Investment Framework for a Rising Interest Rates Environment

Amongst the strategies to employ for the current interest rate environment is a Liability Driven Investment (LDI) approach. 

LDI provides a framework for managing retirement income outcomes in what is likely to be a rising interest rate environment over the years ahead. 

LDI places retirement planning goals at the centre of the investment approach leading to several key benefits:

  1. More stable level of income in retirement;
  2. More efficient use of capital – potentially need less retirement savings; and
  3. Better framework to make trade-off between allocation to equities and the retirement income portfolio in improving the likelihood of reaching desired standard of living in retirement.

Under LDI a more customised investment solution can be developed.

Conversely, if an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their income requirements over retirement.

Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of investment capital.

The additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Accordingly, LDI potentially provides a better framework in which to evaluate the risk of meeting your retirement income goals in a rising interest rate environment.

Retirement Planning (mis) focus

Arguably the primary goal of retirement planning is to provide a stable and secure stream of income in retirement – income to support a desired standard of living in retirement.

However, retirement planning investment approaches often focus too heavily on accumulated wealth e.g. how much do I need to save to retire on?

This could potentially result in the wrong focus.  For example, if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits.  Their income would have dramatically dropped in 2009 to approximately $35k.  That is a big drop in income!  But interest rates have fallen further, currently (Feb 2021) a million dollars invested in New Zealand Term deposits will generate around $10k.

As a result, the focus should not necessarily be on the size of the account value e.g. KiwiSaver account balance.

This reflects that volatility of capital and investment returns are not a true measure of a retiree’s investment risk.

Investment strategies that focus on capital preservation, such as holding high levels of cash and short-term fixed income strategies, are riskier and more volatile relative to the investment goal of generating a stable and secure stream of income in retirement.

Redefining the Retirement Goal

Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with a high probability of achieving them.

Accordingly, the goal for retirement can be split between retirement income (essential goals) and wealth accumulation (aspirational goals). 

Those saving for retirement should be focusing on more than accumulated wealth alone. Other key considerations may include a desired level of retirement spending, meeting children’s education costs, healthcare costs, and a legacy.  These can be considered as future liabilities that need to be met.

Consequently, a better measure of a retiree’s investment risk becomes uncertainty around how much spending can be sustained in retirement.

Liability Driven Investing

Liability-driven investment (LDI) strategies, otherwise known as asset-liability management (ALM), take a complete and holistic approach.

LDI explicitly includes an investor’s current and future liabilities e.g., essential and aspirational goals.

The traditional way of building portfolios focusses more on risk tolerance, return expectations, and accumulated wealth rather than achieving the investment goals outlined above.

LDI creates better portfolios, particularly when it comes to retirement needs.  A more robust portfolio is generated, and the focus is on the key investment risk; failure to meet your investment objectives.

Obviously most financial planning processes take into consideration investment and retirement goals. Nevertheless, LDI makes retirement goals the central piece of constructing a portfolio. With LDI, portfolio allocations and management of risks are relative to meeting retirement objectives.

A more customised investment solution is developed.

See here for more on LDI.

The Benefits of LDI

Dimensional Funds Advisors (DFA) undertook analysis comparing two investment strategies relative to the goal of generating a stable and secure level of income in retirement:

  1. Goals based strategy that looks to generate sufficient income in retirement to match expected spending (consumption). This is the LDI strategy.
  2. Capital preservation strategy that is invested in Cash to manage the volatility of the account balance.

The following conclusions can be drawn from the DFA analysis:

  • The LDI strategy provides a more stable stream of income in retirement;
  • The LDI strategy provides greater clarity and confidence to plan for retirement; and
  • The Cash strategy results in a high level of volatility relative to the goal of generating a stable level of income in retirement.

See here for a detailed review of the DFA Research. 

In simple terms, the LDI strategy is a long-term bond portfolio that matches the expected retirement spending/consumption goal. Effectively, the LDI strategy generates cashflows to match future expected spending.

This reduces volatility relative to retirement spending goals.

Insurance Company’s implement a similar approach in meeting (paying out) future expected liabilities (insurance claims).

DFA conclude that “any strategy that attempts to reduce volatility using short- to intermediate-term fixed income, when the goal is a long-term liability like retirement consumption, will not be as effective as the LDI strategy.”

Although cash is perceived as low risk, it is not low risk when it comes to generating a steady and secure stream of income in retirement. Likewise, short term fixed income securities, while appropriate for capital preservation, are risky if the goal is to meet future spending/consumption in retirement.

In summary a LDI strategy provides the following benefits:

  1. More stable level of income in retirement;
  2. More efficient use of capital – potentially need less retirement savings; and
  3. Better framework to make trade-off between allocation to equities and retirement income portfolio in improving the likelihood of reaching desired standard of living in retirement.

If an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their retirement income requirements.

Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of capital.

This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.

Accordingly, LDI potentially provides a better framework in which to assess the risk of meeting your retirement income goals in a rising interest rate environment.

LDI Investment Framework for Individuals

Under the LDI model there are two portfolios: the liability portfolio and a return seeking portfolio. Most investment products offered today are return seeking portfolios with some dampening down of risk (measured by volatility of returns).

LDI is used by pension funds and insurance companies where their investment objectives and portfolios are primarily reflected in the terms of their future liabilities.

“Institutional” investment approaches such as LDI, Two-portfolio separation, and being more dynamic, are finding their way into wealth management solutions.

