Jun 14

Market Cap Weighted Bond Indices…always tough to beat

The common criticism of market-cap weighted bond indices is that they are inefficient because they are obviously weighted towards those with the most debt. Thus indicating that the index potentially carries more risk than necessary, or than we may want in a portfolio, because those with the most debt carry greater default risk than those with very little debt.

Whilst there is definitely logic to this argument it is missing one essential ingredient…price. If those with the most debt are priced appropriately such that the price reflects all risks associated then any argument of inefficiency is irrelevent.

On the other hand, if there is mispricing it doesn’t mean a bond index fund is a bad place for investment or easily outperformed. Generally speaking, aside from lower fees, if the mispricing favours an overweight to the higher market cap securities then the index will be very hard to outperform given the high weighting towards the cheap assets. Active management has its best opportunity to outperform the index if the mis-pricing is such that the higher market cap securities are over-priced and given those securities are typically the most traded and therefore, in theory, most efficient then it still becomes a difficult task for the active manager to outperform the index.

As a result it is not surprising that bond managers have significant difficulty in outperforming their market cap weighted benchmarks…despite the more frequent agreement among investment professionals that bond indices are more flawed than equity indices, See SPIVA table below…

SPIVA Table Dec 2013

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May 16

Australian Bond Yield Curve…small budget led drop

Aust Government Bond Yield Curve - 14 May 2014

Source: RBA, Delta Research & Advisory

At the e shorter end of the yield curve there hasn’t been a great deal of change. This is completely expected whilst the RBA has signaled its intention to maintain its cash rate at 2.5% for some time and, whilst not easy to tell, this yield curve suggests it will be there for the remainder of 2014. Where the yield curve is most interesting is at the longer end. This year the 10 year bond yield has dropped around 45 basis points and which actually results in a reasonable capital gain if accepting some longer term duration risk, which surprisingly, many managers did. I say surprisingly because most of the “talk” has been around keeping shorter duration positions due to longer term interest rate concerns with rates consistently near record lows.

The longer part of the yield curve is more often than not a refection of the longer term outlook for the Australian economy, which is still somewhat related to inflation expectations and therefore future RBA moves. I am guessing the incredibly negative rhetoric this year leading into the, somewhat cruel, budget may have been a large factor behind the longer term yield drop. I say that because the rhetoric has been round “tightening belts”, expense reduction, or austerity and the like. When a government cuts its expenses a hit to economic growth is a reasonable expectation. Any government initiatives aimed at economic growth will have a reasonable lag before the effects flow through and of course there’s always risks that they won’t.

Moving forward the most interesting indicator to keep an eye on will probably be consumer confidence. There’s little doubt this latest government budget is a cruel budget that in one way or another impacts everyone with the greatest relative impact on the lower income earners. If consumer confidence drops, household spending drops then businesses will respond with cuts too…increased unemployment is expected by all, but if the Australian psychology becomes too negative the RBA may revert to a dovish stance again. At this stage its too early to tell and as mentioned the market is expecting rates to stay at 2.5% for a while and its always a gutsy move to argue with the market. The current yield curve is one that suggests low rates for longer and therefore low inflation too so that’s not a bad place to be for the mortgagee but like the budget, it makes for a continued tough ride for the retired.

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May 09

How often should we rebalance portfolios?

It appears that the financial planning industry is a big believer in rebalancing but a little unsure as to how often. Some accept the automatic quarterly option, some rebalance at the client review, some annual, or even at 13 months to potentially reduce capital gains tax by taking advantage of the 50% CGT discount.

Because the rebalance decision is often made without a second thought, planners often forget that it is in fact an active decision as to the likely frequency of tops and bottoms of the markets they are investing their clients funds into. For example, if you choose a quarterly option for your client, then in effect, its the same as believing it is likely to be a good decision to sell some equities in 3 months if they have gone up compared to other asset classes or buy some more if they underperformed. This assumption may clearly be wrong and may also have little in common with the asset allocation decision which I expect is typically designed with a longer period in mind. In other words, the asset allocation decision is a recommendation of the most efficient asset allocation for a specified time period and that time period is more likely to be multiple years than one quarter. So by rebalancing every quarter there is the risk of diluting the designed benefit of the asset allocation decision which is made with different goals in mind.

