Robust Portfolios

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

/ Kiwi Investor / 1 Comment

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

AB propose:

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

 

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

 

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

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

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

The bold is mine.

 

My Opinion and solution

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

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

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

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

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

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

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

 

Limitations of Target Date Funds

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

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

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

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

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

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

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

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

 

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

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

 

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

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

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Andrew Ang on Factor Investing

/ Kiwi Investor / 4 Comments

Great interview with Andrew Ang on Factor investing.

 

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

 

How to determine what factors to invest in?

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

 

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

 

How should factors be used?

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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

Limitations of Passive Index Investing

/ Kiwi Investor / 3 Comments

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

Market indices suffer from two key short comings:

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

 

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

 

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

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

 

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

 

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

 

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

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

 

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

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

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

 

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

 

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors.

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

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

 

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

 

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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


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Asness on Hedge Fund Returns and Buffet Bet Revisited

/ Kiwi Investor / Leave a comment

Earlier in the year I wrote a post about the Buffett Bet.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of funds” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

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

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

I made three points earlier in the year:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Funds hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.  Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. 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

Finally, someone from the Hedge Fund Industry has come out a said it: Hedge Funds should not be compared to the performance of investing in equities.

Cliff Asness from AQR has, and not for the first time, recently written an article about why Hedge Fund returns should not be compared to equity market returns such as the S&P 500 Index, see The Hedgie in Winter.

The key point Asness makes is that Hedge Funds are not 100% invested in equities.  He estimates that they are in effect 50% invested in equities.  If we use beta terms, where a beta of 1.0 =  100% equities, Hedge Funds have a beta of 0.5.  (For those who are wondering what Beta is, Beta is a measure of how sensitivity an investment is to a market index e.g. S&P 500.  Put another way, how much of the returns from the market index can explain the returns of the investment.  Therefore, with a beta of 0.5 we would expect hedge funds to be less volatile than equities and equity markets performance would only explain some of the returns from hedge funds.)

Asness expresses it more succinctly:

“Comparing hedge funds to 100% equities is flat-out silly. Hedge funds have historically, rather consistently, delivered equity exposure (beta to my fellow geeks) just under 50%. In fact much of their point is, supposedly, to be different from equities. I mean that they are at least partly hedged investments. Put more bluntly, it is in the freaking name!”

That’s right, Hedge Funds look to reduce their equity market exposure, hedge it out.  Therefore they will not capture all of an equities market upside.  Similarly, when equity markets fall significantly, they are not capturing all of this downside as well! i.e. Hedge Funds tend to outperform equity markets in equity bear markets.

Certainly, hedge funds are not going to outperform equities in a strong bull market, as we have recently experienced, as they are not 100% invested in equities.  They are not equities.

Well, you probably would expect a hedge fund manager to say this.  Yip, but I would say he is right on the money.

Furthermore, it is not as if Asness lets Hedge Funds off the hook.  From further analysis in the paper Asness notes that Hedge Fund performance has been “petering out” since the Global Financial Crisis (GFC).  This means they have not added or subtracted much value since the GFC.

I take this to mean they have struggled to meet their investment objectives and historical rate of returns, albeit they may well have delivered mildly positive returns.  Which is not as disastrous as often reported.

The “petering out” of Hedge Fund performance is highlighted by Asness as an area of concern.  The data he presents provides no proofs as to why.  He concludes that Hedge Funds may be less special than before.

That is certainly something to dwell upon.  Hedge Funds can play an important role in a robust portfolio and achieving true portfolio diversification.  The observation by Asness should be considered in the selection of Hedge Fund managers and strategies.

Lastly, there is change occurring across the Hedge Funds industry.  This expected change is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund IndustryAIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry. This includes more transparency and lower fee structures.

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

This is consistent with Hedge Funds playing a valuable role in a truly diversified portfolio.

Happy investing.

Please see my Disclosure Statement

 

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

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Unintended Portfolio Risks – Fixed Interest example

/ Kiwi Investor / 1 Comment

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

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

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

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

 

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors.  See earlier post More Asset Classes Does not Equal More Diversification.

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

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

 

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

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

 

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

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

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

 

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

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

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

 

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

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

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

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

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

 

So what can be done?

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

 

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

 

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

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

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

 

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

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

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

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

 

Happy investing.

 

Please see my Disclosure Statement

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

Are Kiwi-saver investors too conservative?

