Likely poor performing investment managers are relatively easy to identify. Great fund managers much more difficult to identify.
Good performing managers who can consistently add value over time can be identified. Albeit, a well-developed and disciplined investment research process is required.
Those managers that consistently add value are likely to be found regularly in the second quartile of peer analysis. They are neither the best nor the worst performing manager but over time consistently add value over a market index or passive investment. They are not an average manager.
These are key insights I have developed from just under 30 years of researching and collaborating with high calibre and talented investment professionals.
More importantly, modern day academic research is supportive of this view. The conventional wisdom of active management is being challenged, as highlighted in a previous Post.
The author, John Paterson, of this analysis was interviewed in a i3 article.
The key points of Peterson’s analysis and emphasized in the i3 article:
Many of the studies into the ability of active managers to consistently outperform are inherently flawed.
Most of these studies merely confirm that financial markets are not static, therefore they do not say anything about manager performance.
“The failure to find repeated top quartile performance in these ‘tests of manager consistency’ simply reflects the reality that markets are not Static, and says nothing about the existence, or otherwise, of manager consistency.”
The key flaw is that many of the studies on active management focus on the performance of only the top performing managers: whether top quartile performers are able to repeat their efforts from one period to the next.
A wider view of manager performance should be considered, all quartiles should be assessed to determine whether manager performance is random or not.
Those managers that that consistently achieved above average returns are more likely to be found in the second or third quartiles.
In the i3 interview, Paterson discusses more about the results of their research:
“Someone who consistently outperforms doesn’t necessarily look like a top quartile manager. They are more likely to be found in the second quartile,”.
The following comment is also made:
“Most asset managers intuitively know this, because markets are cyclical and if you do something that shoots the lights out in one period, it is likely to do the complete opposite in another period.”
The Australian Experience
Paterson’s analysis also found “Across the studies analysed, it was found that there is very strong evidence that investment managers available to Australian superannuation funds do perform consistently.”
Lastly Paterson comments “And experience tells us that super funds with more active managers have done better than those with largely passive mandates, and often at a lower level of volatility.”
As I have previously Posted, there are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform.
Other reasons for considering an alternatives to a passive index include no readily replicable market index exists, imbedded inefficiency within the Index, and available indices are unsuitable in meeting an investor’s objectives (e.g. Defined Pension Plans).
The decision to choose an alternative to passive investing varies across asset classes and investors.
Therefore, the traditional active versus passive debate needs to be broadened.
The article by Warren and Ezra, covered in a previous Post, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.
They provide five reasons why investors might consider alternatives to passive management.
In doing so they provide examples of circumstances under which an alternative to passive management might be preferred and appreciably widen the debate.
The identification of managers that consistently add value is one reason to consider an alternative to passive management.
There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.
Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.
Under these circumstances a passive approach no longer becomes optimal nor appropriate.
Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.
Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.
Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.
Framework for choosing an Alternative to Passive Investing
They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.
In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.
They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”
Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:
Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.
As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.
The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.
Below I have provided a description of the five reasons investors should seek an alternative to passive index.
Back ground Comments
Warren and Ezra provide some general comments on the state of the industry debate:
They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.
They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”
The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.
Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.
A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.
Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.
Cap-weighting is aligned with investor objectives.
It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.
The same is true for an endowment, insurance company, or foundation.
The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.
The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.
The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.
Reason #1: No Readily Replicable Index is Available
Passive investing assumes an effective index exists that can be easily and readily replicated.
In some instances, an appropriate index to replicate is simply not available, for example:
Unlisted assets such as Private Equity, unlisted infrastructure and direct property
Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.
In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.
Reason #2: The Passive Index Is at Odds with the Investor’s Objectives
Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.
By way of example:
Defined Benefit Pension Plan and tailored fixed-income mandates.
Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.
In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.
DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.
Such situations also exits for insurance companies, endowments, and foundations.
Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.
Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.
The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.
Reason #3: The Standard Passive Index is Inefficiently Constructed
Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.
The article presents two potential reasons an index might be inefficient and proves three examples.
They comment that an index might be inefficient for the following reasons:
the index is built on a narrow or unrepresentative universe; and
the index is constructed in a way that builds in some inefficiency.
As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.
Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.
The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).
There are many shortcomings of fixed-income indices, the article focuses on two:
Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.
Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.
Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.
Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.
However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.
Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.
The following features are outlined in the article to support such a situation:
Market inefficiency situations
Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.
The following situations may provide a manager with a competitive advantage:
Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.
