1999, the 60/40 portfolio delivered a cumulative real return over the next ten years of -3.9%.

 

As outlined in the GMO chart below, Lost Decades for a Balanced Portfolio have happened with alarming and surprising frequency, all preceded by expensive stocks or expensive bonds.

GMO note that both US equities and fixed income are expensive today. As observed by the high CAPE and negative real yield at the bottom of the Chart.

They are of course not alone with this observation, as highlighted by a recent CFA Institute article. I summarised this article in the Post: Past Decade of strong returns are unlikely to be repeated.

lost-decades_12-31-19

 

 

The Balance Portfolio is riskier than you think.

The GMO chart is consistent with the analysis undertaken by Deutsche Bank in 2012, Rethinking Portfolio Construction and Risk Management.

This analysis highlights that the Balanced Portfolio is risker than many think. This is quite evident in the following Table. The Performance period is from 1900 – 2010.

Real Returns

(after inflation)

Compound Annual Return per annum 3.8%
Volatility (standard deviation of returns) 9.8%
Maximum Drawdown (peak to bottom) -66%
% up years 67%
Best Year 51%
Worst Year -31%
% time negative returns over 10 years 22%

The Deutsche Bank analysis highlights:

  • The, 60/40 Portfolio has generated negative real returns over a rolling 10 year period for almost a quarter of the time (22%).
  • In the worst year the Portfolio lost 31%.
  • On an annual basis, real negative returns occur 1 in three years, and returns worse than -10% 1 in every six years
  • Equities dominate risk of a 60/40 Portfolio, accounting for over 90% of the risk in most countries.

 

The 4% average return, comes with volatility, much higher than people appreciate, as outlined in the Table above. The losses (drawdowns) can be large and lengthy.

This is evident the following Table of Decade returns, which line up with the GMO Chart above.

Decade Per annum return
1900s 6.3%
1910s -4.7%
1920s 12.7%
1930s -2.3%
1940s 1.1%
1950s 9.1%
1960s 4.5%
1970s -0.3%
1980s 11.7%
1990s 11.7%
2000s 0.5%

 

We know the 2010s was a great decade for the Balanced Portfolio.  A 10 year period in which the US sharemarket did not experience a bear market (a decline of 20% or more). This is the first time in history this has occurred.

Interestingly, Deutsche Bank highlight the 1920s and 1950s where post war gains, while the 1980s and 1990s were wind-full gains.

The best 4 decades returned 11.3% p.a. and the 7 others 0.7% p.a.

 

As outlined in my last Post, the case for diversifying away from traditional equity and fixed income is arguably stronger than ever before.

 

Happy investing.

 Please read my Disclosure Statement

 

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

Why is the Multi-Asset Portfolio so Popular?

The rise of the Multi-Asset Portfolio can be traced back to the Global Financial Crisis (GFC) in 2008, when many investors “grew disenchanted with the long-time investment mantra that equities were the one true way to wealth. That smug bromide rang hollow when the financial crisis slashed many stock portfolios in half”, according to recent Chief Investment Office (CIO) article, How Multi-Asset Investing Became So Popular.

Following the GFC, the mantra became diversify your holdings. As a result, Multi-Asset Portfolios, which combine equities, fixed income, and an array of other assets, gained greater prominence.

Multi-Asset Portfolios grew more popular on promises of greater capital preservation and sometimes the delivery of superior returns.

As CIO note, the increased prominence of the Multi-Asset Portfolio can be attributed to David Swensen, Yale’s investment chief since 1986. Yale has generated an impressive performance record by investing outside of just equities and fixed income. Their portfolio has included high allocations to private equity, real estate, and other non-traditional assets. (For more on the success of the Endowment model and the fee debate please see this Post.)

 

The CIO article also noted that Multi-Asset Portfolios are most prominent among target-date funds (TDFs), which have become the default offering among 401(k) plans (e.g. US superannuation schemes such as KiwiSaver in New Zealand).

“TDFs have grown five-fold since the financial crisis, reaching $1.09 trillion in 2018, a Morningstar report concluded, with an estimated $40 billion added last year.”

