Portfolio Diversification

Kiwi Investor Blog has published 150 Posts….. so far

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Kiwi Investor Blog has published over 150 Posts, so far! 

Thank you to those who have provided support, encouragement, and feedback. It has been greatly appreciated. Kiwi Investor Blog achieved 100 Posts in October 2019.

Consistent with the current investment environment and the outlook for future investment returns, the key themes of the Kiwi Investor Blog Posts over the last twelve months have been:

  1. Future returns are unlikely to be as strong as those experienced over the last decade
  2. Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to alternatives e.g. Private Equity
  3. What portfolio diversification is, and looks like
  4. Positioning portfolios for the likelihood of higher levels of inflation in the future
  5. Time to move away from the traditional Diversified Balanced Portfolio
  6. Occasions when active Management is appropriate and where to find the more consistently performing managers – who outperform
  7. Investing for Endowments, Charities, and Foundations
  8. Navigating a Bear market, including the benefits of disciplined portfolio rebalancing

Links to the key Posts to each of these themes is provided below.

Kiwi Investor Blog’s primary objective is to make available insights into Institutional investment strategies, practices, and processes to a wider audience in simple language.

The Posts are written in the spirit of encouraging industry debate, challenging the status quo and “conventional wisdoms”, and striving to improve investment outcomes for clients.

Future returns are unlikely to be as strong as those experienced over the last decade

The year started with a sobering outlook for long-term investment returns as outlined in this article by AQR.  The long-term outlook for investment markets has been a dominant theme this year, where the strong returns experienced over the Past Decade are unlikely to be repeated in the next 10 years.  Also see a related Bloomberg article here.

Interestingly, even after the strong declines in March and April of this year, Forecasted investment returns remain disappointing, given the nature of longer-term market returns.

If anything, the outlook for fixed income returns has deteriorated over the course of 2020.

Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to Alternatives

The challenging return environment led to a series of Posts on potential investment strategies to protect your Portfolio from different market environments in the future.

This includes the potential benefits of Tail Risk Hedging and an allocation to Real Assets.

A primary focus of many investment professions currently is what to do with the fixed income allocations of portfolios, as outlined in this article.

This series of Posts also included the case against investing in US equities and the case for investing in US equities (based on 10 reasons by Goldman Sachs that the current US Bull market has further to run).

The investment case for a continued allocation to Government Bonds was also provided.

Theses Post are consistent with the global trend toward the increasing allocations toward alternatives within investment portfolios.  This survey by CAIA highlights the attraction of alternatives to investors and likely future trends of this growing investment universe, including greater allocations to Private Equity and Venture Capital.

One of the most read Post this year has been a comparison between Hedge Funds and Liquid Alternatives by Vanguard, with their paper concluded both bring diversification benefits to a traditional portfolio.

What Portfolio Diversification is, and looks like

Reflecting the current investment environment and outlook for investment returns, recent Posts have focused on the topic of Portfolio Diversification. These Posts have complemented the Posts above on particular investment strategies.

A different perspective was provided with a look at the psychology of Portfolio Diversification.  Diversification is hard in practice, easy in theory, it often involves the introduction of new risks into a Portfolio and there is always something “underperforming” in a truly diversified portfolio.  This was one of the most read Posts over the last six months.

A Post covered what does portfolio diversification look like.  A beginner’s guide to Portfolio diversification and why portfolios fail was also provided.

On a lighter note, the diversification of the New Zealand Super Fund was compared to the Australian Future Fund (both nation’s Sovereign Wealth Funds).

A short history of portfolio diversification was also provided, and was read widely.

The final Post in this series provided an understanding of the impact of market volatility on a Portfolio.

Positioning Portfolios for the likelihood of higher levels of inflation in the future

Investors face the prospects of higher inflation in the future.  Although inflation may not be an immediate threat, this article by Man strongly suggests investors should start preparing their Portfolio for a period of higher inflation.

The challenge of the current environment is also covered in this Post, which provides suggestions for Asset Allocations decisions for the conundrum of inflation or deflation.

Time to move away from the traditional Diversified Portfolio

A key theme underpinning some of the Posts above is the move away from the traditional Diversified Portfolio (the 60/40 Portfolio, being 60% Equities and 40% Fixed Income, referred to as the Balance Portfolio).

Posts of interest include why the Balanced Portfolio is expected to underperform and why it is time to move away from the Balanced Portfolio.  They are likely riskier than you think.

There has been a growing theme over the last nine months of the Reported death of the 60/40 Portfolio.

My most recent Post (#152) highlights that the Traditional Diversified Fund is outdated as it lacks the ability to customise to the client’s individual needs.  Modern day investment solutions need to be more customised, particularly for those near and in retirement.

Occasions when active Management is appropriate and where to find the more consistently performing managers

Recent Posts have also covered the role of active management.

They started with a Post with my “colour” on the active vs passive debate (50 shades of Grey), after Kiwi Wealth got caught up in an active storm.

RBC Global Active Management provided a strong case for the opportunities of active management and its role within a truly diversified portfolio.

While this Post covered several situations when passive management is not appropriate and different approaches should be considered.

Another popular Post was on where investment managers who consistently outperform can be found.

Investing for Endowments, Charities, and Foundations

I have written several Posts on investing for Endowments, Charities, and Foundations.

This included a Post on the key learnings from the successful management of the Yale Endowment.

How smaller Foundations and Charities are increasingly investing like larger endowments.  See here and here.

Navigating a Bear market, including the benefits of disciplined Portfolio rebalancing

Not surprisingly, there have been several Posts on navigating the Bear Market experienced in March and April of this year.

Posts on navigating the event driven Bear Market can be found here and here.

The following Post outlined what works best in minimising loses, market timing or diversification at the time of sharemarket crashes.

This Post highlighted the benefits of remaining disciplined during periods of market volatility, even as extreme as experienced this year, particularly the benefits of Rebalancing Portfolios.

Please see my Disclosure Statement

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

The Case for holding Government Bonds and fixed income

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The case for holding Government Bonds is all about certainty.  The question isn’t why would you own bonds but, in the current environment, why wouldn’t you own bonds to deliver certainty in such uncertain times?