Opportunities arising from differing investor objectives
Opportunities for active management to benefit may exist when:
Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
Investors have differing time horizons e.g. value investors exploit short-term focus of markets
Index fails to cover the opportunity set
The article makes the following points under this heading:
There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”
Reason #5: Skilled Managers Can Be Identified
Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.
Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.
The discussion makes the following points:
At the very least bad managers should be avoided
Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
Not all fund managers are created equal, some are good and some are bad
The research capability and skill to identify and select a manager is an important consideration.
Implementation and Costs
It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.
“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”
The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.
Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.
For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.
The most recent EDHEC Risk Institute’s European Exchange Trade Funds (ETF) survey* provides valuable insights into the developing trends and innovation in relation to the use of ETF in a diversified and robust portfolio.
The following Post outlines the key findings of the EDHEC ETF survey, which is well worth reading.
The changing Purpose of using ETFS
Increasingly ETFs are being used for tactical allocation purposes. Historically the dominant purpose of ETF usage has been to gain a truly passive investment, a long-term buy-and hold investment to gain broad market exposures via the major market indices.
Results by EDHEC indicate there is now a greater usage of ETFs for tactical allocations rather than their role for long-term positions (53% and 51% respectively).
The survey also noted:
Gaining broad market exposure remains the focus of ETF for 73% of users, compared with 52% of respondents using ETFs to obtain specific sub-segment exposure.
As EDHEC note, the increasing focus on sub-segment exposures can be linked to product development, “which has led to the introduction of new products for a multitude of sub-segments of the markets (sectors, styles etc.). It also correlates with the growing use of ETFs for tactical allocations, which tend to favour a more granular investment approach over broad exposures.”
ETF Use continues to Grow**
The adoption of ETF continues to grow, particularly for the traditional asset classes. “In 2019 91% of respondents used ETFs to invest in equities, compared with 45% in 2006. As for governments and corporate bonds, the result went from 13% and 6% in 2006, to 66% and 68%, respectively, in 2019…”
“Investors prefer ETFs for traditional asset classes over alternative asset classes in line with this expression of conservatism in their use of ETFs, which is mainly focused on gaining access to broad market exposure”….
The Survey recorded a high level of satisfaction by investors with ETF in the traditional asset classes.
The survey also notes:
A high percentage of investors (46%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates
Lowering investment cost is the primary driver behind investors’ future adoption of ETFs (74% of respondents in 2019).
ETF investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019) and replace other passive investing products through ETFs (42% of respondents in 2019)
Future Growth and ETF Innovation Drivers
“Ethical/SRI and smart beta equity / factor indices are the main expectations for further development of ETF products”
Further developments where called for in the following market segments:
31% of respondents wished for further development of Ethical/Socially Responsible Investing (SRI) ETFs.
ETFs related to advanced forms of equity indices – namely those based on multi-factor and smart beta indices – 30% and 28% of respondents
In aggregate 45% of respondents would like further development in one of the following areas of either smart beta indices, single-factor indices, and multi-factor indices.
More specifically, the EDHEC Survey found that “respondents would like to see further development of smart beta and factor investing products in the area of fixed income”……“The integration of ESG into smart beta and factor investing, and strategies in alternative asset classes (currencies, commodities, etc.), closely follow.”
EDHEC conclude, “It is likely that the development of new products corresponding to these demands may lead to an even higher take-up of smart beta and factor investing solutions.”
Criteria for selecting ETF Providers
The two main drivers of selecting an ETF provider are Cost and the quality of Cost and Quality of Replication. These two criteria dominate the survey results.
The long-term commitment of the provider, range of solutions, and level of innovation also rank highly.
Smart Beta and Factor Investing
The EDHEC Risk Survey has a large section on the drivers of using Smart Beta and Factor Investing Strategies.
Motivation for Smart Beta and Factor investing strategies include improving performance and managing risk
Albeit, the adoption of these strategies is a small fraction of portfolio holdings.
EDHEC found that there was a preference for passive for open-ended passive funds to invest in equity products, and active solutions to invest in fixed income products.
In relation for smart beta and factor investing the “take-up remains partial despite more than a decade of discussion in the industry, with the vast majority of adopters investing less than 20 per cent of their portfolio in such approaches.”
They find that this is partly due to a lack of ‘transparency and difficulty in accessing information about such strategies”….“In the case of fixed income strategies, investors express doubts over the maturity of research results at this stage. They also see a need for further development of long/short equity strategies based on factors, strategies that address client-specific risk objectives, and strategies that integrate environmental, social and governance (ESG) considerations.”
