Huge growth. Why is the Multi-Asset Portfolio so Popular?

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

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

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

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

 

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

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

 

The Concept: Absolute returns and better risk management

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

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

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

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

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

 

Return Expectations

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

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

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

 

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

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

 

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

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

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

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

 

Growth in Multi-Asset Portfolios to continue

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

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

 

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

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

 

Concluding Remarks

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

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

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

 

Happy investing.

Please read my Disclosure Statement

 

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

Past Decade of strong returns unlikely to be repeated

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

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

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

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

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

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

 

Past Returns

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

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

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

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

 

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

 

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

 

Future Return Expectations

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

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

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

 

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

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

 

US Bond Returns vs. US Starting Bond Yields

US Bond Returns vs US Starting Bond Yields

 

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

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

 

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

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

 

Expected Returns from a Balanced Portfolio

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

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

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

 

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

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

 

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

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

Forewarned is forearmed.

 

Global Pension Crisis

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

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

 

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

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

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

 

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

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

 

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

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

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

 

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

 

Happy investing.

Please read my Disclosure Statement

 

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

Target Date Funds – 25 Years of US Learnings

Launched in 1994, target-date funds now boast assets of more than $2 trillion in the US, according to a recent Wealth Management.com article, Target-Date Funds Aging Gracefully

The article concludes: “Naturally it is difficult to foresee how target date funds will evolve over coming decades, as the list of potential innovations is endless, but one thing is certain: the benefits target-date funds present both to plan participants and sponsors ensure they will play a dominant role in building comfortable retirements for years to come.”

The growth Target-Date Funds (TDF) has significantly changed the Defined Contribution (DC), superannuation, industry in the US.

TDF are also referred to as Life Stages or Life Cycle strategies.

 

Since their launch in 1994 TDF have become to dominate DC plans. According to the Wealth Management.com article total assets in TDF mutual funds alone have grown from about $278 million at the end of 1994 to more than $1.2 trillion in the second quarter of 2019.

Considering other investments, it is estimated that $2 trillion or about 25% of total DC assets today are invested TDF.

 

Why the Growth?

The growth in TDF can be attributed to their appeal to those saving for retirement (Participants) and those offering investment solutions e.g. Sponsors such KiwiSaver Providers.

For the Participant, TDF remove the “burden of creating an asset allocation strategy and choosing the investments through which they would execute it.” Participants do not need to make complicated investment decisions.

For Sponsors, they can “streamline their investment offering (reducing complexity and administrative costs), while meeting their fiduciary responsibility to participants.”

Also, and of particular interest given New Zealand is currently reviewing the Default option for KiwiSaver, TDF have also experienced a significant boost from the enactment of the Pension Protection Act (PPA) in 2006.

As noted by the Wealth Management.com article “The PPA relieved plan sponsors from fiduciary responsibility for investment outcomes if they provided a suitable Qualified Default Investment Alternative (QDIA), such as TDFs, to anyone auto-enrolled in their plans. The combination of auto enrollment and safe harbor relief for plan sponsors paved the way for the wide adoption of TDFs.”

 

Future Growth and Innovation

The growth of funds invested into TDF is expected to grow, primarily from the ongoing innovation of the vehicle.

It is likely that the TDF will evolve into the key investment vehicle over the complete lifecycle of an investor, not only by accumulating capital for retirement (Defined Contribution Fund) but also helping generate a stable and secure income once in retirement (Defined Benefit Fund).

A recent enhancement to TDF is the addition of Guaranteed-income options. These Funds convert into a personalised investment plan for those seeking the security of a guaranteed income for life.

TDF offering guaranteed income are available now in the US, but they have not been widely embraced by either participants or plan sponsors. They do face a higher fee hurdle to be adopted. Albeit, the Wealth Management.com article notes “TDFs offering guaranteed income are likely to gain traction in the DC space. Participants contemplating decades in retirement naturally have concerns about outliving their savings, and guaranteed-income TDFs address that anxiety.”

