What does Portfolio Diversification look like?

What does a diversified portfolio look like?

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

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

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

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

 

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

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

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

 

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

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

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

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

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

Allocations to broad asset classes KiwiSaver Aussie Pension Funds
Cash and Fixed Interest (bonds) 49 31
Equities 48 47
Other / non-traditional assets 1 22

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

 

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

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

 

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

Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

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

 

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

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

 

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

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

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

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

 

Comparison Return Analysis

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

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

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

 

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

 

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

 

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

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

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

 

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

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

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

KiwiSaver Investors are missing out

This is a great article by Stuff outlining the KiwiSaver risk ladder, rung by rung.

However, what struck me is that there is a rung missing on the KiwiSaver ladder.

That rung being the lack of exposure to non-traditional investments, such as Alternatives, including liquid alternatives, hedge funds, and investments into Direct Property and unlisted infrastructure.

 

Based on the Stuff article, there is just 1% within all of the KiwiSaver Funds invested outside of Cash, Fixed Interest (bonds), and Equities (the traditional asset classes).

We don’t have to look far to see how much of anomaly this.

By way of comparison, the Australian Pension Fund Industry, which is the fourth largest Pension market in the world, invests 22.0% into non-traditional assets.

As can be seen in the Table below, Australian Pension Funds, which manages A$2.9 trillion, invests 22.0% into non-traditional assets, meanwhile KiwiSaver has 1% invested outside of the traditional assets. (KiwiSaver Total Assets are just over $50 billion).

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

 

As recently reported by Bloomberg, allocations to non-traditional assets is expected to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

 

The increased allocations to Alternative is a global trend, which is not just in response to current market conditions.

As outlined in a previous Post, Preqin a specialist global researcher of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world, expect Alternatives to make up a larger share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018). This is an issue from the perspective of capacity and ability to deliver superior returns – manager selection will be critical.

 

Globally the trend toward increasing allocations to non-traditional assets has been in play for some time. As one of my first Posts notes, the case for adding alternatives to a traditional portfolio is strong.

This Post highlights that the movement toward Alternatives and non-traditional assets is not revolutionary nor radical, it is seen globally as evolutionary, a natural progression toward building more robust Portfolios that can better weather sharp falls in global sharemarkets.

 

Being more specific about Alternatives, Prequin note investor’s motivation for investing in alternatives are quite distinctive:

  • Private equity and venture capital = high absolute and risk-adjusted returns
  • Infrastructure and real estate = an inflation hedge and reliable income stream
  • Private debt = high risk-adjusted returns and an income stream
  • Hedge Funds = diversification and low correlation with other asset classes
  • Natural Resources = diversification and low correlation with other asset classes

 

Therefore, motives to investing in alternatives range from enhancing returns (Private Equity) and reducing risk through better diversification (Hedge Funds) and hedging against inflation (infrastructure and real estate (property), high exposures to non-traditional assets have benefited Endowments and foundations for many years.

 

I have Posted extensively on the benefits of Alternatives, for example highlighting research they would benefit Target Date Funds and the benefits of Alternatives more generally.

 

So the Question needs to be asked, why do KiwiSaver Funds not invest more into non-traditional assets? Particularly, when globally the trend is to invest in such assets is well established and further growth is expected, while the benefits are well documented.

 

Therefore, KiwiSaver Investors are potentially missing out.  Their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, 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.

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

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 investment 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 with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

 

Growing importance of ESG within the Alternatives sector

The growing importance of ESG within the Alternatives sector is one of the key themes from the JP Morgan Alts Survey March 2019.  This survey provides some fascinating detail on the state of the Global Alternatives industry, including Private Equity, Real Estate, Infrastructure and Hedge Funds.

Some of the other highlights from the survey include:

  • Diversified benefits – correlation matrix
  • Strategy and manager selection is vitally important – dispersion of manager returns
  • Detailed analysis of the varying Alternative categories e.g. hedge funds and real estate, including drivers of returns

 

As noted in previous Posts, Kiwisaver Funds are underweight Alternatives relative to the rest of the world, an alternatives allocation would be beneficial for Target Date Funds, and US Endowment have provided superior long term returns after fees due their successful allocations to Alternatives.

 

The benefits of Alternatives have been well documented and they are set to continue to become a larger part of Client portfolios over time as outlined by the recently published Prequin Global Alternatives Report.