Personally, I see an increasing demand for smart beta and factor investing within fixed income strategies. Whether this is within an ETF structure, time will tell.
Therefore, for product provides to capture the growth and innovation outlined above, as EDHEC highlight, there is work to be done “to improve their solutions for smart beta and factor investing strategies if they are to make it into the mainstream.”
This is an area of opportunity for ETF providers, particularly if it includes an ESG overlay.
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
* The 2019 EDHEC survey gathered information from 182 European investment professionals concerning their practices, perceptions and future plans. Respondents are high-ranking professionals within their organisations (34% belong to executive management and 42% are portfolio managers), with large assets under management (42% of respondents represent firms with assets under management exceeding €10bn). Respondents are distributed across different European countries, with 12% from the United Kingdom, 70% from other European Union member states, 14% from Switzerland and 4% from other countries outside the European Union.
* * At the end of December 2018, the assets under management (AUM) within the 1,704 ETFs constituting the European industry stood at $726bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2018b).
Exchange Traded Funds (EFTs) have not been subject to the same level of rigorous analysis undertaken upon actively managed funds. Yet, ETFs are challenging conventional actively managed funds.
While performance of actively managed funds has been extensively investigated, there is not much known yet about the performance of ETFs.
A recent Paper by Robeco provides insightful analysis of ETF’s performance.
Robeco conclude “that the allure of ETFs finds little empirical support in the data and that ETFs have yet to prove that they can generate better performance than conventional actively managed funds.”
The Robeco paper provides a giant leap forward in bridging the imbalance of analysis between actively managed funds and ETFs.
Robeco rightly points out, the growth in ETFs has come with little supporting evidence.
They note there are areas in which to be cautious:
“the main differentiator of ETFs, continuous trading, should be of little relevance to passive investors, since the whole idea of the passive approach is to buy and hold for the long term and refrain from trading altogether.”
“not every ETF involves low costs. Whereas the cheapest ETFs have annual expense ratios below 0.05%, there are also ETFs with expense ratios above 1%, which makes them more expensive than many mutual funds”
“if the purpose of ETFs were to facilitate passive investing, then, in theory, one ETF on the broad market portfolio would suffice. In reality one would expect perhaps a few more funds because of practical matters such as competition between different providers, different asset classes, or different time zones; however, not thousands of funds. While there is a handful of very big ETFs which track a broad market index such as the S&P 500, the vast majority of ETFs track indices that themselves represent active strategies.“
The Robeco analysis covers US-listed ETFs investing in US equities. It includes analysis of over 900 ETFs, almost $1.9 trillion in AUM, over the period 1993 to the end of 2017.
The Robeco paper also provides a very good analysis on the breakdown of the ETF market, history, size, and different types of strategies.
Robeco’s analysis is the same as that applied to actively managed funds in the academic literature.
“Based on realized returns, 60% of ETFs underperformed the market, 80% exhibited higher volatility, and 80% underperformed in terms of Sharpe ratios. Such figures do not appear to be much different from what has been reported for actively managed mutual funds.“
Robeco zoom in on the different types of ETFs, they find:
the small number of generally big ETFs, which aim to track one of the broad market indices, live up to their promises.
The weak overall performance of ETFs turns out to be mainly driven by the large number of ETFs that do not aim to replicate any of the broad market indices. In particular, leveraged and inverse equity ETFs
Robeco undertook analysis on ETFs invested into common investment styles e.g. size, value, momentum, quality, and low-risk.
Their analysis highlighted that none of them managed to consistently add value relative to a capitalization-weighted market portfolio of all US stocks.
“The magnitude of these alphas again appears to be quite similar to what one might expect from conventional actively managed funds.”
This can be partly attributed to the poor performance of equity factors over recent years. The recent environment has not been favourable for the performance of many equity factors e.g. Value.
As Robeco note, “Given that some factor ETFs do provide large and significant exposures to the targeted factors, they can be expected to add value if factor premiums rebound in the future. A caveat here is that the factor exposures of some ETFs may have been obtained by pure accident, which means that these exposures might change in the future.”
In other words, implementation of the factor exposure is critical, this will determine success or otherwise. The implementation of the factor approach undertaken by the ETF needs to be appropriately researched.
Robeco conclude “the performance of ETFs is not as impressive as one might expect it to be, as investors in these ETFs have collectively realized a performance that does not appear to be much different from the performance that can be expected from the conventional actively managed mutual funds.”
