Low Return Environment Forecasted

Many commentators highlight the likelihood of a low return environment over the next 5 -10 years or more.

Even looking through the shorter-term challenges of the current market environment as highlighted in a recent Post, many publicly available forecasts underline the potential for a low return environment over the longer term.

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

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

Share Markets

Annual Real Return Forecasts

US Large Capitalised Shares

-3.7%

International Shares

0.6%

Emerging Markets

5.3%

   
Fixed Income Markets  
US Fixed Income

-1.7%

International Fixed Income Hedged

-3.7%

Emerging Debt

0.7%

US Cash

0.2%

 

As GMO highlight, these are forward looking returns based on their reasonable beliefs and they are no guarantee of future performance.

Actual results may differ materially from those anticipated in forward looking statements.

 

The variation in sequence of returns is an additional consideration e.g. global sharemarkets could continue to move higher and then fall sharply to generate a 0.6% annual return over the next seven years. Or they could do the reverse, fall sharply within the next year and then float higher over the next 6 years to generate the 0.6% return.

 

The sequencing of returns is important for those in the retirement death zone, see my previous Post on the riskiest time of saving for and being in retirement.

 

Looking at the return forecasts the following observations can be made:

  • Within equity markets Emerging Markets are offering more value and US equities the least; and
  • The return expectations for Fixed Income are very dire, particularly for those developed markets outside of the US.

 

For comparison purposes, the long-term return of US equities is 6.5%.

 

The Fixed Income returns reflect that more than $US15 trillion of fixed income securities across Europe and Japan are trading on a negative yield.

Based on some measures, interest rates are at their lowest level in 5,000 years!

 

GMO is not alone with such longer-term market forecasts, those from Research Affiliates and State Street are provided below. They all have different methodologies and approaches to calculating their forecasts. Notably, they are all pointed in a similar direction.

 

This analysis highlights that outstanding returns have been delivered over the last 10 years, particularly if you are invested in the US and New Zealand sharemarkets and have had longer dated interest rate exposures.

The Balance Portfolio (60% Equities and 40%) has benefited from this environment.

The last 10 years have been amongst the best for a New Zealand investor invested in a Balanced Portfolio, if they had managed to stay fully invested during that time.

The New Zealand sharemarket has returned 13.3% over the last 10 years and New Zealand Government Bonds 5.9%. Therefore, a Balanced Fund has returned 10.3% over the last decade!

Global Equites have returned 10.0%, led higher by the US sharemarket, and Global Bonds 4.3% over the last 10 years. Globally, the Balanced Portfolio has benefited from the 35 year long decline in interest rates.

 

Therefore, the forecast returns are pretty frightening from a Balanced Fund perspective. Certainly, returns are not likely to be as strong over the next ten years as they have been over the last decade.

This calls into question the level diversification of a Balanced Fund of only equities and fixed income.

This issue can be considered from two angles, the need to increase the level of diversification within a Balanced Portfolio and the effectiveness of fixed income in providing diversification benefits to a Balanced Portfolio given historically low interest rates.

On the first issue, although a lack of true portfolio diversification has not disadvantaged investors greatly over the last 5-10 years, the potential to earn other sources of returns from true portfolio diversification may be of more value over the next 10 years. It is certainly a risk that should be considered and managed.

With regards the effectiveness of fixed income in diversify sharemarket risk in the future, this dynamic is best captured by the following insightful observation by Louis Grave: investors are hedging overvalued growth stocks with overvalued bonds.

What he is saying, is that given current valuations in the US of both the sharemarket and fixed income a Balanced Portfolio no longer has the degree of diversification it once had.

Of course, interest rates could fall further, and provide some offset from a falling sharemarket, as they have historically. Nevertheless, the effectiveness and extent of this offset is limited given historically low interest rates.

Most importantly, given current valuations, there is the scenario where both fixed income and sharemarkets underperform at the same time. This would be like the stagflation environment of 1970, where inflation is rising, and economic growth is muted.  This is a scenario worth considering.

In my mind the biggest risks to portfolios are in longer term fixed income securities or “bond proxies”, such as slow-growth and dividend-oriented investments.  Listed Property and infrastructure securities would fall into this definition.

It is quite likely that those looking for diversification benefits from listed property, global and domestic, and listed infrastructure, are likely to be disappointed. As they would had been during the Global Financial Crisis. They only provide limited portfolio diversification benefits, not true portfolio diversification.

 

The expected low returns environment throws up a lot of issues to consider:

  • True Portfolio diversification. Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits e.g. adding global listed property or infrastructure to a multi-asset portfolio that includes global equities.   True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth. Investors are compensated for being exposed to a range of different risks.

