The opportunity and role of active management

RBC Global Asset Management provides a strong case for the opportunity of active management and its role within a truly diversified portfolio.

As they note, there are considerable opportunities within markets for active managers to turn into reliable excess returns.

RBC’s analysis highlights that a large proportion of active share price movements, up to 75%, cannot be explained by market factors.

This is a large opportunity set for active managers. An opportunity set that is found to remain reasonably consistent over time.

The scale of the opportunity as demonstrated by RBC, if successfully captured, provides a potential source of excess returns and a true portfolio diversifier – which is a return outcome largely sourced from company/stock specific risks.

Nevertheless, active managers do need to evolve from historical practices and processes. From this perspective, the paper also provides great insights into the evaluation of a modern day active manager.

With regards to the success of active management, the Conventional Wisdom toward active management is changing. Specifically, the conventional wisdom is too negative on the value of active management.

The RBC article is well worth reading.

 

RBC emphasis “An active manager’s task is to capitalise on the fact that the market or index return is an average, and to use analysis and skill to identify those stocks that produce an above-average return and to avoid those that don’t.”

 

To capture the opportunity identified by RBC, they believe active managers need to find a way to turn share price movements into reliable excess returns.

To do this they believe that active managers must get two things right:

  1. Alpha generation: devise means of explaining and predicting the share price movements that are not explained by factors.
  2. Alpha capture: devise means of efficiently capturing alpha and turning it into reliable portfolio excess returns.

The RBC paper provides a lengthy discussion on what it likely takes to achieve this, including analysing the unique features associated with each business, including ESG factors, taking an active ownership role, and maintaining a long-term perspective.

Each company (security) has a unique performance history, which cannot all be explained by broad market factors.  Financial outcomes are partly dependent on management teams, brand, location, reputation, non-financial factors, and Culture. Analysis needs to be undertaken on the unique factors associated with each business.

Furthermore, accounting data is a poor measure of business value, there are extra financial factors, Governance, employee engagement, Health and Safety, ESG etc etc

 

RBC conclude “that the critical skill for stock pickers is understanding and evaluating extra-financial factors as well as assessing their impact on financial returns. Skill and expertise need to be developed to assess nuanced factors such as corporate culture, employee engagement, customer satisfaction, the business’s social licence to operate, maintenance and safety procedures, R&D effectiveness, brand and reputation, and these will vary from industry to industry and will also shift over time.”

See the article for fuller discussion on their perspective and type of analysis required by a modern day active manager.

 

Portfolio construction is also key, the size of portfolio positions matters.

Equity investments can be held in fractional holdings so it is possible to construct an almost infinite number of portfolios from a relatively modest number of securities.

Different combinations of securities will create portfolios with different factor exposures.   Which will cause variation in portfolio returns.

Therefore, Portfolio construction becomes the framework within which portfolio managers can assess the trade-off between “two often conflicting objectives: maximising exposure to their best investments vs. minimising exposure to unintended factor returns.“

 

My personal view is that many managers under estimate the value added from a solid portfolio construction approach, often it distracts value from a sound stock selection process.

 

One final point, the paper provides a good account of how active management has been disrupted by technology and the information revolution – computing power and access to company information. This has resulted in the rise of passive investing and factor-based investing. This has driven down fees.

The active management industry has changed dramatically, and active management has had to evolve. This is touched on within the Article.

Therefore, the Article provides insight from the perspective of manager selection and a potential lens with which to consider in evaluating modern day active managers.

 

The Role of Active management within a portfolio

From a Kiwi Investor Blog perspective, the active management described by RBC in the Paper “seeks to generate outperformance from stock-specific risk that lies outside the realms of factors. This is a different alpha source, hence it creates a return stream that is not correlated to factor returns.”, highlights the role active management can play within a truly diversified and robust portfolio.

Consistent with RBC, active managers can co-exist with passive and factor based strategies. Active management has a role to play within a Portfolio.

Why? Investors seek to access a wide range of investment risks and returns, seeking true portfolio diversification.

The source of risks and returns from active management that seeks to outperform from stock specific risks is a true portfolio diversifier, if done successfully.

This is consistent with many Posts on Kiwi Investor Blog around the disaggregation of investment returns.

Understanding the disaggregation of investment returns can assist in building a truly diversified and robust portfolio.

It can also help determine the appropriateness of fees being paid and if a manager is adding value.

 

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 and return sources.  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.  For example, the increasing allocation to alternative investment strategies by institutional investors globally, such as hedge fund strategies, to complement more traditional investments is evidence of this.

Essentially, and from a very broad view, investment returns can be disaggregated in to the following three parts:

  1. Market beta. Think equity market exposure NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).
  2. Factor and Alternative hedge fund beta exposures.  See the Disaggregation of Investment Returns Post for a fuller discussion.
  3. Alpha. Alpha is what is left after beta and factors. It is the manager skill to capture the stock specific risks as outlined in RBC paper. Alpha is a risk adjusted return source.

 

With regards to the success of active management, the Conventional Wisdom toward active management is changing, as highlighted in this Post. The linked article in this Post is the most read from Kiwi Investor Blog.

The article undertakes a review of the most recent academic literature on active equity management and concludes by challenging the conventional wisdom of active management, “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.

 

Finally, the disaggregation of investment returns busts opens the active vs passive debate, the debate has moved on. It is no longer an emotive black vs white debate, risk and return sources come in many different shades. A truly diversified portfolio has as many different risk and return exposure as possible. It is from poor portfolio construction that portfolios fail.  The value is in implementation of a truly diversified portfolio.

 

It is evident that New Zealand portfolios need to become more diversified and that Kiwi Saver Investors are missing out.

 

 

Happy investing.

Please read my Disclosure Statement

 

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

Beginners guide to Portfolio Diversification. And why Portfolios Fail.

It is often asked if Modern Portfolio Theory failed during the Global Financial Crisis / Great Recession (GFC).

No, Modern Portfolio Theory did not fail during the GFC. Portfolio construction did.

During the GFC many investors did not have exposure to enough different asset classes and investment risks. This limited their protection from market loses.

Therefore, Investors should consider incorporating a wide range of different investment strategies as their core investment strategy. Investors should also clearly understand the sources of risk within their portfolio.

Furthermore, investors cannot necessarily rely on “what is traditionally thought of as diversification to meet their long-term goals.”

It is likely that many investors remain under-diversified today.

These are the views of a 2013 BlackRock Article, the new diversification: open your eyes to alternatives.

 

The discussion in 2012 with Dr Christopher Geczy is still very relevant today.

As we have seen previously, from what does portfolio diversification look like, many KiwiSaver Funds are under-diversified relative to Australian Superannuation Funds. Likewise, the Australian Future Fund is very well diversified relative to the New Zealand Super Fund.

 

Highlights of the BlackRock article are provided below.

