When Alternatives to Passive Index Investing are Appropriate

There are a wide range of reasons for choosing an alternative to passive investing over and above the traditional industry debate that focuses on whether active management can outperform an index.

Reasons for considering alternatives include no readily replicable market index exists, available indices are unsuitable in meeting an investor’s objectives, and/or there are some imbedded inefficiency within the Index.

Under these circumstances a passive approach no longer becomes optimal nor appropriate.

Or quite simply, an active manager with skill can be identified, this alone is sufficient to consider an alternative to passive indexing.

Importantly, the decision to choose an alternative to passive investing is likely to vary across asset classes, investors, and time.

Also, the active versus passive debate needs to be broadened, which to date seems too narrowly focused on comparing passive investments with the average returns from active equity managers.

Framework for choosing an Alternative to Passive Investing

This article by Warren and Ezra, When Should Investors Consider an Alternative to Passive Investing?, seeks to reconfigure and broaden the active versus passive debate.

They do this by presenting a framework for a more comprehensive consideration of alternatives to passively replicating a standard capitalisation-weighted index in any particular asset class.  

In doing so they provide examples of circumstances under which a particular alternative to passive management might be preferred.

They offer no conclusions as to whether any specific approach is intrinsically superior. “Indeed, the overarching message is that best choices can vary across asset classes, investor circumstances, and perhaps even time.”

Warren and Ezra provide the following Framework for choosing an Alternative to Passive Investing:

Their framework appreciably widens the range of reasons for choosing an alternative to passive investing.

As can be seen in the Table above, they have identify five potential reasons investors should seek an alternative to passive index.

The first three reflect situations where a passive index is either unavailable or unsuitable, and two relate to investor expectations that active management can outperform passive benchmarks.

Below I have provided a description of the five reasons investors should seek an alternative to passive index.

Back ground Comments

Warren and Ezra provide some general comments on the state of the industry debate:

  • They think it is unreasonable to base broad conclusions about the relative efficacy of passive indexing on active managers’ average results in a single asset class or subclass, such as U.S. equities. They note, “What holds true in one market segment may not hold in another.”
  • They also object to the “implicit assumption that in the absence of demonstrable stock-selection skills among managers, passive index replication provides optimal exposure for investors.” This assumption does not take into account differences in investor objectives and circumstances. This is one of the core points of their article.

They maintain, what is missing in the industry debate is “recognition that appropriate structuring and management of investments may well depend on investors’ relative situations.”

Some Context

The default position for passive investing is a capitalisation-weighted (cap-weighting) index, such as the New Zealand NZSX 50 Index and US S&P 500.

Although somewhat technical, the application of a cap-weighting index rests on the three assumptions outlined below.

A breach in any of the following assumptions could justify giving consideration to an alternative approach to passive indexing.

Market efficiency.

Cap-weighting should be chosen under an assumption of perfectly efficient markets, where prices are always correct. Investors may consider alternatives if they believe markets are not fully efficient and that the repercussions of any inefficiencies can be either avoided or exploited.

Cap-weighting is aligned with investor objectives.

It is assumed that cap-weighting indices are aligned with investor objectives. However, this is not always the case. As we see below, a Defined Benefit plan most likely has different objectives relative to a cap-weighted fixed income index.

The same is true for an endowment, insurance company, or foundation.

Index efficacy.

The view of passive indexing as the default assumes that an index is available for the intended purpose. The theoretical view calls for indexes that effectively embody the market portfolio. The industry view requires indexes that deliver the desired type of asset class exposure. In practice, it is possible that for a given asset class no market index exists, or that available indexes have shortcomings in their construction.

The five reasons below for when investors might prefer an alternative to a passive approach are in situations where these three critical assumptions for passive indexing are broken. In such situations passive index is likely to be inappropriate.

The reasons below, also highlight the point that the active versus passive debate often fails to take into account differences in investor objectives and circumstances. The debate needs to be broadened.

Reason #1: No Readily Replicable Index is Available

Passive investing assumes an effective index exists that can be easily and readily replicated.

In some instances, an appropriate index to replicate is simply not available, for example:

  • Unlisted assets such as Private Equity, unlisted infrastructure and direct property
  • Within listed markets were a lack of liquidity exists it becomes difficult to replicate the index, such as small caps, emerging market equities, and high-yield debt.

In these incidences, although a passive product may be available, they “might not deliver a faithful replication of the asset class at low cost.” Accordingly passive investing is not appropriate.

Reason #2: The Passive Index Is at Odds with the Investor’s Objectives

Often a passive index is badly aligned with an investor’s objectives. In such cases an alternative approach may better meet these objectives, often requiring active management to deliver a more tailored investment solution.