 

The innovation and focus of these Funds is consistent with the framework proposed by EDHEC Risk Institute, as I outlined in the Post: A more Robust Investment Solution

They are also consistent with the Next Generation of Retirement solutions promoted by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012. I summarise Professor Merton’s Paper in this Post: Designing a new Retirement System, which is the most read Kiwi Investor Blog Post.

 

Such considerations will greatly increase the efficiency of TDF.

These solutions are about making Finance great Again (Flexicurity in Retirement Income Solutions – making finance great again)

 

New Zealand Perspective

TDF would make more sense as a Default KiwiSaver solution, and stack up better relative to a Balanced Fund option (Balanced Funds not the Solution for Default Kiwi Saver Investors).

Lastly, the criticism of TDF is often due to poor design (In Defence of Target Date Funds).

An example is a large Kiwi Saver provider promoting a 65+ Life Stages Fund which is 100% investment in Cash. This is scandalous as outlined in this research by Dimensional, this research is summarised in the Post High Cash holdings a scandalous investment for someone in retirement.

 

 

Happy investing.

Please read my Disclosure Statement

 

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

The opportunity and role of active management

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

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

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

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

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

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

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

The RBC article is well worth reading.

 

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

 

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

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

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

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

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

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

 

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

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

 

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

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

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

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

 

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

 

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

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

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

 

The Role of Active management within a portfolio

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

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

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

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

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

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

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

 

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

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

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

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

 

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

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

 

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

 

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

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Beginners guide to Portfolio Diversification. And why Portfolios Fail.

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

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

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

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

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

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

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

 

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

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

 

Highlights of the BlackRock article are provided below.

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

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

Currently, many New Zealand investors are missing out.

 

What happened during the GFC?

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

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

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

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

 

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

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

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

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

 

What is the difference between Portfolio Diversification and Portfolio Construction?

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

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

Investors should not think in terms of asset class diversification.

More asset classes does not equal more Portfolio Diversification.

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

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

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

 

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

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

 

What does this look like?

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

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

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

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

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

 

Low Correlated investments

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

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

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

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

 

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

 

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

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

 

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

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

 

Summary

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

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

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

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

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

 

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Reported death of the 60/40 Portfolio

The reported death of 60/40 portfolio, may well be exaggerated, but it certainly is ailing.

As reported by Think Advisor in relation to the 60/40 Portfolio (60% listed equities / 40% fixed income):

“No less than three major firms have issued reports in the last few weeks declaring it dead or ailing: Bank of America Merrill Lynch, Morgan Stanley, and JPMorgan.” 

All three firms have similar reasons:

  • Low expected returns, particularly from Fixed Income
  • Reduced portfolio diversification benefits from Fixed Income

For example, JP Morgan: “Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” “The days of simply insulating exposure to risk assets with allocation to bonds are over.” (A risk asset example is listed equities.)

 

With regards to the declining diversification benefits from Fixed Income in a portfolio Bank of America make the following point: Fixed Income (Bonds) have functioned as an offset to equity market loses over the last 20 years, this may not occur in the immediate future.

Technically, fixed income has had a negative correlation to equity markets over the past 20 years, interestingly, this did not prevail in the prior 65 years.

 

Underpinning these views is the expectation of lower investment returns than experienced over the last 10 years. Access to JP Morgan’s Longer-term Capital Market assumptions are provided in the article.

There is no doubt we are living in challenging times and we are heading into a low return environment.  I covered in this in a previous Post: Low Return Environment Forecasted.  This Post provides an indication of the level of returns expected over the next 5 – 10 years.

 

What to do?

JPMorgan strategists are calling for “greater flexibility in portfolio strategy and greater precision in executing that strategy.”

I agree, to my mind, a set and forget approach won’t be appropriate in a low return environment, where higher levels of market volatility are also likely.

Naturally they are calling for a greater level of portfolio diversification and are recommending, Corporate bonds, Emerging market equities and bonds, U.S. real estate, Private equity, and Infrastructure investment.  The last three are unlisted investments.

 

 

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, more advanced approaches are available.