 

Therefore, not surprisingly, according to JP Morgan, “Institutional investors are flocking to hedge funds this year, even after a turbulent 2018 marked by poor performance and market volatility.”

The demand for hedged funds is driven by the search for market-beating returns and diversification.

They found that about a third of respondents plan to boost allocations, up from 15 percent in 2018. Just 13 percent expect a decrease while 55 percent said they plan to maintain current allocations.

As a recent Bloomberg article highlighted, the hedge fund industry took its biggest annual loss last year since 2011, declining 4.8 percent on a fund-weighted basis, according to Hedge Fund Research Inc. Managers were hurt by volatility that trampled markets, and hedge funds saw $33.5 billion in outflows.

JPMorgan polled 227 investors with about $706 billion in hedge fund assets for its annual Institutional Investor Survey.

 

For those new to Alternatives, a recent Investment News article provides some wonderful insights into the benefits of Alternatives and implementation challenges with clients.

With regards to the benefits of Alternatives, comments by Dick Pfister, founder and president of AlphaCore Capital, a firm that allocates between 15% and 30% of client assets to alternative investments, are worth highlighting.

“We look at some alternatives as diversifiers,” he said. “But we will also look at other alternatives as ways to capture chunks of up markets.”

The article notes the “message that investors, advisers and allocators like Mr. Pfister understand is that the big picture perspective rarely looks good for alternative investments, which is why those who dwell on broad category averages often get stopped at the gate.”

The article continues “Making the case for alternatives, which are generally designed to neutralize market beta and enhance alternative alpha, is never easy when market beta is robust in the form of a bullish stock market.”

“That is the reality of allocating to alternative investments. To benefit from the diversifying factors, investors and advisers must appreciate that losing less than the market can often mean gaining less than the market.”

“There’s always something to complain about when you have a diversified portfolio,” said Hans-Christian Winkler, a financial planner at Claraphi Advisory Network, where client portfolios have between 20% and 30% allocated to alternatives.

“A diversified portfolio will never outperform the market, but in times like the last quarter of 2018, when we saw the market down 20% from the high, our portfolios with alternatives were down 5%,” he added. “By using alternatives, you are spreading out your risk and making your investment portfolio a lot less bond-market- and stock-market-dependent.”

 

These are key points, they highlight the benefits but also the challenges when it comes to positioning Alternatives with clients and stakeholders e.g. Trustees, Investment Committees.

Alternatives “underperform” on a relative basis when equity and bond markets perform strongly.  This can have some challenges with Clients, the article is well worth reading from this perspective, as it provides insights into how a number of Advisors are positioning Alternatives with their Clients.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Further growth expected for an Alternative future – Prequin

The outlook for Alternative investments continues to look bright according to the recent Prequin Global Alternatives Report.

Prequin note investor’s motivations for investing in alternatives are quite distinctive:

Private equity and venture capital, motives = high absolute and risk-adjusted returns

Infrastructure and real estate, motives = an inflation hedge and reliable income stream

Private debt, motives = high risk-adjusted returns and an income stream

Hedge Funds, motives = diversification and low correlation with other asset classes

Natural Resources, motives = diversification and low correlation with other asset classes

Prequin comment “Set against these objectives, it becomes clear why investors have not only consistently increased their allocations to alternative assets over the past decade, but also why they are planning to continue to do so in the years ahead (not to mention the growing number of investors that come into alternatives each year – i.e. growing ‘participation’).”

Interestingly, investors are expressing an increasing allocation not only to those alternatives that have exceeded expectations recently (Private equity and venture capital, private debt, infrastructure, real estate), but are also looking to increase allocations to areas where recent performance has disappointed – notably hedge funds and natural resources. As they note “the diversification and low correlation offered by these assets may be especially attractive in a challenging returns environment.”

 

Importantly, the Prequin survey is set against a backdrop where investors “see a challenging environment ahead for returns.”

They also note that continued growth is expected despite alternative assets having enjoyed a “tremendous decade of growth” and “becoming ever more vital in investors’ portfolios worldwide;”

 

With regards to expected growth, “Preqin is sticking with its forecast for further growth of alternative assets to 2023: from $8.8tn in assets under management in 2017 to $14.0tn in 2023.”

 

The full Prequin report is available and covers each of the Alternative strategies outlined above.