Goals-Based Investing is the wealth management counterpart to LDI. By way of example is EDHEC Risk Institute Goal-Based Investing Approach.

EDHEC suggest investors should maintain two portfolios:

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

And, over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting retirement income levels.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the goal of generating income in retirement.

Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations of income in retirement.

With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.

See here for more on the EDHEC Goals Based Investment approach.

Please read my Disclosure Statement

 

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

Competitor Analysis KiwiSaver Conservative Funds – the value of a good investment strategy

An analysis of KiwiSaver Conservative Funds identifies a variation in underlying asset allocations, despite there being a generic look at a higher level (Income / Growth split).

The area of most pronounced difference is within the Income asset class allocations: Cash, New Zealand Fixed Income, and International Bonds.  There are also nuances within each of these asset classes, particularly level of benchmark duration risk.

These differences will drive performance outcomes, having nothing to do with active management skill and very little in relation to fees paid.

Portfolio performance is primarily driven by portfolio construction and implementation decisions.  The value of a good investment strategy.

Within the Income asset classes, the decision on duration and credit quality will drive performance (absolute returns and relative to peers).  These decisions impact return outcomes over both the short and longer term.

A comparison to Australian Super Funds with similar objectives provides useful insights into asset allocation decisions being made in New Zealand.

Analysis of Balance and Growth KiwiSaver Funds has also been undertaken and will be provided at a later date.

Analysis of KiwiSaver Conservative Funds

The Table below provides average, min, and max allocations of the Strategic Asset Allocations of 12 KiwiSaver Providers’ Conservative Funds, sourced from their latest Statements of Investment Policy and Objectives (SIPO).

  Cash Fixed Income
NZ
Fixed Income
International
Income
Allocation
Average 15.6%22.7%39.1%77.4%
Min1.0%14.0%28.0%70.0%
Max30.0%36.0%50.0%82.0%
Median17.3%23.0%40.5%79.0%
 Listed Equities
New Zealand
Listed Equities
International
Listed
Property
AlternativesGrowth
Allocation
Average6.6%12.4%4.0%2.1%22.7%
Min4.0%9.0%0.0%0.0%18.0%
Max9.5%16.0%7.5%5.0%30.0%
Median6.3%12.5%4.0%1.6%21.0%

Income Assets

From a top level, by and large the managers are tightly grouped around 77% allocation to Income assets (Cash, NZ Fixed Income and International Bonds). 

There are a small group of four managers which are outliners, with income allocations closer to 70%.  

This group is materially different from the bulk of the managers.  They tend to have lower cash allocations and much higher equity allocations. Only one of these managers has a material weighting outside of the listed equity markets e.g. Alternatives.

Within Income Assets

The variation within Income asset class occurs at both the asset allocation and performance benchmark level.  Both of which drive performance outcomes.

As can be seen from the Table above the variation in the allocation to Cash is extreme. Ranging from 1.0% to 30.0%.

Maintaining high levels of cash does not make a portfolio less risky. High levels of cash can raise risks relative to certain investment objectives, particularly if the investor is seeking a stable and more predictable income stream in retirement.

High levels of cash increase the variation of income in retirement and is less effective in providing portfolio protection at the time of sharp sharemarket declines.  On both counts, longer maturing fixed income provides a better solution.  See here for why holding high levels of cash at retirement can be scandalous.

Given the current environment of very low interest rates and higher equity market valuations in the US and NZ, a higher weighting to cash could be warranted.

The key benefits of cash are that it is highly liquid, provides emergency funds without impacting longer-term investments, and can arguably be “dry powder” funds when sharemarkets decline sharply.  The key to the dry powder factor is having the investment discipline to act accordingly.

The allocations to Fixed Income (NZ Fixed Income and Global Bonds) are tighter, ranging from 50% – 76%, and averaging around 62%.

The allocation International Bonds is higher relative to domestic Bonds, on average making up 64% of the Fixed Income Allocations. International Bonds are the largest asset allocation weight within the portfolios of just under 40%.

Risk and Investment Management

From a risk management, and investment management perspective, a portfolio’s capital allocations to cash, NZ Fixed Income, and International Bonds are less relevant relative to the Portfolio’s duration and credit exposures.

A more accurate way of looking at risk, and managing a portfolio, is a Portfolio’s level of duration and credit exposure.

Duration is a key risk measure, and in general reflects a portfolios capital value sensitivity to changes in interest rates. Duration is measured in years.  For example, assuming your Portfolio’s duration is 6 years, if interest rates rise by 1% the portfolio will decline by 6%, all else being equal.

See here for an explanation of Duration and here for credit risk.

Generally, those with a higher allocation to International Bonds have a higher level of interest rate risk.  These portfolios would have benefited more from the significant decline in interest rates over the last 20 years.

From a high level, the range in total Portfolio duration is estimated to be:

Total Portfolio Duration
Average 4.06
Min 3.27
Max 5.01
Median 3.99

These are estimates, based on current index duration and portfolio asset allocations.  The key points are, this is a more accurate view of portfolio risk and there is a reasonable spread in duration risk amongst the managers.

From this perspective, investors must be careful in assessing the relative risk of a Conservative Fund based on asset allocations alone.

By way of example, some Managers manage to a lower duration international bond index.  Thus, despite having a higher international bond allocation these Portfolios may have lower interest rate risk (duration) than a portfolio with a lower international bond allocation but managing to a higher duration index. They may also have the same level of interest rate risk!

Therefore, what is important is how much duration risk a portfolio should have in meeting its investment objectives.