By way of example:

Defined Benefit Pension Plan and tailored fixed-income mandates.

Best practice for a Defined Benefit (DB) plan is to implement a tailored fixed income mandate that closely matches expected liabilities.

In such a case a passive index approach is not appropriate given the duration and cashflows of the DB plan are unique and highly unlikely to be replicated by an investment into a passive index based on market capitalisation weights.

DB plan managers may also likely prefer more control over other exposures, such as credit quality relative to a passive index.

Such situations also exits for insurance companies, endowments, and foundations.

Notably, an individual investor has a unique set of future liabilities, represented by their own cashflows and duration. Accordingly, investing into a passive market index product may not be appropriate relative to their investment objectives. A more active decision should be made to meet cashflow, interest rate risk, and credit exposure objectives.

Listed infrastructure provides another example where the passive index may be at odds with the investor’s goals. Some investors may want to target certain sectors of the universe that provides greater inflation protection, thus requiring a different portfolio relative to that provided by a passive market index exposure.

The article also provides example in relation to Sustainable and ethical investing and Tax effectiveness.

Reason #3: The Standard Passive Index is Inefficiently Constructed

Where alternatives are available, it makes no sense to invest in an inefficient index. This represents a suboptimal approach, particularly if an alternative can deliver a better outcome.

The article presents two potential reasons an index might be inefficient and proves three examples.

They comment that an index might be inefficient for the following reasons:

  • the index is built on a narrow or unrepresentative universe; and
  • the index is constructed in a way that builds in some inefficiency.

As they highlight, these issues are best outlined through the discussion of examples. I briefly cover two.

Equities

Alternative indexing/passive approaches such as factor investing and fundamental investing are “active” decision relative to a market-capitalised index.

The basis for these alternative approaches is that equity capital market indices are flawed (Fundamental Investing) and inefficient (e.g. factor investing such as value and small caps outperform the broader market over time).

Fixed income

There are many shortcomings of fixed-income indices, the article focuses on two:

  • Fixed income indices do not fully represent the asset class. Therefore, more efficient portfolios may be built by including off-benchmark securities.
  • The largest issuers dominate fixed income indices and it can be argued these are the less attractive governments/companies to invest in, because they are most in need of funding (and hence of lower quality), or are issuing debt to take advantage of low interest rates, which are unattractive to the investor.

Reasons #4 and #5 The final two reasons are more aligned with the traditional question of whether investors can access managers that can be expected to outperform the index.

Reason #4 features that could lead to active investment managers outperforming the passive alternative in aggregate.

Active management is often defined as a zero-sum game before transaction costs, and a negative-sum game after transaction costs. Therefore, active management as a whole cannot outperform.

However, this dynamic need not apply to all investors and it is quite likely that there is a subsector of investors that can consistently outperform the index.

Therefore, a review of the environment in which managers operate might establish if they are able to maintain a competitive advantage.

The following features are outlined in the article to support such a situation:

Market inefficiency situations

Market inefficiencies offer the potential for active managers to outperform the index, nevertheless managers need to be appropriately placed to capture any excess rewards of these inefficiencies.

The following situations may provide a manager with a competitive advantage:

  • Information advantage: An active manager could have an advantage where the market is “widely populated by less-informed investors” e.g. emerging markets and small caps.
  • Preferential access to desirable assets: e.g. where active managers have better access to initial public offerings and sourcing lines of stock. In unlisted markets private equity manager has well established relationships and ability to provide capital and/or appropriate skills.
  • Economic value-add: e.g. in unlisted assets active management can add value to the underlying asset.

Opportunities arising from differing investor objectives

Opportunities for active management to benefit may exist when:

  • Some investors are comfortable with earning below-market returns e.g. investors who place greater weight on liquidity or are not willing to accept certain risk exposures
  • Investors have differing time horizons e.g. value investors exploit short-term focus of markets

Index fails to cover the opportunity set

The article makes the following points under this heading:

  • There is the potential to outperform by investing outside the index whenever the index does not provide a comprehensive coverage of the available market
  • The intensity of competition is also a factor in success or otherwise of an active manager. For example, the results on manager skill of the highly institutionalise US market may not translate into other markets and asset class where competition is less fierce.
  • Cyclicality of markets needs to be considered, with managers likely to perform in different market environments i.e. they tend to underperform when cross-sectional volatility is low, or markets are driven more by thematic forces. As they note, this has limited relevance in the long run, but may add a “timing element to any evaluation of active versus passive investment.”