 

The Concept: Absolute returns and better risk management

The Multi-Asset Portfolio is based on the concept of absolute returns, where the focus is on generating a more targeted and less volatile investment return outcome. There is a greater focus on risk management relative to that undertaken within a traditional portfolio. The intensity and sophistication of risk management employed depends on the type of absolute return strategy.

The absolute return universe is very broad, ranging from Multi-Asset Portfolios to those with a much greater focus on absolute returns such as the plethora of Hedge Fund strategies, including Risk Parity as discussed in the CIO article.

This contrasts with the traditional balanced fund, which are generally less diversified, portfolio risk is dominated by the equity exposures, and returns are much more subject to the vagaries of investment markets. The management of risk is more focused on relative returns i.e. how performance goes relative to a market benchmark, rather than returns relative to an absolute return outcome.

A Multi-Asset Portfolio generally has more of an absolute return focus than a Traditional Portfolio. It achieves this by having a more truly diversified portfolio, moving beyond the traditional Balanced Portfolio (60% equities and 40% Fixed Income), to incorporate a greater array of different investment strategies and risk management approaches within the portfolio.

As the CIO article comments, “There’s a strong argument for Swensen-like multi-asset funds that range beyond stocks and bonds, adding solid helpings of commodities, real estate and all kinds of other asset classes. With such an array, the thinking goes, you’re best protected when recessions thunder in.”

 

Return Expectations

The CIO article made the following observation, Multi-Assets Portfolios are “expected to return 4.5% annually through 2024, according to Casey Quirk, an arm of Deloitte Consulting. That isn’t a daunting growth rate, but the figure should have a decent chance of holding steady, while public markets lurch around, especially in the next recession.”

To put this into perspective, a recent CFA Institute article estimated that a Balanced Portfolio will return 3.1% over the next 10 years.

It is highly likely we are heading into a “Low Return Environment”.

 

As a result, a different investment approach to that which has been successful over the last 20-30 years is likely needed to invest successfully in what is expected to be a Challenging Investment Environment.

As the CIO article notes, “But multi-asset now goes far beyond the simple stock-bond duality, which seems insufficient to deliver the best diversification. The most salient problem with the basic pairing nowadays is that bonds are paying low interest rates. Their ability to score capital gains is limited because rates don’t have much left to fall before they hit zero. “These don’t work as well as they used to,” observed Deepak Puri, CIO Americas for Deutsche Bank Wealth Management.”

 

I fear the lessons from the GFC and 2000 Tech Bubble are fading from the collective memory, as equity markets reach historical highs and investors chase income from within equity-income sectors of the sharemarket.

In addition, more advanced portfolio management approaches have been developed over the last 20 – 30 years.

It would seem crazy that these learnings are not reflected in modern day investment portfolios. In a previous Post: A Short History of Portfolio Diversification, it is not hard to see how the Multi-Asset Portfolio has developed over time and is preferred by many large institutional investors.

Meanwhile, this Post: What Portfolio Diversification looks like, compares a range of investment portfolios, including the KiwiSaver universe, to emphasis what a Multi-Asset Portfolio does look like.

 

Growth in Multi-Asset Portfolios to continue

Increasingly the Multi-Asset Portfolios are taking market share from traditional portfolios.

Institutional investors are increasingly adopting a more absolute return investing approach. This has witnessed an increased allocation, and growth in Funds Under Management, in underlying strategies, “such as private equity, hedge funds, real estate, natural resources, and other strategies whose assets aren’t publicly traded.”

 

An underlying theme of the CIO article is the Death of the Balance Portfolio, which I covered in a previous Post.

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, as noted above, more advanced approaches can be implemented. For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

 

Concluding Remarks

The current market environment, of low expected returns, might quicken the evolution in portfolio construction toward greater adoption of Multi-Asset Portfolios and a more absolute return focus.

Therefore, the value is in implementation, identifying the suitable underlying investment strategies to construct a truly diversified portfolio, within an appropriate fee budget.

Wealth management practices need to be suitably aligned with this value adding activity.

 

Happy investing.