From an investment governance perspective, Investment Committees should not be debating the level of allocation to cash, international, or NZ fixed interest without first considering what is the most appropriate level of portfolio duration risk to target in meeting investment objectives.  This is a different conversation and focus.

There is evidence that at least one of managers takes such an approach, maintaining a very low allocation to cash and a high allocation to Fixed Income.  This portfolio is not necessarily riskier than the other Funds just because it has a low cash holding.

Lastly, it should be noted that the duration on the International Bond Index has almost doubled over the last 10 years.  Therefore, if portfolio allocations to international bonds have remained static over the last 10 years, the risk of this allocation has increased along with the total portfolio’s risk profile.  Unfortunately, with interest rates so low, the return prospects are less, yet the risks have increased.

For more on the unintended risks within fixed income see here

Growth asset

As would be expected, the Growth Allocation is reasonably tight around 23%, the flip side of the Income Allocation.

Listed equities, including New Zealand equities, international equities, and listed property and infrastructure dominate the growth allocations i.e. there is very little investment in Alternatives.

Direct Property dominates the Alternative allocations.

Of interest, on average Domestic equities (New Zealand and Australia) make up around 35% of the core equities allocations e.g. domestic and international listed equities ex listed property and infrastructure.

Overall, core equities make up 19% of portfolios, domestic equities are around 6.5% of a Conservative Portfolio.

Ratio of Domestic Equities
in Core Equities Allocation
Core Listed Equities
Portfolio Allocation
Average 34.5%19.0%
Min25.0%13.0%
Max47.4%22.5%
Median31.5%19.5%

The Growth allocations will be discussed in more depth when presenting the results of the Balance and Growth Fund’s allocations.

Australian Fund Comparison

The Table below presents the average, min, max, and medium asset allocations of the largest Super Funds in Australia.  This list is dominated by Industry Funds.

The list includes funds with Conservative in their name and/or have similar return objectives to the KiwiSaver Funds.  The return objectives are express as inflation plus a margin e.g. CPI + 1.0%.

The following quick observations can be made:

  1. The Australian Funds have lower allocations to Income Assets than the New Zealand Funds, this is consistent with the Australian Funds having higher CPI + return objectives.  A return objective is necessary to undertake portfolio modelling. Also, don’t always choose a Fund my its name!
  2. At the same time, the Aussie Funds have much higher Cash allocations relative to the NZ Funds.
  3. The above means the Australian Funds have much lower Fixed Income allocations.  They also only show Fixed Income, not domestic and international bonds breakdown, which is consistent with the discussion above.
  4. Interestingly, the listed equity allocation is in line with the Kiwi Funds, around 20%.  However, the weighting in Australia to domestic equities in the total core equities allocation is closer to 50%, compared to 35% in NZ.  Domestic equities make up around 9% of a Conservative Fund in Australia, compared to 6.5% in New Zealand. Albeit, the Australian Funds do have a higher risk profile.
  5. The Australian Funds have significantly higher allocations to Alternatives than the NZ Funds.  When you consider a similar core equities allocations and higher cash allocations in Australia, the higher Alternatives allocation comes at the expense of Fixed Income.
Australian
Super Funds
CashFixed IncomeIncome
Allocation
Average27.5%36.7%59.6%
Min23.0%28.5%53.0%
Max37.0%67.0%67.0%
Median25.0%30.3%58.3%
Listed Equities
Domestic
Listed Equities
International
AlternativesGrowth
Average9.1%11.1%21.8%40.4%
Min7.0%7.0%6.0%33.0%
Max11.5%17.5%29.5%47.0%
Median9.5%10.5%24.0%41.8%

The Alternatives allocation will be discussed in more depth when presenting the results of the Balance and Growth Fund’s allocations.

Please read my Disclosure Statement

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

Coronavirus – Financial Planning Challenges

For those near retirement this year’s global pandemic has thrown up new challenges for them and their Financial Advisor.

Early retirement due to losing a job, the running down of emergency funds, and a low interest rate environment are new challenges facing those about to retire.

Events this year are likely to have significant repercussions for how individuals conduct their financial planning.  Specifically, how they approach spending and saving goals.

The pandemic will likely have lasting implications for how people think about creating their financial and investment plans, and therefore raises new challenges for the Advisors who assist them.

These are the key issues and conclusions outlined by Christine Benz, director of personal finance for Morningstar, in her article, What the Coronavirus Means for the Future of Financial Planning.

In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”

Although the article is US centric, there are some key learnings, which are covered below.

How the Pandemic Has Impacted Financial Planning for Emergencies

The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”

Lower income families are more at-risk during times of financial emergencies.  Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment.  This rises to 52% for middle income households.

It is advisable to have emergency funds outside of super.

The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”

An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.

Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.

From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.

Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”

The concept of sidecar funds has recently been discussed in New Zealand.

Financial Planning for Early Retirement

The prospect of premature retirement will pose an urgent challenge for some clients. 

Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.

The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.

Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….

They note the following challenges in early retirement:

  • Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
  • Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period. 

Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans.  Often the decision to retire is about more than money.

Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration.  Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.

Accommodating Low Yields in a Financial Plan

The low interest rate (yield) environment is a challenge for all investors. 

Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.

Return expectations from fixed income securities (longer dated (maturity) securities) are very low.  Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.

In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%.  Expected returns on higher quality corporate bonds are not that much more enticing.

As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“

The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.