This is the central argument for holding government bonds within a portfolio.  The case for holding government bonds is well presented in a recent article by Darren Langer, from Nikko Asset Management, Why you can’t afford not to own government bonds.

As he argues, government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

The article examines some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It is well worth reading.

Why you can’t afford not to own government bonds

The argument against holding government bonds are based on expectations of higher interest rates, higher inflation, and current extremely low yields.

As argued in the article, although these are all very valid reasons for not holding government bonds, they all require a world economy that is growing strongly.  This is far from the case currently.

They key point being made here, in my opinion, is that the future is unknown, and there are numerous likely economic and market outcomes.

Therefore, investors need to consider an array of likely scenarios and test their assumptions of what is “likely” to happen.  For example, what is the ‘normal’ level of interest rates? Are they likely to return to normal levels when the experience since the Global Financial Crisis has been a slow grind to zero?

Personally, although inflation is not an issue now, I do think we should be preparing portfolios for a period of higher inflation, as I outline here.  Albeit, this does not negate the role of fixed income in a portfolio.

The article argues that current conditions appear to be different and given this it is not unrealistic to expect that inflation and interest rates are likely to remain low for many years and significantly lower than the past 30 years.

In an uncertain world, government bonds provide certainty. Given multiple economic and market scenarios to consider, maintaining an allocation to government bonds in a genuinely diverse and robust portfolio does not appear unreasonable on this basis.

Return expectations

Investors should be prepared for lower rates of returns across all assets classes, not just fixed income.

A likely scenario is that governments and central banks will target an environment of stable and low interest rates for a prolonged period.

In this type of environment, government bonds have the potential to provide a reasonable return with some certainty. The article argues, the benefits to owning bonds under these conditions are two-fold:

  1. A positively sloped yield curve in a market where yields are at or near their ceiling levels. Investors can move out the curve (i.e. by buying longer maturity bonds) to pick up higher coupon income without taking on more risk.
  2. Investors can, over time, ride a position down the positively-sloped yield curve (i.e. over time the bond will gain in value from the passing of time because shorter rates are lower than longer rates). This is often described as roll-down return.

The article concludes, that although fixed income may lose money during times of strong economic growth, rising interest rates, and higher inflation, these losses can be offset by the gains on riskier assets in a portfolio.  Losses on fixed income are small compared to potential losses on other asset classes and are generally recovered more quickly.

No one would suggest a 100% allocation to government bonds is a balanced investment strategy; likewise, not having an allocation to bonds should also be considered unbalanced. 

“But a known return in an uncertain world, where returns on all asset classes are likely to be lower than the past, might just be a good thing to have in a portfolio.”

The future role of fixed income in a robust portfolio has been covered regularly by Kiwi Investor Blog, the latest Post can be found here: What do Investors need in the current environment? – Rethink the 40 in 60/40 Portfolios?

The article on the case for government bonds helps bring some balance to the discussion around fixed income and the points within should be considered when determining portfolio investment strategies in the current environment.

Happy investing.

Please see my Disclosure Statement

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

Understanding the Impact of Volatility on your Portfolio

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A key investment concept is volatility drag. Volatility drag provides a framework for considering the trade-off between the “cost” and “benefit” of reducing portfolio volatility.

The volatility of your portfolio matters. Reducing portfolio volatility helps deliver higher compound returns over the longer-term. This leads to a greater accumulation of wealth over time.

When introducing volatility reduction strategies into a Portfolio a cost benefit analysis should be undertaken.

The cost of reducing portfolio volatility cannot be considered in isolation.

The importance of volatility and its impact on an investment portfolio is captured in a recent article by Aberdeen Standard Investment (ASI), The long-term benefits of finding the right hedging strategy.

The ASI article is summarised below.  Access to article via LinkedIn is here.

It is widely accept that avoiding large market losses and reducing portfolio volatility is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, an ongoing and uninterrupted endowment, or meeting Pension liabilities.

Understanding Volatility Drag

Volatility Drag is a key concept from the paper: if you lose 50% one year, and make 50% the next, your average return may be zero but you’re still down 25%. This is commonly referred to as the “volatility drag.”

The main disconnect some investors have is they look at returns over a discrete period, such as a year, or the simple average return over two years (zero in the case above).

Instead, investors should focus on the realised compound rate.  The compound annualised return in the above example is -13.97% versus simple average return of zero.

ASI make the following point: “The compound (geometric) rate of return will only equal the arithmetic average rate of return if volatility is zero. As soon as you introduce volatility to the return series, the geometric IRR will start falling, relative to the average return.”

This is a key concept to understand.  Volatility reduces compounded returns over time, therefore it impacts on accumulated wealth.  The focus should be on the actual return investors receive, rather than discrete period returns.  Most investment professionals understand this.

Cashflows, into and out of a Portfolio, also impact on actual returns and therefore accumulated wealth.  This is why a 100% equities portfolio is unlikely to be appropriate for the vast majority of investors. The short comings of a high equity allocations is outlined in one of my previous Posts: Could Buffett be wrong?

Thought Experiment

In the article ASI offers a thought experiment to make their point, a choice between two hypothetical investments:

  1. Investment A, has an average annual return of 1% with 5% volatility.
  2. Investment B, has twice the average return (2%) but with four times the volatility (20%).

An investor with a long term horizon might allocate to the higher expected return investment and not worry about the higher levels of volatility.  The view could be taken because you have a longer term investment horizon more risk can be taken to be rewarded with higher returns.

In the article ASI provides simulated track records of the two investments over 50 years (the graph is well worth looking at).

As would be expected, Investment B with the 20% volatility has a much wider range of possible paths than the lower-volatility Investment A.

What is most interesting “despite having double the average annual return, the more volatile strategy generally underperforms over the long term.”

This is evident in the Table below from the ASI article, based on simulated investment returns:

 Average Annual ReturnStandard Deviation of Annual ReturnsAverage total return after 50 yearsAverage realised internal rate of return (IRR)
A1%5%+53%0.88%
B2%20%-3.0%-0.07%

Note, how the IRR is lower than the average annual return e.g. Investment A, IRR is 0.88% versus average annual return of 1.0%.  As noted above, they are only the same if volatility is zero. 