They are presented to provide the rationale for seeking true portfolio diversification, as pursued by many of the largest investors worldwide, including Super Funds, Pension Funds, Foundations, Endowments, Family Officers, and Sovereign Wealth Funds. This group also includes the ultra-wealthy.

Albeit, the opportunity to have a truly diversified portfolio is open to all investors, the value is in implementation.

Currently, many New Zealand investors are missing out.

 

What happened during the GFC?

In short, as we all know, what happened during the GFC was a spike in financial market volatility, this led to all markets behaving in a similar fashion – technically market correlations moved to one. This reduces the benefits of diversification. As a result, many markets fell sharply in tandem.

Those markets that where already quite highly correlated became more correlated e.g. listed property with the broader share market.

As we also know, this often happens at time of market crisis, nevertheless, correlations can spike higher without a crisis.

The BlackRock article provides a comparison of market correlations prior to the GFC and correlations during the GFC.

 

For clarity, there are benefits from investing in different asset classes, regions, and so forth.

Nevertheless, although a traditional “Balanced Portfolio”, 60% shares / 40% Fixed Income, provides a smoother ride than an undiversified portfolio, the risks of the Balanced Portfolio are dominated by its sharemarket exposures.

It is well understood that for the Balanced Portfolio almost all the risk comes from the sharemarket exposures. On some estimates over 90% of the risk of a Balanced Portfolio comes from sharemarkets.

Therefore, investors should not only clearly understand the sources of risk, but also the magnitude of these risks within their portfolio.

 

What is the difference between Portfolio Diversification and Portfolio Construction?

Diversification is not as obvious as many think e.g. as outlined above in relation to listed property, a portfolio exposed to different asset classes may not be that well diversified.

As a result, and a key learning from the GFC, investors need to think in terms of risk exposures – risk diversification.

Investors should not think in terms of asset class diversification.

More asset classes does not equal more Portfolio Diversification.

This is because returns from of a range of asset classes are driven by many of the same factors. These can include: economic growth; valuation; inflation; liquidity; credit; political risk; momentum; manager skill; option premium; and demographic shifts.

So while investors have added a range of asset classes to their portfolio (such as property, infrastructure, distressed debt, and commodities) their portfolio risk remains similar at the expense of adding greater complexity and management cost.

Therefore, increasingly institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

 

From a portfolio construction, and technical, perspective, this means thinking in terms of risk exposures and “getting exposure to as many different and non-correlated types of risk that they can.”

Portfolio construction = “building a portfolio based on risk exposures and not just so-called “asset classes” or “sub-classes.””

 

What does this look like?

Investors should seek exposure to a variety of risk exposures in proportion to their risk tolerances and individual circumstances.

The point being everyone should have a broadly diversified portfolio to the greatest extent they can. Investors should hold as many different assets and risk exposes as they possibly can.

Therefore, portfolios should likely include real assets, international investments, and long/ short investments. Alternative and Alternative investment strategies.

The real value is in implementing the portfolio construction, accessing the appropriate risk exposures efficiently.

As BlackRock emphases, Investors need to work with their financial professionals to choose and blend the risk exposures that make sense for their unique circumstances.

 

Low Correlated investments

If the objective is to seek a truly diversified portfolio, the exposure to low correlated assets, both in general and particularly in times of stress, is necessarily.

These exposures are largely gained via Alternative investments or Alternative Investment strategies.

“Alternatives” are a broad category, as defined by BlackRock, offering “sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio.”

The concept of alternative investing is about going beyond what a traditional Balanced Portfolio might look like, by introducing new sources of diversification.

 

BlackRock provides a very good discussion on Alternatives, types of assets that would be considered alternatives and a discussion around implementation – highlighting the portfolio benefits of adding alternatives to a portfolio (improving the risk/reward profile). Also noting Alternative investments feared better during the GFC.

 

It is important to emphasis, as does BlackRock, that the inclusion of alternatives into the traditional portfolio is not a radical departure from the notion of managing risk and constructing portfolios. It helps in understanding what risks are being taken and broadens portfolio diversification.

The inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.

 

BlackRock makes a final and important point, the world presents countless risks, and not all those risks can be accounted for in a traditional Balanced Portfolio. Investors need to be diversified in general, but they also need to be diversified for the extreme. If not, they may be setting themselves up for failure.

Do not become too dependent on one source of investment returns.

 

Summary

Investors need to clearly understand the sources of risk in their portfolios and should consider incorporating a wide range of different investment strategies and assets as their core investment strategy.

Furthermore, investors cannot necessarily rely on what is traditionally thought of as diversification to meet their long-term goals.

It was not Portfolio Theory that failed during the GFC but Portfolio Construction.

And this is where the real value lies, the ability and knowledge to implement a truly diversified portfolio.

Many investors very likely remain under-diversified today. Their portfolios do not fully reflect the key learnings from history as outlined in this Post.

 

In my mind, many New Zealand Investors are missing out.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

New Zealand Super Fund vs the Australian Future Fund

The analysis below compares the variation in portfolio allocations between the Sovereign Wealth Funds of New Zealand and Australia, the New Zealand (NZ) Super Fund (Kiwis) and Australian Future Fund (Aussies).

Many of the insights are relevant for those saving for retirement or are in retirement.

A light-hearted approach is taken.

 

A previous Post, What Does Diversification Look Like compared Australian Superannuation Funds to the KiwiSaver universe, the Aussies won easily, with more diverse portfolio allocations.

However, this comparison is amongst the top echelon of the nation’s investment funds, a Test match of portfolio diversification comparisons, sovereign wealth fund vs sovereign wealth fund, the All Blacks vs the Wallabies, the Black Cap vs the Baggy Green, the Silver Ferns vs the Diamonds ………………

Let’s gets stuck into the Test Match Statistics.

 

Test Match in Play

 

NZS

Future Fund

Kiwi vs Aussie Difference

Int’l Equities

56.0%

18.5%

37.5%

Emerging Markets

11.0%

10.0%

Domestic Equities

4.0%

7.0%

Fixed Income

9.0%

9.0%

Alternatives
Infrastructure & Timberland

7.0%

7.5%

-0.5%

Property

2.0%

6.7%

-4.7%

PE

5.0%

15.8%

-10.8%

Alternatives 13.5%

-13.5%

Rural

1.0%

Private Mkts

3.0%

Public Mkts

2.0%

Cash

11.9%

100%

100%

           
High Level Allocations          
Equities

71.0%

35.5%

35.5%

Fixed Income

9.0%

9.0%

0.0%

Cash

11.9%

-11.9%

Alternatives

20.0%

43.5%

-23.5%

100%

100%

 

High Level Match Coverage:

  • The Kiwis are highly reliant on International Equities to drive performance – let’s hope they don’t get injured.
  • The Aussies currently have a higher allocation to Cash – are they holding something in reserve
  • The Aussies, with a higher Alternative allocation, on the surface, and looking at the detail below, have a more broadly diversified line up – depth to come off the bench
  • The Aussies have a much higher allocation to Private Equity,15.8 vs 5% – might have something to do with their schooling
  • Interestingly both have a similar allocation to Emerging Market Equities ~10% – both are willing to be adventurous

 

The standout is the difference in the international equities exposures, the Kiwis have a ~37% higher allocation, the majority of this difference is invested into Private Equity (+~10%), Property (+~4.7%), and Alternatives (+~13%) by the Aussies.