The impact of low interest rates on “withdrawal rates” is highlighted in the graph below, which was provided by Morningstar in a separate article, The Math for Retirement Income Keeps Getting Worse, Revisiting the 4% withdrawal rule

The 4% withdrawal rate 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.

For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate. 

As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.

When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively.  This implies a negative expected return after inflation.

The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020.  The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time.  A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.

As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.

Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved.  They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.

This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.

Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”

The 4% withdrawal rate is an industry “rule of thumb”.  Further discussion on the sustainability of the 4% withdrawal rate can be found here.

I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.

The following Post on what investors should consider doing in the current market environment may be of interest. This Post outlines some investment strategies which may help in maintaining a higher withdrawal rate from an investment portfolio.

Likewise, this Post on how greater customisation of the client’s invest solution is required and who would benefit most from targeted investment advice may also be of interest.

Lastly, Wealth Management.com covers Benz’ article in Retirement Planning in a Pandemic.

Please read my Disclosure Statement

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

The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

Although it has been evident for several years, the current investment environment highlights the shortcomings of the one size fits all multi-asset portfolio (commonly known as Diversified Funds such as Conservative, Balanced, and Growth Funds, which maintain static Strategic Asset Allocations, arising to the reference of the “Policy Portfolio”).

The mass-produced Diversified Funds downplay the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

However, saving for retirement is an individual experience requiring tailoring of the investment solution.   Different investors have different goals and circumstances.  This cannot be easily achieved within a one size fits all Diversified Fund.

Modern-day investment solutions involve greater customisation.  This is particularly true for those near or in retirement.

A massive step toward offering increased customisation of the Wealth Management investment solution is the framework of two distinctive “reference” portfolios: A Return Seeking Portfolio; and Liability-Hedging (Capital Protected) Portfolio.

Details and implementation of this framework are provided in the next section.  The benefits of the framework include:

  • A better assessment of the risks needed to be taken to reach a client’s essential goals and how much more risk is involved in potentially attaining aspirational goals;
  • An approach that will help facilitate more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework helps in assessing what is the best course of action and trade-offs involved; and
  • A more efficient use of invested capital.  This is a very attractive attribute in the current low interest rate environment.  The framework will be more responsive to changing interest rates in the future.

These benefits cannot be efficiently and effectively achieved within the traditional Diversified Fund one size fits all framework; greater customisation of the investment solution is required.

With modern-day technology greater customisation of the investment solution can easily be achieved.

The technology solution is enhanced with an appropriate investment framework also in place.

Implementation of the Modern-Day Wealth Management Investment Solution

The reasons for the death of the Policy Portfolio (Diversified Fund) and rationale for the modern-day Wealth Management investment solution are provided below.

Modern-day investment solutions have two specific investment portfolios:  

  • Return seeking Portfolio that is a truly diversified growth portfolio, owning a wide array of different return seeking investment strategies; and
  • Capital Protected (Liability) Portfolio, is more complex, particularly in the current investment environment.  See comments below.

The allocations between the Return Seeking portfolio and Capital Protected portfolio would be different depending on the client’s individual circumstances.  Importantly, consideration is given to a greater array of client specific factors than just risk appetite and risk and return outcomes e.g. other sources of income, assets outside super.

Although the return seeking portfolio can be the same for all clients, the Capital Protected (Liability) portfolio should be tailored to the client’s needs and objectives, being very responsive to their future cashflow/income needs, it needs to be more “custom-made”.

The solution also involves a dynamic approach to allocate between the two portfolios depending on market conditions and the client’s situation in relation to the likelihood of them meeting their investment objectives.  This is a more practical and customer centric approach relative to undertaking tactical allocations in relation to a Policy Portfolio.

The framework easily allows for the inclusion of a diverse range of individual investment strategies.  Ideally a menu offering an array of investment strategies can be accessed allowing the customisation of the investment solution for the client by the investment adviser.

Implementation is key, which involves identifying and combining different investment strategies to build customised robust investment solutions for clients.

The death of the Policy Portfolio

Modern Portfolio Theory (MPT), the bedrock of most current portfolios, including the Policy Portfolio, was developed in the 1950s.

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements have been made based on the ongoing academic and practitioner research into building more robust investment solutions.  See here for a background discussion.

The Policy Portfolio is the strategic asset allocation (SAA) of a portfolio to several different asset classes deemed to be most appropriate for the investor e.g. Diversified Funds

It is a single Portfolio solution.

A key industry development, and the main driver of the move away from the old paradigm, is the realisation that investment solutions should not be framed in terms of one all-encompassing Policy Portfolio but instead should be framed in terms of two distinct reference Portfolios.

A very good example of the two portfolios framework is provided by EDHEC-Risk Institute and is explained in the context of a Wealth Management solution.  They describe the two reference portfolios framework involving:

  1. Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
  2. Performance Seeking Portfolio, this is a portfolio that seeks growth in asset value.

The concept of two separate portfolios is not new, it dates to finance studies from the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The concept of two portfolios has also been endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.  Kahneman discusses the idea of a “regret-proof policy” here.

The death of the Policy Portfolio was first raised by Peter Bernstein in 2003.

Reasons for the death of Policy Portfolio include:

  • there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.
  • Investors should be dynamic; they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Many institutional investors have moved toward liability driven investment (LDI) solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.  More can be found on LDI here.

These “institutional” investment approaches, LDI, portfolio separation, and being more dynamic are finding their way into Wealth Management solutions around the world.