Reason #5: Skilled Managers Can Be Identified

Where a skilled manager can be identified, this is a sufficient condition to adopt an alternative to passive management alone.

Nevertheless, the ability and capacity to identify a skilled manager is necessary where an alternative to passive management is to be contemplated.

The discussion makes the following points:

  • At the very least bad managers should be avoided
  • Markets can never be perfectly efficient, therefore some room exists for outperformance through skill
  • Not all fund managers are created equal, some are good and some are bad
  • The research capability and skill to identify and select a manager is an important consideration.

Implementation and Costs

It is important to note, the framework aims first to work out whether there is a case for rejecting a passive index default. The next step is then to ask how much an investor is willing to pay and how the alternative can be accessed.

“In most cases this alternative will be what is traditionally known as “actively managed investing.” In other circumstances this need not be the case, or the skills-based component may be minor.”

The cost versus the benefit and accessing the preferred alternative approach to passive index are key implementation issues.

Concluding Comments

Warren and Ezra make the point that too much of the debate on active versus Passive relies on the analysis of US equities, they think it is unreasonable to base broad conclusions about the efficiency of passive indexing on a single asset class or subclass.

They are not alone on this, as outlined on this previous Kiwi Investor Blog Post, there are many studies that challenge the conventional wisdom of active management.

For the record, please see this Post, Kiwi Wealth caught in an active storm, on my thoughts on the active vs passive debate, we really need to move on and broaden the discussion. The debate is not black vs White, as highlighted in this article, there are large grey areas.

Happy investing.

Please see my Disclosure Statement

 

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

Preparing your Portfolio for a period of higher inflation

Although inflation is not a threat currently the case for a period of higher than average inflation can be easily made.

From an investment perspective:

  1. A period of high inflation is the most challenging period for traditional assets e.g. equities and Fixed Income;
  2. Before the inflation period, as we move from the current period of deflation there is a period of reflation, during which things will feel okay for a while; and
  3. During the higher inflation period the leadership of investment returns are likely to change.

These are some of the key insights from a recent Man article, Inflation Regime Roadmap.

Following an extensive review of previous inflation/deflationary episodes Man clearly articulate the case for a period of higher inflation is ahead.

As Man note the timing of moving to a higher inflation environment is uncertain.

As outlined below, they provide a check list of factors to monitor in anticipation of higher inflation.

Nevertheless, although the timing of a higher inflation environment is uncertain, Man argue the need for preparation is not and should commence now.

Investors need to be assessing the robust of their portfolios for a higher than average inflation environment now.

Man identify several strategies they expect will outperform during a period of higher inflation.

Investment Implications

The level and direction of inflation is important.

This is evident in the diagram below, which Man refer to as the Fire and Ice Framework.

The performance of investment strategies differs depending on the inflation environment.

As can be seen in the diagram, the traditional assets of equities and bonds (fixed income securities) have on average performed poorly in the inflation periods (Fire).

Also, of note is that the benefits of Bonds in providing portfolio diversification benefits are diminished during these periods, as signified by the positive stock-bond correlation relationship.

As Man note, and evident in the diagram above, the path to inflation is via reflation, so things will feel good for a while.

Importantly, there will be a regime change, those investment strategies that have flourished over the last 10 years are likely to struggle in the decade ahead.

The expected new winners in a higher inflation environment are succinctly captured in the following diagram.

As can been seen in the Table above, Man argue new investment strategies are needed within portfolios.

These include:

  • Alternative risk premia and long-short (L/S) type strategies, rather than traditional market exposures (long only, L/O) of equities and fixed income which are likely to generate real negative returns (See Fire and Ice Framework).
  • Real Assets, such inflation-linked bonds, precious metals, commodities, and real estate.

Man also expect leadership within equity markets to change toward value and away from growth and quality. Those companies with Pricing Power are also expected to benefit.

Several pitfalls to introducing the new strategies to a portfolio are outlined in the article.

Time for Preparation is now

As mentioned the timing of a transition to a higher inflation environment is uncertain. Certainly markets are not pricing one in now.

Nevertheless, the preparation for such an environment is now. Man highlight:

  • the likelihood of an inflationary regime is much higher than it has been in recent times;
  • the investment implications of this new regime would be so large that all the things that have worked are at risk of stopping to work; and
  • given that markets are not priced for higher inflation at all, the market inflationary regime may well start well before inflation actually kicks in, given the starting point.

Man believe investors have some time to prepare for the regime shift. Nevertheless, those preparations should start now.

In addition, Man provide a check list to monitor to determine progress toward a higher than average inflation environment.

