New Zealand Investment Portfolios

Is a value bias part of the answer in navigating today’s low interest rates?

/ Kiwi Investor / 1 Comment

The Value Factor (value) offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Exploring an array of different investment strategies and questioning the role of bonds in a portfolio are key to building a robust portfolio in the current low interest rate environment.

There will also be a need to be more dynamic and flexible to take advantage of market opportunities as they arise.

From this perspective, a value tilt within a portfolio is one investment strategy to consider in potentially boosting future investment returns.

The attraction of Value

Evidence supporting a value tilt within a robust portfolio is compelling, albeit opinion is split.

Nevertheless, longer-term, the “Rotating into Value stocks offers substantial upside in terms of return versus the broad market” according to GMO.

GMO presents the case for a value tilt to navigate today’s low interest rates in their Second Quarter 2020 Letter, which includes two insightful articles, one by Ben Inker and another by Matt Kadnar. 

Value is at cheapest relative to the broader market since 1999, based on GMO’s analysis.  Value is in the top decile of attractiveness around the world, as highlighted in the following figure.

Spread of Value for MSCI Regional Value Factors (GMO)

As of 6/30/2020 | Source: MSCI, Worldscope, GMO

Is Value Investing Dead

As mentioned, the opinion on value is split.

A research paper by AQR earlier in the year addressed the key criticisms of value, Is (Systematic) Value Investing Dead?

For a shorter read on the case for value Cliff Asness, of AQR, Blog Post of the same title is worth reading.

AQR’s analysis is consistent with GMO’s, as highlighted in the Graph and Table below.

The Graph below measures the Price-to-Book spread of the whole US sharemarket from December 1967 to March 2020.

This spread was at the 100th percentile versus 50+ years of history on the 31 March 2020 i.e. value is at it cheapest based on 50 years of data.

Price-to-Book Spread (AQR)

Asness’s Blog Post highlights “expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive.” (March 2020).

It is the same story when looking at different measures of value for the US sharemarket, as highlighted in the Table below.

Value is at its cheapest on many measures (AQR)

‘Don’t ask the barber whether you need a haircut’

This quote by Warren Buffett springs to mind when considering the analysis from GMO and AQR, both being value orientated investors.  As Asness states, AQR has a horse in the race.

However, as outlined in his Post, he undertakes the same analysis as above and controls for, just to name a few:

  • Excluding all Technology, Media, and Telcom Stocks
  • Excluding the largest stocks
  • Excluding the most expensive stocks
  • Industry bets
  • Industry neutrality
  • Quality of company

Analysis is also undertaken using other measures of value, Price-Sales, P/E, using trailing and forecast earnings (these are in addition to Price-Book).

The attraction of value remains based on different measures of value and when making the adjustments to market indices as outlined above.

Asness argues value is exceptionally cheap, probably the cheapest it has ever been in history (March 2020).

The AQR analysis shows this is not because of an outdated price-to-book nor because of the dominance of highly expensive mega-cap stocks.  Investors are paying more than usual for stocks they love versus the ones they hate.  There is a very large mispricing.

The AQR research paper mentioned above, looked at the common criticisms of value, such as:

  1. increased share repurchase activity;
  2. the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems;
  3. the changing nature of monetary policy and the potential impact of lower interest rates; and
  4. value measures are too simple to work.

 Across each criticism they find little evidence to support them.

Are we there yet?

We do not know when and how the valuation gap will be closed. 

Nevertheless, the evidence is compelling in favour of maintaining a value tilt within a portfolio, and certainly now is not the time to give up on value.

This is not a widely popular view, and quite likely a minority view, given the underperformance of value over the last ten years.  As clearly demonstrated in the Graph below provided by Top Down Charts.

However, from an investment management perspective, 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 ten years.

It is too early to give up on value, news of its death are greatly exaggerated, on this, Asness makes the following point, value is “a strategy that’s “worked” through the 1920s – when a lot of stocks were railroads, steel, and steamship companies – through the Great Depression, WWII, the 1950s – which included some small technological changes like rural electrification, the space race and all the technology that it spanned – the internet age (remember these same stories for why value was broken back in 1999-2000?)………. Value certainly doesn’t depend on technological advancement being stagnant! But in a time when it’s failed for quite a while (again, that just happens sometimes even if it’s as good as we realistically think it is), it’s natural and proper that all the old questions get asked again. Is now different?”

I don’t think so.

Please see my Disclosure Statement

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

What matters for Retirement is Income not the value of Accumulated Wealth

/ Kiwi Investor / 11 Comments

This is the first of two Posts on why a greater focus should be placed on generating a level of income in retirement as an investment goal.

This Post outlines why income matters as an investment goal and the second Post covers why variability of retirement income is a better measure of risk rather than variability of capital.

A greater focus on income is different to the current industry approach, where accumulation of wealth has a higher priority. This is important of course. Yet a greater focus on generating income as an investment goal is not that radical. It is consistent with the age of the Defined Benefit investment solution. Therefore, it is not a new concept.