The Preqin-Alternatives-in-2019-Report, for example, provides some interesting facts and figures on Hedge Funds:

  • 59% of Surveyed investors believe we are the top of the equity cycle, 40% intend to position their portfolios defensively
  • 79% of surveyed investors intent to maintain or increase their level of allocation to hedge funds over the next 12 months

 

For further articles on Alternatives by Kiwi Investor Blog:

  1. An Alternative Future for Kiwisaver Funds
  2. Alternatives Investments will improve the investment outcomes of Target-Date Funds
  3. Future’s Hedge Funds
  4. Investment Fees and Investing like an Endowment – Part 2
  5. Perspective of the Hedge Fund Industry
  6. Adding Alternatives to and Investment Portfolio – Part 3 – Investing Like an Endowment Fund
  7. Adding Alternatives to and Investment Portfolio – Part 2
  8. Adding Alternatives to and Investment Portfolio

 

 

Happy investing.

 

Please see my Disclosure Statement

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

 

 

An Alternative Future for Kiwisaver Funds

I have blog previously on the benefits of Alternative investments for a robust portfolio.

They would benefit Target Date Funds (Life Cycle Funds) and they have benefited Endowments and foundations for many years.

As the Funds Under Management (FUM) grows within Kiwisaver there will be an increasing allocation to Alternative investments. This will include the likes of unlisted assets (Private equity, direct property, and direct infrastructure), hedged funds, and liquid alternative strategies such as Alternative Risk Premia strategies.

 

A recent paper by Preqin, Preqin-Future-of-Alternatives-Report-October-2018, assesses the likely size, shape and make-up of the global alternative assets industry in 2023, the emphasis being on private capital and hedge funds.

Preqin are specialist global researchers of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world.

 

Needless to say, Alternatives are going to make up a large share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018).

 

This is an issue from the perspective of capacity and ability to deliver superior returns.  Therefore, manager selection will be critical.

 

Preqin outlined the drivers of future growth as the following:

  • Alternatives’ track record and enduring ability to deliver superior risk-adjusted returns to its investors, Investors need to access alternative sources of return, and risk, such as private capital.
  • They note the steady decline in the number of listed stocks, as private capital is increasingly able to fund businesses through more of their lifecycle;
  • A similar theme is playing out in the debt markets, there are increasing opportunities in private debt as traditional lenders have exited the market; and
  • The emerging markets are seen as a high growth area.

 

According to Preqin the following factors are also likely to drive growth:

  • Technology (especially blockchain) will facilitate private networks and help investors and fund managers transact and monitor their portfolios, and reduce costs vs public markets.
  • Control and ESG: investors increasingly want more control and influence over their investments, and the ability to add value; private capital provides this.
  • Emerging markets: the Chinese venture capital industry already matches that of the US in size; further emerging markets growth will be a ‘double whammy’ of GDP growth + higher penetration of alternative assets.
  • Private individuals: the ‘elephant in the room’, as the mass affluent around the world would like to increase their investment in private capital if only the structures and vehicles (and regulation) permitted; technology will help.

 

The Preqin report covers many other topics and interviews in relation to the Alternative sector.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

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

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

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

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

 

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

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

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

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

 

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

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

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

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

 

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

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

 

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

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

 

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

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

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

 

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

 

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

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

 

Implementation Considerations

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

Their comments of fees hits the mark:

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

Think about after fee outcomes.

 

Concluding remarks

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

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

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

 

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

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

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

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

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Asness on Hedge Fund Returns and Buffet Bet Revisited

Earlier in the year I wrote a post about the Buffett Bet.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of funds” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

I made three points earlier in the year:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Funds hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.  Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. Most, if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

Finally, someone from the Hedge Fund Industry has come out a said it: Hedge Funds should not be compared to the performance of investing in equities.

Cliff Asness from AQR has, and not for the first time, recently written an article about why Hedge Fund returns should not be compared to equity market returns such as the S&P 500 Index, see The Hedgie in Winter.

The key point Asness makes is that Hedge Funds are not 100% invested in equities.  He estimates that they are in effect 50% invested in equities.  If we use beta terms, where a beta of 1.0 =  100% equities, Hedge Funds have a beta of 0.5.  (For those who are wondering what Beta is, Beta is a measure of how sensitivity an investment is to a market index e.g. S&P 500.  Put another way, how much of the returns from the market index can explain the returns of the investment.  Therefore, with a beta of 0.5 we would expect hedge funds to be less volatile than equities and equity markets performance would only explain some of the returns from hedge funds.)