Inflation Check List to Monitor

The paper undertakes a thorough review of different inflation regimes and the drivers of them. The review and analysis on inflation makes up a large share of the report and is well worth reviewing.

Man identify five significant regime changes to support their analysis:

  1. Hoover’s Depression and Roosevelt’s New Deal (Deflation to Reflation)
  2. WW2-1951 Debt Work-down (Inflation to Disinflation).
  3. The Twin Oil Shocks of the 1970s (Inflation).
  4. Paul Volcker (Disinflation).
  5. The Global Financial Crisis (Deflation to Reflation and back again).

As noted in the list above, we are currently in a deflationary environment (again) – Thanks to the Coronavirus Pandemic.

Man expect the deflationary forces over the last decade are likely to fade in the years ahead. As a result inflation is likely to pick up. Central banks are also likely to allow an overshoot relative to inflation targets. Their independence could also be at risk.

They argue the current deflationary status quo is unsustainable, high debt levels leading to underinvestment in product assets resulting in lower levels of spare capacity and rising levels of inequality around the world will lead to policy responses by both governments and central banks that will result in a period of higher than average inflation.

They provide a checklist of factors to monitor, which includes:

  1. Inflation Momentum, which is broadly neutral currently
  2. Measures of inflation in the pipeline, which are currently deflationary
  3. Economic slack, which is large and heavily deflationary at present
  4. Labour market tightness, which is loose and heavily deflationary presently
  5. Wage inflation, currently neutral to inflationary
  6. Inflation Expectations, sending mixed signals at this time

Man conclude their dashboard is more deflationary than inflationary. They also believe this could change quite rapidly if demand picks up faster than expected.

Concluding Remarks

Man’s view on the outlook for inflation are not alone, a number of other organisations hold similar views.

Although inflation is not a problem now, it is highly likely to become of a greater concern to investors than recent history.

This will likely lead to a change in investment return leadership. Those investment strategies that have worked well over the last 10 years are unlikely to work so well in the decade ahead. Man propose some they think will perform better in such an environment, there are likely others.

A review of current portfolio holdings should be undertaken to determine the robustness to a different inflation regime. This is a key point.

The performance of real assets in different economic environments was covered in a previous Post, Real Assets offer real diversification benefits, this Post covered analysis undertaken by PGIM.

Happy investing.

Please see my Disclosure Statement

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

An Alternative Future for Kiwisaver Funds

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

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

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

 

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

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

 

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

Preqin’s estimates are staggering:

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

 

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

 

Preqin outlined the drivers of future growth as the following:

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

 

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

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

 

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

 

Happy investing.

 

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

 

Please see my Disclosure Statement

US Recession Warning Indicators

As you will know the US economy is into its second longest period of economic expansion which commenced in June 2009.

Should the US economy continue to perform until July 2019, which appears likely, the US will enter its longest period of economic expansion. The longest expansion was 10 years, occurring during the tech expansion of the 1990s, the current expansion is nine years.

Similarly, the US sharemarket is into its longest bull market run, having not experienced a drop-in value of greater than 20% (bear market) since March 2009.

As a rule, sharemarkets generally enter bear markets in the event of a recession.

 

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

Since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

 

Statistically:

  • The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  • The average Bear Market period lasted 1.3 years with an average loss of -41
  • Historically, and on average, equity markets tend not to peak until six – twelve months before the start of a recession.

 

Therefore, let’s look at some of the Recession indicators.

In a recent article by Brandywine, they ran through some of the key indicators for a US recession.

Federal Reserve Bank of Atlanta’s GDP Nowcast.

This measure is forecasting annualised economic growth of 4.4% in the third quarter of 2018. This follows actual annualised growth of 4.2% in the second quarter of 2018.

Actual US economic data is strong currently. Based on the following list:

  • US unemployment is 3.7%, its lowest since 1969
  • Consumer Confidence is at an 18 year high
  • US wages are growing at around 3%, the savings rate is close to 6%, leaving plenty of room for consumers to increase spending
  • Small business confidence is at all-time highs
  • Manufacturing and non-manufacturing surveys are at their best levels for some time (cycle highs)

 

Leading Indicators

The Conference Board’s Index of Leading Indicators, an index of 10 components that includes the likes of the ISM New Order Index, building permits, stock prices, and the Treasury yield curve.

The Conference Board’s Index is supportive of ongoing economic activity in the US.

 

Yield Curve

The shape of the yield curve, which is normally upward sloping, meaning longer term interest rates are higher than short term interest rates, has come in for close attention over the last six months. I wrote a about the prospect of a negative yield curve earlier in the year.