The rationale for the focus on income is provided below.

The inspiration and material for these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Nobel Prize winner Professor Robert Merton. The Podcast is 90 minutes in length, full of great conversation about retirement income, and well worth listening to.

 

During the Podcast discussion on why the focus should be on income and not accumulated wealth a definition of the standard of living in retirement needed to be determined.

From this perspective, Merton argues a standard of living in retirement is better defined as an amount of income, not a pot of money (accumulated wealth).

He argues the focus on income is consistent with what the Government provides you in retirement, a level of income. It is also much like a Defined Benefit where a level of income is provided and not a pot of money.

Also, the concept of income is easier to understand. You can see how rich I am with X amount of capital, but when converted to income that can be generated from that capital one can quickly see that the amount of capital may not be sufficient to support a desired standard of living in retirement. This is a key point.

Merton makes a strong case income is what matters in retirement and not how big your pot of money is.

As he says, people say, “If I have enough money, I’ll get the income. It will be fine.”

This may be true for the super wealthy but is not reality for many people facing the prospect of retirement.

Merton provides an example: twelve years ago in the US, if you had a million dollars you could generate $50k in interest, three years ago you could get a tenth of 1%, an income of $1k per million.

You’ve lost 98% of your income. As Merton says, what would you do if I lost 98% of your wealth!

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

Merton is more direct with the following: “Let’s be clear the goal, the purpose for retirement. Not for the silly other things but for retirement is a stream of income sufficient to sustain a standard living and that standard of living is measured by income.”

“Just knowing the amount of money you have doesn’t tell you how you can live. That’s the message and we have to get that clear both so that savers and people in plans are trying to figure out how they’re doing. We need to tell them the amount they can buy as an indicator of how close to where they are.”

What Merton is saying here, is we should let people know what level of income can be generated from their pot of money. This provides a better measure and insight as to how they are placed for retirement.

Further to this point, volatility of accumulated wealth is not a good measure of how well we are doing.

More importantly, we should focus on the volatility of expected income in retirement, not current volatility of capital. This is covered in the next Post – What matters for retirement is income not the value of Accumulated Wealth – Focus on likely variability of Income not variability of Capital

For the time being: “What matters for retirement is income not the value of the pot of money” Merton.

The investment knowledge is currently available to design investment solutions that can better meet client’s income requirements in retirement to support the standard of living they wish to attain. It will result in the implementation of different investment strategies based in Liability Driven Investing (Goal Based Investing). A more Robust Retirement Income Solution is required.

The benefit being, there will be an increased likelihood that investment outcomes are more consistent with Client’s retirement objectives.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Is the 4% rule dead? – Approaches to Generating Retirement Income

/ Kiwi Investor / 6 Comments

The 4% rule of thumb equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

Bill Bengen developed this rule in 1994.

There have been numerous other studies since and the rule has gained wide acceptance.

Essential to these studies is the expected returns from markets. By and large previous studies have been undertaken using US Equity market data.

Nevertheless, this raises several key questions: are returns from the US representative of other country’s expected equity market returns? and will the historical returns generated in the US be delivered in the future?

 

The 4% rule has been challenged in a recent article by Wade Pfau.

Pfau has expanded the research to include other developed nations (17 in total) and lengthening the analysis to 30 – 40 years.

Pfau concluded:

  • the 4% real withdrawal rule has simply not been safe;
  • even with perfect foresight, only 4 of 17 countries had a safe withdrawal rate above 4%; and
  • a 50/50 allocation to bonds and stocks had zero successes for the 17 countries.

 

At a minimum, investment outcomes can be improved from:

  • Increasing levels of portfolio diversification e.g. the use of alternatives;
  • A dynamic asset allocation approach that adjusts withdrawals to market conditions; and
  • An appropriate rebalancing strategy.

 

Pfau’s article is well worth reading, he concludes “It may be tempting to hope that asset returns in the twenty-first century United States will continue to be as spectacular as in the last century, but Bogle (2009) cautions his readers, “Please, please please: Don’t count on it” (page 60).”

 

The most insightful observation

In my mind the most important insight from Pfau’s study was that safety of generating retirement income does not come “from conservative asset allocations, and the findings from this figure suggest that from an international perspective, stock allocations of at least 50 percent during retirement should be given careful consideration.”

I say this given the sharp reduction in equities by many Target Date Funds and many Target Date Funds have limitations, see a recent post and another I posted earlier in the year.

 

More robust and innovative retirement solutions are required

We are living longer, and the concept of retirement is changing. New and more sophisticated investment solutions are required.

Thankfully the investment knowledge and approaches are available to provide a safer and sustainable level of retirement income.

These new strategies are based on Goal Based Investing, drawing on the insights of Liability Driven Investing (LDI) approaches employed by the likes of Insurance Companies and Defined Benefit plans.

The new generation of retirement investment solutions involve a more goal-based investment approach and something more akin Target Date Fund 2, which involves the adoption of a more sophisticated fixed interest solution.