The performance drag, or “cost”, is due to volatility.

Implications and recognising the importance of volatility

The concept of Volatility Drag provides a framework for considering the trade-off between the “cost” and benefit of reducing portfolio volatility.

The ASI article presents this specifically in relation to the benefits of portfolio hedges, as part of a risk mitigation strategy, and their costs with the following points:

  1. The annual cost can be considered in the context of the potential benefits that come from lowering volatility and more effectively compounding returns.
  2. Putting on exposures with flat or even negative expected returns can still increase your total portfolio return over time if they lower your volatility profile sufficiently.
  3. It is meaningless, therefore, to look at the costs of hedges in isolation.

These points are relevant when considering introducing any volatility reduction strategies into an Investment Portfolio i.e. not just in relation to tail risk hedging. A cost benefit analysis should be undertaken, investment costs cannot be considered in isolation.

As ASI note, investors need to consider the overall portfolio impact of introducing new investment strategies, specifically the impact on the downside volatility of a portfolio is critical.

There are a number of ways of reducing portfolios volatility as outlined below, including the risk mitigation strategies of the ASI article.

Modern Portfolios

The key point is that the volatility of your portfolio matters.  Reducing portfolio volatility helps in delivering better compound returns over the longer-term.

Therefore, exploring ways to reduce portfolio volatility is important.

ASI outline the expectation that volatility is likely to pick up in the years ahead, “especially considering the current extreme settings for fiscal and monetary policy combined with rising geopolitical tensions.”

They also make the following pertinent comment, “Uncertainty and volatility aren’t signals for investors to exit the market, but while they persist, we expect investors will benefit over the medium term from having strategies available to them that can help manage downside volatility.”

ASI also note that investors have access to a wide range of tools and strategies to manage volatility.  This is particularly relevant in relation to the risk mitigation hedging strategies that manage downside volatility and are the focus of the ASI article.

Therefore, a modern day portfolio will implement several strategies and approaches to reduce portfolio volatility, primarily as a means to generate higher compound returns over time. This is evident when looking at industry leading sovereign wealth funds, pension funds, superannuation funds, endowments, and foundations around the world.

Strategies and Approaches to reducing Portfolio Volatility

There are a number of strategies and approaches to reducing portfolio volatility, Kiwi Investor Blog has recently covered the following:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.  Thus reducing portfolio volatility and enhancing long-term accumulated returns.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and portfolio benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging, highlighting that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.
  5. What do investors need in the current environment? – Rethink the ‘40’ in the 60/40 Portfolios?: With extremely low interest rates and the likelihood fixed income will not provide the level of portfolio diversification as experienced historically this Post concludes Investors will need to rethink their fixed income allocations and to think more broadly in diversifying their investment portfolio.

Happy investing.

Please see my Disclosure Statement

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

Image from CFA Institute Blog: When does Volatility Equal Risk?

What do Investors need in the current environment? – Rethink the ‘40’ in 60/40 Portfolios?

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Investors seeking to generate higher returns are going to have to look for new sources of income, allocate to new asset classes, and potentially take on more risk.

Investing into a broader array of fixed income securities, dividend-paying equities, and alternatives such as real assets and private credit is likely required.

Investors will need to build more diversified portfolios.

These are key conclusions from a recent article written by Tony Rodriquez, of Nuveen, Rethinking the ‘40’ in 60/40 Portfolios, which appeared recently in thinkadvisor.com.

The 60/40 Portfolio being 60% equities and 40% fixed income, the Balanced Portfolio. The ‘40’ is the Balanced Portfolio’s 40% allocation to fixed income.

In my mind, the most value will be added in implementation of investment strategies and manager selection.

In addition, the opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Putting It All Together

The thinkadvisor.com article provides the following Table.

Source: Nuveen

This Table is useful in considering potential investment ideas.  Actions taken will depend on the individual’s circumstances, including investment objectives, and risk tolerance.

The Table provides a framework across three dimensions to consider how to tackle the current investment challenge of very low interest rates.

Those dimensions are:

  1. The trade-off between level of income generated and risk tolerance (measured by portfolio volatility), e.g. lower income and reduced equity risk
  2. “How to do it” in meeting the trade-off identified above e.g. increase credit and equity exposures to seek higher income
  3. “Where to find it”, types of investments to implement How to do it e.g. active core fixed income, real assets (e.g. infrastructure and real estate), higher yielding credit assets.

Current Investment Environment

These insights reflect the current investment environment of extremely low interest rates.

More specifically the article starts with the following comments: “For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.”

Tony calls for action, “With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?”

This would be a worthy discussion for Investment Advisers and Consultants to have with their clients.

Returns from fixed income are relatively predictable, unlike equity market returns.  Current fixed income yields are the best predictor of future returns.  With global government bond yields around zero and global investment grade credit providing not much more, a return of greater than 1% p.a. from traditional global bond markets over the next 10 years is unlikely.

Fixed income returns over the next 10 years are highly likely to be below the rate of inflation.  Therefore, the risk of the erosion of purchasing power from fixed income is very high.  This is a portfolio risk that needs to be managed. 

Although forecasted returns from equities are also low compared to history, they are higher than those expected from traditional fixed income markets.

What should Investors do?

The article provides some specific guidance in relation to fixed income investments and a view on the outlook for the global economy.

The key point from the article, in my mind, is that for investors to meet the current investment challenges over the next decade they are going to need a more broadly diversified portfolio than the traditional 60/40 portfolio.

I also think it is going to require greater levels of active management.

This will involve a rethink of the ‘40’ fixed income allocation.  Specifically, the focus will be on generating higher returns and that fixed income is likely to provide less protection to a Balanced Portfolio at times of sharemarket declines than has been experienced historically.

Ultimately, a broader view of the 60/40 Portfolio’s construction will need to be undertaken. 

This is likely to require thinking outside of the fixed income universe and implementing a more robust and truly diversified portfolio.

Implementation will be key, including strategy and manager selection.