 

  • Consistent with the above, there is a growing evolution within the Wealth Management Industry, a paradigm shift which is resulting in the death of the Policy Portfolio (i.e. Balanced Portfolio).

 

  • The growing risks with traditional market indices and index funds, as highlighted by the low return forecasts.

 

  • Increased innovation within Exchange Traded Funds as investors seek to diversify their traditional market exposures.

 

I plan to write more on the last two points in future Posts.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

Research Affiliates – 10 Year Forecast Real (After Inflation)

Share Markets

Real Return Forecasts

US Large Capitalised Shares

0.7%

International Shares

3.2%

Emerging Markets

7.7%

   
Fixed Income Markets  
US Fixed Income

-0.8%

International Fixed Income Hedged

-0.5%

Emerging Debt

4.2%

US Cash

-0.3%

 

State Street also provides:

  • They are more optimistic in relation to developed market sharemarket, with Emerging Markets outperforming developed markets, Global Listed Property underperforms both developed and emerging market equities
  • They see very low returns from Global Fixed Income.

Designing a new Retirement System and Goal-Based Wealth Management

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

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

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

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

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

 

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

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

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

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

Merton begins

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

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

 

And he concludes:

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

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

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

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

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

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

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

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

 

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

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

 

 

Now to the Body of the Article:

Background

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

The current system is far from ideal.

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

What are members seeking to achieve?

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

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

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

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

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

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

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

 

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

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

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

 

Next-generation retirement planning

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

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

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

 

But how is that achieved?

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

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

 

The key point of these questions: 

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

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

 

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

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

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

 

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

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

 

 

Wealth versus sustainable income as the goal

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

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

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

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

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

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

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

 

Investment Reporting

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

Therefore, the measure of risk is important.

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

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

 

Essential and desired income goals – Goals-Based Investing

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

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

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

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

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

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

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

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

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

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

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

 

Pension Alerts

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

At which point in time they have three options:

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

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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

In defence of Target Date Funds

This is a great article from i3 providing some interesting perspectives into Target Date Funds, referred to as Life-Cycle strategies in Australia.

Target Date Funds have been around since the 1990s and have had an increasing presence in Australia following the MySuper legislation of 2012, which set the legal requirements for the default pension (KiwiSaver) options in Australia.

As a result, many Australian providers introduced Life-Cycle Funds as default options. Target Date Funds are also increasingly the default option in the USA.

 

It is fair to say there has been wide spread criticism of Target Date Funds.

Some of this criticism is warranted, nevertheless, consistent with the point made in the i3 article, the criticism of Target Date Funds is often the result of the poor design of the Fund itself, rather than the concept of a Target Date Fund.

For example, as noted in the article, the Australian Productivity Commission “criticised a number of existing life-cycle strategies for derisking too early and not being as good as many balanced fund options.”

This is fair criticism, but it is a design issue. I have previously noted that at least one KiwiSaver provider places their clients into 100% Cash at age 65, that is scandalous.

On the positive side, the Commission “acknowledged life-cycle strategies could help in addressing sequencing risk”.

 

These themes are touched on in the interview with Michael Block, Chief Investment Officer with Australian Catholic Superannuation.

“To always place a member who is 20 years old with a 60-year old member in the same strategy is clearly ridiculous,” Block says in an interview with [i3] Insights.

“Why would any fund use a one-size strategy that clearly does not fit all?”

“I absolutely concede, especially with people living longer, that moving members into a low-risk strategy at 60 is not a great idea. Even at 60 years old, a member is likely to have a 30-year investment horizon and should still have a decent amount of growth assets,” he says. (Growth asset include equities, alternatives and non-traditional assets.)

As the article notes: “The result of the shift is that half of the fund’s members now have a higher allocation to growth assets, while one-quarter, generally older members, have a lower allocation. The rest have retained a similar exposure to growth assets.”

 

Comments on De-risking

De-risking is reducing the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

Australian Catholic Super looks to reduce the allocation to equities in small annual increments, 31 steps to be precise, not the normal 3-4 lumpy transactions of many Target Date Funds.

“As long as you still contribute to your super, you’ll get a better outcome compared to a single-strategy investment option,” Block says. (An example of a single strategy is a Conservative or Balance Fund.)

“This gradual process of derisking also reduces a member’s sequencing risk as there is never more than a 2 per cent reduction in growth assets in any given year.”

This makes some sense and is a nice design feature of their Target Date Funds.

 

Customisation

The Australian Catholic Super’s life-cycle fund is based on age only. They hope to add other variables over time, such as account balance and salary.