/ Kiwi Investor / Leave a comment

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

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

The NZ industry should be discussing these issues more broadly.

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

 

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

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

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

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

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

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

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

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

 

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

A good advice model recognises this issue.

 

The underlying investment solutions need to be more targeted in relations to investment objectives.  For example the “conservative” allocation (described by EDHEC-Risk as the Goal-hedging portfolio, see post above) is a fixed interest portfolio of duration risk (interest rate risk), high quality credit, and inflation linked securities.  Nevertheless, investment decisions are not made relative to market indices nor necessarily a view on the outlook for interest rates and credit.  Investment decisions are made with the view to match future income replacement requirements, matching of future cashflows and client liabilities.  This is akin to what Insurance companies do to match their future liabilities.

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

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

 

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

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

Not all of these risk exposures can be accessed cheaply.

 

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

 

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

 

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

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

 

Happy investing.

Please see my Disclosure Statement

 

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

 

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A Robust Framework for generating Retirement Income

/ Kiwi Investor / 25 Comments

How much Income do you need in Retirement?

The focus is often on accumulated wealth e.g. how much do you need to save to retire on?

This could potentially result in the wrong focus.  For example if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits, furthermore their income would have dramatically dropped in 2009.  Current income on a million dollars would be approximately $35k.  That’s a big drop in income!  This also does not take into account the erosion of buying power from inflation. [Note: this Post was written in 2018, the current income on $1m in February 2021 is less than $10k.]

Of course, retirees can draw down capital, the rules of thumb are, ………… well, ………..less than robust.

The wrong focus on wealth accumulation can potentially lead to yield chasing in retirement which leads to unintended risks within investment portfolios.

More robust approaches are being developed

The global retirement challenge is leading to new Goal Based Investing solutions.  Goal-based investing is the counterpart to Liability Driven Investing (LDI), which is used by pensions and insurance companies where their investment objectives are reflected in the terms of their future liabilities.

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

An innovative, rigorous, and robust investment framework for solving the retirement challenge is being developed by EDHEC, along with the Operations Research and Financial Engineering Department at Princeton University, and supported by Merrill Lynch.

The framework being developed has some practical applications.  The EDHEC-Princeton Framework:

Defines the Retirement goal

The goal for retirement can be split between wealth and replacement income.

Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with high probabilities.

Different Risk Focus

The retirement framework results in a different focus on risk.

Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations in potential income in retirement.

With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.

Therefore, the real risk is about not achieving the investment goal.  Risk is not fluctuations of returns or underperforming a market index, but instead the true investment risk is failure to achieve investment goals.  This is how investment outcomes should be measured and reported against.

Investment Management Attributes

With the EDHEC-Princeton framework the following portfolio management processes can be adjusted to increase the probability of meeting the investment goals:

  1. Hedging – this is the least risky portfolio that matches future income requirements
  2. Diversification – this is the most efficient way to achieve returns relative to goals
  3. Insurance – this is a dynamic interplay between hedging and return seeking portfolio in the context of what is the worst case scenario in pursuing the investment goals. The trade-off is between downside protection and upside participation.  The measure of risk is underachieving the investment goals.

From this framework, EDHEC argue investors should maintain two portfolios:

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

Over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting replacement income levels.

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

EDHEC-Princeton Retirement Goal-Based Investing Indices

To reflect this retirement investment solution framework EDHEC and Princeton University have developed the EDHEC-Princeton Retirement Goal-Based Investing Indices.

The EDHEC-Princeton Retirement Goal-Based Investing Indices represents the value of a dynamic strategy that aims to offer high probabilities of reaching attractive levels of replacement income for 20 years in retirement while securing, on an annual basis, 80% of the purchasing power in terms of retirement income of each dollar invested.

This is the strategy of investing into a goal-hedging portfolio, that delivers stable replacement income in retirement, and the performance-seeking portfolio, which offer the upside potential needed to reach higher income levels with high probabilities, as outlined above

It will be really interesting to follow how these indices perform.

The investment framework developed by EDHEC has intuitive appeal and is robust in the context of developing an investment solution for the retirement challenge.  There are a some investment solutions currently available in the Target Date/Life Cycle options that are aligned with the above investment approach, as there are many that don’t.

These solutions are better than many of the Target Date Funds that have a number of short comings.

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

Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the right goal, replacement income in retirement.