Evolution of Wealth Management – Implementation of the new Paradigm

In relation to Wealth Management, the new paradigm has led to Goal-Based investing (GBI) for individuals. GBI focuses is on meeting investor’s goals along similar lines that LDI does for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  1. Disaggregation of investor preferences into a hierarchical list of goals, with a key distinction between essential and aspirational goals, and the mapping of these groups to hedging portfolios possessing corresponding risk characteristics (Liability Hedging Portfolio).
  2. On the other hand, it involves an efficient dynamic allocation to these dedicated hedging portfolios and a common performance seeking portfolio.

GBI is consistent with the two portfolios approach, fund separation, LDI, and undertaking a dynamic investment approach.

The first portfolio is the Liability Hedging Portfolio to meet future income requirements, encompassing all essential goals.

The objective of this Portfolio is to secure with some certainty future retirement income requirements. It is typically dominated by longer dated high quality fixed income securities, including inflation linked securities.  It does not have a high exposure to cash. In the context of meeting future cashflow requirements in retirement Cash is the riskiest asset, unless the cashflows need are to be met in the immediate future.  For further discussion on the riskiness of cash in the context of retirement portfolios see here.

The second portfolio is the return seeking portfolio or growth portfolio. This is used to attain aspirational goals, objectives above essential goals. It is also required if the investor needs to take on more risk to achieve their essential goals in retirement i.e. a younger investor would have a higher allocation to the Return Seeking Portfolio.

The Growth Portfolio would be exposed to a diversified array of risk exposures, including equities, developed and emerging markets, factor exposures, and unlisted assets e.g. unlisted infrastructure, direct property, and Private Equity.

Allocations between the Hedging Portfolio and the Growth Portfolio would depend on an individual’s circumstances e.g. how far away they are from reaching their desired standard of living in retirement.

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals.

This will will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

Importantly, the framework will help facilitate a more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework also helps in assessing what is the best course of action and trade-offs involved.

For those wanting a greater appreciation of EDHEC’s framework please see their short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

A more technical review of these issues has also been undertaken by EDHEC.

Please see my Disclosure Statement

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

Understanding the Impact of Volatility on your Portfolio

A key investment concept is volatility drag. Volatility drag provides a framework for considering the trade-off between the “cost” and “benefit” of reducing portfolio volatility.

The volatility of your portfolio matters. Reducing portfolio volatility helps deliver higher compound returns over the longer-term. This leads to a greater accumulation of wealth over time.

When introducing volatility reduction strategies into a Portfolio a cost benefit analysis should be undertaken.

The cost of reducing portfolio volatility cannot be considered in isolation.

The importance of volatility and its impact on an investment portfolio is captured in a recent article by Aberdeen Standard Investment (ASI), The long-term benefits of finding the right hedging strategy.

The ASI article is summarised below.  Access to article via LinkedIn is here.

It is widely accept that avoiding large market losses and reducing portfolio volatility is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, an ongoing and uninterrupted endowment, or meeting Pension liabilities.

Understanding Volatility Drag

Volatility Drag is a key concept from the paper: if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”

The main disconnect some investors have is they look at returns over a discrete period, such as a year, or the simple average return over two years (zero in the case above).

Instead, investors should focus on the realised compound rate.  The compound annualised return in the above example is -13.97% versus simple average return of zero.

ASI make the following point: “The compound (geometric) rate of return will only equal the arithmetic average rate of return if volatility is zero. As soon as you introduce volatility to the return series, the geometric IRR will start falling, relative to the average return.”

This is a key concept to understand.  Volatility reduces compounded returns over time, therefore it impacts on accumulated wealth.  The focus should be on the actual return investors receive, rather than discrete period returns.  Most investment professionals understand this.

Cashflows, into and out of a Portfolio, also impact on actual returns and therefore accumulated wealth.  This is why a 100% equities portfolio is unlikely to be appropriate for the vast majority of investors. The short comings of a high equity allocations is outlined in one of my previous Posts: Could Buffett be wrong?

Thought Experiment

In the article ASI offers a thought experiment to make their point, a choice between two hypothetical investments:

  1. Investment A, has an average annual return of 1% with 5% volatility.
  2. Investment B, has twice the average return (2%) but with four times the volatility (20%).

An investor with a long term horizon might allocate to the higher expected return investment and not worry about the higher levels of volatility.  The view could be taken because you have a longer term investment horizon more risk can be taken to be rewarded with higher returns.

In the article ASI provides simulated track records of the two investments over 50 years (the graph is well worth looking at).

As would be expected, Investment B with the 20% volatility has a much wider range of possible paths than the lower-volatility Investment A.

What is most interesting “despite having double the average annual return, the more volatile strategy generally underperforms over the long term.”

This is evident in the Table below from the ASI article, based on simulated investment returns:

 Average Annual ReturnStandard Deviation of Annual ReturnsAverage total return after 50 yearsAverage realised internal rate of return (IRR)
A1%5%+53%0.88%
B2%20%-3.0%-0.07%

Note, how the IRR is lower than the average annual return e.g. Investment A, IRR is 0.88% versus average annual return of 1.0%.  As noted above, they are only the same if volatility is zero. 

The performance drag, or “cost”, is due to volatility.

Implications and recognising the importance of volatility

The concept of Volatility Drag provides a framework for considering the trade-off between the “cost” and benefit of reducing portfolio volatility.

The ASI article presents this specifically in relation to the benefits of portfolio hedges, as part of a risk mitigation strategy, and their costs with the following points:

  1. The annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
  2. Putting on exposures with flat or even negative expected returns can still increase your total portfolio return over time if they lower your volatility profile sufficiently.
  3. It is meaningless, therefore, to look at the costs of hedges in isolation.