Using just Australian bonds and Australian equities I undertook a little experiment to find out which rebalance frequency may produce the better results. The experiment starts with 50% allocated to Australian Bonds and 50% to Australian equities and I rebalance at various intervals starting from Dec 1976 (that”s how far back my data goes) to see which end up with the best result. For the purposes of simplicity, I ignore tax and transactions costs (which is a very important consideration with real money) and the results are shown in Chart 1 below…

Chart 1

Rebalance Chart 1

Source: Delta Research & Advisory

Its obviously a fairly close race over almost 40 years so Chart 2 provides a close-up that more clearly shows the winner…

Chart 2

Rebalance Chart 2

Source: Delta Research & Advisory

…and the winner is the 2 yearly rebalance, with second place going to the annual rebalance and ;last place to “no rebalance”. Now its important to point out that these results are far from complete. Why? because that start date is always 31/12/1976 and the end date always 30/4/2014, and therefore when rebalancing occurs there are some dates (like yearly anniversaries) that are always rebalanced on, whilst the months of Jan, Feb, Apr, May, July, Aug, Oct, Nov never experience a rebalance. So for completion to this experiment different start dates, and rebalance months should be used. As alluded to before, the rebalance decision is a passive decision but essentially is still making a call that it is worth selling one asset and buying another at particular points in time.

Either way, these early results are interesting. A two year rebalance can provide other guaranteed and obvious benefits over monthly, quarterly, six monthly, and annual rebalancing…that is, lower tax consequences and lower transaction costs. Finally, there is no over pattern at this point in time…given the worst results are the less frequent “no rebalance” and 5 year, and the best beating the more frequent rebalancing options…perhaps its suggesting that the stronger performing equity markets are more likely to behave on a 2 year cycle…to be honest, I’m not sure yet.

The early results show 2 years may be best rebalance period but don’t take this for granted and please look out for a completed experiment in the weeks to come.

Please note, I have to admit that I got a little lazy and failed to do any literature search for others that may have written on the rebalancing subject so I hope the early results to this experiment with the latest Australian data still adds a little value to the debate.



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May 05

Revisiting Asset Weighted Returns and the Lifecycle Fund

Given the start of MySuper this year, superannuation trustees have released numerous lifecycle funds to satisfy this new legislation. Whilst lifecycle funds have been popular among superannuation trustees, the investment and adviser community haven’t been so complimentary. Either way, lifecycle funds definitely have a place in the investment landscape and they provide an approach to investment that is cognisant of a very simple concept that is often overlooked by some superannuation trustees’ choice of default fund…asset weighted returns.

So for the purpose of my new readers I have reproduced some analysis previously posted in this blog …the slightly more flawed analysis and similar article can be found here otherwise please read on…

…After thinking about asset-weighted returns and how to apply this thinking throughout the working life of a superannuation member, I did the following little exercise. I know this has probably been done to death by the lifecycle investment gurus out there but I thought I’d see for myself what I would come up with…its not perfect but more than adequate.

We start with an 18 year old with no superannuation, earning $20,000pa. Obviously 9% must be contributed to super under Australian law (back in 2011), and we also assume his/her income would grow at 4%pa which is roughly in line with average growth rates in AWOTE (Average Weekly Ordinary Times Earnings…I think). Another assumption is that the superannuation investment would grow at an annual rate of 7%pa after tax, which is obviously well above the risk free rate but over a working life of more than 40 years I’d like to think is achievable for a ‘balanced’ investment across multiple asset classes.

A summary of these simplistic results are in table 1 below…

Table 1

Super Balance Growth

Source: Delta Research & Advisory

Now, obviously in the real world, one’s income and superannuation contributions will fluctuate, and of course investment returns will also fluctuate (don’t I know it!!). But, overall the outcomes from Table 1 don’t look too unreasonable.

Step 2 in this exercise is to consider ‘Value at Risk’ or VaR. Whilst VaR is a concept that has been blasted in recent years thanks to its mis-applicaton leading up to the GFC, its still not a bad way of looking at downside risk.

Using various risk and return assumptions, across generic portfolios ranging from 0% risky assets to 100% risky assets, we calculate VaR for each portfolio…the definition is that the portfolio has a 1 in 40 chance of returning lower than the VaR result. For example, we assume for a 70% risky asset portfolio it has a 1 in 40 chance of achieving a return worse than -10.5% in any one year and for a 30% risky portfolio a 1 in 40 chance of returning worse than -3.8%…you may think this is a little optimistic but sobeit, its probably not too far off.

Using this information and using the outcomes from Table 1 for each year from age 18 to 65, we do not wish to have more than $30,000 at risk (that is a 1 in 40 chance of losing more than $30,000 of superannuation). This is an arbitrary amount that could be anything but for the purposes of this exercise I have randomly chosen $30,000.

Now for the quant geeks reading this I know there should be some optimisation techniques with regards to the inputs but in keeping things simple we use the balance figures from Table 1. Using the calculated VaR results for each portfolio, Chart 1 shows what the maximum exposure to risky assets needs to be throughout my example’s working life.