“In a perfect world, you would ask everyone what they wanted out of a superannuation fund and tailor an individual portfolio for them, but if you don’t have complete information, then a life-cycle strategy based on age is a good attempt at mass customisation,” he says.

 

Quite true, it is a start, and a good start at that. With further sophistication of the investment approach and the helping hand of technology the mass customised investment solutions is not far away.

Increased customisation of the superannuation solution is the future.  Customisation will consider the generation of a required level of income in retirement, take into consideration income earned outside of super, risk preferences, account balance, and any likely endowments. Such customisation is available now.

 

More on Target Date Funds

For those wanting more on Target Date Funds, I have previously Posted on their Short Comings and suggested improvements.  They are also worth considering as the KiwiSaver Default Option.

Lastly, Target Date Fund can be improved upon by a more sophisticated approach to the management of the Cash and Fixed Interest allocation, this is well documented by the research undertaken by Dimensional Funds Advisors which I covered in a previous Post.

 

Interestingly, Kiwis can learn from the Aussies, maybe not when it comes to rugby, or certain cricket practices, but most certainly we can learn from them when it comes to Superannuation and the management of Pension Funds.

 

Happy investing.

Please see my Disclosure Statement

 

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

Optimal Private Equity Allocation

TIAA (Teachers Insurance and Annuity Associations of America Endowment & Philanthropic Services) has published a paper offering insights into the optimal way of building an allocation to Private Equity (PE).

“Private equity is an important part of institutional portfolios. It provides attractive opportunities for long-term investors to harvest the illiquidity premium over time and extract the value created by hands-on private equity managers.”

 

Private equity is by its nature is illiquid. This in turn makes rebalancing a challenge. That is why a PE allocation that is too large endangers the entire portfolio, especially in times of crisis when secondary markets seize up.

 

According to recent analysis by Prequin, the popularity and growth of PE, and other alternative investments, is expected to continue.

Furthermore, recent Cambridge Associates analysis on those Endowments and Foundations with the better long-term performance records had “one thing in common: a minimum allocation of 15% to private investments.

 

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. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors, for which illiquidity is one factor.

In my mind, direct private investments, such as Private Equity, Direct Property, and Unlisted Infrastructure have a place in a genuinely diversified and robust Portfolio.

 

From this perspective, the TIAA paper is very useful as it considers how to build and maintain an allocation to PE within a well-diversified portfolio.  They assume building out the PE allocation over time to an equilibrium allocation.

The Paper provides valuable insights into the asset allocation process of what is a complicated asset to model given cash commitments (capital calls) are made overtime and there is uncertainty as to when invested capital will be returned (distributions). TIAA model for both of these variables, in a relatively conservative manner.

The TIAA Paper notes that investors have no control over the rate and timing of capital calls and distributions. Therefore, the paper focuses on two key variables Investors can control for: an annual commitment rate and the risk profile of the assets waiting to be invested in private equity assets i.e. where to invest the cash committed to PE but not yet called.

 

TIAA propose a robust process to determine an appropriate allocation to PE to ensure the allocation can be maintained and the benefits of PE are captured over time.

“Obtaining the benefits of an allocation to private equity, while also avoiding its inherent illiquidity pitfalls, can only occur through an effective, risk-based strategy for executing the build-out to the long-term equilibrium state.”

The goal of the paper is to develop a framework and a sound approach.

 

The results:

TIAA’s modelling suggests that a target allocation to private equity strategies in the range of 30% to 40% presents minimal liability and liquidity risks.

TIAA also suggest, that for long term investors, such as Endowments, capital awaiting investment in private equity should be invested in risk assets with higher expected returns, such as public equities (sharemarkets).

 

This level of allocation is probably high for most, and particularly KiwiSaver Funds.

Nevertheless, KiwiSaver Funds are underweight Private investments and Alternatives, particularly relative to the Superannuation industry in Australia.

Given the overall lack of allocation to private investments, including PE, Direct Property, and Unlisted Infrastructure, many KiwiSaver providers are most likely over estimating their liquidity needs to the detriment of investment performance over the longer term.

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

 

TIAA Analysis

With regards to the TIAA paper, they develop a simple three asset portfolio of Fixed Income, Public equities, and Private equities. TIAA use sophisticated modelling techniques looking at a number of variables, including:

  1. the annual commitment rate; and
  2. Risk profile of the assets waiting to be invested in private equity.

The annual commitment is defined as the new commitment to private equity every year as a percentage of last year’s total portfolio value.