An inverted yield curve, where shorter term interest rates (e.g. 2 years) are higher than longer term interest rates (e.g. 10 years) has a pretty good record in predicting a recession, in 18 months’ time on average.

With the recent rise of longer dated interest rates the prospect of an inverted yield curve now looks less likely.

Albeit, with the US Federal Reserve is likely to raise short term interest rates again this year and another 3-4 times next year the shape of the yield curve requires on going monitoring.

Having said that, an inverted yield curve alone is not sufficient as a predictor of economic recession and needs to be considered in conjunction with a number of other factors.

 

Brandywine conclude, “what does a review of some well-known recession indicators tell us about the current—and future—state of the U.S. expansion? The information provided by the indicators is mixed, but favors the continuation of the current expansion. The leading indicators are telling us the economy should continue to expand well into next year—at least.”

In favour of ongoing economic expansion is low unemployment, rising wages, simulative financial conditions (e.g. low interest rates are supportive of ongoing growth, as are high equity prices), high savings rate of consumer and their low levels of debt. Lastly government spending and solid corporate profitability is supportive of economic activity over the medium term.

As a word of caution, ongoing US – China trade dispute could derail global growth. Other factors to consider are higher interest rates in combination with a higher oil price.

Noting, Equity markets generally don’t contract until interest rates have gone into restrictive territory. This also appears some time away but is a key factor to monitor.

Lastly, a combination of higher oil prices and higher interest rates is negative for economic growth.

 

I have used on average a lot in this Post, just remember: “A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 Happy investing.

 

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

 

Please see my Disclosure Statement

Trustees should be aware of the shocking cost of timing markets and what is the best solution

Cambridge Associates recently published a research report concluding it does not pay to be out of the market.

” Investors who take money out of the market too early stand to “risk substantial underperformance,”

Cambridge advised investors concerned about the length of the current bull market not to bail out of equity markets earlier than necessary in an attempt to avoid exposure to downturns.

This seems timely given current market volatility.

As the article notes, it is hard to time markets “because trying to time re-entry to get back into the markets at lower levels leads to substantially lower long-term returns, the researchers found. For example, the report showed that being out of the market for just the two best quarters since the turn of the last century cut cumulative real returns on U.K. equities by more than 50 percent.”

“That effect is even more profound in the United States, where sitting out the best two quarters cut cumulative real returns by more than two thirds, according to the report.”

“While no investor should be ignoring valuations, becoming too focused on timing an exit has substantial risks,” said Alex Koriath, head of Cambridge’s European pensions practice, in a statement accompanying the research. “The best periods for returns tend to be very concentrated, meaning that exiting at the wrong time could drag down cumulative returns significantly.”

 

This is a pertinent issue given the US sharemarket is into its longest bull market run in history. Also, of interest, historically on average, markets perform very strongly over the final stages of a bull market run. Lastly, bull markets tend to, more often than not, end six-twelve months prior to a recession. Noting, this is not always the case. Albeit, the consensus is not forecasting a recession in the US for some time. It appears, the probability of a US recession in the next couple of years is low.

The key forward looking indicators, such as shape of the yield curve, significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders are not signalling a recession is on the horizon in the US. Please see my earlier posts History of Sharemarket corrections – An Anatomy of equity market corrections

 

What is the answer?

It is difficult to time markets. AQR came to a similar conclusion in a recent article. AQR argue the best form of defence is a truly diversified portfolio. I agree and this is a core focus of this Blog.

As we know equity markets have drawdowns, declines in value of over 20%. In the recent AQR article they estimate that there have been 11 episodes of 20% plus drawdowns since 1926, a little over once every 10 years! Bearing in mind the last major drawdown was in 2008 – 09.

The average peak to trough has been -33% and on average it has taken 27 months to get back to the pre-drawdown levels.

As AQR note, we cannot consistently forecast and avoid these severe down markets. In my mind, conceptually these drawdowns are the risk of investing in equities. With that risk, comes higher returns over the longer term relative to investing in other assets.

At the very least we can try and reduce our exposure by strategically tilting portfolios, as AQR says, “if market timing is a sin, we have advocated to “sin a little””.

 

I agree with the Cambridge Associates article to never be out of the market completely and with AQR to strategically tilting the portfolio. These tilts should primarily be based on value, be subject to a disciplined research process, and focused more on risk reduction rather than chasing returns. This approach provides the opportunity to add value over the medium to longer term.

 

Nevertheless, by far a better solution is to truly diversify and build a robust portfolio. This is core to adding value, portfolio tilting is a complementary means of adding value over the medium to long term relative to truly diversifying the portfolio.