For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

The current market environment might quicken the evolution in portfolio construction.

 

Modern day Portfolios should reflect the lessons learnt over time, particularly from the Dot Com market collapse and the Global Financial Crisis (GFC or Great Recession).

Understanding the history of Portfolio Diversification is important. Modern Portfolio Theory (MPT) was developed in the 1950s and resulted in the 60/40 portfolio.

Although MPT is still relevant today, the Post on the Short History of Portfolio Diversification highlights much more has been learnt since the 1950s.

 

Furthermore, we can now more easily, and more cheaply, gain greater portfolio diversification.  This includes an increasing allocation to alternative investment strategies and smarter ways to access investment returns.

This in part reflects the disaggregation of investment returns as a result of increased computer power and advancements in investment research.

As a result, Portfolios do not need to be over reliant on equities and fixed income to generate returns. A broad array of risks and return sources should be pursued.

This is particularly important for portfolios that have regular cashflows.  High listed equity allocations in these portfolios is a disaster waiting to happen e.g. Charities, Foundations, Endowments.

While those near or just entering retirement are vulnerable to Sequencing Risk and should look to diverse their portfolio’s away from listed equities.

 

There is still a place for active management, where real skill and truer sources of excess return are worth exploring and accessing. In fact, they complement the above developments.

There are shades of grey in investment returns, as a result the emotive active vs passive debate is out-dated.

 

I think KiwiSaver Investors are missing out and their portfolios should be more diversified.

 

Happy investing.

Please see my Disclosure Statement

 

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

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.

 

 

Kiwi Investor Blog achieves 100 not out

Kiwi Investor Blog achieves 100 Posts.

Thank you to those who have provided support, encouragement and feedback. It has been greatly appreciated.

 

Before I briefly outline some of the key topics covered to date by Kiwiinvestorblog.com, the “intellectual framework” for the Blog has largely come from EDHEC Risk Institute in relation to Goals-Based investing and how to improve the outcomes of Target Date Funds in providing a more robust investment solution.

Likewise, Noble Laureate Professor Robert Merton’s perspective on designing an appropriate retirement system has been influential. Regulators and retirement solution providers should take note of his and EDHEC’s work.

Combined, EDHEC and Professor Merton, are helping to make finance useful again.

Their analysis into more robust retirement solutions have the potential to deliver real welfare benefits for the many people that face a challenging retirement environment.

A Goals-Based approach also helps the super wealthy and the High Net worth in achieving their investment and hopefully philanthropic goals, resulting in the efficient allocation of capital.

The investment knowledge is available now to achieve this.

 

To summaries, the key topics of Kiwi investor blog:

 

  • Likewise, much ink has been spilt over Target Date Funds. I believe these are the vehicle to achieving the mass production of the customised investment solution. Furthermore, they are likely to be the solution to the KiwiSaver Default option. The current generation have many shortcomings and would benefit by the implementation of more advanced investment approaches such as Liability Driven Investing. This analysis highlights that Target Date Funds that are 100% invested in cash at time of retirement are scandalous.

 

 

  • The first kiwiinvestorblog Post was an article by EDHEC Risk Institute outlining the paradigm shift developing within the wealth management industry, including the death of the Policy Portfolio, the move toward Goals-Based Investing and the mass production of customised investment solutions. These themes have been developed upon within the Blog over the last 22 months.

I covered the EDHEC article in more depth recently.

 

 

  • The mass production of customised investment solutions has been a recurrent topic. Mass customisation enabled by technology will be the Uber Moment for the wealth management industry. Therefore, the development of BlackRock and Microsoft collaborating will be worth following.

 

 

 

  • Several Posts have been on Responsible Investing. I am in the process of writing a series of articles on Responsible Investing. The next will be on Impact Investing. The key concern, as a researcher, is identifying those managers that don’t Greenwash their investment approach and as a practitioner seeing consistency in terminology.  The evidence for Responsible Investing is compelling and there is a wide spectrum of approaches.