“An annual commitment rate results in a long-term equilibrium percentage of the portfolio in private equity assets, as well as the portfolio’s corresponding unfunded commitment level. The unfunded commitment level is important from a risk perspective as it represents a nominal liability to fund future capital calls, regardless of the prevailing market environment at the time of capital calls.”

TIAA note that at low rates of annual commitment the equilibrium rate of PE is about twice the unfunded ratio. Therefore, a 6% annual commitment rate will result in a base case unfunded ratio of around 15%, and a PE allocation of around 30% at equilibrium.

For those wanting a brief overview of the methodology, All About Alpha provides a great summary.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in this report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

A well diversified and robust portfolio will be able to meet these motivations.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, 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. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative, and hedge fund risk premia. And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above. There has been a disaggregation of investment returns.

Not all of these risk exposures can be accessed cheaply.

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

 

Challenging the conventional wisdom of active management

The attached paper, Challenging Conventional Wisdom of Active mgmt *, undertakes a review of the most recent academic literature on active equity management.  It concludes by challenging the conventional wisdom of active management.

 

The conventional wisdom of active management, which is based on research over 20 years old, runs along the lines of the following:

  1. The average fund underperforms after fees.
  2. The performance of the best funds does not persist.
  3. Some fund managers are skilled, but few have skill in excess of costs.

 

Nevertheless, a review of the current literature finds a substantial body of research that disagrees with the conventional wisdom of active management.

 

The authors of the paper conclude “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.

The literature that followed Carhart (1997), the basis of current conventional wisdom of active management, has documented that “active managers have a variety of skills and tend to make value-added decisions, such that, after accounting for all costs, many actively managed funds appear to generate positive value for investors.”

“While the debate between active and passive is not settled and many research challenges remain, we conclude that the current academic literature finds active management more promising for investors than the conventional wisdom claims.”

 

Quoting from the paper’s introduction:

  1. “Regarding average performance, Berk and van Binsbergen (2015) find the average active fund outperforms an equivalent index fund by 36 basis points per year, while Cremers, Petajisto, and Zitzewitz (2012) and Linnainmaa (2013) show that standard approaches to estimating average fund performance can be biased against finding that active management adds value.”
  2. “Considering performance persistence, Bollen and Busse (2005) and Kosowski, Timmermann, Wermers, and White (2006) both find some evidence of persistence among top-performing funds.
  3. “Several studies identify groups of funds that appear to have skill in excess of costs. For example, Cremers and Petajisto (2009) show that funds with ‘high active share,’ meaning funds with holdings that greatly differ from their benchmark, tend to outperform their benchmark. They also show that the performance of funds with low active share drives the results of previous studies indicating that the average actively managed fund underperforms. Similarly, Amihud and Goyenko (2013) show that funds with past performance that is not readily explained by common factors, such as the performance of large-cap stocks versus small-cap stocks, perform well in the future.”

 

“The research has also considered how the actions of active managers create value in different ways. Wermers (2000), among others, shows that many funds select stocks that outperform the market, while Kaplan and Sensoy (2005) and Jiang, Yao, and Yu (2007) show that some funds can correctly time the market. Other research finds that active managers create value through corporate oversight (Iliev and Lowry, 2015) and tax management (Sialm and Starks, 2012). The returns on these activities vary; Pastor, Stambaugh, and Taylor (2017) and von Reibnitz (2018) show that the amount of value creation depends on market conditions. “

 

It must be remembered that it over 20 years since the publication of Carhart’s landmark study on mutual funds.  Its conclusion—that the data did “not support the existence of skilled or informed mutual fund portfolio managers”—helped form the ‘conventional wisdom’ that active management does not create value for investors.

 

20 years on, this paper could well be a landmark paper and is well worth reading.

 

I don’t want to enter the passive vs active debate. I find it very dogmatic. From personal experience I can see a place for both passive and active management, including the use of Exchange Traded Funds and alternative investment strategies. There are active managers who can consistently add value, nevertheless they are rare.

I do think some people hold on to some pretty outdated views on active management and analysis based only on US Mutual Fund data may have its limitations.

 

Often it is hard to identify successful active managers. A recent paper from a very well respected British university concluded that Asset Consultants were not very good at identifying successful managers.  Nevertheless, their research results showed that active managers did outperform on average!!

 

With regards to fees, see my Post, Investment Fees and Investing like an Endowment – Part 2.

 

From my own investment management experience there are a couple of guiding principles I always reflect upon, which I think are relevant for the active vs passive debate:

  1. Beware of Hubris before the fall
  2. “It is better to be roughly right than precisely wrong” quote attributed to John Maynard Keynes

 

Happy investing.