There will still be a role for fixed income within a Portfolio, particularly duration.  Depending on individual circumstances, higher yielding securities, emerging market debt, and active management of the entire fixed income universe, including duration, is something to consider.  More of an absolute return focus may need to be contemplated.

Outside of fixed income, thought should be given to thinking broadly in implementing a more robust and truly diversified portfolio. 

Kiwi Investor Blog has highlighted the following areas in previous Posts as a means to diversify a portfolio and address the current investment challenge:

  1. Real Assets offer real diversification: this Post outlines the investment risk and return characteristics of the different types of Real Assets and the diversification benefits they can bring to a Portfolio under different economic scenarios, e.g. inflation, stagflation.
  2. Sharemarket Crashes – what works best in minimising loses, market timing or diversification: This Post outlines the rationale for broad portfolio diversification to manage sharp sharemarket declines rather than trying to time markets.  The Post presents the reasoning and benefits of investing into Alternative Assets.
  3. Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging: This Post outlines the case for Tail Risk Hedging.  A potential strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge.
  4. Protecting your portfolio from different market environments – including tail risk hedging debate: This Post compares the approach of broad portfolio diversification and tail risk hedging.  Highlighting that that not one strategy can be effective in all market environments.  Therefore, investors should diversify their diversifiers.

There have been a number of articles over recent months calling into question the robustness of the Balanced Portfolio of 60% Equities / 40% Fixed Income going forward.  I have covered this issue in previous Posts, here and here.

Why the Balanced Portfolio is expected to underperform is outlined in this Post.

Lastly, also relevant to the above discussion, please see this Post on preparing Portfolios for higher levels of inflation.

Call to Action

In appealing to Tony’s call for action, there has probably never been a more important time in realising the value of good investment advice and honest conversations of investment objectives and portfolio allocations. 

Perhaps it is time to push against some outdated conventions, seek new investments and asset classes.

The opportunity for Investment Advisors and Consultants to add value to client investment outcomes over the coming years has probably never been more evident now than in recent history.

The value of good investment advice at this juncture will be invaluable.

Addendum

For a perspective on the current market environment this podcast by Goldman Sachs may be of interest.

In the podcast, Goldman Sachs discuss their asset allocation strategy in the current environment, noting both fixed income and equities look expensive, this points to lower returns and higher risks for a Balanced Portfolio.  They anticipate an environment of below average returns and above average volatility.

Happy investing.

Please see my Disclosure Statement

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

Is it an outdated Investment Strategy? If so, what should you do? Tail Risk Hedging?

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Those saving for retirement face the reality that fixed income may no longer serve as an effective portfolio diversifier and source of meaningful returns.

In future fixed income is unlikely to provide the same level of offset in a portfolio as has transpired historically when the inevitable sharp decline in sharemarkets occur – which tend to happen more often than anticipated.

The expected reduced diversification benefit of fixed income is a growing view among many investment professionals.  In addition, forecast returns from fixed income, and cash, are extremely low.  Both are likely to deliver returns around, if not below, the rate of inflation over the next 5 – 10 years.

Notwithstanding this, there is still a role for fixed income within a portfolio.

However, there is still a very important portfolio construction issue to address.  It is a major challenge for retirement savings portfolios, particularly those portfolios with high allocations to cash and fixed income. 

In effect, this challenge is about exploring alternatives to traditional portfolio diversification, as expressed by the Balanced Portfolio of 60% Equities / 40% Fixed Income. I have covered this issue in previous Posts, here and here.

Outdated Investment Strategy

There are many ways to approach the current challenge, which investment committees, Trustees, and Plan Sponsors world-wide must surely be considering, at the very least analysing and reviewing, and hopefully addressing.

One way to approach this issue, and the focus of this Post, is Tail Risk Hedging. (I comment on other approaches below.)

The case for Tail Risk Hedging is well presented in this opinion piece, Investors Are Clinging to an Outdated Strategy At the Worst Possible Time, which appeared in Institutional Investor.com

The article is written by Ron Lagnado, who is a director at Universa Investments.  Universa Investments is an investment management firm that specialises in risk mitigation e.g. tail risk hedging.

The article makes several interesting observations and lays out the case for Tail Risk Hedging in the context of the underfunding of US Pension Plans.  Albeit, there are other situations in which the consideration of Tail Risk Hedging would also be applicable.

The framework for Equity Tail Risk Hedging, recognises “that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns.”

By way of positioning, the article argues that a reduction in Portfolio volatility leads to better investment outcomes overtime, as measured by the Compound Annual Growth Return (CAGR).  There is validity to this argument, the reduction in portfolio volatility is paramount to successful investment outcomes over the longer-term.

The traditional Balance Portfolio, 60/40 mix of equities and fixed income, is supposed to mitigate the effects of extreme market volatility and deliver on return expectations.

Nevertheless, it is argued in the article that the Balanced Portfolio “limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance.”

In other words, “It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.”

The article provides some evidence of this, highlighting that “large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points.” 

Essentially, the argument is made that the Balanced Portfolio has not delivered on its promise historically and is an outdated strategy, particularly considering the current market environment and the outlook for investment returns.

Meeting the Challenge – Tail Risk Hedging

The article calls for the consideration of different approaches to the traditional Balance Portfolio.  Naturally, they call for Tail Risk Hedging.

In effect, the strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge (protection of large equity loses).

It is argued that this will result in a higher CAGR over the longer term given a higher allocation to equities and without the drag on performance from fixed income.

The Tail Risk Hedge strategy is implemented via an options strategy.

As they note, there is no free lunch with this strategy, an “options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns.”

This is the inverse to some investment strategies, which provide incremental gains over extended periods and then short sharp losses.  There is indeed no free lunch.

My View

The article concludes, “diversification for its own sake is not a strategy for success.”

I would have to disagree.  True portfolio diversification is the closest thing to a free lunch in Portfolio Management. 

However, this does not discount the use of Tail Risk Hedging.

The implementation of any investment strategy needs to be consistent with client’s investment philosophy, objectives, fee budgets, ability to implement, and risk appetite, including the level of comfort with strategies employed. 

Broad portfolio diversification versus Tail Risk Hedging has been an area of hot debate recently.  It is good to take in and consider a wide range of views.

