Liquid Alternative Investment Strategies

Investment strategies for the year(s) ahead – how to add value to a portfolio

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At this time of the year there are a plethora of economic and market forecasts for next year.  This Post is not one of them.

Outlined below are several investment strategies investors should consider in building more robust portfolios for the years ahead and to increase the odds of meeting their investment objectives.

These strategies directly address the current investment environment and the developing theme over 2020 that the traditional Balanced portfolio, of 60% equities and 40% fixed income, is facing several head winds, and likely to disappoint from a return perspective in the decade ahead.

A recent FT article captures this mood, titled: Investors wonder if the 60/40 portfolio has a future | Financial Times

In the article they make the following comment “The traditional 60/40 portfolio — the mix of equities and bonds that has been a mainstay of investment strategy for decades — is at risk of becoming obsolete as some investors predict years of underperformance by both its component parts.”

I first Posted about the potential demise of the Balanced Portfolio in 2019, see here, and again in early 2020, see here.   These Posts provide background as too why many investment professionals are questioning the likely robustness of the Balance Portfolio in the years ahead given the current investment environment.

In essence, there are two themes presented for the bleak outlook for the Balanced Portfolio.

The first is that fixed income and equities (mainly US equities) are expensive, so now may not be a great time to invest in these markets.

The second theme is that with interest rates at very low levels, there is doubt that fixed income can still effectively protect equity portfolios in a severe market decline in ways they have done historically.

For more on the low expected return environment, first Theme, see these Posts here and here.  This Post also outlines that although markets fell sharply in March 2020, forecast future returns remain disappointing.

The strategies discussed below address the second theme, the expected reduced effectiveness of fixed income to protect the Balance Portfolio at the time of severe sharemarket declines.

The Balance Portfolio has served investors well.  Although equities and fixed income still have a role to play in the future, there is more that can be done.

The strategies outlined below are “the more that can be done“, they aim to improve the risk and return outcomes for the Balance Portfolio in the years ahead.

For the record, I anticipate the global economy to continue to repair next year, experiencing above average growth fuelled by the roll out of the Covid-19 vaccines and underpinned by extraordinary low interest rates and generous government spending programs.  Global equities will continue to perform well in this environment, the US dollar will weaken further, commodity prices will move higher, value and emerging markets to outperform.

The Case for holding Government Bonds

Before looking at some of the strategies to improve on the Balance Portfolio, it goes without saying there is a role for equities in most portfolios.  The case for and against US equities are found here and here respectively.

There is also a role for holding Fixed Income securities, primarily government bonds.

This Post reviews some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It also brings some balance to present discussions around fixed income and the points within should be considered when determining portfolio allocations in the current market environment.

The central argument for holding government bonds within a portfolio: Government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

In a recent Financial Times article PIMCO argues the case for the 60/40 portfolio in equities and fixed income.   

In relation to fixed income they argue, that although “returns over the horizon may be harder to achieve, but bonds will still play a very important role in portfolios”.  The benefits being diversification and moderation of portfolio volatility.

However, they argue in relation to fixed income investors must target specific regions and parts of the yield curve (different maturity dates) to maximise return and diversification potential.

PIMCO see opportunities in high-quality assets such as mortgage-backed securities from US government agencies, areas of AA and AAA rated investment-grade corporate bonds, and emerging market debt that is currency hedged.

They conclude: “One answer for 60/40 portfolio investors is to divide fixed-income investments into two subcomponents — hedging and yield assets.”

Rethinking the “40” in the 60/40 Portfolio

This Post outlines a thinkadvisor.com article which provides a framework to consider potential investment ideas in the current extremely low interest rate environment, by examining the 40% fixed income allocation within the 60/40 Portfolio (Balanced Portfolio).

The basis of the article is that investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk. This likely involves investing into a broader array of fixed income securities, dividend-paying equities, and alternatives, such as real assets and private credit.

The Role of Liquid Alternatives and Hedge Funds

I have no doubt investors are going to have to look for alternative sources of returns and new asset classes outside equities and fixed income over the next decade.