 

As for the detail

  New Zealand Australia
Infrastructure & Timberlands

Of the total 7%, 5% is in Timberlands, the Kiwis have 1% invested in NZ rural land and farms

Of the 7.5%, 1.7% is invested in listed infrastructure equities, 3.4% is invested in Australian assets, 2% is invested offshore. An array of infrastructure assets is invested in.
Alternatives Not sure how this is categorised by the Kiwis (Public Markets?), they have 2% invested in Natural Catastrophe Reinsurance and Life Settlements.

 

The Kiwis also have allocations to Merger Arbitrage.

The Aussies have 13.5% invested into Multi-Strategy/Relative Value hedge fund strategies, Macro – Directional strategies, and Alternative Risk Premia strategies.

 

These strategies are relatively easy to invest into and provide well documented portfolio diversification benefits relative to other hedge fund type strategies.

Property   1.9% of the Fund is invested in Listed Property, 4.8% is invested in direct property.

 

Post-Match interviews

It is true, the only interview is with my keyboard, and the above is high level and rudimentary.

Nevertheless, on the surface the Aussies appear to have a more broadly diversified line up, which may play into their hands in tougher games e.g. global equity bear market.

There is certainly less of a reliance on listed equities to drive the performance of the Aussies.

Put another way, the Aussies might have a better line up to get them through a world cup campaign, able to hold up in different playing conditions (i.e. different market environments. The exception would be a strong global equity bull market, which would favour the Kiwis. Albeit the Aussie’s performance has been competitive over the last 10 years relative to the Kiwis – unlike the Wallabies!).

 

Therefore, the Aussie portfolio allocation will lead to a smoother and more consistent team performance.

 

Why the Difference

The difference in portfolio allocations can be for several reasons. I would like to highlight the following:

 

Investment Objectives

In many respects they both have similar objectives, to support future Government spending. They are both investing for future generations. The Kiwi specifically for future super payments and Aussies more so for the General Fund.

 

Return Objectives

Interestingly they have similar return objectives.

From 1 July 2017 the Aussie’s long-term benchmark return target has been CPI + 4% to 5% per annum. This has been lowered from previous years, reflecting a changed investment environment.

The Kiwi’s don’t appear to have a specific return target.

Nevertheless, the Kiwi Reference Portfolio, which they are currently reviewing, is expected to generate a return of Cash plus 2.7%.

The Reserve Bank of New Zealand (RBNZ) in a 2015 research paper estimated the long-term “neutral” 90-day interest rate is around 4.3%. Although this seems high given the current market environment, bear-in-mind it is a long-term estimate.

If we assume inflation is 2%, the mid-point of the RBNZ’s inflation target range of 1-3%, and a lower Cash rate, then Cash generates a 2% return over inflation.

Thus, the Kiwi objective is comparable to a CPI + 4.7% return.

 

Therefore, the return objectives are not too dissimilar between the two Teams, even if we make further conservative assumptions around the long-term neutral interest rate in New Zealand and its expected return above inflation – which I think will come down from its historical average.

If anything, the Kiwi’s return objective is more conservative than the Aussies, all else being equal, this would support a lower equity allocation relative to the Aussies, not a higher equity allocation as is the case.

 

It is interesting, for similar return objectives they have such a difference in equity exposure.

This is an issue of implementation.

The Aussies are seeking a broader source of returns through Private Equity, Alternative strategies, direct property, and unlisted infrastructure.  This will help them in different playing conditions – market environments.

 

Drawdown Requirements

There is a difference in when the funds will be drawn upon i.e. make payments to the Government.

In Australia, legislation permits drawdowns from the Future Fund from 1 July 2020. The Government announced in the 2017-18 budget that it will refrain from making withdrawals until at least 2026-27.

The Kiwis have a bit longer, from around 2035/36, the Government is expected to begin to withdraw money from the Fund to help pay for New Zealand superannuation. On current forecasts, a larger, permanent withdrawal period will commence in 2053/54.

 

Therefore, the Funds do have different maturity profiles and this can be a factor in determining the level of equity risk a portfolio may maintain.

 

One way of looking at this is that the Aussies are closer to “retirement”, there will no longer be deposits into the Fund and only capital withdrawals from 2026. Much like entering retirement.

Therefore, it would be prudent for them to have a lower equity allocation and higher level of portfolio diversification at this time, so there is a wider return source to draw upon.

The Kiwis have a bit longer until they enter retirement.

I would imagine that the Kiwis will move their portfolio closer to the current Aussies portfolio over time, as they “age” and get closer to the decumulation/drawdown phase (retirement), expected to commence around 2035 (16 years’ time).

The Kiwis will likely be considering this now, as they will want to reduce their sequencing risk, which is the risk of experiencing a major drawdown just before and just after entering the drawdown phase (retirement). I covered this in a previous Post, The Retirement Death Zone.

Likewise, they will not want to hold high levels of Equities once withdrawals commence (are in retirement).

Maintaining high levels of listed equities can significantly reduce the value of a portfolio that has regular withdrawals and there is a high level of market volatility. This is the case for Charities, Foundations, and Endowments.

For more on this, see my previous Post, Could Buffett be wrong, which highlights the impact on portfolios when there are regular withdrawals and equity market volatility.

 

Team Philosophy

Differences in Investment Philosophy could account for differences in portfolio allocations. Nevertheless, there does not appear to be any measurable difference in Philosophy.

 

Resources and fee budgets

This is probably the most contentious factor. Fund size, team resources, and fee budgets can influence portfolio allocations. Those with a limited fee budget will find it challenging to diversify equity risk.

I am not saying this is an issue for the Kiwis, I would only be speculating. The Aussies have a good size budget based on their recent annual report.

Let’s hope it is not a factor for the Kiwis, an appropriate investment management fee budget will be required for them to satisfactorily meet their objectives and exceed expectations – as any good sports team know.

This is an aged old industry issue. My Post on Investment Fees and Investing like US Endowments covers my thoughts on the fee budget debate.

 

Happy investing.

Please see my Disclosure Statement

 

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

Reported death of the 60/40 Portfolio

The reported death of 60/40 portfolio, may well be exaggerated, but it certainly is ailing.

As reported by Think Advisor in relation to the 60/40 Portfolio (60% listed equities / 40% fixed income):

“No less than three major firms have issued reports in the last few weeks declaring it dead or ailing: Bank of America Merrill Lynch, Morgan Stanley, and JPMorgan.” 