True diversification in this sense is to add investment strategies that are lowly correlated with equities, while at the same time are expected to make money over time. Specifically, they help to mitigate the drawdowns of equities. For example, adding listed property and listed infrastructure to an equity portfolio is not providing true portfolio diversification.

In this sense truly “alternative” investment strategies need to be considered e.g. Alternative Risk premia and hedge fund type strategies. Private equity and unlisted assets are also diversifiers.

Again conceptually, there is a cost to diversifying. However, it is the closest thing in finance to a free lunch from a risk/return perspective i.e. true portfolio diversification results a more efficient portfolio. Most of the diversifying investment strategies have lower returns to equities. There are costs to diversification whether using an options strategy, holding cash, or investing in alternative investment strategies as a means to reduce sharp drawdowns in portfolios.

Nevertheless, a more diversified portfolio is a more robust portfolio, and offers a better risk return outcome.

Also, very few investor’s objectives require to be 100% invested in equities. For most investors a 100% allocation to equities is too volatile for them, which raises the risk that investors act suboptimal during periods of market drawdowns and heightened levels of market volatility i.e. sell at the bottom of the market

 

A more robust and truly diversified portfolio reduces portfolio volatility increasing the likelihood of investors reaching their investment goals.

 

As AQR note, diversification is not the same thing as a hedge. Uncorrelated means returns are influenced by other risks. They have different return drivers.

From this perspective, it is also worth noting that adding diversifying strategies to any portfolio means adding new risks. The diversifiers will have their own periods of underperformance, hopefully this will be at a different times to when other assets in the portfolio are also underperforming. Albeit, just because they have periods of underperformance does not mean they are not portfolio diversifiers.

AQR perform a series of model portfolios which highlight the benefits of adding truly diversifying strategies to a traditional portfolio of equities and fixed interest.

No argument there as far as I am concerned.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is All-Passive Really the Best Thing for Target-Date Funds?

A recent AB article highlights the limitation of some Target-Date Funds (Life Cycle Funds).

AB propose:

“With market returns expected to be lower going forward, target-date funds that invest in passively managed underlying components are at risk of underdelivering. We think diversifying beyond traditional asset classes and tapping alpha opportunities with a multi-manager structure can increase the chances of success. “

 

I would argue more broadly, despite the market outlook, any passive portfolio that only invests into the traditional markets of equities, bonds, and cash are not well diversified for a range of possible economic and market outcomes. They are further at risk if they take a set and forget approach to the overarching strategic asset class positioning of the fund i.e. these short-comings are not limited to passively managed Target-Date Funds.

 

In short, AB argue that the outlook for traditional markets (beta) is challenging. As a result, this environment pose:

“major headwinds to target-date funds as they work to provide the growth participants need. Target-date funds that invest only in traditional asset classes, such as large-cap equities and core bonds through indices, face limitations in their glide path designs. This can make it a struggle for target-date funds to meet participants’ needs in anything but a high-return, low-risk market environment. And in terms of environments, that ship has likely sailed for now.”

Further: “A lower-beta landscape challenges a popular line of thinking that says investing in funds with the lowest fees will ensure compliance with plan sponsors’ fiduciary responsibilities. Low fees aren’t the end all and be all. For one thing, focusing too much on fees could cause sponsors to overlook other factors in retirement investing that also have fiduciary implications.”

The bold is mine.

 

My Opinion and solution

Increase the diversification of the Target-Date Fund and more actively manage the glide path of the strategy.

There could well be a blend of active and passive strategies.

Quite obviously increasing true portfolio diversification is paramount to building robust portfolios and increasing the likelihood of achieving investment objectives.

The prospect of a low returning environment only reinforces this position.

As mentioned in my last post, Reports of the death of Diversification are greatly exaggerated, also see my post Invest more like an Endowment, which also touches on the fee debate, investors should seek true portfolio diversification. The portfolio should be constructed to meet an investor’s objectives “through a range of potential outcomes”. There would appear to be a diverse range of likely economic and market outcomes currently.

Robust portfolios are positioned for a range of outcomes and are “forecast-free as possible”.

We all know a robust portfolio is broadly diversified across different risks and returns.   Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

 

Limitations of Target Date Funds

The AB article touches on the limitations of most Target-Date Funds, weather the underlying asset classes are actively or Index (passively) managed.

Essentially, most Target-Date Funds have two main short comings:

  • They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration by way of example future income requirements or likely endowments, level of income earned to retirement, or investor’s risk profile.