In summary, the retirement investment solution needs to 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), much like an insurance company does in undertaking a liability driven investing approach.  Focusing purely on an accumulated capital value and management of market risk alone may lead to insufficient replacement income in retirement, or inefficient trade-offs are made prior to and in 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 retirement goals.

Happy investing.

Please see my Disclosure Statement

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

Future’s Hedge Funds

/ Kiwi Investor / 1 Comment

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

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

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

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

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

 

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

 

Arndt, continues:

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

 

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

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

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

 

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

 

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

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

Combined the Future Fund has a more robust portfolio.

 

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

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

 

Happy investing.

 

Please see my Disclosure Statement

 

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

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Perspectives of the Hedge Fund Industry

/ Kiwi Investor / 3 Comments

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.

This is capture in the recently published AIMA paper (Alternative Investment Management Association), Perspectives – Industry Leaders on the Future of the Hedge Fund Industry

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

Hedge fund’s largest clients are Pension Funds, University Endowments, and Sovereign Wealth Funds.

Access to hedge fund strategies is becoming increasingly available to retail investors.  Hedge Funds, and hedge fund strategies, are no longer the exclusive domain of High Net Wealth Worth individuals.

 

Summary of the Report’s Executive Summary

  1. Paradigm shift. The industry is experiencing significant transformation as investors seek new investment solutions to more cheaply access different return streams. This has witnessed an innovation of investment solutions that fit between the traditional hedge fund and the traditional actively managed listed market funds.  These new investment solutions are providing the benefits of increased portfolio diversification for lower fees and increased transparency relative to the traditional hedge fund.  These cheaper return streams are the factor betas and alternative hedge fund betas. There has been a disaggregation of investment returns as a result of recent investment solution innovation.
  1. Hedge Funds can still produce alpha (risk adjusted excess returns) but it is getting harder due to increased competition and the greater ease of access to financial data and computing power.
  1. Therefore, an increasing employment of artificial intelligence and advanced cutting-edge quantitative techniques will likely grow across the hedge fund industry.
  1. The integration of Responsible Investing will likely rise across the hedge fund industry.
  1. The hedged fund firm is likely to change from its current traditional model, employing outside of the traditional business school graduate, employing a greater diversity of talent, flatten organisational structures, and encourage more collaborative environments.
  1. Hedge Fund firms will likely look to partner more with investors and co-invest.
  1. This will see a different focus on distribution and ownership models.

 

Points One and Two are of the most relevant to the focus of Kiwiinvestorblog.

The changing dynamics of the hedge fund industry has implications for the wider funds management industry e.g. downward pressure on fees, the blurring of the lines between traditional fund managers and hedge fund managers investment solutions, and the increased weight on traditional active equity managers to deliver genuine alpha – the closest index fund is on the endangered extinction list!

Importantly, the change taking place is making it easier, cheaper, and more transparent to implement truly diversified and robust multi-asset portfolios.  This is evident in the thoughts expressed in the quotes provided below and throughout the Report.

Section One of the Report formed the basis of an earlier blog on the Disaggregation of Investment Returns between market beta, factor and hedge fund beta, and alpha (linked aboved).

Pages 37 – 43 of the Report has a good discussion on whether hedged funds can still generate alpha (risk adjusted excess returns).

Understanding these sources of returns will help in building truly diversified portfolios.  It will also make the quotes more meaningful.  A greater appreciation of where the industry is moving will also be gained.

 

The following quotes from the Report help bring this all together.

Happy investing

 

Key quotes from within the Report:

“The past years have brought significant changes to the hedge fund industry. What was once a boutique industry serving high-net-worth individuals now serves some of the world’s largest investors. The products offered by hedge fund firms are changing to meet the needs of this wider and more diverse investor universe. The alpha-beta returns dichotomy of yesteryear is being replaced with a new range of investment solutions tailored to the needs of a wider range of investors.”

 

“A majority of investable assets in the total hedge fund pot will go to some form of risk premium investment strategy or a low-to-average correlation type of investment product, because investors have become increasingly more technical and have caught on to the fact that some investment strategies can be replicated for lower fees. Going forward, I expect more than half of the hedge fund investable universe will comprise of the top ten largest investment strategies being commoditised into more low-cost investment products—the so-called liquid alternatives. The remainder of the universe will comprise of high-end niche investment strategies that are capacity constrained, and are able to deliver true alpha.”