 

 

  • There has been a focus on the issues faced by those near or in Retirement, such as the Retirement Planning Death Zone. These discussions have led to conclusion that Warren Buffet could be wrong in recommending high allocations to a low cost index funds. Investment returns are greatly impacted by cashflows into and out of the retirement fund.

 

  • I don’t tend to Post around current market conditions; market views and analysis are readily available. I will cover a major market development, more to provide some historical context, for example the anatomy of sharemarket corrections, the interplay between economic recession and sharemarket returns, and lastly, I first covered the topic of inverted yield curves in 2018.  I provided an update more recently, Recessions, inverted yield curves, and Sharemarket returns.

 

My word for 2019 is Flexicure, as outlined in my last Post of 2018, Flexicurity in Retirement Income Solutions – making finance great again – which brings together many of the key topics outlined above.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Low Return Environment Forecasted

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.

The most often referenced longer-term return forecasts are the GMO 7 Year Asset Class Forecast.

As at 31 July 2019 they estimated the real returns (returns after 2.2% inflation) for the following asset classes as follows:

Share Markets

Annual Real Return Forecasts

US Large Capitalised Shares

-3.7%

International Shares

0.6%

Emerging Markets

5.3%

   
Fixed Income Markets  
US Fixed Income

-1.7%

International Fixed Income Hedged

-3.7%

Emerging Debt

0.7%

US Cash

0.2%

 

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.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Research Affiliates – 10 Year Forecast Real (After Inflation)

Share Markets

Real Return Forecasts

US Large Capitalised Shares

0.7%

International Shares

3.2%

Emerging Markets

7.7%

   
Fixed Income Markets  
US Fixed Income

-0.8%

International Fixed Income Hedged

-0.5%

Emerging Debt

4.2%

US Cash

-0.3%

 

State Street also provides:

  • 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.

Designing a new Retirement System and Goal-Based Wealth Management

This Post covers an article by Nobel Laureate Professor Robert Merton: Funding Retirement: Next Generation Design, which was written in 2012.

It is a relatively long but easy article to read, very entertaining, he is a wonderful conversationalist with some great analogies.

It should be read by all, particularly those interested in developing a robust Retirement System.

The concepts underlie a move globally to the development of more innovative investment solutions to meet a growing need from those in retirement.

I have tried to summarise his concepts below, probably without full justice.

 

Before we begin, it is important to emphasis, what Professor Merton has in mind is a retirement system that supports a mass produced and truly customised investment solution.

This is not a hypothetical investment strategy/approach he is advancing, cooked up in a laboratory, investment strategies are already in place in Europe and the United States based on the concepts outlined in his article.

These concepts are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions. The performance of these solutions and those provided by the likes of BlackRock can be tracked by the indices they produce.

The behavioural finance aspects of these approaches are outlined in a previous Post.

Merton begins

Due to excessive complexity in investment choices and a focus on the wrong goals, hundreds of millions of low- to middle-income earners face a precipitous decline in their living standards upon their departure from the workforce.

But it doesn’t have to be that way. Technology, innovation and our understanding of what are meaningful choices about retirement funding mean we are now in a position to design a better system that serves all people, not just the wealthiest ones.

 

And he concludes:

In designing a new retirement system, Merton argues first we need to define the goal. He defines the goal as helping participants achieve income throughout retirement, adjusted to keep pace with inflation.

Merton notes, the current system is no longer sustainable and requires individuals to make overly complex investment decisions and the industry bombards them with jargon that is meaningless to them.

Therefore, he argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.

This requires customisation of the investment strategy. Asset allocation strategies should be personalised. And, each individual is given regular updates on how “they” are travelling in ways that make sense to them.

However, unlike simple target-date funds that mechanically set the asset allocation using a crude calculation based on a single variable — the participant’s age — Merton proposes a customised, dynamically managed solution based on each participant’s tailored goals for desired outcomes, life situation, expected future contributions and other retirement-dedicated assets, including current savings accumulated, and any other retirement Benefit entitlements.