The debate between providing portfolio protection (Tail Risk Hedging vs greater Portfolio Diversification) hit colossal proportions earlier in the year with a twitter spat between Nassim Nicholas Taleb, author of Black Swan and involved in Universa Investments, and Cliff Asness, a pioneer in quant investing and founder of AQR.

I provide a summary of their contrasting perspectives to portfolio protection as outlined in a Bloomberg article in this Post.  There are certainly some important learnings and insights in contrasting their different approaches.

The Post also covered a PIMCO article, Hedging for Different Market Environments.

A key point from the PIMCO article is that not one strategy can be effective in all market environments.  This is an important observation.

Therefore, maintaining an array of diversification strategies is preferred, PIMCO suggest “investors should diversify their diversifiers”.

They provide the following Table, which outlines an array of “Portfolio Protection” strategies.

In Short, and in general, Asness is supportive of correlation based like hedging strategies (Trend and Alternative Risk Premia) and Taleb the Direct Hedging approach.

From the Table above we can see in what type of market environment each “hedging” strategy is Most Effective and Least Effective.

For balance, more on the AQR perspective can be found here.

You could say I have a foot in both camps and are pleased I do not have a twitter account, as I would likely be in the firing line from both Asness and Taleb!

To conclude

I think we can all agree that fixed income is going to be less of a portfolio diversifier in future and produce lower returns in the future relative to the last 10-20 years. 

This is an investment portfolio challenge that must be addressed.

We should also agree that avoiding large market losses is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, ongoing and uninterrupted endowment, or meeting future Pension liabilities.

In my mind, staying still is not going to work over the next 5-10 years and the issues raised by the Institutional Investor.com article do need to be addressed. The path taken is likely to be determined by individual circumstances.

Happy investing.

Please see my Disclosure Statement

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

The Cost of timing markets and moving to a more conservative investment option

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Missing the sharemarket’s five best days in 2020 would have led to a 30% loss compared to doing nothing.

The 2020 covid-19 sharemarket crash provides a timely example of the difficulty and cost of trying to time markets.

The volatility from global sharemarkets has been extreme this year, nevertheless, the best thing would had been to sit back and enjoy the ride, as is often the case.

By way of example, the US S&P 500 sharemarket index reached a historical high on 19th February 2020.  The market then fell into bear market territory (a decline of 20% or more) in record time, taking just 16 trading days, beating the previous record of 44 days set in 1929. 

After falling 33% from the 19th February high global equity markets bounced back strongly over the following weeks, recording their best 50-day advance.

The benchmark dropped more than 5% on five days, four of which occurred in March. The same month also accounted for four of the five biggest gains.

Within the sharp bounce from the 23rd March lows, the US sharemarkets had two 9% single-day increases.  Putting this into perspective, this is about equal to an average expected yearly return within one day!

For all the volatility, the US markets are nearly flat for the period since early February.

A recent Bloomberg article provides a good account of the cost of trying to time markets.

The Bloomberg article provides “One stark statistic highlighting the risk focuses on the penalty an investor incurs by sitting out the biggest single-day gains. Without the best five, for instance, a tepid 2020 becomes a horrendous one: a loss of 30%.”

As highlighted in the Bloomberg article, we all want to be active, we may even panic and sit on the side line, the key point is often the decision to get out can be made easily, however, the decision to get back in is a lot harder.

The cost of being wrong can be high.

Furthermore, there are better ways to manage market volatility, even as extreme as we have encountered this year.

For those interested, the following Kiwi Investor Blog Posts are relevant:

Navigating through a bear market – what should I do?

One of the best discussions I have seen on why to remain invested is provided by FutureSafe in a letter to their client’s 15th March 2020.

FutureSafe provide one reason why it might be the right thing for someone to reduce their sharemarket exposure and three reasons why they might not.

As they emphasis, consult your advisor or an investment professional before making any investment decisions.

I have summarised the main points of the FutureSafe letter to clients in this Post.

The key points to consider are:

  • Risk Appetite should primarily drive your allocation to sharemarkets, not the current market environment;
  • We can’t time markets, not even the professionals;
  • Be disciplined and maintain a well-diversified investment portfolio, this is the best way to limit market declines, rather than trying to time market
  • Take a longer-term view; and
  • Seek out professional investment advice before making any investment decisions

Protecting your portfolio from different market environments

Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or a lasting endowment.

The complexity and different approaches to providing portfolio protection has been highlighted by a recent twitter spat between Nassim Nicholas Taleb and Cliff Asness.

The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

I provide a summary of this debate in Table format in this Post.  

Also covered in this Post is an article by PIMCO on Hedging for Different Market Scenarios. This provides another perspective and a summary of different strategies and their trade-offs in different market environments.

Not every type of risk-mitigating strategy can be expected to work in every type of market environment.

Therefore, maintaining an array of diversification strategies is preferred “investors should diversify their diversifiers”.

Sharemarket crashes, what works best in minimising loses, market timing or diversification?

The best way to manage periods of severe sharemarket declines is to have a diversified portfolio, it is impossible to time these episodes.

AQR has evaluated the effectiveness of diversifying investments during market drawdowns, which I cover in this Post.

They recommend adding investments that make money on average and have a low correlation to equities.

Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, they tend to do worse on average over the longer term.

Alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and have higher returns.

Portfolio diversification involves adding new “risks” to a portfolio, this can be hard to comprehend.

Happy investing.

Please see my Disclosure Statement

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




Asset Allocations decisions for the conundrum of inflation or deflation?

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One of the key questions facing investors at the moment is whether inflation or deflation represents the bigger risk in the coming years.

Now more than ever, given the likely economic environment in the years ahead, investors need to consider all their options when building a portfolio for their future.  This may mean a number of things, including: increasing diversification, investing in new or different markets, being active, and flexible to take advantage of unique opportunities as they arise.

Those portfolios overly reliant on traditional markets, such as equities and fixed income in particular, run the risk of failing to meet to their investment objectives over the next ten years.