These points are relevant when considering introducing any volatility reduction strategies into an Investment Portfolio i.e. not just in relation to tail risk hedging. A cost benefit analysis should be undertaken, investment costs cannot be considered in isolation.

As ASI note, investors need to consider the overall portfolio impact of introducing new investment strategies, specifically the impact on the downside volatility of a portfolio is critical.

There are a number of ways of reducing portfolios volatility as outlined below, including the risk mitigation strategies of the ASI article.

Modern Portfolios

The key point is that the volatility of your portfolio matters.  Reducing portfolio volatility helps in delivering better compound returns over the longer-term.

Therefore, exploring ways to reduce portfolio volatility is important.

ASI outline the expectation that volatility is likely to pick up in the years ahead, “especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.”

They also make the following pertinent comment, “Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility.”

ASI also note that investors have access to a wide range of tools and strategies to manage volatility.  This is particularly relevant in relation to the risk mitigation hedging strategies that manage downside volatility and are the focus of the ASI article.

Therefore, a modern day portfolio will implement several strategies and approaches to reduce portfolio volatility, primarily as a means to generate higher compound returns over time. This is evident when looking at industry leading sovereign wealth funds, pension funds, superannuation funds, endowments, and foundations around the world.

Strategies and Approaches to reducing Portfolio Volatility

There are a number of strategies and approaches to reducing portfolio volatility, Kiwi Investor Blog has recently covered the following:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.  Thus reducing portfolio volatility and enhancing long-term accumulated returns.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and portfolio benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging, highlighting that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.
  5. What do investors need in the current environment? – Rethink the ‘40’ in the 60/40 Portfolios?: With extremely low interest rates and the likelihood fixed income will not provide the level of portfolio diversification as experienced historically this Post concludes Investors will need to rethink their fixed income allocations and to think more broadly in diversifying their investment portfolio.

Happy investing.

Please see my Disclosure Statement

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

Image from CFA Institute Blog: When does Volatility Equal Risk?

What do Investors need in the current environment? – Rethink the ‘40’ in 60/40 Portfolios?

Investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk.

Investing into a broader array of fixed income securities, dividend-paying equities, and alternatives such as real assets and private credit is likely required.

Investors will need to build more diversified portfolios.

These are key conclusions from a recent article written by Tony Rodriquez, of Nuveen, Rethinking the ‘40’ in 60/40 Portfolios, which appeared recently in thinkadvisor.com.

The 60/40 Portfolio being 60% equities and 40% fixed income, the Balanced Portfolio. The ‘40’ is the Balanced Portfolio’s 40% allocation to fixed income.

In my mind, the most value will be added in implementation of investment strategies and manager selection.

In addition, the opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Putting It All Together

The thinkadvisor.com article provides the following Table.

Source: Nuveen

This Table is useful in considering potential investment ideas.  Actions taken will depend on the individual’s circumstances, including investment objectives, and risk tolerance.

The Table provides a framework across three dimensions to consider how to tackle the current investment challenge of very low interest rates.

Those dimensions are:

  1. The trade-off between level of income generated and risk tolerance (measured by portfolio volatility), e.g. lower income and reduced equity risk
  2. “How to do it” in meeting the trade-off identified above e.g. increase credit and equity exposures to seek higher income
  3. “Where to find it”, types of investments to implement How to do it e.g. active core fixed income, real assets (e.g. infrastructure and real estate), higher yielding credit assets.

Current Investment Environment

These insights reflect the current investment environment of extremely low interest rates.

More specifically the article starts with the following comments: “For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.”

Tony calls for action, “With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?”

This would be a worthy discussion for Investment Advisers and Consultants to have with their clients.

Returns from fixed income are relatively predictable, unlike equity market returns.  Current fixed income yields are the best predictor of future returns.  With global government bond yields around zero and global investment grade credit providing not much more, a return of greater than 1% p.a. from traditional global bond markets over the next 10 years is unlikely.

Fixed income returns over the next 10 years are highly likely to be below the rate of inflation.  Therefore, the risk of the erosion of purchasing power from fixed income is very high.  This is a portfolio risk that needs to be managed. 

Although forecasted returns from equities are also low compared to history, they are higher than those expected from traditional fixed income markets.

What should Investors do?

The article provides some specific guidance in relation to fixed income investments and a view on the outlook for the global economy.

The key point from the article, in my mind, is that for investors to meet the current investment challenges over the next decade they are going to need a more broadly diversified portfolio than the traditional 60/40 portfolio.

I also think it is going to require greater levels of active management.

This will involve a rethink of the ‘40’ fixed income allocation.  Specifically, the focus will be on generating higher returns and that fixed income is likely to provide less protection to a Balanced Portfolio at times of sharemarket declines than has been experienced historically.

Ultimately, a broader view of the 60/40 Portfolio’s construction will need to be undertaken. 

This is likely to require thinking outside of the fixed income universe and implementing a more robust and truly diversified portfolio.

Implementation will be key, including strategy and manager selection.

There will still be a role for fixed income within a Portfolio, particularly duration.  Depending on individual circumstances, higher yielding securities, emerging market debt, and active management of the entire fixed income universe, including duration, is something to consider.  More of an absolute return focus may need to be contemplated.

Outside of fixed income, thought should be given to thinking broadly in implementing a more robust and truly diversified portfolio. 