 

EDHEC-Risk Institute

From this perspective I like the EDHEC-Risk Institute framework which places a greater emphasis on generating retirement income.

EDHEC argue investors should maintain two portfolios:

  1. Goal-hedging portfolio – this replicates future replacement income goals
  2. Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns

 

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels. There is no predetermined path. Investment decisions are made relative to increasing the probability of achieving a level of retirement income.

The Goal-hedging portfolio is a sophisticated fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities. Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit, they are made with the view to match future replacement requirements, matching of future cashflows. This is akin to what Insurance companies do to match their future liabilities (LDI).

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge. It looks to address the shortcoming of many Target Date Funds.

 

The EDHEC framework is a more efficient framework than the rule of thumbs that reduce the growth allocations towards defensive/income, and the income component is invested into market replicating cash and fixed income portfolios.

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement. The industry, by and large, has a too greater focus on accumulated wealth.

Accumulated wealth is important, but more importantly will it deliver the required replacement income in retirement.

 

In summary, the retirement investment solution needs to focus on generating a sufficient and stable stream of replacement income in retirement. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI), much like an insurance company does in undertaking a liability driven investing approach. Focusing purely on an accumulated capital value and management of market risk alone like many of the current Target Date Funds may lead to insufficient replacement of income in retirement for some investors.

Lastly, and not least, a good advice model is vital and technology also has a big role to play in the successful implementation of these strategies.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Reports of the death of Diversification are greatly exaggerated.

/ Kiwi Investor / 2 Comments

Is Portfolio Diversification dead?

One could think so given the extraordinary performance of equities over the last five to six years and the absence of a significant market correction.

The US equity market is likely to record its longest running bull market in August of this year, which is the longest period of time without a 20% or more fall in value.  The equity market correction in February/March of this year ended a record period of historically low volatility for US equities, having experienced their longest period in history without a 5% or greater fall in value.

 

This is a theme picked up by Joe Wiggins in a recent post on his Blog site, Behavioural Investment, titled “The Death of Diversification”.

Wiggins proposes that the success of equities over the last few years could be used by some to argue as evidence of the failure of portfolio diversification.  Furthermore, such has been the superior performance of equities that some could argue “prudent diversification” is no longer important.

The benign environment could well lead some to believe this, reflecting there has been “scant reward” for holding other assets.  Diversification has come at a “cost”.

Of course such a worldly view, if held, is rubbish.

Wiggins does not hold these views.  He does however indicate it is hard in this environment to argue for the benefits of diversification.

Nevertheless the benefits of portfolio diversification still exist.

It is not a time to become complacent, nor suffer from FOMO (Fare of missing out).

 

Building robust and truly diversified portfolios will never go out of fashion.

This is well summed up in Wiggins’s post:

“The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.

 

Well said.

I like the turn of phrase: as forecast-free as possible.

In my opinion, a portfolio still needs to be dynamically managed and tilted to reflect extreme valuations and a shifting economic environment, the focus should be on factors rather than asset classes.

Invest like an Endowment, seek true diversification and always remember the long-term benefits of 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 “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.

 

I’ll leave the final comment from a great post from Wiggins:

“At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles.  Take the long-term view and remain diversified”

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Andrew Ang on Factor Investing

/ Kiwi Investor / 4 Comments

Great interview with Andrew Ang on Factor investing.

 

Two key take outs from my perspective in relation to Factor Investing.

 

How to determine what factors to invest in?

  1. Ensure the factor generates a return as a reward for bearing a specific set of risks. The risk return profile results from market structures, an economic value, or investors’ behavioural bias.
  2. The excess return from the factor needs to be persistent and will be there over time.
  3. The factor is a unique and a differentiated source of return, different to the risk return profile of the market (beta), and lowly correlated with other factors.
  4. The factor is scalable, the factor can be delivered relatively cheaply and with scale.

 

As you know, there are lots of reported factors (the factor zoo). I tend to agree that there are a limited number, value, momentum, quality, size, and minimum volatility appear to have the greatest foundation of work in supporting their existence, economic rationale, and persistence over time.

 

How should factors be used?

  1. To complement an existing portfolio of active managers, preferable active managers with genuine idiosyncratic risk exposures e.g. non-factors more company specific risks.
  2.  Replace a traditional index exposure to get a more efficient market exposure, this could enhance your returns and/or reduce risk, see previous post on short comings of passive indexing.
  3.  Express a view within a portfolio e.g. over or under weight certain factors that are attractive or unattractive at certain points in the business cycle.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Advancements in Portfolio Management

/ Kiwi Investor / 6 Comments

Hi. This is my first post.

Welcome to Kiwi Investor blog.

The attached article provides insights into the current and likely future direction of the Global Funds Management industry. I have a lot of time for the EDHEC Risk Institute.

This will appeal to those within the industry and those interested in ensuring their investments are being well managed.

None of it is of course investment advice. I’ll add material over time with the view that we can all build better portfolios that address our key investment risk: the failure to meet our investment objectives.

EDHEC-Whitepaper-JOIM

 

Please see my Disclosure Statement