They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.

  • The glide path does not take into account current market conditions.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

      • Delays in pace of transitioning from risky assets to safer assets
      • May require step off the glide path given extreme risk environments

Most Target-Date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, which both suggest that the optimal strategy should also display an element of dependence on the current state of the economy.

 

Therefore, there is the risk that some Target-Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income. See A more Robust Retirement Income Solution is needed.

Target-Date Funds (Life Cycle Funds) focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.   The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk. A better solution is required.

 

The optimal Target-Date fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within market

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Limitations of Passive Index Investing

The short comings of investing into market index benchmarks are not widely discussed, nor understood.

Market indices suffer from two key short comings:

  1. They have exposures to unrewarded risks, they are therefore suboptimal e.g. think concentration risk, the best example of which is the Finnish Market Index which at one point Nokia made up over 50% of the Index. In New Zealand Telecom once made up over 30% of the Market Index.
  1. Poor Diversification of rewarding risk exposures e.g. they are not efficient. See discussion below.

 

The first short coming is well understood and often highlighted.  This is an issue with the current US market with the growing dominance of the Technology stocks which now make up 25% of the market.  Apple currently makes up around 4% of the S&P 500, this compares to IBM’s 7% weighting in the late 1970s.  Transport stocks dominated the S&P 500 for over 60 years in the mid-1880s to early 1900s.  Therefore unrewarded risks, such as concentration risks, have been a common feature of market indices and benchmarks.

 

The second short coming is less well understood.  In effect, market indices are poorly allocated to known risk premia from which excess returns can be generated from.

For example, and to the point, given their construction market indices are underweight the value and size premia.  These are known systematics risks for which investors are rewarded e.g. the value and size premia

 

Of course we are talking about the rise of Factor Investing, which I covered in an earlier post.

 

We are also not talking about a “factor zoo”, there are a number of limited rewarding risk premia, which are likely to include the likes of value and size (small cap), momentum, and low volatility.  Profitability, quality, and carry are potentially others to consider as well.  Implementation of Factor strategies is key.

 

Fama and French, the fathers of Finance, developed the 3 Factor model in the 1990s.  The 3 factor model includes market risk, value, and size.  It has now become a 5 factor model.  Their pioneering work forms the basis of a very successful global Funds Management business.

This stuff is not new, yet large amounts of money flow into the inefficient and sub-optimal market index funds.  Bond indices are more suboptimal than equity market indices.

 

Therefore, factor exposures provide a more efficient exposure for investors.

The go to analogy on understanding Factors comes from Professor Andrew Ang, factors in markets are like nutrients in food:

“Factors are to assets what nutrients are to food. Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It’s the nutrients in the food that matter. And similarly, the factors matter, not the asset labels.”

 

Factor investing is part of a strong movement by institutional investors away from investing into “asset classes” but thinking more about looking through asset class labels and investing into the underlying factors.

 

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 factors.

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.

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 momentum.

 

This is part of a wider shift within the global Wealth and Funds Management industry.  The industrial revolution that EDHEC Risk discusses.  There are better ways of doing things, such as Goal Based Investing.

 

Remember, Modern Portfolio Theory (MPT) is over 65 years old, it is hardly modern anymore.  Although the fundamentals of the benefits of diversification remain, greater insights have been gained over the years and more efficient approaches to building robust portfolios have been developed.

 

Happy investing.

 

Please see my Disclosure Statement

 

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


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Unintended Portfolio Risks – Fixed Interest example

A lot of investment professionals understand the issue outlined in this post.

Not so the investment public, for example KiwiSaver Investors.  Are they aware that their “Conservative” Kiwisaver Default Funds have become more risky over recent years?

And how are Investment Committees addressing the limitations of market indices?  Particularly those who blindly follow them.

It worries me with the high concentration of international fixed interest in the KiwiSaver Default Funds.  There is a lot of room for disappointment.

 

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 factors.  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

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.

 

An example of the benefits of this approach is very evident in fixed interest.

As we know, duration is a key risk factor that drives fixed interest securities. (Duration is a measure of a fixed interest securities price/value sensitivity to changes in interest rates.  The longer the duration e.g. 10 years, the great the securities price sensitivity and change in value from movements in interest rates i.e. a 90 day cash security has very little duration risk and value sensitivity to changes in interest rates.  Lastly, as interest rates increase the price/value of a fixed interest security falls.  Conversely if interest rates fall the price rises.)

 

Fixed interest indices have become more risky over the last 10 years.  Not because interest rates have reached historical lows.  Many have predicted we witnessed the end of a 35 year bull market in fixed interest markets last year.