 

*The paper is: Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds, K.J. Martijn Cremers, Jon A. Fulkerson, and Timothy B. Riley, September 2018.

 

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

Are Kiwi-saver investors too conservative?

Fisher Funds recently released research suggesting those nearing retirement, and in retirement, should reduce their growth assets allocation more slowly than currently implemented in New Zealand (NZ) and that the NZ Funds Management industry should do more to help shake Kiwis out of their too conservative approach to investing.  As reported on Good Returns.

This is an interesting piece of research.  At the very least, credit where credit is due.

The NZ industry should be discussing these issues more broadly.

It is disappointing to see these discussions transcend into a debate over fees.  Fees are important.  So too is the appropriateness of the investment strategy being implemented.  And arguably, investment strategy is more important.  Investment strategy and fees can be debated independently.  Perhaps the comment by Fisher Funds, as reported by Good Returns, “too-conservative investment was a bigger concern than fees, which gets more attention”, was too much for some.

 

I’d imagine in some circumstances Fisher’s comment would be true, subject to the level of fees being paid and mismatch of investment strategy relative to a Client’s investment objectives.

And that is where I would like to jump in.  The focus on the growth / income split and rule of thumb of reducing the growth allocations with age is potentially misleading.

The investment strategy is obviously subject to the individual’s circumstances, including age, level of current income, other assets, risk appetite, risk tolerance, planned retirement age to name a few, but most important is required level of replacement income in retirement and any aspirational goals e.g. legacies.

Therefore, the investment strategy should focus not only on wealth accumulation but also the level of replacement income in retirement.

Many of the Life Cycle Funds based on cohorts of age and only managing market risk (through the reductions in growth assets) have a number of shortcomings.  e.g. many are not managing inflation risk and longevity risk.  Lastly, most Life Cycle Funds don’t make revisions to asset allocations due to market conditions, it is a naïve glide path.

More importantly, the vast majority of the Life Cycle Funds, particularly in Australasia, are not focusing on generating or hedging replacement income in retirement.

The New Zealand industry is behind global developments in this area, more robust approaches are being developed.

Globally the retirement income challenge is leading to new Goal Based Investing solutions.  Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.  See my post A more Robust Retirement Income Solution

 

Arguably the main challenge facing retirees is to have a sufficient and stable stream of replacement income.

A good advice model recognises this issue.

 

The underlying investment solutions need to be more targeted in relations to investment objectives.  For example the “conservative” allocation (described by EDHEC-Risk as the Goal-hedging portfolio, see post above) is a 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.  Investment decisions are made with the view to match future income replacement requirements, matching of future cashflows and client liabilities.  This is akin to what Insurance companies do to match their future liabilities.

The investment strategy required to generate a stable stream of replacement income is much more sophisticated that a fixed interest laddered approach or investments into term deposits.  Particularly with retirement lasting for 20 – 25 years.  NZer’s are lucky, as they have had, at least historically, high real interest rates.

From this perspective, the Good Returns article noted that a Kiwi Fund providers Life Cycle Fund was invested 100% in Cash for those over 65, if this is true, this is a very risky investment solution for someone in retirement.  Let’s hope they are getting the appropriate level of  investment advice.

 

Of course this leads into the fee debate.  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.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative and hedge fund risk premia.  And of course, true alpha from active management, returns that cannot be explained by the return sources outlined above.  There has been a disaggregation of returns.

Not all of these risk exposures can be accessed cheaply.

 

I’ll say it again, fees paid are important.  Nevertheless, the race to be the lowest cost provider may not be in the best interest of clients from the perspective of meeting their unique investment objectives.  Sophisticated investors such as endowments, insurance companies, pension funds, and Sovereign Wealth Funds, are taking a different perspective.  Albeit, their approach is not inconsistent with fees being an important “consideration” that should be managed, and managed appropriately.  They likely manage to a fee “budget”, as they manage to a risk budget.

 

A balanced and appropriate approach is required, with the focus always on achieving the investment objective.

 

So are Kiwi Saver investors invested too conservatively?  Quite likely.  Is the solution to have higher equity allocations? Not necessarily.

The answer is to have more goal orientated investment solutions with a focus on managing the biggest investment risk, failure to meet your investment objectives.  To achieve this, may require a higher level of fees than the lowest cost “products” in the market.  Lastly, the goal is not about beating markets, it’s about meeting investment objectives.  Risk is not solely measured by the level of equities you have in a portfolio.  Risk is the probability of meeting your investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

cropped-title-picture-enhanced.jpg