All three firms have similar reasons:

  • Low expected returns, particularly from Fixed Income
  • Reduced portfolio diversification benefits from Fixed Income

For example, JP Morgan: “Lower returns from bonds create a challenge for investors in navigating the late-cycle economy,” “The days of simply insulating exposure to risk assets with allocation to bonds are over.” (A risk asset example is listed equities.)

 

With regards to the declining diversification benefits from Fixed Income in a portfolio Bank of America make the following point: Fixed Income (Bonds) have functioned as an offset to equity market loses over the last 20 years, this may not occur in the immediate future.

Technically, fixed income has had a negative correlation to equity markets over the past 20 years, interestingly, this did not prevail in the prior 65 years.

 

Underpinning these views is the expectation of lower investment returns than experienced over the last 10 years. Access to JP Morgan’s Longer-term Capital Market assumptions are provided in the article.

There is no doubt we are living in challenging times and we are heading into a low return environment.  I covered in this in a previous Post: Low Return Environment Forecasted.  This Post provides an indication of the level of returns expected over the next 5 – 10 years.

 

What to do?

JPMorgan strategists are calling for “greater flexibility in portfolio strategy and greater precision in executing that strategy.”

I agree, to my mind, a set and forget approach won’t be appropriate in a low return environment, where higher levels of market volatility are also likely.

Naturally they are calling for a greater level of portfolio diversification and are recommending, Corporate bonds, Emerging market equities and bonds, U.S. real estate, Private equity, and Infrastructure investment.  The last three are unlisted investments.

 

 

Personally, I think the death of 60/40 Portfolio is occurring for more fundamental reasons. The construction of portfolios has evolved, more advanced approaches are available.

For those interested I covered this in more detail in a recent Post: Evolution within the Wealth Management Industry, the death of the Policy Portfolio. (The Policy Portfolio is the 60/40 Portfolio).

The current market environment might quicken the evolution in portfolio construction.

 

Modern day Portfolios should reflect the lessons learnt over time, particularly from the Dot Com market collapse and the Global Financial Crisis (GFC or Great Recession).

Understanding the history of Portfolio Diversification is important. Modern Portfolio Theory (MPT) was developed in the 1950s and resulted in the 60/40 portfolio.

Although MPT is still relevant today, the Post on the Short History of Portfolio Diversification highlights much more has been learnt since the 1950s.

 

Furthermore, we can now more easily, and more cheaply, gain greater portfolio diversification.  This includes an increasing allocation to alternative investment strategies and smarter ways to access investment returns.

This in part reflects the disaggregation of investment returns as a result of increased computer power and advancements in investment research.

As a result, Portfolios do not need to be over reliant on equities and fixed income to generate returns. A broad array of risks and return sources should be pursued.

This is particularly important for portfolios that have regular cashflows.  High listed equity allocations in these portfolios is a disaster waiting to happen e.g. Charities, Foundations, Endowments.

While those near or just entering retirement are vulnerable to Sequencing Risk and should look to diverse their portfolio’s away from listed equities.

 

There is still a place for active management, where real skill and truer sources of excess return are worth exploring and accessing. In fact, they complement the above developments.

There are shades of grey in investment returns, as a result the emotive active vs passive debate is out-dated.

 

I think KiwiSaver Investors are missing out and their portfolios should be more diversified.

 

Happy investing.

Please see my Disclosure Statement

 

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

Charitable Foundation Investing, with Endowments

It is vitally important that Foundations, Endowments, and Charities have customised investment programs to better support their very long-term goals.

Not only is a customised investment program important in meeting their investment objectives, such a robust process will also help them in attracting new donors.

This Post reviews a paper written by Cambridge Associates on how community foundations can develop customized investment programs to better support their long-term goals.

The key to success is to have exposure to a truly diversified range of investment risks and returns.  A more diversified portfolio is recommended which has better risk and return outcome than a portfolio solely reliant on Equities and Fixed Income.

A high listed equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.

The point is that Foundations, Charities, and Endowments can increase their overall diversification and this will provide stronger return expectations. They need to play to their strengths, which includes their longevity.

 

As Cambridge note in their paper “One of the most important roles of a community foundation is to steward philanthropic assets well. A thoughtful and disciplined investment approach increases the probability of generating higher portfolio returns and amplifies the foundation’s philanthropic impact.”

“Each Foundation has a unique focus on the needs and priorities of its particular community, which translates into a particular mix of assets under management.”

Implementing a successful investment program requires a customized approach that considers all the philanthropic funds under management, their role in supporting philanthropy and programs, and how they come together in the aggregate.

 

Cambridge argue that an investment strategy that employs the endowment model can differentiate a foundation in a vast landscape of options available to donors. i.e. they are likely to attract more donors.

The Endowment Model of investing can deliver on investment and stewardship goals, but the approach requires a deep understanding of risk, liquidity, and investable assets, and may not be the appropriate strategy for all assets under management.

The endowment model is anchored to four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

 

Therefore, given “that each organization brings a unique combination of circumstances, the development of the optimal investment program starts with an enterprise review. This provides a deeper understanding of a foundation’s assets, fundraising flows, and the role the investment assets play in supporting the mission. These factors frame the portfolio’s risk and liquidity, which are then reflected in investment policy and implemented in portfolio construction.”

To illustrate a more robust investment approach, Cambridge provide an illustrated example by creating a representative community foundation with $500 million in assets under management.

 

As you know, Foundations, University Endowments, and Charities deliver a range of philanthropic, programmatic, and investment services.

Community foundations lead and serve their local community, fundraise, and deliver programs. Like private foundations, they identify grant-making opportunities and support charitable causes with grants and program-related investments.

 

Tailored investment solution

“Once truly short-term philanthropy has been set aside, community foundations often find that the aggregate portfolio of funds is aligned with a long-term investment strategy, because spending is matched by fundraising. This provides a level of stability for investment assets and indicates that liquidity requirements do not constrain investment policy. The foundation’s portfolio is in an advantageous position where spending needs are matched or exceeded by inflows of new funds, so the investment portfolio can take on more illiquidity to achieve return objectives.”

 

An individual can be characterised in a simply fashion, future liabilities of desired spending in retirement need to be “matched” by investment assets. This is the basis of Liability Driven Investing for Banks and Insurance companies and Goals-Based Investing for the individual.  Such an approach is appropriate for a Charity, Foundation, and Endowment.

 

Foundation Example

After undertaking a review of their representative Foundation, Cambridge note the foundation has a substantial level of non-endowed funds, those funds behave like long-term capital because of strong fundraising that replenishes fund levels each year. The foundation can thus grow assets and offer donors a risk-appropriate, competitive return on their philanthropic funds. “Optimizing the endowment investment offering further distinguishes the foundation from competitors.”

Given these endowment characteristics Cambridge argue the foundation can have a greater emphasis on less liquid investments such as private investments.

