The reality is that asset allocations can only do so much

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.”

Please see my Disclosure Statement

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

Perspectives of the Hedge Fund Industry

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

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

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

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

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

 

Summary of the Report’s Executive Summary

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

 

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

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

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

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

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

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

 

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

Happy investing

 

Key quotes from within the Report:

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

 

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

 

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

 

Please see my Disclosure Statement

Factor Investing

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.

 

Please see my Disclosure Statement