Please read my Disclosure Statement

 

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

Past Decade of strong returns unlikely to be repeated

The current return assumption for the average US public pension fund is 7.25%, according to the National Association of State Retirement Administrators (NASRA), highlighted in a recent CFA Institute Blog: Global Pension Funds the Coming Storm.

This compares to the CFA Institute’s (CFA) article expected return for a Balanced Portfolio of 3.1% over the next 10 years.  A Balanced Portfolio is defined as 60% Equities and 40% Fixed Income.

Therefore, the article concludes that a 7.25% return assumption is “overly optimistic in a low return interest rate environment”.

The expected low return environment will place increasing pressure on growing pension liabilities and funding deficits. This is over and above the pressures of an aging population and the shift toward Defined Contribution (DC) superannuation schemes e.g. KiwiSaver.

This environment will likely require a different approach to the traditional portfolio in meeting the growing liabilities of Define Benefit (DB) Plans and in meeting investment return objectives for DC superannuation Funds such as KiwiSaver in New Zealand.

The value will be in identifying and implementing the appropriate underlying investment strategies.

 

Past Returns

For comparison purposes an International Balanced Portfolio, as defined above, has returned around 7.8% over the last 10 years, based on international fixed income and global sharemarket indices.

A New Zealand Balanced Portfolio has returned 10.3%, based on NZ capital market indices only.

New Zealand has had one of the best performing sharemarkets in the world over the last 10 years, returning 13.5% per annum (p.a.), this compares to the US +11.3% p.a. and China -0.7% p.a.. Collectively, global sharemarkets returned 10.2% p.a. in the 2010s.

Similarly, the NZ fixed income markets, Government Bonds, returned 5.4% p.a. last decade. The NZ 5-year Government Bond fell 4.1% over the 10-year period, boosting the returns from fixed income. Interestingly, the US 5-year Bond is only 1% lower compared to what it was at the beginning of 2010.

 

It is worth noting that the US economy has not experienced a recession for over ten years and the last decade was the only decade in which the US sharemarket has not experienced a 20% or more decline. How good the last decade has been for the US sharemarket was covered in a previous Post.

 

In New Zealand, as with the rest of the world, a Balanced Portfolio has served investors well over the last ten or more years. This reflects the strong returns from both components of the portfolio, but more particularly, the fixed income component has benefited from the continue decline in interest rates over the last 30 years to historically low levels (5000 year lows on some measures!).

 

Future Return Expectations

Future returns from fixed income are unlikely to be as strong as experienced over the last decade. New Zealand interest rates are unlikely to fall another 4% over the next 10-years!

Likewise, returns from equities may struggle to deliver the same level of returns as generated over the last 10-years. Particularly the US and New Zealand, which on several measures look expensive. As a result, lower expected returns should be expected.

The lower expected return environment is highlighted in the CFA article, they provide market forecasts and consensus return expectations for a number of asset classes.

 

As the article rightly points out, one of the best estimates of future returns from fixed income is the current interest rate.

As the graph below from the article highlights, “the starting bond yield largely determines the nominal total return over the next decade. So what you see is what you get.”

 

US Bond Returns vs. US Starting Bond Yields

US Bond Returns vs US Starting Bond Yields

 

In fact, this relation has a score of 97% out of 100%, it is a pretty good predictor.

The current NZ 10 Government Bond yield is ~1.65%, the US 10-Year ~1.90%.

 

Predicting returns from equity markets is more difficult and comes with far less predictability.

Albeit, the article concludes “low returns for US equities over the next 10 years.”

 

Expected Returns from a Balanced Portfolio

The CFA Article determines the future returns from a Balance Portfolio “By combining the expected returns from equities and bonds based on historical data, we can create a return matrix for a traditional 60/40 portfolio. Our model anticipates an annualized return of 3.1% for the next 10 years. That is well below the 7.25% assumed rate of return and is awful news for US public pension funds.”

Subsequent 10-Year Annualized Return for Traditional 60/40 Equity/Bond Portfolio

Subsequent 10 years annualized Return for Traditional 60 40 Equity Bond Portfolio.png

 

This is a sobering outlook as we head into the new decade.