The point is that the Foundation can increase its overall diversification and this will provide stronger return expectations. Foundations, Charities, and Endowments need to play to their strengths.

 

With such an approach the Foundation is more likely to preserve its purchasing power and grow market value over time.

A more diversified portfolio is recommended which has better risk and return outcome than a portfolio solely reliant on Equities and Fixed Income.

As would be expected by any asset consultant extensive portfolio modelling has been undertaken to understand the resilience and robustness of the portfolio under different market conditions.

As would also be expected a more robust portfolio translates into greater performance over the long term, often with similar if not better protection in poor market conditions i.e. down markets.

 

Likewise, with an increased allocation to illiquid assets, stress testing of different liquidity scenarios is undertaken to gain an understanding of the recommended portfolio’s ability to support annual foundation operations, programs, and grant-making.

Scenario analysis includes the foundation deciding to maintain its level of grant-making to help grantees weather financial challenges, despite the fact that the effective spending rate will exceed its policy target, and the scenario were the Foundation cuts the fundraising achievement level in half, reducing the rate in which new capital is added to the portfolio.

Cambridge conclude ”To evaluate whether the recommended investment portfolio is a good fit, the foundation’s staff, investment committee, and board need to assess whether they are comfortable with the potential portfolio losses and levels of spending presented by a stress scenario. They will also need to consider whether the foundation will maintain grant funding (as modelled) or even grow grant funding in an economic downturn. While an investment policy’s focus is long term, it needs to be able to withstand difficult short-term periods.”

 

 

I have written a number of blogs on the risk of having high equity weightings and the benefits of true portfolio diversification.

A high equity allocation is detrimental to a portfolios that have regular cashflows i.e. Endowments, Charities, and Foundations. This was covered in a previous Post, Could Buffet be wrong? This Post highlights the devastating impacts listed equity market volatility has on a portfolio such as an Endowment/Charity/Foundation which need to provide regular income and to periodically draw on capital.

For those wanting a short history on the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest. Current investment portfolios should reflect key learnings from previous market meltdowns.

My last Post, What Does a Diversified Portfolio Look Like? May also be of interest. This Post highlights that a diversified portfolio has a number of risk and return exposures and is not overly reliant on listed equities to generate investment outcomes.

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

What does Portfolio Diversification look like?

What does a diversified portfolio look like?

This is answered by comparing a number of portfolios, as presented below.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.   Investors are compensated for being exposed to a range of different risks.

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

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.

 

This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.

The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).

To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.

 

Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe.  Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.

I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.

WTW Model Reference Portfolio Typical US Advisor
Domestic Cash 2.0%
Domestic Fixed Interest 13.0% 15.0% 28.0%
Global Fixed Interest 15.0%
Domestic Equities 15.0% 25.0% 35.0%
International Equities 20.0% 40.0% 12.0%
Emerging Markets 5.0% 5.0% 4.0%
Listed Property 3.0%
Global Property 3.0%
Listed Infrastructure 3.0%
Alternative Beta 8.0%
Hedge Funds 7.0% 8.0%
Private Equity 8.0% 4.0%
Unlisted Infrastructure 5.0%
Alternative Credit 8.0%
US High Yield 4.0%
Commodities / Real Estate 4.0%
Emerging Markets Bonds 1.0%
100.0% 100.0% 100.0%
Broad Asset Classes
Cash and Fixed Income 15.0% 30.0% 28.0%
Listed Equity 49.0% 70.0% 51.0%
Non Traditional 36.0% 0.0% 21.0%
100.0% 100.0% 100.0%

Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta

The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.

Allocations to broad asset classes KiwiSaver Aussie Pension Funds
Cash and Fixed Interest (bonds) 49 31
Equities 48 47
Other / non-traditional assets 1 22

From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.

 

If a picture tells a thousand words, the Tables above speak volumes.

The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.

 

It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).

Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

Globally allocations to alternatives are set to grow, as outlined in this Post.

 

The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.

Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments.  As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).

 

Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.

The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.

Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.

Although investors can experience strong performance, they can also experience very weak performance.

 

Comparison Return Analysis

Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.

By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.

It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.

 

The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.

 

Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%

 

A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.  They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?

Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.

For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.

 

Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.

As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

A short history of Portfolio Diversification

Advancements in technology and new knowledge have made it easier to diversify portfolios and manage investment management fees. Greater clarity over sources of returns have placed downward pressure on active manager’s fees.  True sources of portfolio diversification can command a higher fee and are worth considering.

Is your portfolio managed as if it is the 1980s? the 1990s? Does it include any of the key learnings from the Tech Bubble crash of 2000 and the market meltdown of the Global Financial Crisis (GFC or Great Recession)?

Finally, is your portfolio positioned for future trends in portfolio management?

 

Below I provide a shot history of the evolution of portfolio diversification. The evolution of portfolio diversification is interesting and can be referenced to determine how advanced your portfolio is.

 

The framework, idea, and some of the material comes from a very well written article by Aberdeen Standard Investments (ASI).

Unless stated otherwise, the opinions and comments below are mine.

 

Standing on the Shoulders of Giants

Nobel Laureate and pioneer of investment theory Harry Markowitz’s 1952 paper “Portfolio Selection” provided the foundations for Modern Portfolio Theory (MPT).

Markowitz’s analysis provided the mathematical underpinnings for portfolio optimisation.

The key contribution of Markowitz was the quantification of portfolio “risk”. Portfolio Risk was measured by the variation in investment returns – standard deviation of returns.

Markowitz’s paper led to the concept of an “optimal portfolio”, a framework in which both risk and returns are considered. Optimal portfolios offer the maximum expected return for a defined level of risk.

The benefits of diversification were clear to see. Diversification reduces risk without sacrificing returns.

As the ASI article noted: Markowitz called diversification “the only free lunch in finance”.

MPT led to the establishment of the 60:40 portfolio, a portfolio of 60% equities and 40% fixed income.

Increased Diversification of the 60:40 Portfolio

The 60:40 portfolio dominated for a long period time. This portfolio was also largely domestically orientated i.e. the concept of investing internationally was not widely practiced in the 1960 – 70s, even early 1980s.

The next phase in portfolio diversification largely focused on increasing the level of diversification within the equity and fixed income components of 60:40 Portfolio.

As outlined in the ASI paper, four trends combined to drive a broadening of investments in 1980s and 90s:

  • deregulation of financial markets
  • rapid growth in emerging markets
  • financial innovation
  • academic ‘discoveries’.

Deregulation played a major role, particularly the ending of fixed currency exchange rates and the relaxing of capital controls. This enabled an increased level of investing internationally.

This also coincided with the discovery of the “emerging markets”, leading to an increased allocation to emerging market equities and fixed income securities.

Financial innovation resulted in the development of several new financial instruments, including mortgage-backed securities, high-yield bonds (formally called Junk Bonds), and leverage loans.