Asness expresses it more succinctly:

“Comparing hedge funds to 100% equities is flat-out silly. Hedge funds have historically, rather consistently, delivered equity exposure (beta to my fellow geeks) just under 50%. In fact much of their point is, supposedly, to be different from equities. I mean that they are at least partly hedged investments. Put more bluntly, it is in the freaking name!”

That’s right, Hedge Funds look to reduce their equity market exposure, hedge it out.  Therefore they will not capture all of an equities market upside.  Similarly, when equity markets fall significantly, they are not capturing all of this downside as well! i.e. Hedge Funds tend to outperform equity markets in equity bear markets.

Certainly, hedge funds are not going to outperform equities in a strong bull market, as we have recently experienced, as they are not 100% invested in equities.  They are not equities.

Well, you probably would expect a hedge fund manager to say this.  Yip, but I would say he is right on the money.

Furthermore, it is not as if Asness lets Hedge Funds off the hook.  From further analysis in the paper Asness notes that Hedge Fund performance has been “petering out” since the Global Financial Crisis (GFC).  This means they have not added or subtracted much value since the GFC.

I take this to mean they have struggled to meet their investment objectives and historical rate of returns, albeit they may well have delivered mildly positive returns.  Which is not as disastrous as often reported.

The “petering out” of Hedge Fund performance is highlighted by Asness as an area of concern.  The data he presents provides no proofs as to why.  He concludes that Hedge Funds may be less special than before.

That is certainly something to dwell upon.  Hedge Funds can play an important role in a robust portfolio and achieving true portfolio diversification.  The observation by Asness should be considered in the selection of Hedge Fund managers and strategies.

Lastly, there is change occurring across the Hedge Funds industry.  This expected change is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund IndustryAIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry. This includes more transparency and lower fee structures.

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

This is consistent with Hedge Funds playing a valuable role in a truly diversified portfolio.

Happy investing.

Please see my Disclosure Statement

 

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

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Future’s Hedge Funds

A really interesting article by the Chief Investment Officer: A New Generation of Hedge Funds Can Provide Stability, Australia’s sovereign wealth fund CIO is betting hedge funds can help reduce risk.

The article covered a number of themes from my earlier Blog Post Perspective of the Hedge Fund Industry

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.  This is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry.  The AIMA paper is covered in the Post above.

The following Quotations from the Chief Investment Office article by Raphael Arndt, CIO of Australia’s A$166 billion sovereign wealth fund, the Future Fund, are consistent with the AIMA Paper:

  • “Hedge funds have an important portfolio role to play in generating returns that are uncorrelated to equity markets,” Arndt said last week in a speech before the Insurance Investment Forum in Torquay, Australia.
  • “For the Future Fund, hedge funds have a very specific purpose in our portfolio.  This is to reduce risk—and in particular to provide returns during market environments involving prolonged periods of losses in equity markets.”

 

From Kiwi Investor’s perspective a well designed and implemented Hedge Fund solution is particularly attractive for an insurance company.

 

Arndt, continues:

  • “I recognize that hedge funds have historically had a public relations problem, being associated with high fees, a lack of transparency, and perceptions of poor ethics and customer focus,” said Arndt.
  • But Arndt said this perception of hedge funds is a dated stereotype that he refers to as “hedge funds 1.0,” which has given way to what he calls “hedge funds 2.0”—a newly evolved generation of hedge funds.

 

This sentiment very much comes out in the AIMA paper As Arndt emphasised, many hedge funds run institutional-quality investment process.  If they don’t, they don’t receive institutional money.  This not only relates to the investment management process, it includes issues such as management of counter party risk, operational risk management, regulatory risk management, and transparency of portfolio risk exposures.

Lastly, after outlining the type of hedge fund solution the Future Fund runs, Arndt comments:

  • “I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC type event in equity markets,” said Arndt. “The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.
  • “It’s time to re-examine what hedge funds offer,” he added. “The industry has evolved and improved, and features a new breed of managers that are different from their predecessors.”

 

These comments are also consistent with points made in my earlier post on Investment Fees and Investing like an Endowment – Part 2 and Disaggregation of Investment Returns.

 

In effect, the Future Fund uses Hedge Funds to provide return diversification, they use Hedge Funds so they can invest into riskier assets like equities and illiquid asset such as infrastructure, property, and private equity.

We all know a robust portfolio is broadly diversified across different risks and returns.

Combined the Future Fund has a more robust portfolio.