Over the last decade portfolio returns have primarily been driven by traditional market returns, equity and fixed income “beta“. This may not be the case when we look back in ten-years’ time.

 

This is a time to be cautious. Portfolio strategy will be important, nevertheless, implementation of the underlying strategies and manager selection will be vitally important, more so than the last decade. The management of portfolio costs will also be an essential consideration.

It is certainly not a set and forget environment. The challenging of current convention will likely not go unrewarded.

Forewarned is forearmed.

 

Global Pension Crisis

The Global Pension crisis is well documented. It has been described as a Financial Climate Crisis, the risks are increasingly with you, the individual, as I covered in a previous Post.

As the CFA article notes, the expected low return environment adds to this crisis, as a result deeper cuts to government pensions and greater increases in the retirement age are likely. This will led to greater in-equality.

 

This is a serious issue for society, luckily there is the investment knowledge available now to help increase the probability of attaining a desired standard of living in retirement.

However, it does require a shift in paradigm and a fresh approach to planning for retirement, but not a radical departure from current thinking and practices.

For those interested, I cover this topic in more depth in my post: Designing a New Retirement System. This post has been the most read Kiwi Investor Blog post. It covers a retirement system framework as proposed by Nobel Laureate Professor Robert Merton in his 2012 article: Funding Retirement: Next Generation Design.

 

Lastly, the above analysis is consistent with recent calls for the Death of the Balanced Portfolio, which I have also Blogged on.

Nevertheless, I think the Balanced Portfolio is being replaced due to the evolution within the wealth management industry globally, which I covered in a previous Post: Evolution within Wealth Management, the death of the Policy Portfolio. This covers the work by the EDHEC-Risk Institute on Goals-Based Investing.

 

In another Posts I have covered consensus expected returns, which are in line with those outlined in the CFA article and a low expected return environment.

In my Post, Investing in a Challenging Investment Environment, suggested changes to current investment approaches are covered.

Finally, Global Economic and Market outlook provides a shorter-to-medium term outlook for those interested.

 

Please note, I do not receive any payment or financial benefit from Kiwi Investor Blog, and a link to my Discloser Statement is provided below.

 

Happy investing.

Please read my Disclosure Statement

 

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

The opportunity and role of active management

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

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

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

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

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

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

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

The RBC article is well worth reading.

 

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

 

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

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

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

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

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

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

 

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

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

 

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

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

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

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

 

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

 

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

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

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

 

The Role of Active management within a portfolio

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

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

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

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

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

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

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

 

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

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

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

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

 

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

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

 

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

 

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

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Beginners guide to Portfolio Diversification. And why Portfolios Fail.

It is often asked if Modern Portfolio Theory failed during the Global Financial Crisis / Great Recession (GFC).

No, Modern Portfolio Theory did not fail during the GFC. Portfolio construction did.

During the GFC many investors did not have exposure to enough different asset classes and investment risks. This limited their protection from market loses.

Therefore, Investors should consider incorporating a wide range of different investment strategies as their core investment strategy. Investors should also clearly understand the sources of risk within their portfolio.

Furthermore, investors cannot necessarily rely on “what is traditionally thought of as diversification to meet their long-term goals.”

It is likely that many investors remain under-diversified today.

These are the views of a 2013 BlackRock Article, the new diversification: open your eyes to alternatives.

 

The discussion in 2012 with Dr Christopher Geczy is still very relevant today.

As we have seen previously, from what does portfolio diversification look like, many KiwiSaver Funds are under-diversified relative to Australian Superannuation Funds. Likewise, the Australian Future Fund is very well diversified relative to the New Zealand Super Fund.

 

Highlights of the BlackRock article are provided below.

They are presented to provide the rationale for seeking true portfolio diversification, as pursued by many of the largest investors worldwide, including Super Funds, Pension Funds, Foundations, Endowments, Family Officers, and Sovereign Wealth Funds. This group also includes the ultra-wealthy.

Albeit, the opportunity to have a truly diversified portfolio is open to all investors, the value is in implementation.

Currently, many New Zealand investors are missing out.

 

What happened during the GFC?