The use of derivatives also grew rapidly following the establishment of Option Pricing Theory.

Other academic discoveries led to style investing, such as value and growth, and the rise of investing into smaller companies to add value and increase diversification.  Style investing has been superseded by factor investing, which is discussed further below.

ASI conclude, that at the end 1990’s portfolio diversification could be characterised as including:

  • domestic and international equities
  • value and growth stocks
  • large-cap and small-cap stocks
  • developed and emerging markets
  • government, mortgage and corporate fixed income securities.

 

Fundamentally, this is still a portfolio of equities and bonds. Nevertheless, compared to the domestic two-asset class 60:40 Portfolio of the 1960 – 70s it offered more diversification and weathered the severe market declines of tech bubble burst in 2000 and GFC better.

Pioneering Portfolio Management – the Yale Endowment Model

The 2000’s witnessed the emergence of the “Endowment Model”. This followed a period of strong performance and evidence of their diversification benefits during the tech bubble burst of 1999-2000.

The Endowment model has been characterised as being based on four core principles: equity bias, diversification, use of less-liquid or complex assets, and value-based investing.

Endowments allocate the largest percentages of their portfolios to alternative asset classes like hedge funds, private equity, venture capital, and real assets e.g. property.

The endowment model was pioneered by David Swensen at Yale University. Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity.

For more on diversification approach adopted by Endowments and Sovereign Wealth Funds please see my previous Post Investment Fees and Investing like and Endowment – Part 2.

Learnings from Norway

The extreme severity the GFC tested all portfolios, including the Endowment Model.

The dislocation in markets muted the benefits of diversification from alternative investments and left many questioning the actual level of diversification within their portfolio.

In 2009 this disappointment prompted the Norwegian Government Pension fund to commission a study to investigate their returns during the GFC.

The study was undertaken by three prominent professors, Andrew Ang (Columbia Business School), William Goetzmann (Yale University) and Stephen Schaefer (London Business School). The paper is well worth reading.

This study went on to influence portfolio diversification considerations and captures some major learnings from the GFC. The study brought factor investing into greater prominence.

Factors are the underlying drivers of investment returns.  The Nordic study recommended that factor related returns should take centre stage in an investment process.

As a result, the Norwegians rethought about how they structured their portfolios. Other countries have followed, incorporating factor investing into their asset allocations.

Please see my previous Post on Factor Investing and this interview with Andrew Ang, one of the authors of Nordic study, for further details.

Innovation and pressure on Investment Management Fees

The period since the GFC has yielded an increasing level of innovation. This innovation has been driven in part by factor investing, technology advancements, pressure on reducing investment management fees, and increased demand to access more liquid alternative investment strategies to further diversify portfolios.

The disaggregation of investment turns has provided a new lens in which to view portfolio diversification. With technology advancements and the rise of factor investing returns from within markets have been isolated. Broadly speaking, investment returns can be attributed to: market exposures (beta e.g. sharemarkets); underlying factors (e.g. value and momentum); hedge fund strategy returns (e.g. relative value and merger arbitrage); and returns purely attributable to manager skill (called alpha, what is left if the previous sources cannot explain all the return outcome). For a fuller discussion please see my earlier Post on Disaggregation of Investment Returns.

These trends have resulted in the proliferation of ETFs and the downward pressure on investment management fees. The active manager has been squeezed, with investors only wanting to pay fees relative to the source of return i.e. very very low fees for beta and higher fees for alpha.

These developments have also resulted in the rise of liquid alternatives. Returns once attributed to hedge funds can now be more easily accessed, from a cost and liquid perspective.

Increasingly these strategies are available in an Exchange Trade Fund (ETF) structure.

True Portfolio Diversification

Consequently, there is a now a greater ability to significantly diversify the portfolios of the 1980s and 1990s and take on the learnings from GFC and 2000 Tech bubble.

Increasingly 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 listed liquid 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.

True diversification involves taking the learnings from the endowment model and the Norwegian Government Pension Fund study.

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios. For further discussion, see my previous Post on adding alternatives to a portfolio, it is an Evolution not a Revolution.  This Post highlights that more asset classes does not equal more diversification may also be of interest.

Goal Based Investing and the extinction of the 60:40 Portfolio

Advancements in technology have helped investors understand the different dimensions of risk better and move away from the sole risk measure of MPT (standard deviation of returns).

Likewise, there has been a growing appreciation that failure to meet your investment objectives is the greatest investment risk.

More advanced portfolio construction approaches such as Liability Driven Investing (LDI) have been embraced.

Goal-Based Investing for the individual is based on the concepts of LDI.

The move toward Goal-Based Investing completely upturns portfolio construction, likely resulting in the extinction of the 60:40 Portfolio.

This paradigm shift within the industry is best captured by analysis undertaken by EDHEC Risk Institute.  I covered the most relevant EDHEC article in more depth recently for those wanting more information. This Post outlines future trends in Wealth Management.

Future Direction of Diversification

The ASI article finishes by discussing several trends they believe are reshaping portfolio construction. Some of these trends have been discussed on Kiwiinvestorblog.

I would like to highlight the following trends identified by ASI:

  1. Investors continue to shift from traditional to alternative assets, see the recent Prequin Post.
  2. Investors are increasingly integrating environmental, social and governance (ESG) analysis into their decision-making process.
  3. Opportunities to invest in emerging markets are increasing.
  4. Individuals have to take more responsibility for their financial futures. This is known as the Financial Climate Change.

 

As ASI conclude “If done well, diversification can lead to improved long-term returns delivered in a smoother fashion.”

I would also add, and it is worth reflecting upon, although the benefits of diversification are without question, Modern Portfolio Theory of the 1950s can hardly be considered modern.

 

Happy investing.

Please see my Disclosure Statement

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

Investing in a Challenging Investment Environment

The Global financial backdrop can be summarised as:

  1. Late Cycle
    • The US economy is into its longest period of uninterrupted growth, it has been over ten years since the Global Financial Crisis (GFC) and the US experiencing a recession.
    • Likewise, the US sharemarket is into it longest period without incurring a 20% or more fall (which would be a bear market).
  2. Exceptionally low interest rates. As you will be aware over $14 trillion of European and Japanese fixed income securities are trading on negative interest rates.
  3. Central Banks around the world are reducing short-term interest. By way of example, the US Federal Reserve has undertaken a mid-cycle adjustment, with more to come, the European Central Bank recently cut interest rates, as has China’s Central Bank. The Reserve Bank of Australia and the Reserve Bank of New Zealand have reduced cash rates very aggressively in recent months. It appears that interest rates will remain lower for longer.
  4. Rising geo-political risk, namely an ongoing and escalating trade dispute between the US and China, while Brexit has a cameo role on the global stage, and there are rising tensions in the middle-east.
  5. Global growth has slowed. The pace of economic activity has slowed around the world, this is most noticeable in Europe, Japan, and China, and is concentrated within the manufacturing sector. The service sectors have largely been unaffected.