 

It has worked well for them, the article states: “As of the end of March, the Future Fund reported a return of 8.5% per year over the last 10 years, compared to a target benchmark return of 6.7% per year during that same time period.”

This is a very good result, successfully managing into their stated investment objectives.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

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Perspectives of the Hedge Fund Industry

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.

This is capture in the recently published AIMA paper (Alternative Investment Management Association), Perspectives – Industry Leaders on the Future of the Hedge Fund Industry

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

Hedge fund’s largest clients are Pension Funds, University Endowments, and Sovereign Wealth Funds.

Access to hedge fund strategies is becoming increasingly available to retail investors.  Hedge Funds, and hedge fund strategies, are no longer the exclusive domain of High Net Wealth Worth individuals.

 

Summary of the Report’s Executive Summary

  1. Paradigm shift. The industry is experiencing significant transformation as investors seek new investment solutions to more cheaply access different return streams. This has witnessed an innovation of investment solutions that fit between the traditional hedge fund and the traditional actively managed listed market funds.  These new investment solutions are providing the benefits of increased portfolio diversification for lower fees and increased transparency relative to the traditional hedge fund.  These cheaper return streams are the factor betas and alternative hedge fund betas. There has been a disaggregation of investment returns as a result of recent investment solution innovation.
  1. Hedge Funds can still produce alpha (risk adjusted excess returns) but it is getting harder due to increased competition and the greater ease of access to financial data and computing power.
  1. Therefore, an increasing employment of artificial intelligence and advanced cutting-edge quantitative techniques will likely grow across the hedge fund industry.
  1. The integration of Responsible Investing will likely rise across the hedge fund industry.
  1. The hedged fund firm is likely to change from its current traditional model, employing outside of the traditional business school graduate, employing a greater diversity of talent, flatten organisational structures, and encourage more collaborative environments.
  1. Hedge Fund firms will likely look to partner more with investors and co-invest.
  1. This will see a different focus on distribution and ownership models.

 

Points One and Two are of the most relevant to the focus of Kiwiinvestorblog.

The changing dynamics of the hedge fund industry has implications for the wider funds management industry e.g. downward pressure on fees, the blurring of the lines between traditional fund managers and hedge fund managers investment solutions, and the increased weight on traditional active equity managers to deliver genuine alpha – the closest index fund is on the endangered extinction list!

Importantly, the change taking place is making it easier, cheaper, and more transparent to implement truly diversified and robust multi-asset portfolios.  This is evident in the thoughts expressed in the quotes provided below and throughout the Report.

Section One of the Report formed the basis of an earlier blog on the Disaggregation of Investment Returns between market beta, factor and hedge fund beta, and alpha (linked aboved).

Pages 37 – 43 of the Report has a good discussion on whether hedged funds can still generate alpha (risk adjusted excess returns).

Understanding these sources of returns will help in building truly diversified portfolios.  It will also make the quotes more meaningful.  A greater appreciation of where the industry is moving will also be gained.

 

The following quotes from the Report help bring this all together.

Happy investing

 

Key quotes from within the Report:

“The past years have brought significant changes to the hedge fund industry. What was once a boutique industry serving high-net-worth individuals now serves some of the world’s largest investors. The products offered by hedge fund firms are changing to meet the needs of this wider and more diverse investor universe. The alpha-beta returns dichotomy of yesteryear is being replaced with a new range of investment solutions tailored to the needs of a wider range of investors.”

 

“A majority of investable assets in the total hedge fund pot will go to some form of risk premium investment strategy or a low-to-average correlation type of investment product, because investors have become increasingly more technical and have caught on to the fact that some investment strategies can be replicated for lower fees. Going forward, I expect more than half of the hedge fund investable universe will comprise of the top ten largest investment strategies being commoditised into more low-cost investment products—the so-called liquid alternatives. The remainder of the universe will comprise of high-end niche investment strategies that are capacity constrained, and are able to deliver true alpha.”

 

“Changing investor expectations are forcing hedge fund firms to rethink the investment solutions that they offer. The pace of technological change and the rise of artificial intelligence is leading some to question whether the hedge fund proposition will even exist in a few years. Responsible investment, meanwhile, is becoming more of a priority for hedge fund firms, as they gradually overcome their reluctance to constrain themselves. All of these changes are in turn forcing hedge fund firms to re-evaluate their own inner workings, from how they service investors through to how they build a business that outlasts its founders.”

 

Please see my Disclosure Statement