In short, as we all know, what happened during the GFC was a spike in financial market volatility, this led to all markets behaving in a similar fashion – technically market correlations moved to one. This reduces the benefits of diversification. As a result, many markets fell sharply in tandem.

Those markets that where already quite highly correlated became more correlated e.g. listed property with the broader share market.

As we also know, this often happens at time of market crisis, nevertheless, correlations can spike higher without a crisis.

The BlackRock article provides a comparison of market correlations prior to the GFC and correlations during the GFC.

 

For clarity, there are benefits from investing in different asset classes, regions, and so forth.

Nevertheless, although a traditional “Balanced Portfolio”, 60% shares / 40% Fixed Income, provides a smoother ride than an undiversified portfolio, the risks of the Balanced Portfolio are dominated by its sharemarket exposures.

It is well understood that for the Balanced Portfolio almost all the risk comes from the sharemarket exposures. On some estimates over 90% of the risk of a Balanced Portfolio comes from sharemarkets.

Therefore, investors should not only clearly understand the sources of risk, but also the magnitude of these risks within their portfolio.

 

What is the difference between Portfolio Diversification and Portfolio Construction?

Diversification is not as obvious as many think e.g. as outlined above in relation to listed property, a portfolio exposed to different asset classes may not be that well diversified.

As a result, and a key learning from the GFC, investors need to think in terms of risk exposures – risk diversification.

Investors should not think in terms of asset class diversification.

More asset classes does not equal more Portfolio Diversification.

This is because returns from of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.

Therefore, increasingly institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

 

From a portfolio construction, and technical, perspective, this means thinking in terms of risk exposures and “getting exposure to as many different and non-correlated types of risk that they can.”

Portfolio construction = “building a portfolio based on risk exposures and not just so-called “asset classes” or “sub-classes.””

 

What does this look like?

Investors should seek exposure to a variety of risk exposures in proportion to their risk tolerances and individual circumstances.

The point being everyone should have a broadly diversified portfolio to the greatest extent they can. Investors should hold as many different assets and risk exposes as they possibly can.

Therefore, portfolios should likely include real assets, international investments, and long/ short investments. Alternative and Alternative investment strategies.

The real value is in implementing the portfolio construction, accessing the appropriate risk exposures efficiently.

As BlackRock emphases, Investors need to work with their financial professionals to choose and blend the risk exposures that make sense for their unique circumstances.

 

Low Correlated investments

If the objective is to seek a truly diversified portfolio, the exposure to low correlated assets, both in general and particularly in times of stress, is necessarily.

These exposures are largely gained via Alternative investments or Alternative Investment strategies.

“Alternatives” are a broad category, as defined by BlackRock, offering “sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio.”

The concept of alternative investing is about going beyond what a traditional Balanced Portfolio might look like, by introducing new sources of diversification.

 

BlackRock provides a very good discussion on Alternatives, types of assets that would be considered alternatives and a discussion around implementation – highlighting the portfolio benefits of adding alternatives to a portfolio (improving the risk/reward profile). Also noting Alternative investments feared better during the GFC.

 

It is important to emphasis, as does BlackRock, that the inclusion of alternatives into the traditional portfolio is not a radical departure from the notion of managing risk and constructing portfolios. It helps in understanding what risks are being taken and broadens portfolio diversification.

The inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.

 

BlackRock makes a final and important point, the world presents countless risks, and not all those risks can be accounted for in a traditional Balanced Portfolio. Investors need to be diversified in general, but they also need to be diversified for the extreme. If not, they may be setting themselves up for failure.

Do not become too dependent on one source of investment returns.

 

Summary

Investors need to clearly understand the sources of risk in their portfolios and should consider incorporating a wide range of different investment strategies and assets as their core investment strategy.

Furthermore, investors cannot necessarily rely on what is traditionally thought of as diversification to meet their long-term goals.

It was not Portfolio Theory that failed during the GFC but Portfolio Construction.

And this is where the real value lies, the ability and knowledge to implement a truly diversified portfolio.

Many investors very likely remain under-diversified today. Their portfolios do not fully reflect the key learnings from history as outlined in this Post.

 

In my mind, many New Zealand Investors are missing out.

 

Happy investing.

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