Kiwi Investor Blog has highlighted the following areas in previous Posts as a means to diversify a portfolio and address the current investment challenge:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging.  Highlighting that that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.

There have been a number of articles over recent months calling into question the robustness of the Balanced Portfolio of 60% Equities / 40% Fixed Income going forward.  I have covered this issue in previous Posts, here and here.

Why the Balanced Portfolio is expected to underperform is outlined in this Post.

Lastly, also relevant to the above discussion, please see this Post on preparing Portfolios for higher levels of inflation.

Call to Action

In appealing to Tony’s call for action, there has probably never been a more important time in realising the value of good investment advice and honest conversations of investment objectives and portfolio allocations. 

Perhaps it is time to push against some outdated conventions, seek new investments and asset classes.

The opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Addendum

For a perspective on the current market environment this podcast by Goldman Sachs may be of interest.

In the podcast, Goldman Sachs discuss their asset allocation strategy in the current environment, noting both fixed income and equities look expensive, this points to lower returns and higher risks for a Balanced Portfolio.  They anticipate an environment of below average returns and above average volatility.

Happy investing.

Please see my Disclosure Statement

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

A Robust Framework for generating Retirement Income

How much Income do you need in Retirement?

The focus is often on accumulated wealth e.g. how much do you need to save to retire on?

This could potentially result in the wrong focus.  For example if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits, furthermore their income would have dramatically dropped in 2009.  Current income on a million dollars would be approximately $35k.  That’s a big drop in income!  This also does not take into account the erosion of buying power from inflation. [Note: this Post was written in 2018, the current income on $1m in February 2021 is less than $10k.]

Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.

The wrong focus on wealth accumulation can potentially lead to yield chasing in retirement which leads to unintended risks within investment portfolios.

More robust approaches are being developed

The global retirement challenge is leading to new Goal Based Investing solutions.  Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.

Arguably the main challenge facing retirees is to have a sufficient and stable stream of replacement income.

An innovative, rigorous, and robust investment framework for solving the retirement challenge is being developed by EDHEC, along with the Operations Research and Financial Engineering Department at Princeton University, and supported by Merrill Lynch.

The framework being developed has some practical applications.  The EDHEC-Princeton Framework:

Defines the Retirement goal

The goal for retirement can be split between wealth and replacement income.

Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with high probabilities.

Different Risk Focus

The retirement framework results in a different focus on risk.

Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations in potential income in retirement.

With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.

Therefore, the real risk is about not achieving the investment goal.  Risk is not fluctuations of returns or underperforming a market index, but instead the true investment risk is failure to achieve investment goals.  This is how investment outcomes should be measured and reported against.

Investment Management Attributes

With the EDHEC-Princeton framework the following portfolio management processes can be adjusted to increase the probability of meeting the investment goals:

  1. Hedging – this is the least risky portfolio that matches future income requirements
  2. Diversification – this is the most efficient way to achieve returns relative to goals
  3. Insurance – this is a dynamic interplay between hedging and return seeking portfolio in the context of what is the worst case scenario in pursuing the investment goals. The trade-off is between downside protection and upside participation.  The measure of risk is underachieving the investment goals.

From this framework, 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.

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 income requirements, matching of future cashflows.  This is akin to what Insurance companies do to match their future liabilities.

EDHEC-Princeton Retirement Goal-Based Investing Indices

To reflect this retirement investment solution framework EDHEC and Princeton University have developed the EDHEC-Princeton Retirement Goal-Based Investing Indices.

The EDHEC-Princeton Retirement Goal-Based Investing Indices represents the value of a dynamic strategy that aims to offer high probabilities of reaching attractive levels of replacement income for 20 years in retirement while securing, on an annual basis, 80% of the purchasing power in terms of retirement income of each dollar invested.

This is the strategy of investing into a goal-hedging portfolio, that delivers stable replacement income in retirement, and the performance-seeking portfolio, which offer the upside potential needed to reach higher income levels with high probabilities, as outlined above

It will be really interesting to follow how these indices perform.

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge.  There are a some investment solutions currently available in the Target Date/Life Cycle options that are aligned with the above investment approach, as there are many that don’t.

These solutions are better than many of the Target Date Funds that have a number of short comings.

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income and where 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.

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income.  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 may lead to insufficient replacement income in retirement, or inefficient trade-offs are made prior to and in retirement.

Importantly the investment management focus is not on beating a market index, arguing about fees (albeit they are important), the focus is on how the Investment Solution is tracking relative to the retirement goals.

Happy investing.

Please see my Disclosure Statement

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

Investment Fees and Investing like an Endowment – Part 2

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.  This has diminishing diversification benefits e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.

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

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative and hedge fund risk premia.  And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above.  There has been a disaggregation of returns.

Not all of these risk exposures can be accessed cheaply.

 

The 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.

Unlisted infrastructure, unlisted real estate, hedged funds, and private equity are amongst the favoured alternatives by Endowments, Sovereign Wealth Funds, and Superannuation Funds.

As reported by the New York Times recently “Yale continues to diversify its holdings into hedge funds, where it has 25 percent of its assets, and venture capital, with a 17 percent stake, in addition to foreign equity, leveraged buyouts and real estate, as well as some bonds and cash. That diversification strategy, which Mr. Swensen pioneered, is widely followed by larger institutions.”

Yale has approximately 20% allocated to listed equities, domestic and foreign combined, and seeks to allocate approximately one-half of the portfolio to the illiquid asset classes of leveraged buyouts, venture capital, real estate, and natural resources.