 

“Changing investor expectations are forcing hedge fund firms to rethink the investment solutions that they offer. The pace of technological change and the rise of artificial intelligence is leading some to question whether the hedge fund proposition will even exist in a few years. Responsible investment, meanwhile, is becoming more of a priority for hedge fund firms, as they gradually overcome their reluctance to constrain themselves. All of these changes are in turn forcing hedge fund firms to re-evaluate their own inner workings, from how they service investors through to how they build a business that outlasts its founders.”

 

Please see my Disclosure Statement

Disaggregation of Investment Returns

/ Kiwi Investor / 14 Comments

Understanding the disaggregation of investment returns can assist in building a truly diversified and robust investment 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 factors. 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.  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.  Alternative strategies are added so as to reduce overall portfolio volatility, resulting in a more attractive portfolio risk return profile.

The inclusion of alternative strategies can assist in providing greater probability in meeting investment objectives.

 

An understanding of the different return and risk outcomes can be gained by disaggregating investment returns.

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

  1. Market beta. Think equity market exposures to the NZX50 or S&P 500 indices (New Zealand and America equity market exposures respectively).  Market Index funds provide market beta returns i.e. they track the returns of the market e.g. S&P 500 and NZX50
  2. Factor betas and Alternative hedge fund beta exposures.  Of the sources of investment returns these are a little more ambiguous and contentious than the others.  This mainly arises from use of terminology and number of investable factors that are rewarding.  My take is as follows, these betas fit between market betas and alpha.
    1. Factor Beta exposures.  These are the factor exposures for which I think there are a limited number.  The common factors include value, momentum, low volatility, size, quality/profitability, carry.  These were outlined in this blog and are often referred to as Smart beta – see diagram below.
    2. Alternative hedge fund betas.  Many hedge fund returns are sourced from well understood investment strategies.  Therefore, a large proportion of hedge fund returns can be explained by common hedge fund risk exposures, also known as hedge fund beta or alternative risk premia or risk premia.  Systematic, or rule based, investment strategies can be developed to capture a large portion of hedge fund returns that can be attributed to a hedge fund strategy (risk premia) e.g. long/short equity, managed futures, global macro, and arbitrage hedge fund strategies.  The alternative hedge fund betas do not capture the full hedge fund returns as a portion can be attributed to manager skill, which is not beta and more easily accessible, it is alpha.

 

Lastly, and number three, there is Alpha.  Alpha is what is left after beta.  It is manager skill.  Alpha is a risk adjusted measure. In this regard, a manager outperforming an index is not necessarily alpha.  The manager may have taken more risk than the index to generate the excess returns, they may have an exposure to one of the factor betas or hedge fund betas which could have been captured more cheaply to generate the excess return.  In short, what is often claimed as alpha is often explained by the factor and alternative hedge fund betas outlined above.  Albeit, there are some managers than can deliver true alpha.  Nevertheless, it is rare.

 

These broad sources of return are captured in the diagram below, provided in a recent hedge fund industry study produced by the AIMA (Alternative Investment Management Association).

Another key distinction, in the most beta and factor betas are captured by investing long (i.e. buying securities and holding) while alternative hedge fund betas are captured by going both long and short and generally being market neutral i.e. having a limited exposure to market betas e.g. equity market risk.

The framework above is also useful for a couple of other important investment considerations.  We can use this framework to determine:

  1. Appropriateness of the fees paid. Obviously for market beta low fees are paid e.g. index fund fees.  Fees increase for the factor betas and then again for the alternative hedge fund betas.  Lastly, higher fees are paid to obtain alpha, which is the hardest to produce.
  1. If a manager is adding value – this was touched on above. Can a manager’s outperformance, “alpha”, be explained by “beta” exposures, or it truly unique and can be put down to manager skill.

 

Lastly, and most importantly, to obtain a truly diversified portfolio, a robust portfolio should have exposures to the different return and risk sources outlined above.

Accessing the disaggregation of investment returns has come increasingly available due to advancements in technologies and the lowering of transaction costs.  It is also having a fundamental impact on the global funds management industry, including hedge funds.

Furthermore, the determination of institutional investors to pay appropriate fees for return sources has witnessed the development of investment strategies that appropriately match fees for sources of return and risk.

Happy investing.

 

Return aggregation

 

Please see my Disclosure Statement