Conundrum Facing Investors

A recent article by Alan Dunne, Managing Director, Abbey Capital, The Inflation-Deflation debate and its Implications for Asset Allocation, which recently appeared in AllAboutAlpha.com, clearly outlines the conundrum currently facing investors.

As the article highlights, one of the “key questions facing investors at the moment is whether inflation or deflation represents the bigger risk for the coming years. Economists are split on this….”

Following a detailed analysis of the current and likely future economic environment and potential influences on inflation or deflation (which is well worth reading) the article covers the Implications for Asset Allocations.

Inflation or Deflation: Implications for Asset Allocations

The article makes the following observations as far as asset class performance in different inflation environments, based on historical observations:

  • Deflation like in the 1930s, is negative for equities but positive for Bonds.
  • If inflation picks ups, or even stagflation, that would be negative for real returns on financial assets and real assets may be favoured.

They conclude: “the current uncertainty highlights the importance of holding diversified portfolios, with exposure to a range of traditional and alternative assets and strategies with the potential to deliver returns in different market environments.”

Current Environment

Abbey Capital anticipate greater co-ordination of policy between governments (fiscal policy) and central banks (monetary policy). 

As they note, “many economists draw a parallel between the current scenario and the substantial increase in government debt during World War II. One of the consequences of higher debt levels is that we may see pressure on central banks to maintain interest rates at low levels and maintain asset purchases to ensure higher bond issuance is not disruptive for bond markets i.e. coordination of monetary and fiscal policies.”

I think this will be the case.  The Bank of Japan has maintained a direct yield curve control policy for some time and the Reserve Bank of Australia has implemented a similar policy recently.  Direct yield curve control is where the central bank will target an interest rate level for the likes of the 3-year government bond.

In the environment after World War II debt levels were brought back to more manageable levels by keeping interest rates low (a process known as financial repression).

From a government policy perspective, financial repression reduces the real value of debt over time.  It is the most palatable of a number of options.

Financial repression is potentially negative for government bonds

With interest rates so low, and likely to remain low for some time given policies of financial repression the real return (after inflation) on many fixed income instruments and cash could be negative.

A higher level of inflation not only reduces the real return on bonds but potentially also reduces the diversification benefits of holding bonds in a portfolio with equities.

The diversification benefits of bonds in the traditional 60 / 40 equity-bond portfolio (Balanced Portfolio) has been a strong tail wind over the last 20 years.

The more recent low correlation between bonds and equities is evident in the Chart below, which was presented in the article.

The Chart also highlights that the relation of low correlation between equities and bonds, which benefits a Balanced Portfolio, has not always been present.

As can be seen in the Chart, in the 1980s, when inflation was a greater concern, inflation surprises were negative for both bonds and equities, they became positively correlated.

What should investors do?

“Investors are therefore left with the challenge of finding alternatives for government bonds, ideally with a low or negative correlation to equities and protection against possible inflation.”

The article runs through some possible investment solutions and approaches to meet the likely challenges ahead.  I have outlined some of them below.

I think duration (interest rate risk) and credit can still play a role within a broad and truly diversified portfolio.  Within credit this would likely involve expanding the universe to include the likes of high yield, securitised loans, private debt, inflation protections securities, and emerging market debt as examples.

The key and most important point is that a robust portfolio will be less reliant on tradition asset classes, traditional asset class betas, to drive investment return outcomes.  This is likely to be vitally important in the years ahead.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios.  Not only within asset classes, such as the fixed income example provided above, but across the portfolio to include the likes of real assets and liquid alternatives.

Real assets

Abbey Capital comment that “Real assets such as property and infrastructure should provide protection against higher inflation for long-term investors but may not be attractive for investors valuing liquidity.”

Although the maintenance of portfolio liquidity is important, Real assets can play an important role within a robust portfolio.

For the different types of real assets, their investment characteristics, and likely performance and sensitivity to different economic environments, including economic growth, inflation, inflation protection, stagflation, and stagnation please see the Kiwi Investor Blog Post, Real Assets Offer Real Diversification.  The extensive analysis has been undertake by PGIM.  

Liquid Alternatives

Abbey Capital provide a brief discussion on liquid alternatives with a focus on managed futures.  Not surprisingly given their pedigree.

They provide the following Table which highlights the benefit of liquid alternatives and hedge funds at time of significant sharemarket declines (drawdowns).

Concluding Remarks

Being a managed futures manager, it is natural to be cautious of Abbey Capitals concluding remarks, being reminded of the Warren Buffet quote, “Never ask a barber if you need a haircut.”

Nevertheless, the Abbey Capital’s economic analysis and investment recommendations are consistent with a growing chorus, all singing from a similar song sheet. (Perhaps we could call this a “Barbers Quartet”!)

Without having an axe to grind, and in all seriousness, I have covered similar analysis and comments in previous Posts, the conclusions of which have a high degree of validity and should be considered, if not a purely from portfolio risk management perspective so as to understand any gaps in current portfolios for a number of likely economic environments.

The key and most important point is that robust portfolios will be less reliant on traditional asset classes, traditional asset class betas, to drive investment return outcomes.

Accordingly, investors will need to be more active, opportunistic, and maintain very broad and truly diversified portfolios

Therefore, it is hard to disagree with one of the concluding remarks by Abbey Capital “To account for the competing requirements in a portfolio of returns, low correlation to equities, liquidity and possible inflation protection, investors may need to build robust portfolios with a broader mix of assets and strategies.”

Other Reading

For those interested, previous Kiwi Investor Blog posts of relevance to the Abbey Capital article include:

Preparing your Portfolio for a period of Higher Inflation, this is the Post of most relevance to the current Post, and covers a recent Man article which undertook an analysis of the current economic environment and historical episodes of inflation and deflation.

Man conclude that although inflation is not an immediate threat, the likelihood of a period of higher inflation is likely in the future, and the time to prepare for this is now.  Man recommends several investment strategies they think will outperform in a higher inflation environment.

Protecting your portfolio from different market environments – including tail risk hedging debate, compares the contrasting approaches of broad portfolio diversification and tail risk hedging to manage through difficult market environments. 

It also includes analysis by PIMCO, where it is suggested to “diversify your diversifiers”.