This Post is not to be taken as an assault on ETFs, they can play a role in a robust portfolio. As can active management. There are shades of grey in investment returns, as a result the emotive active vs passive debate is outdated.
Nevertheless, the growth in Exchange Traded Funds has been spectacular over the last decade and it is only appropriate they are subject to the same level of rigorous research as an actively managed investment strategy.
All investment decisions should be based on robust, independent, diligent, and thorough investment analysis.
Although this may appear self-evident too many, there are good reasons to be cautious in the selection of ETFs as highlighted by the Robeco analysis.
We need to change the conversation on investment management fees.
Kiwi Wealth recently released an insightful article on the case for having your money managed actively.
This article has, inevitably, being meet with a passionate defence of Index Management (also referred to as Passive Management). A debate that has been going on for some time, and we really need to move on!
Kiwi Wealth make the following comment in the introduction:
“The “active versus passive” debate has been a fixture in the investment industry for nearly 50 years. Passive investing is one of the cheapest ways to access equity markets globally, and has helped to drive down fees across the board. Passive investment managers and their suppliers have gone further than just offering low cost products however, and have portrayed actively-managed portfolios as a bad option for investors. We disagree, and believe, headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.”
I can’t disagree with that.
As the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio.
The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).
The black and white debate is evident in this GoodReturns article, Passive Managers Reject Criticism. Also note the comments section as well.
I have written a number of Posts on Index management, highlighting their limitations, and risks, albeit I can see a role for them as part of a portfolio, as I can active management.
As with active management, it is important to understand and appreciate the limitations of what you are investing in.
I also hope we don’t follow Australia’s lead as an industry and focus too much on investment management fees. There is an appropriate level of fees, but it is not the lowest cost provider.
Index Funds do buy high and sell low, primarily because companies move in and out of indices.
Analysis by Research Affiliates highlights the trading costs of Index Funds (Passive Funds). Index Fund providers understand this and seek to minimise these costs.
As an aside, passive index funds are not passive, they are actively managed.
Albeit, there are huge trading costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns. Index Funds incur these costs.
These costs are high, Research Affiliates estimates the difference in return between a company exiting and entering an Index to be 9.52%. The majority of this performance difference occurs on the day of index changes. It also only occurs on that proportion of the portfolio that is changing.
Stocks entering an Index tend to underperform over the next 12 months, while those leaving an Index tend to outperform over the following year.
For more, see this article on why low cost index investing is not necessarily low risk.
In another Post I highlighted that Index Funds have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated.
These articles are separate to the current issue of overvaluation in sectors of the US market, recently labelled, rather misleadingly, an Index Bubble, by Michael Burry, who was one of the first investors to call and profit from the subprime mortgage crisis of 2007-08 that triggered the Global Financial Crisis.
The research Paper attached to this Post is the most downloaded paper from Kiwiinvestorblog.
Closely related, and what has busted open the active vs passive debate, leading to the shades of grey, is the disaggregation of investment returns – the isolation of drivers of investment returns.
As the Post highlights returns can be broadly attributed to three drivers: Market returns (beta), factors and hedge fund strategies beta, and alpha (returns after the betas, which can be purely attributed to manager skill).
The disaggregation of investment returns is prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge. These are “active” returns.
The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.
As you know, the isolation of the drivers of investment returns is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay high fees for an “active” return outcome that can be sourced more cheaply.
Many commentators highlight the likelihood of a low return environment over the next 5 -10 years or more.
Even looking through the shorter-term challenges of the current market environment as highlighted in a recent Post, many publicly available forecasts underline the potential for a low return environment over the longer term.
As at 31 July 2019 they estimated the real returns (returns after 2.2% inflation) for the following asset classes as follows:
Annual Real Return Forecasts
US Large Capitalised Shares
Fixed Income Markets
US Fixed Income
International Fixed Income Hedged
As GMO highlight, these are forward looking returns based on their reasonable beliefs and they are no guarantee of future performance.
Actual results may differ materially from those anticipated in forward looking statements.
The variation in sequence of returns is an additional consideration e.g. global sharemarkets could continue to move higher and then fall sharply to generate a 0.6% annual return over the next seven years. Or they could do the reverse, fall sharply within the next year and then float higher over the next 6 years to generate the 0.6% return.
The sequencing of returns is important for those in the retirement death zone, see my previous Post on the riskiest time of saving for and being in retirement.
Looking at the return forecasts the following observations can be made:
Within equity markets Emerging Markets are offering more value and US equities the least; and
The return expectations for Fixed Income are very dire, particularly for those developed markets outside of the US.