Chart 1

GlidePath - Lifecycle Experiment

Source: Delta Research & Advisory


As can be seen, this chart has a very similar glide path that many of the lifecycle funds have. Maximum exposure to risky assets does not start to decline until around age 50 and at age 65 the maximum exposure to risky assets is around 30%.

These outcomes can easily be adjusted on an individual basis depending on risk/return expectations, super contributions, as well as how much super balance one wants to put at risk over time. But these results use my rough estimates.

Now we all experience asset weighted returns…i.e. it hurts more when we lose more money…so…bottom line…if we consider asset-weighted returns and minimising downside dollar specific risk as we move towards the latter part of one’s working life, when designing asset allocation for a superannuation member the evidence supports a lifecycle/glidepath approach to investing superannuation.

Despite this result, there is nothing necessarily wrong with the “balanced” fund as it may well have the best return per unit risk over long periods of time. However, it is an approach that only considers return per unit risk and ignores the size of the underlying balance. The Srategic Asset Allocaiton approach is largely based on a time-weighted approach to investing versus the asset-weighted approach that is the lifecycle or glidepath approach. Both are valid but they depend upon the desired investment objectives which are clearly different.

One final point about MySuper funds (which are funds designed for cohorts) that many overlook….they are almost guaranteed to be inappropriate for the individual investor who is highly likely to have completely different investment objectives…and this is particularly the case for the lifecycle fund just as it may be for the “balanced” fund.


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Apr 24

Absolute return investing…a nice goal but disappointment is likely

Absolute return investing, according to many definitions, is about getting positive returns irrespective of the overlying “market” return of whatever asset class the investor is being exposed to. This essentially means that any “absolute” returning investment needs to employ strategies that are independent of market direction. For example, if the market (and it can be any market) is declining in value, the absolute return investment will need to have long exposures that still may move up (and they may include put options), or perhaps be trading in the direction of the down market by short selling that market…whether at a security level or market level (e.g. futures, CFDs, ETFs, or options).

OK…so that said, absolute return strategies must demonstrate skill in market timing…so they can profit in up and down markets. Much more easily said than done.

Like these first two paragraphs most discussion on absolute return investing just  focuses on achieving a positive return….but there is no mention of how much and what timeframe. Let’s face it, achieving a positive return is very very easy…just place your funds in a bank deposit, choose your term and voila…you have a government guaranteed “absolute return” for your chosen term!

So, what defines an absolute return fund in terms of required size of return and desirable timeframe? My personal belief based on discussions with advisers and investors suggests the required return is “equity-like” and the measured timeframe is 1 year…so each year, investors expect and want to see a positive return that is in the ballpark of cash plus 3 to 4% or perhaps a minimum of 10%pa. So today that means an annual return of around 7% to 10% each year…again much more easily said than done and I would suggest that the risk required to achieve this return goal is quite significant.

So I thought I’d have a look at hedge funds available in Australia (and reported to Morningstar) to see how they’ve actually performed in recent years. I thought I’d give them a helping hand by only looking at the last 5 years (i.e. very close to the bottom of the sharemarket) and there were only 51 strategies that had a 5 year track record…surely there’d be more but no. I chose hedge funds specifically because all other investment categories are “long only” meaning they can’t employ the above-mentioned strategies to profit in down markets.

Of those 51 hedge fund strategies, only 19 did not have a negative return over any 12 month rolling period in the last 5 years…to be honest I thought it would be lower so not a bad result. Of those 19, only 3 failed to have an average return above 7%pa…

…So my positively biased analysis has yielded 16 different hedge funds available in Australia that may meet the investor and adviser’s definition of an absolute return fund…and that’s out of many many more than 3,000 funds available in Australia…as a side note, I also wonder how they’ll go when Global Government Stimulus is no longer the norm and interest rates are much higher?…but I digress.

When you consider that a very high proportion of investors (& advisers) have an “absolute return” investment objective you have to wonder why there are so few investments that are designed to achieve it. The bottom line is that absolute return investing is incredibly difficult and achieved by very few. My personal thoughts and conclusion to absolute return investing…it’s fine to have positive returns year-in year-out as an objective or goal, but absolute returns should never be presented as an expectation as disappointment is inevitable. When aiming for “equity like” returns be prepared for the occasional negative year or two or three.

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Mar 25

Mortgage Funds…still on the nose to me…but perhaps for different reasons than others

Over the last 12 months I’ve increasingly had inquiries about investing in mortgage funds. During the GFC, pretty much all liquid mortgage funds froze their investor’s funds so access was only available in periodic dribs and drabs and for many this process is still playing out. However, there are some new funds which have raised capital in the last few years, are currently liquid, and with the GFC largely behind us, some investors and advisers are getting curious again.

Whilst I absolutely acknowledge that every investment should be considered in terms of its future return potential (not its past), there is one grating problem mortgage funds have that has bothered me for as long as I can recall…and will always be a sticking point…their pricing.