Not only will this help in increasing the odds of meeting investment objectives, but it will also help protect portfolios in periods of severe sharemarket declines, thus reducing portfolio volatility, a role traditionally played by fixed income within a multi-asset portfolio.

The best way to manage periods of severe sharemarket declines, as experienced in the first quarter of 2020, is to have a diversified portfolio.  It is impossible to time these episodes.

AQR has evaluated the effectiveness of diversifying investments during market drawdowns.

They recommend adding investments that make money on average and have a low correlation to equities i.e. liquid alternatives and hedge fund type strategies. 

AQR argue diversification should be true in both normal times and when most needed: during tough periods for equities.  Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, they tend to do worse on average over the longer term.

Alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and have higher returns.

Lastly, Portfolio diversification involves adding new “risks” to a portfolio, this can be hard to comprehend.  Diversification can be harder to achieve in practice than in theory.

This Post provides a full summary and access to the AQR article.

The case for Trend (momentum) Strategies

A sub-set of Alternatives and hedge funds is Trend/Momentum.

In this recent article MAN present the benefits of introducing Trend following strategies to the traditional Balanced Portfolio. Man note, “Another element that we believe can be of great help to bond-equity portfolios in the future is time-series momentum, or trend-following.”

Their analysis highlights that adding trend-following results in a significant improvement relation to the Balanced Portfolio, by improving returns, decreases volatility, and reducing the degree of losses when experienced (lower downside risk – drawdowns).

The case for Tail Risk Hedging

The expected reduced diversification benefits of fixed income in a Portfolio is a growing view among many investment professionals.

This presents a very important portfolio construction challenge to address, particularly for those portfolios with high allocations to fixed income.

There are many ways to approach this challenge,

This Post focuses on the case for Tail Risk Hedging.  It also outlines other approaches.

In my mind, investment strategies to address the current portfolio challenge need to be considered. The path taken is likely to be determined by individual circumstances.

Comparing a diversified approach versus Tail Risk Hedging

On this note, the complexity, and different approaches to providing portfolio protection, was highlighted by a twitter spat between Nassim Nicholas Taleb (Tail Risk Hedging) and Cliff Asness (broad Portfolio Diversification) from earlier in the year.

I provide a summary of this debate in Table format accessed in this Post, based on a Bloomberg article. 

Several learnings can be gained from their “discussion”.

Also covered the Post was an article by PIMCO on Hedging for Different Market Scenarios. This provides another perspective and a summary of different strategies and their trade-offs in different market environments.

Not every type of risk-mitigating strategy can be expected to work in every type of market environment.

Therefore, maintaining an array of diversification strategies is preferred “investors should diversify their diversifiers”.

Hedge Funds vs Liquid Alternatives – both bring diversification benefits to a traditional portfolio say Vanguard

Vanguard recently concluded that investors should carefully consider liquid alternatives and hedge funds.

This is a very good article presenting the benefits Alternatives would bring to a Balanced Portfolio.

Their research highlighted that Hedge Funds and Liquid Alternatives both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest that liquid alternatives are often viable options for investors compared to hedge funds.

Although hedge funds and liquid alternatives deliver valuable portfolio diversification benefits, “it is crucial that investors assess funds on a standalone basis, as the benefits from any alternative investment allocation will be dictated by the specific strategy of the manager(s).”

The most important feature in gaining the benefits of hedge funds and liquid alternatives is manager selection.  Implementation is key.

Access to this research can be found here.

Private Equity Characteristics and benefits to a Portfolio

For those investors that can invest into illiquid investments, Private Equity (PE) is an option.

Portfolio analysis, also undertaken by Vanguard, demonstrates that PE can play a significant role in strategic, long-term, diversified portfolios.

PE is illiquid and so must be actively managed, introducing both illiquidity and manager specific risk to a multi-asset portfolio. Conventional asset allocation approaches often omit illiquidity and active risk dimensions from the risk-return trade-off. Therefore, these models do not reflect the unique aspects of PE and tend to over allocate to PE.