For comparison purposes, the long-term return of US equities is 6.5%.
The Fixed Income returns reflect that more than $US15 trillion of fixed income securities across Europe and Japan are trading on a negative yield.
Based on some measures, interest rates are at their lowest level in 5,000 years!
GMO is not alone with such longer-term market forecasts, those from Research Affiliates and State Street are provided below. They all have different methodologies and approaches to calculating their forecasts. Notably, they are all pointed in a similar direction.
This analysis highlights that outstanding returns have been delivered over the last 10 years, particularly if you are invested in the US and New Zealand sharemarkets and have had longer dated interest rate exposures.
The Balance Portfolio (60% Equities and 40%) has benefited from this environment.
The last 10 years have been amongst the best for a New Zealand investor invested in a Balanced Portfolio, if they had managed to stay fully invested during that time.
The New Zealand sharemarket has returned 13.3% over the last 10 years and New Zealand Government Bonds 5.9%. Therefore, a Balanced Fund has returned 10.3% over the last decade!
Global Equites have returned 10.0%, led higher by the US sharemarket, and Global Bonds 4.3% over the last 10 years. Globally, the Balanced Portfolio has benefited from the 35 year long decline in interest rates.
Therefore, the forecast returns are pretty frightening from a Balanced Fund perspective. Certainly, returns are not likely to be as strong over the next ten years as they have been over the last decade.
This calls into question the level diversification of a Balanced Fund of only equities and fixed income.
This issue can be considered from two angles, the need to increase the level of diversification within a Balanced Portfolio and the effectiveness of fixed income in providing diversification benefits to a Balanced Portfolio given historically low interest rates.
On the first issue, although a lack of true portfolio diversification has not disadvantaged investors greatly over the last 5-10 years, the potential to earn other sources of returns from true portfolio diversification may be of more value over the next 10 years. It is certainly a risk that should be considered and managed.
With regards the effectiveness of fixed income in diversify sharemarket risk in the future, this dynamic is best captured by the following insightful observation by Louis Grave: investors are hedging overvalued growth stocks with overvalued bonds.
What he is saying, is that given current valuations in the US of both the sharemarket and fixed income a Balanced Portfolio no longer has the degree of diversification it once had.
Of course, interest rates could fall further, and provide some offset from a falling sharemarket, as they have historically. Nevertheless, the effectiveness and extent of this offset is limited given historically low interest rates.
Most importantly, given current valuations, there is the scenario where both fixed income and sharemarkets underperform at the same time. This would be like the stagflation environment of 1970, where inflation is rising, and economic growth is muted. This is a scenario worth considering.
In my mind the biggest risks to portfolios are in longer term fixed income securities or “bond proxies”, such as slow-growth and dividend-oriented investments. Listed Property and infrastructure securities would fall into this definition.
It is quite likely that those looking for diversification benefits from listed property, global and domestic, and listed infrastructure, are likely to be disappointed. As they would had been during the Global Financial Crisis. They only provide limited portfolio diversification benefits, not true portfolio diversification.
The expected low returns environment throws up a lot of issues to consider:
True Portfolio diversification. Institutional investors accept 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. 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.
Consistent with the above, there is a growing evolution within the Wealth Management Industry, a paradigm shift which is resulting in the death of the Policy Portfolio (i.e. Balanced Portfolio).
The growing risks with traditional market indices and index funds, as highlighted by the low return forecasts.
Increased innovation within Exchange Traded Funds as investors seek to diversify their traditional market exposures.
I plan to write more on the last two points in future Posts.
They are more optimistic in relation to developed market sharemarket, with Emerging Markets outperforming developed markets, Global Listed Property underperforms both developed and emerging market equities
They see very low returns from Global Fixed Income.
A recent AB article highlights the limitation of some Target-Date Funds (Life Cycle Funds).
“With market returns expected to be lower going forward, target-date funds that invest in passively managed underlying components are at risk of underdelivering. We think diversifying beyond traditional asset classes and tapping alpha opportunities with a multi-manager structure can increase the chances of success. “
I would argue more broadly, despite the market outlook, any passive portfolio that only invests into the traditional markets of equities, bonds, and cash are not well diversified for a range of possible economic and market outcomes. They are further at risk if they take a set and forget approach to the overarching strategic asset class positioning of the fund i.e. these short-comings are not limited to passively managed Target-Date Funds.