The duration of most international fixed interest indices has increased over the last 10 years.  Duration being the measure of risk.

Therefore, fixed interest indices have become more risky from an interest rate perspective given an increase in duration.

 

By way of example, the duration of most international fixed interest indices have increased by 1.5 – 2 years over the last 8-10 years.

In a recent piece by Blackstone they noted the duration of the Bloomberg Barclays Agg Bond Index moved from 4.4 years in 2016 to 6.3 years (as of 5/2018).

Blackstone also noted that the biggest risk to investors is not recognizing that the data changed. History proves bond yields do move higher.

 

What does this mean for a number of the Kiwisaver Default Funds that have around 30% of their portfolio invested in international fixed interest?

In 2008, a 30% allocation to international fixed interest meant a duration contribution to a multi-asset portfolio of 1.65 years, assuming an index duration of 5.5 years.

In 2018, the 30% allocation to international fixed interest means a duration contribution to a multi-asset portfolio of 2.1 years, assuming an index duration of 7.0 years.

Therefore, the duration risk of the portfolio has increased by around half a year, an increase of almost a third.

As a result the multi-asset portfolio has become more volatile to movements in interest rates.

 

So what can be done?

  1. A new index with a lower duration could be used. It would need to be 5.5 years to bring the multi-asset portfolio’s risk back to levels displayed in 2008, all else equal.
  1. The portfolio allocation to global fixed interest could be reduced. The multi-asset portfolio weighting would need to be reduced to 24% from 30%, a reduction of 6%, to bring the portfolio’s duration risk back to the levels displayed in 2008, all else equal.
  1. A combination of the above.

 

However, on all occasions, Portfolio risk has been brought back to levels of 10 years ago.  Further action would be required if one had a negative view on the outlook for interest rates and wanted to de-risk the portfolio further.  Noting we are probably at the end of 35 year bull market in fixed interest.

 

This issue is often exasperated further by increasing the multi-assets portfolio’s allocation to Listed Property and Infrastructure as a means to increase yield, given a reduction in interest rates.  Listed property and infrastructure are interest rate sensitive sectors of the equity markets.

Therefore, increasing allocations to these sectors often only increases portfolio duration risk and equity risk at the same time.  Not great if interest rates increase sharply, as they have over the last year internationally.

Portfolio risk has not been reduced if a factor focused approach is taken.  A new asset class does not necessarily reduce portfolio risk, despite what a portfolio optimisation model may say!

 

In conclusion, and the key point, it is not how much international and NZ Fixed Interest to allocate to within a portfolio that is important.  What is importnat is how much duration risk should the portfolio have in meeting its investment objectives.

Investment committees should not be debating the level of allocation to international or NZ fixed interest without first considering what is the most appropriate level of portfolio duration risk to target.  This is a different conversation and focus.

Implementation of the duration target can then be made in relation to the international and NZ fixed interest allocation split.  An issue in this consideration is that NZ investors have NZ liabilities e.g. NZ inflation risk

This is a subtle but an important shift in thinking to build more robust portfolios.

 

Happy investing.

 

Please see my Disclosure Statement

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

The Market Fox interviews a Wise Owl of the Australian Investment Industry

This is worth sharing, a Podcast interview by Daniel Griolio with Jack Gray, an Australian investment industry veteran.

This is a great interview for those new and old to the industry.

 

Although Jack is wise, he is not silent like an owl.  Jack is well known to many within the industry for his forthright views, okay strong opinions.  Which is great, we need more of this to challenge the status quo and to have intellectually honest debates.  Not to make things more complicated but to challenge some of the industry practices.  Jack touches on the downside of holding strong beliefs and being willing to share them in the Podcast, it comes with a cost.  It is who he is, he calls out if he believes things are wrong.

Jack joined the investment industry later in life after a career in Academia, he talks about how he had to learn things from scratch, there are some great insights here e.g. what advice would you give to a young Jack Gray starting out?

The interview is wide ranging and Daniel does a great job keeping it flowing, with lots of good discussion, stories, and introspection.

Topics include:

  • thinking about probabilities;
  • heuristics;
  • you don’t need a lot of maths to be comfortable investing;
  • IQ vs temperament in investing successfully;
  • the short term focus of the industry;
  • industry agency issues;
  • investment firms learning to play to their strengths and being different;
  • IA; and
  • Robo Advice.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Future’s Hedge Funds

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

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

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

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

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

 

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

 

Arndt, continues:

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

 

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

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

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

 

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

 

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

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

Combined the Future Fund has a more robust portfolio.

 

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

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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

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