Vanguard addresses these issues: outlining four key reasons why the economic returns of private equity are different to those of public equities; highlighting the key risks that need to be accounted for when undertaking portfolio modelling including illiquid assets such as PE; and presenting the adjustments they make to portfolio modelling to address the illiquid features of PE and smoothed nature of historical returns.

This results in more realistic characteristics for PE that can be used for portfolio modelling purposes, reflected in the portfolio allocations generated in the article and the conclusion that PE can play a significant role in strategic, long-term, diversified portfolios.

A review of Vanguard’s analysis and their results can be found in this Post.

Real Assets Offer Real diversification benefits

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, Inflation-linked Bonds, Commodities, and Foreign Currencies offer real diversification benefits to a portfolio of just equities and fixed income.

The benefits of Real Assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investment portfolios where objectives are linked to inflation.

These are the conclusions of a recent study by PGIM.

PGIM provide a brief outline of the investment characteristics for several real assets. They then look at the sensitivity of the real assets to economic growth, inflation, equity markets, and fixed income.

They note there is wide diversity in real assets’ sensitivities to inflation and growth, and stocks and bonds. These sensitivities vary over time and are best mitigated by holding a portfolio of real assets.

Therefore, PGIM construct and analyse three real asset strategy portfolios – Diversification, Inflation-Protection and Stagnation-Protection to reach their conclusions.

I provide a detailed summary of the PGIM Report in this Post.

Portfolio Tilts

Adding Emerging Markets and Value tilts to a Portfolio are potential areas to boost future investment returns in what is likely to be a low return environment over the next decade.

Value of Emerging Markets

Emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.

The case for investing into emerging markets is well documented: a growing share of global economic activity in the years ahead and current attractive valuations underpin the case for considering a higher weighting to emerging markets within portfolios. Particularly considering the low interest rate environment and stretched valuation of the US sharemarket. This is evident in market return forecasts.

Is a Value bias part of the answer in navigating today’s low interest rate environment

Value offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Value is exceptionally cheap, probably the cheapest it has ever been in history, based on several valuation measures and after making adjustments to market indices to try and prove otherwise, such as excluding all Technology, Media, and Telecom Stocks, excluding the largest stocks, and the most expensive stocks.

There is also little evidence to support the common criticisms of value, such as increased share repurchase activity, low interest rates, and rise of intangible assets.

This is not a popular view, and quite likely minority view, given the underperformance of value over the last ten years.

However, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next decade.

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

The reality is that asset allocations can only do so much

/ Kiwi Investor / 1 Comment

It is estimated US public pension plans would need to leverage a Balance Portfolio of 60% equities and 40% fixed income by 47% to achieve their 7.25% actuarial return target in the years ahead. 

Such is the challenge facing all investors in the current low interest rate environment.

Investors face some very tough decisions in the future and may be forced to consider significant asset allocation shifts.  Increasing the tolerance for risk and illiquidity are likely actions required to boost future investment returns.

Investors are going to have consider something different, from a return perspective, buying bonds is not going to cut it.  Likely actions may include considering substitutes to fixed income to provide portfolio stability and some diversification during periods of equity market weakness.

The reality is that asset allocation decisions can only do so much.

These are the key conclusions from an article written by Rob Croce, PhD, of Mellon and Aaron Filbeck, that recently appeared in AllAboutAlpha.

The article covers three potential solutions for investors to consider in boosting future investment returns.

Meeting the Pension Fund Challenge

The above conclusions are determined in the context of the challenge facing US public pension plans.

On average US pension plans currently have target returns assumptions of 7.25% on average, this is down from 8% in 2000.

In the year 2000, US 10-year government bond interest rates were 6%.  Therefore there “was little headwind to meeting return objectives”….

However, with the dramatic fall in interest rates over the last 20 years, the “gap” between long-term interest rates and return assumptions has widened materially.  This is highlighted in Figure 1 below, from the article. 

The gap is currently around 6%, compared to 2% in 2000!