To improve effectiveness of engagement of the Participant, all of the complexity of the investment strategy is kept under the bonnet, out of sight. The user is asked a series of simple questions around their essential and their desired income targets. Once they achieve a very strong likelihood (more than 96 per cent) of reaching that desired income, they lock in an asset allocation to match that desired lifetime income at retirement.

Merton concludes, this is not a hypothetical investment strategy/approach. Such strategies are currently being implemented in Europe and the United States.

And, it begins and ends with turning the focus back onto what superannuation should be about — ensuring people have adequate incomes in retirement.

 

Therefore, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.  Such a strategy limits the downside and upside relative to the investment objects – narrowing the variation of likely outcomes relative to a desired level of income in retirement.

Therefore, it increases the probability of reaching a desired level of income in retirement.

 

 

Now to the Body of the Article:

Background

Merton identifies the shortcomings of the current retirement system, particularly the shift from Defined Benefit (DB) to Define Contribution (DC) has burdened the users with having to make complex decisions about issues in which they have no knowledge or expertise.

The current system is far from ideal.

Therefore, in considering how to reshape the system, Merton argues we should start by establishing the goal.

What are members seeking to achieve?

To his mind, people “want an inflation adjusted level of funding that allows them to sustain the standard of living in retirement that they have grown accustomed to in the final years of their working lives.”

Merton then asks: How do we define a standard of living in financial terms?

Traditionally this has been a sufficiently large lump sum. “Indeed, that is the premise of most DC plans, including most in the Australian superannuation system. The focus is on amassing a sufficiently large lump sum in the accumulation phase“.

However, “in reality, when talking about a standard of living, people think of income”.

For example a Government sponsored pension is described in terms of an annual/weekly payment. Likewise DB plans were expressed as income per year for life and not by its lump-sum value.

This is why DB plans were so attractive to the investor. The income was to be received and there were no complex decisions to be made.

Contrast this to the DC system, there is a mirror of products and investment decisions that need to be made and it is no wonder people sit in default funds and are not engaged.

 

Furthermore, over and above the complexity Merton notes: “most DC plan allocations take no account of individual circumstances, including human capital, housing and retirement dedicated assets held outside the DC plan. Those are all important inputs for an allocation decision customised to the needs of each person.”

Therefore, he argues the next generation of retirement solutions need to meet the following criteria:

  • To be robust, scalable, low-cost investment strategies that make efficient use of all dedicated retirement assets to maximise the chance of achieving the retirement income goal and manage the risk of not achieving it.
  • A risk-managed customised solution with individually tailored goals for each member — taking into account his or her age, salary, gender, accumulation plan and other assets dedicated to retirement.
  • A solution that is effective even for individuals who never provide information or who never become involved in the decision making process at all. And, for those who do become engaged, we need a solution that gives them meaningful information about how they are travelling and what they can do if they are not on track to achieve their retirement income goals.
  • Allows plan sponsors (or pension fund trustees) to control their costs and eliminate balance sheet risk.

 

Next-generation retirement planning

Merton argues: “The simplest retirement solution is one in which the members do absolutely nothing. They provide no information and make no decisions. In fact, they are not engaged in the process at all until they reach retirement.”

He acknowledges that such extreme behaviour is rare, nevertheless, a well-designed retirement solution would display such characteristics.

It has to be to a standard that when members do engage “(it) enhances the chances of success in achieving the desired income goal.”

 

But how is that achieved?

Investment solutions need to be designed based on questions that are meaningful for people, such as:

  • What standard of living do you desire in retirement?
  • What standard of living are you willing to accept?
  • What contribution or savings rate are you willing or able to make?

 

The key point of these questions: 

“Such questions embed the trade-off between consumption during work life and consumption in retirement and they make sense to people, unlike questions about asset allocation.”

Importantly the focus is not on what investments you should have or your “risk preference”, it is on what are your retirement goals.

 

The objective is to create a simple design with only a handful of relevant choices.