In short, AB argue that the outlook for traditional markets (beta) is challenging. As a result, this environment pose:
“major headwinds to target-date funds as they work to provide the growth participants need. Target-date funds that invest only in traditional asset classes, such as large-cap equities and core bonds through indices, face limitations in their glide path designs. This can make it a struggle for target-date funds to meet participants’ needs in anything but a high-return, low-risk market environment. And in terms of environments, that ship has likely sailed for now.”
Further: “A lower-beta landscape challenges a popular line of thinking that says investing in funds with the lowest fees will ensure compliance with plan sponsors’ fiduciary responsibilities. Low fees aren’t the end all and be all. For one thing, focusing too much on fees could cause sponsors to overlook other factors in retirement investing that also have fiduciary implications.”
The bold is mine.
My Opinion and solution
Increase the diversification of the Target-Date Fund and more actively manage the glide path of the strategy.
There could well be a blend of active and passive strategies.
Quite obviously increasing true portfolio diversification is paramount to building robust portfolios and increasing the likelihood of achieving investment objectives.
The prospect of a low returning environment only reinforces this position.
Robust portfolios are positioned for a range of outcomes and are “forecast-free as possible”.
We all know a robust portfolio is broadly diversified across different risks and returns. Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.
Limitations of Target Date Funds
The AB article touches on the limitations of most Target-Date Funds, weather the underlying asset classes are actively or Index (passively) managed.
They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration by way of example future income requirements or likely endowments, level of income earned to retirement, or investor’s risk profile.
They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
The glide path does not take into account current market conditions.
Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:
Delays in pace of transitioning from risky assets to safer assets
May require step off the glide path given extreme risk environments
Most Target-Date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, which both suggest that the optimal strategy should also display an element of dependence on the current state of the economy.
Therefore, there is the risk that some Target-Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income. See A more Robust Retirement Income Solution is needed.
Target-Date Funds (Life Cycle Funds) focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk. The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk. A better solution is required.
The optimal Target-Date fund asset allocation should be goal based and multi-period:
It requires customisation by goals, of human capital, and risk preferences
Some mechanism to exploit the possibility of mean reversion within market
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.
Research Affiliates highlight that stocks added to market weighted indices are “routinely priced at a substantial premium to market valuation multiples (i.e., buying high), while discretionary deletions (excepting removals related to mergers, acquisitions, and other corporate actions) are routinely of deep-discount value stocks (i.e., selling low). In fact, additions tend to be priced at valuation multiples—using a blend of price-to-earnings (P/E), price-to-cash-flow (P/CF), price-to-book (P/B), price-to-sales (P/S), and (if available) price-to-dividends (P/D) ratios—that average over three times as expensive as those of deletions. This helps explain why from October 1989 through December 2017, the performance of additions lagged discretionary deletions by an average of over 2,200 basis points (bps) in the 12 months following the addition or deletion. Once investors recognize this buy-high/sell-low dynamic, they can avail themselves of some surprisingly simple ways to earn above-market returns”.
Obviously Index Fund providers understand this and may adjust their trading activities around additions and deletions from an index to minimise trading costs and impacts on performance.
A passive index solution is not passive, they are actively managed.
Nevertheless, there are costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns.
Given Index Funds look to closely match market index returns (low tracking error) they incur these costs.
Based on the Research Affiliates analysis if Index Funds were to tolerate a higher level of tracking error they would add value above the index they are tracking by avoiding the longer term costs of market index changes. This is achieved largely by delaying changes to their portfolios.
Some serious thought needs to be given when appointing a passive index provider.
What are these costs?
The costs reflect that a stock outperforms over the period from the date it is announced it will be included in a market index until the effective date (when it is added to the market index).
Similarly, stocks removed from the market index underperform the market from the date of the announcement until effective date.
Research Affiliates estimates that additions outperform the market by 5.23% on average over the period between announcement date and effective date.
They also estimate that deletions underperformed the market by 4.29% on average over the period from announcement date to the day they are removed from the market index.
A total return different of 9.52%! (this analysis was undertaken over the period October 1989 to December 2017)
Research Affiliates also estimate that over one-third of the performance differential takes place on the day the Index makes the changes (e.g. adds the new stocks and makes the deletions).
As Research Affiliates says, the additions win big before they are added to the market index and deletions lose big before they’re dropped out.
Furthermore, once a stock is added to a market index, on average it underperforms the market over the next twelve months.
Likewise, a stock deleted from the market index will on average outperform the market over the next 12 months.
There is value to be added around market index changes and more broadly the rebalancing policy of an investment portfolio.
Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.