Lastly, Sharemarket crashes – what works best in minimising losses, market timing or diversification, covers a research article by AQR, which concludes the best way to manage periods of severe sharemarket decline is to have a diversified portfolio, it is impossible to time these episodes.  AQR evaluates the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

Happy investing.

Please see my Disclosure Statement

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

Hedged Funds vs Equities – lessons from the Warren Buffet Bet Revisited

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“The Bet” received considerable media attention following the 2017 Berkshire Hathaway shareholder letter in 2018.

To recap, the bet was between Warren Buffet and Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 Index over the 10-year period ending December 2017. Buffet took the S&P 500 to outperform.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10-year period.

There are some astute investment lessons to be learnt from this bet, which are very clearly presented in this AllAboutAlpha article, A Rhetorical Oracle, by Bill Kelly.

Before reviewing these lessons, I’d like to make three points:

  1. I’d never bet against Buffet!
  2. I would not expect a Funds of Funds Hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Funds.
  3. Most if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

This is not to say Hedged Funds should not form part of a truly diversified investment portfolio.  They should, as should other alternative investments.

Nevertheless, I am unconvinced Hedge Fund’s role is to provide equity plus like returns. 

By and large, alternatives, including Hedge Funds, offer a less expensive way of providing portfolio protection as their returns “keep up” with equities, see the previous Kiwi Investor Blog Sharemarket crashes – what works best in minimising losses, market timing or diversification. 

One objective in allocating to alternatives is to add return sources that make money on average and have low correlation to equities.  Importantly, diversification is not the same thing as “hedging” a portfolio

Now, I have no barrow to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed appropriately across a portfolio.

In this regard and consistent with the points in the AllAboutAlpha article:

  1. Having a well-diversified portfolio is paramount and results in better risk-adjusted returns over time.

Being diversified across non-correlated or low correlated investments is important, leading to better risk-adjusted outcomes. 

Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will likely add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime. 

Minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio will not fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting one’s investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

I am unlikely to ever suggest to be 100% invested in equities for the very reason of the second point in the article, as outlined below.

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10-12 years, particularly in the 2008 – 2014 period.  Not many I suspect.  This would also be true of the most recent market collapse in 2020.

The research is very clear, on average investors do not capture the full value of equity market returns over the full market cycle, largely because of behavioural reasons.

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See an earlier Post, the inclusion of Alternatives has been an evolutionary process, not a revolution.

Staying the course is the biggest battle for most investors.  Therefore, take a longer-term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else.

I like this analogy of using standard deviation of returns as a measure of risk. It captures the risks associated with a very high volatile investment strategy such as being 100% invested in equities:

“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.

Please see my Disclosure Statement

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

Private Equity receives a boost from the US Department of Labor – significant industry potential

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Based on the US Department of Labor (DOL) guidance US retirement plans, Defined Contribution (DC), can include certain private equity strategies into diversified investment options, such as target date or balanced funds, while complying with ERISA (laws that govern US retirement plans).

 

This is anticipated to result in better outcomes for US investors.

It is also anticipated to provide a further tailwind for the Private Equity sector which is expected to experience significant growth over the decade ahead, as outlined

 

Private equity investments have long been incorporated in defined benefit (DB) plans, DC plans, 401(k) retirement plans similar to KiwiSaver Funds offered in New Zealand and superannuation funds around the world, have mainly steered away from incorporating Private Equity in their plans due to litigation concerns.

By way of summary, the DOL provides the following guidance. In adding a private equity allocation, the risks and benefits associated with the investment should be considered.

In making this determination, the fiduciary should consider:

  1. whether adding the asset allocation fund with a private equity component would offer plan participants the opportunity to invest their accounts among more diversified investment options within an appropriate range of expected returns net of fees and the diversification of risks over a multi-year period;
  2. whether using third-party investment experts as necessary or managed by investment professionals have the capabilities, experience, and stability to manage an asset allocation fund that includes private equity effectively;
  3. limit the allocation to private equity in a way that is designed to address the unique characteristics associated with such an investment, including cost, complexity, disclosures, and liquidity, and has adopted features related to liquidity and valuation.

It is worth noting that the SEC (U.S. Securities and Exchange Commission) has adopted a 15% limit on investments into illiquid assets by US open-ended Funds such as Mutual Funds (similar to Unit Trusts) and ETFs.

 

In addition, the DOL suggests consideration should be given to the plan’s features and participant profile e.g. ages, retirement age, anticipated employee turnover, and contribution and withdrawal patterns.

The DOL letter outlines a number of other appropriate considerations, such as Private Equity to be independently valued in accordance with agreed valuation procedures.

It is important to note the guidance is in relation to Private Equity being offered as part of a multi-asset class vehicle structure as a custom target date, target risk, or balanced fund. Private Equity cannot be offered as a standalone investment option.

The DOL letter can be accessed here.

 

Size of the Market and innovation

As noted DC plans have been reluctant to invest in Private Equity, by contrast DB plans allocate 8.7% of their assets to Private Equity, based on a 2019 survey of the US’ 200 largest retirement plans.

It is estimated that as much as $400 billion of new assets could be assessed by Private Equity businesses as a result of the DOL guidance, as outlined in this FT article.

Increased innovation is expected, more Private Equity vehicles that offer lower fees and higher levels of liquidity will be developed.

A number of Private Equity firms are expected to benefit.

For example, Partners Group and Pantheon stand to benefit, see below for comments, they launched Private Equity Funds with daily pricing and liquidity in 2013. These Funds were designed for 401(k) plans.

As you would expect, they reference research by the Georgetown Center for Retirement Initiatives which concludes that including a moderate allocation to private equity in a target-date fund could increase the participant’s annual retirement income by at least 6%.

They also comment, private markets provide valuable diversification in an investment portfolio in light of a shrinking public markets sector that has seen the number of US publicly-traded companies decline by around 50% since 1996.

This observation is consistent with one of the key findings from the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The DOL guidance will provide another tailwind for Private Equity.

 

For those interested, this paper by the TIAA provides valuable insights into the optimal way of building an allocation to Private Equity within a portfolio.

 

Potentially significant Industry Impact

The DOL Letter has been well received by industry participants as outlined in this P&I article.