 

Against this backdrop the US sharemarket has outperformed, continually reaching all-time highs, likewise for the New Zealand sharemarket.

Value stocks have underperformed high growth momentum stocks. The performance differential between value and growth is at historical extremes.

Lastly emerging Markets have underperformed the developed world.

 

A good assessment of the current environment is provided in this article by Byron Wien. It is a must read, Plenty to worry about but not much to do.

 

It is not all gloom and doom

The US consumer is in very good shape, reflecting record low unemployment, rising wages, and a sound property market. The US consumer is as bigger share of the global economy as is China. Although it is not growing as fast as China, a solid pace of growth is being recorded.

Overall, economic data in the US has beaten expectations over recent weeks (e.g. retail sales).

Globally the manufacturing sectors are expected to recover over the second half of this year, leading to a rebound in global growth. Low interest rates will also help global growth.  Nevertheless, growth will remain modest and inflation absent.

Globally, in most countries, Sharemarket’s dividend yields are higher than interest rates. This means that sharemarkets can fall in value over the next 5-10 years and still outperform fixed income.

 

How to invest in current environment

Recently there has been #TINA movement: There Is No Alternative to Equities.

Certainly equities have performed strongly on a year to date basis, so have fixed income securities (their value increases as interest rates fall).

The traditional 60/40 portfolio, 60% Equities and 40% Fixed Income, has performed very strongly over the last 6-9 months, this comes after a difficult 2018.

#TINA and the longer term performance of the 60/40 portfolio is covered in this AllAboutAlpha Article, which is well worth reading.

The 60/40 portfolio has performed well over the last 10 years, and has been a strong performer over the longer term.

This performance needs to be put into the context that interest rates have been falling for the last 35 years, this has boosted the returns from the Fixed Income component of the portfolio.  Needless to say, this tail wind may not be so strong in the next 35 years.

This indicates that future returns from a 60/40 portfolio will be lower than those experienced in more recent history.

There are lots of suggestions as to what one should do in the current market environment.  This article on Livewire Markets provides some flavour.

No doubt, you will discuss any concerns you have with your Trusted Advisor.

 

At a time like this, reflect on the tried and true:

Seek “True” portfolio Diversification

The AllAboutAlpha article references a Presentation by Deutsche Bank that makes “a very compelling case for building a more diversified portfolio across uncorrelated risk premia rather than asset class silos”.

The Presentation emphasises “The only insurance against regime shifts, black swans, the peso problem and drawdowns is to seek out multiple sources of risk premia across a host of asset classes and geographies, designed to harvest different features (value, momentum, illiquidity etc.) of the return generating process, via a large number of small, uncorrelated exposures

The above comments are technical in nature and I will explain below. Albeit, the Presentation is well worth reading: Rethinking Portfolio Construction and Risk Management.

 

In a nutshell, the above comments are about seeking “true” portfolio diversification.

Portfolio diversification does not come from investing in more and more asset classes i.e. asset class silos. This has diminishing diversification benefits over the longer term and particularly at the time of market crisis e.g. adding global listed property or infrastructure to a multi-asset portfolio that already includes global equities.

True portfolio diversification is achieved by investing in different risk factors (i.e. premia) that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth by way of example.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta (e.g. equities and fixed income), smart beta (e.g. value and momentum factors), alternative and hedge fund risk premia, illiquidity e.g. Private Equity, Direct Property, and unlisted infrastructure. And of course, true alpha from active management, returns that cannot be explained by the risk exposures just outlined. There has been a disaggregation of returns.

US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification, along with the heavy investment into alternative investments and factor exposures. They are a model of world best investment management practice.

Therefore, seek true portfolio diversification, this is best way to protect portfolio outcomes and reduce the reliance on sharemarkets and interest rates driving portfolio outcomes.

As the Presentation says, a truly diversified portfolio provides better protection against large market falls and unexpected events i.e. Black Swans.

True diversification leads to a more robust portfolio.

(I have written a number of Post on Alternatives and the expected growth in institutions investing in alternatives globally.)

 

Customised investment solution

Often the next bit advice is to make sure your investments are consistent with your risk preference.

Although this is important, it is also fundamentally important that the investment portfolio is customised to your investment objectives and takes into consideration a wider range of issues than risk preference and expected returns and volatility from capital markets.

For example, income earned up to and after retirement, assets outside super, legacies, desired standard of living in retirement, and Sequencing Risk (the period of most vulnerability is either side of the retirement age e.g. 65 here in New Zealand).

 

Think long-term

I think this is a given, and it needs to be balanced with your customised investment objectives as outlined above. Try to see through market noise, don’t over trade and don’t take on more risk to chase returns.

It is all right to do nothing, don’t be compelled to trade, a less traded portfolio is likely more representative of someone taking a longer term view.

Also look to financial planning options to see through difficult market conditions.

 

There are a lot of Investment Behavioural issues to consider, the idea of the Regret Portfolio approach may resonate, and the Behavioural Tool Kit could be of interest.

 

AllAboutAlpha has a great tagline: “Seek diversification, education, and know your risk tolerance. Investing is for the long term.”

Kiwiinvestorblog is all about education, it does not provide investment advice nor promote any investment and receives no payments. Please follow the links provided for a greater appreciation of the topic in discussion.

 

And, please, build robust investment portfolios. As Warren Buffet has said: “Predicting rain doesn’t count. Building arks does.” ………………….. Is your portfolio an all weather portfolio?

 

Happy investing.

Please see my Disclosure Statement

 

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

 

KiwiSaver Investors are missing out

This is a great article by Stuff outlining the KiwiSaver risk ladder, rung by rung.

However, what struck me is that there is a rung missing on the KiwiSaver ladder.

That rung being the lack of exposure to non-traditional investments, such as Alternatives, including liquid alternatives, hedge funds, and investments into Direct Property and unlisted infrastructure.

 

Based on the Stuff article, there is just 1% within all of the KiwiSaver Funds invested outside of Cash, Fixed Interest (bonds), and Equities (the traditional asset classes).

We don’t have to look far to see how much of anomaly this.

By way of comparison, the Australian Pension Fund Industry, which is the fourth largest Pension market in the world, invests 22.0% into non-traditional assets.

As can be seen in the Table below, Australian Pension Funds, which manages A$2.9 trillion, invests 22.0% into non-traditional assets, meanwhile KiwiSaver has 1% invested outside of the traditional assets. (KiwiSaver Total Assets are just over $50 billion).

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

 

As recently reported by Bloomberg, allocations to non-traditional assets is expected to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

 

The increased allocations to Alternative is a global trend, which is not just in response to current market conditions.

As outlined in a previous Post, Preqin a specialist global researcher of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world, expect Alternatives to make up a larger 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 – manager selection will be critical.