 

The Yale Endowment recently released its annual report which gained some publicity.

The following quote received a lot of press:  “In advocating the adoption of a passive indexing strategy, Buffett provides sound investment advice for the vast majority of individuals and institutions that are unable (or unwilling) to commit the resources (human and financial) necessary for active management success. Yet, Buffett’s advice is not appropriate for the cohort of endowments that possess the capabilities to pursue successful active management programs.”

The Yale report was published not long after the Buffet Bet concluded.

Buffet’s investment advice was highlighted further this week surrounding publicity of the Berkshire Hathaway Annual meeting.

 

At the centre of this exchange is investment management fees.

Don’t get me wrong, fees are important.  Yet smart investors are managing fees as part of a multi-dimensional investment puzzle that needs to be solved in meeting client investment objectives.  Other parts of the puzzle may include for example liquidity risk, risk appetite, risk tolerance, cashflow requirements, investing responsibly, and client future liabilities, to name a few.

This is more pressing currently, these issues need to be considered in light of the current market conditions of an aging US equity bull market and historically low interest rates and the growing array of different investment solutions that could potential play a part in a robust investment portfolio.

The debate on fees often misses the growing complexities faced in meeting specific investment objectives.  The debate becomes commoditised.  The true risk of investing, failure to meet your investment objectives, often gets pushed into the background.

 

The importance of this? EDHEC recently highlighted many of the current retirement products do not adequately address the true retirement savings goal – replacement income in retirement.

This is not addressed by many of the target date / life cycle funds, nor is it the role of the accumulation 60/40 (equities/bonds) Fund of your standard superannuation fund.  Life cycle funds predominately manage market risk, there are other risks that need to be managed, some of which are outlined above, replacement income in retirement should also be added.

As EDHEC further highlighted, this is a serious issue for the industry, and more so considering the world’s pension systems are under enormous stress due to underfunding and a rising demographic imbalance with an aging population.  Furthermore, globally, there has been a shift of managing retirement risk to the individual i.e. the move away from Defined Benefit to Defined Contribution.

 

As a result, a greater focus is needed on investment solutions in replacing income needs in retirement.  This requires a greater awareness and matching of people’s retirement liabilities, a Goal Based Investment solution (Liability Driven Investing).

The management of client liabilities, and the design of the customised investment solutions needs to be implemented prior to retirement.  As many are currently discovering, a portfolio of cash and fixed interest securities, no matter how cheaply it is provided, is not meeting retirement income needs.

The debate needs to move on from fees to the appropriateness of the investment solutions in meeting an individual’s retirement needs.

The advice model is critical.

This is a big challenge, and I’ll blog more on this over time.

 

I’ll say it again, fees paid are important.  Nevertheless, the race to be the lowest cost provider may not be in the best interest of clients from the perspective of meeting client investment objectives.  The focus and design of “products” is primarily on accumulated value, a greater focus is required on replacement income in retirement.

Sophisticated investors such as endowments, insurance companies, pension funds, and Sovereign Wealth Funds, are taking a different perspective to the commoditised retail market.  Albeit, their approach is not inconsistent with fees being an important “consideration” that should be managed, and managed appropriately.  They likely manage to a fee “budget”, as they manage to a risk budget.

 

It is very critical that the Endowments get it right.  Endowments are a crucial component of university budgets. During the global financial crisis of 2008 many endowments had to significantly cut back their spending due to the falling value of their Endowment Funds.  It is estimated that distributions from the Yale endowment to the operating budget of the University have increased at an annualized rate of 9.2 percent over the past 20 years.  The Endowment Fund is the university’s largest source of revenue.  The Fund is expected to contribute $1.3 billion to the University this year, this is equal to approximately 34% of the Yale’s operating budget.

Much can be learned from how endowments construct portfolios, take a long term view, and seek to match their client’s liability profile.  An overriding focus on fees will lead away from investing successfully in a similar fashion.

 

The endowment approach can be applied to an individual’s circumstances, particularly high net worth individuals.  The more complex the situation, the better, and the more value that can be added.

There will be a growing demand for more tailored investment solutions.

EDHEC argue an industrial revolution is about to take place in money management, this will involve a shift from investment products to investment solutions “While mass production has happened a long time ago in investment management through the introduction of mutual funds and more recently exchange traded funds, a new industrial revolution is currently under way, which involves mass customization, a production and distribution technique that will allow individual investors to gain access to scalable and cost-efficient forms of goal-based investing solutions.”

 

For the record, as reported by the Institutional Investor: For the 20-year period ending June 30, Yale’s endowment earned a 12.1 percent annualized return, beating its benchmark Wilshire 5000 stock index, which gained 7.5 percent. A passive portfolio with a 60 percent stock allocation and 40 percent in bonds, meanwhile, had a 20-year return of 6.9 percent.

 

Lastly, I am a very big fan of Buffet, and one should read the two books by the two key people who have reportedly had a big influence on him, number one is obvious, Benjamin Graham’s The Intelligence Investor, and the other Philip A Fisher, Common Stocks and Uncommon Profits.  I preferred the later to the former.

It is also well worth reading David Swensen’s book: Pioneering Portfolio Management. Yale has generated the highest returns among its peers over the last 20 years.

 

Build robust investment portfolios.  As Warren Buffet has said: “Predicting rain doesn’t count.  Building arks does.”

Invest for the long-term.

Happy investing.

 

Please see my Disclosure Statement

 

My favourite part of New Zealand

150

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