Figure 1: Difference Between Average Plan Actuarial Return Assumption and 10-Year US Treasury Yield

Source: NASRA, Bloomberg, CAIA calculations

What have US pension plans done over the last 20 years as the return gap has widened:

  • Reduced their allocations to fixed income;
  • Allocated more to equities; and
  • Allocated more to alternatives.

“ According to Public Plans Data, from 2001 to 2009, the average pension allocation to alternative investments increased from 8.7% to 15.7%, which only accelerated after the Global Financial Crisis (GFC). Over the next decade, allocations to alternatives nearly doubled, reaching nearly 27% by the end of 2019.”

The increased allocation to Equities and Alternatives at the expense of fixed income is highlighted in the following Figure also provided in the article.

Figure 2: Average Allocations for the 73 Largest State-Sponsored Pension Funds

Source: Pew Research. Data as of 2016

At the same time US pension plans remain underfunded. 

The challenge facing US pension plans has been known for some time, the article notes, “In general, pension trustees seem to be faced with two potential solutions – take on more (or differentiated) risks or improve funding statuses through higher taxation or slashing benefits.”

How big is the Pension Fund Return Challenge?

The article analyses potential solutions to “filling the gap” between current interest rates and the assumed target rate of return for US pension funds.

The first approach uses risk premia-based analysis, focusing on the amount of return that can be generated over and above holding just risk-free short-term US Government bonds.

Starting with a traditional Balanced Portfolio, 60% domestic stocks and 40% U.S. 10-year bonds, the analysis seeks to determine how much risk would need to be taken to reach the 7.25% return target. Assuming historical return premia, but with the current level of interest rates.

In relation to return assumptions, the Article notes “Since 1928, stocks have outperformed the risk free asset by 6.2% at 20% volatility and 10-year U.S. government bonds have outperformed the risk-free asset by 1.5%, for Sharpe ratios of 0.3 and 0.2, respectively. For cash, we have decided to use its current near-zero return, rather than its 3.3% average return during that period.”

The results, “there is effectively no unlevered portfolio of stocks and bonds that can reliably deliver many investors’ 7.25% target return over time. Because of the nature of the problem, the solution will likely force pension investors to consider taking on leverage.”

This reflects the low interest rate environment, returns on equities will be lower on an absolute return basis.  Although equities are still expected to earn a “premium” above cash, the absolute return will be lower given the cash rate is so low (0%). The 6% equity premium is earnt on 0%, not the average 3.3% cash rate since 1928. 

The article estimates, for the Balance Portfolio to achieve the 7.25% return objective it would need to be levered by 47%.  This would increase the Portfolio’s volatility to 17.75% from 12%.

As they note, this is not a sustainable solution.  Nevertheless, it provides an indication of how much more risk needs to be taken to achieve the 7.25% return target in the current low interest rate environment.

Therefore, the article highlights the return challenge all investors face.  The leveraging of portfolios is not going to be a viable option for most investors.

The Potential Role of Alternatives

The article looks at two “hypothetical alternative allocations as potential solutions for U.S. pension funds to hit their 7.25% return, one illiquid and the other liquid.”

  1. Private Equity (illiquid).
  2. Hedge Funds or Diversified Assets (liquid)

Their analysis seeks to achieve the return outcome of 7.25% with less volatility than the levered Balance Portfolio above of 17.75% with an allocation to Private Equity and Liquid Alternatives separately.

Based on their analysis, and assumptions, they conclude the inclusion of Private Equity and Liquid Alterative strategies could help in reaching the 7.25% return assumption.

They note that Private Equity and Liquid Alternatives are “two examples provide different solutions for the same problem”.

The article also notes that there are many strategies that do not make sense e.g. anything that takes them further from their return target for the sake of diversification or anything illiquid with an expected return below their target portfolio return.

Key insights

The article wraps up with some key insights, including “buying bonds isn’t going to cut it from a return target perspective today,”…..

They also demonstrated that to meet return targets US pension plans are going to have consider something different.  “And while each pension fund is different, risk tolerance and liquidity needs will need to be managed.”