 

Globally the trend toward increasing allocations to non-traditional assets has been in play for some time. As one of my first Posts notes, the case for adding alternatives to a traditional portfolio is strong.

This Post highlights that the movement toward Alternatives and non-traditional assets is not revolutionary nor radical, it is seen globally as evolutionary, a natural progression toward building more robust Portfolios that can better weather sharp falls in global sharemarkets.

 

Being more specific about Alternatives, Prequin note 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

 

Therefore, motives to investing in alternatives range from enhancing returns (Private Equity) and reducing risk through better diversification (Hedge Funds) and hedging against inflation (infrastructure and real estate (property), high exposures to non-traditional assets have benefited Endowments and foundations for many years.

 

I have Posted extensively on the benefits of Alternatives, for example highlighting research they would benefit Target Date Funds and the benefits of Alternatives more generally.

 

So the Question needs to be asked, why do KiwiSaver Funds not invest more into non-traditional assets? Particularly, when globally the trend is to invest in such assets is well established and further growth is expected, while the benefits are well documented.

 

Therefore, KiwiSaver Investors are potentially missing out.  Their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives.

 

Happy investing.

Please see my Disclosure Statement

 

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

KiwiSaver and OECD Pension Scheme Recommendations

The OECD has identified for some time the growing importance of Defined Contribution (DC) pension schemes.

There has been a major shift globally away from Defined Benefit (DB) schemes to DC, such as KiwiSaver here in New Zealand.

As a result, the individual has become increasingly responsible for investment decisions, for which they are generally not well equipped to make.   This has been likened to a “financial climate change” by the World Economic Forum

The OECD has undertaken a review of DC potential drawbacks and how to incorporate them into regulatory frameworks to protect members. This led to the formation of a Core Principles of Private Pension Regulation.

In addition, the OECD Roadmap for the Good Design of DC Pension Plan made several recommendations.

 

Off interest to me, from the perspective of designing investment solutions, were the following:

  • Ensure the design of DC pension plans is internally coherent between the accumulation and pay-out phases and with the overall pension system. 

 

  • Consider establishing default life-cycle investment strategies as a default option to protect people close to retirement against extreme negative outcomes. 

 

  • For the pay-out phase, encourage annuitisation as a protection against longevity risk.

 

The OECD made a number of other recommendations which also have merit and they are provided below.

 

The OECD Core Principles of Private Pension Regulation emphasised that the objective is to generate retirement income.

Importantly, investment strategies should be aligned with this objective and implement sound risk management practices such as diversification and asset-liability matching.

“These should be appropriately employed in order to achieve the best outcome for the plan members and beneficiaries” (Guidelines 4.1).

Interestingly, these principles should apply not only to KiwiSaver, but to any forms of voluntary savings plans and mandatory arrangements.

 

The emphasis on generating retirement income and coherency between accumulation and pay-out phase (de-cumulation) are important concepts.

 

In my mind, a greater focus should be placed on generating income in retirement at the later stages of the retirement accumulation phase i.e. at least 10-15 years out from retirement. This is achieved by using asset-liability matching techniques as recommended by the OECD. The investment knowledge is available now to achieve this.

This reflects that the goal of most modern investment Products is to accumulate wealth and risk is defined as volatility of capital. Although these are important concepts, and depending on the size of the Pool, the focus on accumulated wealth my not lead to the generation of a stable and sufficient level of income in retirement.

This is a key learning out of Australia as they near the end of the “accumulation” phase of their superannuation system.

The central point is, without a greater focus on generating Income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

 

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement.

 

I have Posted previously on the concept of placing a greater focus on retirement income as the investment goal (as recommended by the OECD). The argument for such a goal is well presented by Noble Memorial Prize in Economic Sciences Professor Robert Merton.

Professor Merton highlights that for retirement, income matters, and not the value of Accumulated Wealth.

He also argues that variability of retirement income is a better measure of risk rather than variability of capital.

 

It is appropriate to consider the OCED recommendations at a time that the New Zealand Government are reviewing the Kiwisaver Default Provider arrangements.

This Review is being undertaken by the Ministry of Business, Innovation & Employment (MBIE) and submissions are due 18 September 2019.

This GoodReturns article provides some context.

 

It is also important to note that there is a paradigm shift underway within the wealth management industry. The industry is evolving, new and improved products are being introduced to the markets in other jurisdictions.

New and innovative financial products are disrupting traditional markets by offering alternative ways to receive retirement income. The new approaches combine existing products in new and different ways. While they do not always provide guaranteed lifetime income, the innovations nevertheless can give savers options and features that annuities do not provide.

For example, Managed Payout Funds in the USA are a major alternative to an annuity. These Funds are designed to produce a relatively consistent level of annual income but that does not guarantee that outcome. They are similar in some respects to Target Date Funds (TDFs) but have a different objective.

 

More robust investment solutions are being developed to meet the retirement income challenge, they also display Flexicurity.   EDHEC Risk Institute provides a sound framework for the development of Robust Investment Solution and the need for more appropriate investment solutions.

Increasingly the robust solution is a Goal-Based investment solution coupled with longevity annuities that begin to make payments when the owner reaches an advanced age (e.g. 80) as a means to manage longevity risk.

 

The future also entails an increasing level of customisation. This reflects that saving for retirement is an individual experience requiring much more tailoring of the investment solution than is commonly available now. Different investors have different goals.

The investment techniques and approaches are available now to better customise investment solutions in relation to the conservative allocations within ones portfolio so as to generate a level of income to meet retirement goals.

Likewise, the allocation to risky assets (e.g. equities) should also be based on individual goals and circumstances.

The risky asset allocation should not be based on age alone, other factors such as assets outside of Super, other forms of income, and tolerance for risk in meeting aspiration retirement goals for example should also be considered.

 

In summary, the retirement investment solution needs be customised and focus on generating a sufficient and stable stream of replacement income. This goal needs to be considered over the accumulation phase, such that hedging of future income requirements is undertaken prior to retirement (LDI). Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement of income in retirement, greater variation of income in retirement, and/or other inefficient trade-offs are made during retirement.

Importantly the investment management focus is not on beating a market index, arguing about fees (albeit they are important), the focus is on how the Investment Solution is tracking relative to the “individuals” retirement goals.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

The OECD also recommends:

  1. Encourage people to enrol, to contribute and contribute for long periods.
  2. Improve the design of incentives to save for retirement, particularly where participation and contributions to DC pension plans are voluntary.
  3. Promote low-cost retirement savings instruments.
  4. Establish appropriate default investment strategies, while also providing choice between investment options with different risk profile and investment horizon.
  5. Promote the supply of annuities and cost-efficient competition in the annuity market.
  6. Develop appropriate information and risk-hedging instruments to facilitate dealing with longevity risk.
  7. Ensure effective communication and address financial illiteracy and lack of awareness.