The article stresses that the guidance will help quell some sponsor’s litigation fears and  with a good prudent process Private Equity can be added to a portfolio.

 

The DOL believes the guidance letter “helps level the playing field for ordinary investors and is another step by the department to ensure that ordinary people investing for retirement have the opportunities they need for a secure retirement.”

 

The DOL Letter is in response to a Groom Law Group request on behalf of its clients Pantheon Ventures and Partners Group, who have developed private equity strategies that can accommodate DC plans. The DOL specifically referenced Partners Groups Funds and commented their Private Equity Funds are “designed to be used as a component of a managed asset allocation fund in an individual account plan.”

Partners Group said in a statement that the DOL has taken “a major step toward modernizing defined contribution plans and providing participants with a more secure retirement. At a time when working families are struggling to save, this guidance gives fiduciaries the certainty they need to finally provide main street Americans access to the same types of high-performing, diversifying investments as wealthy and large institutional investors, all within the safety of their 401(k) plans.”

Further comments by Partner Group can be found here.

 

Happy investing.

Please see my Disclosure Statement

 

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

Protecting your Portfolio from different market environments – including tail risk hedging

/ Kiwi Investor / 8 Comments

Avoiding large market losses is vital to accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement or an ongoing and uninterrupted endowment.

 

The complexity and different approaches to providing portfolio protection (tail-risk hedging) has been highlighted by a recent twitter spat between Nassim Nicholas Taleb, author of Black Swan, and Cliff Asness, a pioneer in quant investing.

The differences in perspectives and approaches is very well captured by Bloomberg’s Aaron Brown article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

I provide a summary of the contrasting perspectives in the Table below as outlined by Brown’s article, who considers both men as his friends.

There are certainly some important learnings and insights in contrasting the different approaches.

 

PIMCO recently published an article Hedging for Different Market Scenarios. This provides another perspective.

PIMCO provide a brief summary of different strategies and their trade-offs in diversifying a Portfolio.

They outline four approaches to diversify the risk from investing in sharemarkets (equity risk).

In addition to tail risk hedging, the subject of the twitter spat above between Taleb and Asness, and outlined below, PIMCO consider three other strategies to increase portfolio diversification: Long-term Fixed Income securities (Bonds), managed futures, and alternative risk premia.

PIMCO provide the following Graph to illustrate the effectiveness of the different “hedging” strategies varies by market scenario.PIMCO_Hedging_for_Different_Market_Scenarios_1100_Chart1_58109

As PIMCO note “it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.”

As they emphasise “not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.”

A brief description of the diversifying strategies is provided below:

  • Long Bonds – holding long term (duration) high quality government bonds (e.g. US and NZ 10-year or long Government Bonds) have been effective when there are sudden declines in sharemarkets. They are less effective when interest rates are rising. (Although not covered in the PIMCO article, there are some questions as to their effectiveness in the future given extremely low interest rates currently.)
  • Managed Futures, or trend following strategies, have historically performed well when markets trend i.e. there is are consistent drawn-out decline in sharemarkets e.g. tech market bust of 2000-2001. These strategies work less well when markets are very volatile, short sharp movements up and down.
  • Alternative risk premia strategies have the potential to add value to a portfolio when sharemarkets are non-trending. Although they generally provide a return outcome independent of broad market movements they struggle to provide effective portfolio diversification benefits when there are major market disruptions. Alternative risk premia is an extension of Factor investing.
  • Tail risk hedging, is often explained as providing a higher degree of reliability at time of significant market declines, this is often at the expense of short-term returns i.e. there is a cost for market protection.

 

A key point from the PIMCO article is that not one strategy can be effective in all market environments.

Therefore, maintaining an array of diversification strategies is preferred “investors should “diversify their diversifiers””.

 

It is well accepted you cannot time markets and the best means to protect portfolios from large market declines is via a well-diversified portfolio, as outlined in this Kiwi Investor Blog Post found here, which coincidentally covers an AQR paper. (The business Cliff Asness is a Founding Partner.)

 

A summary of the key differences in perspectives and approaches between Taleb and Asness as outlined in Aaron Brown’s Bloomberg’s article, Taleb-Asness Black Swan Spat Is a Teaching Moment.

My categorisations Asness Taleb
Defining a tail event Asness refers to the worst events in history for investors, such as the 5% worst one-month returns for the S&P 500 Index.

Research by AQR shows that steep declines that last three months or less do little or no damage to 10-year returns.

It is the long periods of mediocre returns, particularly three years or longer, that damages longer term performance.

 Taleb defines “tail events” not by frequency of occurrence in the past, but by unexpectedness. (Black Swan)

Therefore, he is scathing of strategies designed to do well in past disasters, or based on models about likely future scenarios.

 

 

 
Different Emphasis

The emphasis is not only on surviving the tail event but to design portfolios that have the highest probability of generating acceptable long-term returns.   These portfolios will give an unpleasant experience during bad times.

 

 Taleb prefers tail-risk hedges that deliver lots of cash in the worst times. Cash provides a more pleasant outcome and greater options at times of a crisis.

Investors are likely facing a host of challenges at the time of market crisis, both financial and nonfinancial, and cash is better.
Different approaches AQR strategies usually involve leverage and unlimited-loss derivatives.

 

 Taleb believes this approach just adds new risks to a portfolio. The potential downsides are greater than the upside.
Costs AQR responds that Taleb’s preferred approaches are expensive that they don’t reduce risk.

Also, the more successful the strategy, the more expensive it becomes to implement, that you give up your gains over time e.g. put options on stocks

 Taleb argues he has developed methods to deliver cash in crises that are cheap enough that they actually add to long-term returns while reducing risk.

 

 
Investor behaviours Asness argues that investors often adopt Taleb’s like strategies after a severe market decline. Therefore, they pay the high premiums as outlined above. Eventually, they get tire of the paying the premiums during the good times, exit the strategy, and therefore miss the payout on the next crash. Taleb emphasises the bad decisions investors make during a market crisis/panic, in contrast to AQR’s emphasis on bad decisions people make after the market crisis.

 

 

 

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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