Merton also argues that “we need a design that does not change, at least in the way that users interact with it. An unchanging design leads to tools that people will be more likely to learn and use. In fact, a design that is unchanging is almost as important as a design that is simple.“

Something simple and consistent is easier for people to learn and remember than something complicated and changing.

 

A point made in the article, is that the design can be simple, but what is underneath can be complex. The underlying investment solution needs to flexible and innovative to improve performance over time. Not fixed, rigid, and independent of the changing market environments.

“We must, therefore, design a system that is user friendly, one that people can become familiar with and thus are willing to use — a system in which the designers do the heavy lifting, so users need only make lifestyle decisions that they understand and the system then translates into the investment actions needed to achieve those goals.”

 

 

Wealth versus sustainable income as the goal

The second dimension is the use of wealth as a measure of economic welfare.

Merton makes a strong case Income is what matters in retirement and not how big your pot of money is i.e. Lump sum, or accumulated wealth.

It is often said that if you have enough money you will get the income and everything will be fine. This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

By way of example: A New Zealander who retired in 2008 with a million dollars, would have been able to generate an annual income of $80k by investing in retail term deposits. Current income on a million dollars would be approximately $30k if they had remained invested in term deposits. That’s a big drop in income (-63%) and also does not take into account the erosion of buying power from inflation.  You would be a bit concerned if you lost 63% of your lump sum!

The point being, knowing you had a million dollars did not tell you about a lifestyle that could be supported in retirement.

Focusing on accumulated wealth does not distinguish between the standard of living and wealth as the objective.

As Merton says “Sustainable income flow, not the stock of wealth, is the objective that counts for retirement planning.”

 

Investment Reporting

Merton makes another, and important point, the reporting of Investment results to members is not trivial. Crucially what is reported to members by providers heavily influences behaviour e.g. volatility of capital as a measure of risk influences behaviour, often bad behaviour.

Therefore, the measure of risk is important.

From this perspective, in Merton’s mind reporting should focus on the level of income that will be generated in retirement. This is the most important measure. The volatility of likely income in retirement is a better measure risk.

And from this standpoint it is encouraging that KiwiSaver providers are required to include retirement savings and income projections in annual statements sent to KiwiSaver members from 2020 onwards.

 

Essential and desired income goals – Goals-Based Investing

The system Merton is describing “seeks to increase the likelihood of reaching nominated income goals by sacrificing the possibility of doing significantly better than desired”.

In effect he is seeking to narrow the likely outcomes, technically speaking the “distribution” of income outcomes in retirement.

We do this by focusing on desired and essential target income goals.

These goals are what the member would see as a good retirement income given their set of circumstances and on how much risk would be acceptable in achieving those goals.

The desired income goal would be defined as a level of income that while not guaranteed, has a very high probability of being achieved and which serves to indicate the degree of risk of the member’s strategy.

Therefore, the investment objective is to maximise the estimated probability of achieving a desired level of income in retirement.

Accordingly, as the probability of reaching the desired level of income in retirement rises risk is reduced so as to “lock in” the chances of achieving the goal at retirement.

As Merton notes “by taking as much risk as possible off the table when it is no longer needed, we are trading off the possibility of achieving ‘even more’ against increasing materially the probability of achieving the goal.”

In this way, the investment strategy is focused entirely on achieving the retirement income goal, no consideration is given to achieving more than that goal.

Such a strategy limits the downside and upside relative to the investment objects – narrows the variation of likely outcomes relative to the desired level of income in retirement.

Therefore, it increases the probability of reaching desired level of income in retirement, particularly relative to a less focussed investment strategy.

 

Pension Alerts

Merton recommends that should a Member’s progress suggest they have a less that say 50% probability of reaching their retirement income goal they are contacted.

At which point in time they have three options:

  1. increase their monthly contributions;
  2. raise their retirement age; and/or
  3. take more risk.

The Member gets these alerts during the accumulation phase. This can be formal systematic process under which the plan sponsor and trustees, as part of their fiduciary responsibilities, seek to guide that member to a good retirement outcome.

 

Happy investing.

 

Please see my Disclosure Statement

 

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