“We think that the current, low yield environment could potentially open institutions up to the idea of using low-risk liquid absolute return strategies as substitutes for fixed income investments. We believe they will increasingly look for investments that provide portfolio stability values and some diversification during risk-off environments, similar to that of traditional fixed income, but potentially provide the return of fixed income two decades ago.”

Reading this article made me think of the following John Maynard Keynes quotes:

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”

“When my information changes, I alter my conclusions. What do you do, sir?”

“It is better to be roughly right than precisely wrong.”

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

Perspectives of the Hedge Fund Industry

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

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

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

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

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

 

Summary of the Report’s Executive Summary

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

 

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

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

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

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

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

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

 

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

Happy investing

 

Key quotes from within the Report:

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

 

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

 

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

 

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Factor Investing

/ Kiwi Investor / 7 Comments

Factoring Investing, along with Alternative Investment Strategies, true portfolio diversification, Goal Based Investing (Liability Driven Investing), building robust investment portfolios, behavioural economics, and Responsible Investing, will be key themes of future blogs.

I thought this was a good article to cover as the first blog on Factor Investing:  The Case For Adding Factors To Your Portfolio.

This is a good article for those new to Factor Investing or at the beginning of considering the addition of factor exposures into a portfolio.  There are many articles like this from other provides.

 

A few of key points from the article:

  1. A factor can be thought as any characteristic relating a group of securities that is important in explaining their return and risk.
  1. Factor Investing is not new. It has been around for sometime within the industry, Value and Growth in the old days.  The drivers of value and momentum have been recognised by academics and professionals for decades.

What has changed, particularly over the last 5 years, is the technology that makes it easier and cheaper to capture market factors.

  1. There are not that many rewarding factors, Value, Quality, Momentum, Size and Minimum volatility are the most robust, Carry is another (I’ll blog separately on what each of these are).

Most of these factors can be found across most “asset classes” e.g. equities, fixed interest, commodities and currencies.

  1. Factors exposures can be used to determine if an active manager is adding true excess returns (alpha – risk adjusted excess returns), or just providing a market factor exposure which can be gained cheaply. It is a tough environment for active investors, they are being squeezed by passive index funds and cheaper factor funds (sometime referred to as smart beta strategies).  Albeit, a high level of sophistication is required in developing an effective factor investment strategy.
  1. Factor investing can deliver more efficient portfolios. This means better reward for risk taken.  Well-constructed factor investment strategies eliminate or reduce the exposure to unwanted and un-reward market risks. The article uses an America’s Cup analogy of reducing frictions to make the boat go faster– note New Zealand is the current holder of the America’s Cup.

Therefore, factor investment strategies can provide a more efficient portfolio outcome than selecting Industry Sectors or active management by way of example.

  1. Not all factors will perform equally well at every moment. Factors can underperform the wider and broader equity market and the other factors for long periods of time e.g. the Value factor has underperformed the broader global equity index for about 10 years currently!

Therefore, diversification across the factors is often recommended.

 

From a more advanced perspective, a portfolio that invests across multiply factors across multiply asset classes, and that can invest both long and short, e.g. go long stocks with favourable rewarding factors and sell short those stocks that do not display the rewarding factors, is likely the most efficient means of factor investing.  Such a strategy could well make up an allocation within a Liquid Alternatives Investment Strategy.

 

As an aside and not to confuse:

The above factors e.g. value, momentum and carry are factors that can be used to explain the drivers of securities within an asset classes e.g. equities fixed interest, and currencies

There are also macro factors, these explain at a higher level what drives a multi-asset portfolio.  Macro factors can explain more than 90% of returns across a multi-asset portfolio.  These macro factors can be used to determine an appropriate allocation to the different asset classes e.g. equities versus fixed interest exposures given preferred risk tolerance and investment objectives.

Macro factors include, economic growth, real interest rates, inflation, credit, emerging markets, and liquidity.  This is a topic for a future blog.

 

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