As fixed income securities, mortgages are very complex. Credit risk is difficult to truly understand because investors don’t have any information on the borrowers; Duration risk is incredibly difficult to work out because loans may have the ability to prepay…so when your variable interest rate goes up, you may think hooray, only to see the principal and interest repaid early for you to miss out on that exposure you thought you had.

Let’s not also forget that mortgages are held over property and there may be other mortgage conditions such as minimum LVR requirements, or other financial conditions…these are risks we don’t really see as investors but surely they are conditions that should result in mortgage prices that will go up and down as these risks become lower or greater.

It is clearly these complexities that make a book of mortgages so difficult to price, so mortgage providers just stick with a $1 unit price and simply pay out the interest. It appears the only time a unit price moves is when there is a default…but even then, I have to admit I’m not so sure…as there appears to be very very few defaults or perhaps the defaults simply impact the income payable.

I could show you the price of numerous large mortgage funds over the last few years, but a flat line priced at $1 doesn’t make for a particularly interesting chart so I have chosen not to expose any names.

Anyway, this complete lack of pricing ability by mortgage product providers is why I will continue to avoid mortgage funds.

In my humble opinion, transparency is a very important investment characteristic and its clearly lacking in these products…but there also appears to be no solution.

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Feb 25

Investment Fees…room to trim (wonkish)

When a financial adviser gains a investment client, on an ongoing basis that client pays fees for 3 main services/providers…

  1. Financial Adviser
  2. Investment Management…typically a fund manager
  3. Platform…for investment administration and reporting

There can always be a fair amount of debate as to what the true margins are, particularly given some of the vertically integrated companies might be a little creative in some transfer pricing between the above businesses. However, with IOOF Holding releasing their half yearly results today I thought I’d take a peak at their margins for each of these businesses to see how they stack up.

IOOF’s financial advice businesses include such brands as Bridges, Ord Minnett, and a few more; their investment management brands include their Multimix diversified funds as well as Perennial…both active managers; whilst they have numerous platforms businesses that include IOOF Pursuit, Lifetrack and more. Each of these businesses are substantial and relatively mature so their margins should be a reasonable indicator for their respective sub-industries…

…So what are the margins for each of these substantial businesses?

  1. Financial Advice – 0.23%
  2. Investment Management – 0.26%
  3. Platforms – 0.69%

Whilst I’m sure my logic here is not exact, I’m also sure that many in the industry will not be surprised to see platforms having the biggest margin of all.

In this current environment of continued regulatory change, increased fee transparency, and clients and advisers looking to save wherever they can, there’s no doubt many platforms have reduced their fees but there’s also little doubt that there is some way to go. These large margins are why there are so many platforms in the market…despite the rhetoric, they can survive on relatively low FUM.

BUT…lets not forget those high fee charging managers who have a LOT of room to move…and there are two that always spring to my mind. Firstly because they charge the highest fees and secondly because they are very popular (of course…good performance too). They are Platinum and Magellan!

Every adviser’s favourite long/short global equities manager, Platinum Funds Management recently released their half yearly report…and for the half year Platinum’s investment management revenue was a respectable ~$130million (excluding performance fees and admin fees)…however their total expenses over the same period was just over $21million…resulting in a profit margin that to me borders on way way too much..i.e. 84% (and don’t forget I excluded performance fees).

Every adviser’s more recent favourite global equity manager, Magellan, isn’t too much different. Like Platinum, they charge the big fees and now they’re reaping the rewards…management fees of $59million and $18.3million of total expenses resulting in a profit margin of 69% (excluding performance fees).

Of course, everyone is happy to pay the big fees if the returns they deliver are big also…and there is no problem there (although both Platinum’s and Magellan’s flagship global equities fund unperformed their benchmark over the past year (to 31 Jan) but when you still return 39%…whoopy do!). Either way, lets hope these massive profit  margins that are highly unlikely to go away soon, don’t change the focus of the portfolio managers from managing our client’s money to spending their massive wealth. If they don’t perform…there’s not necessarily any need to withdraw your money…but definitely ask for some lower fees!

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Jan 14

Cliff’s Top 10 Peeves…and a couple of my own

I know this is possibly a little old now but one of my recent favourite articles is about to be published in the Financial Analysts Journal, My Top 10 Peeves, by Cliff Asness of AQR. Just click the article name to open and read for yourself.

There are quite a few gems in there but I have to admit my favourite peeve of Cliff’s are some of the things that people say, like…

  • “Its a stockpicker’s market”, and
  • “There’s a lot of cash on the sidelines”

…I have to admit they drive me nuts too.

This article got me thinking about what my biggest peeve is, and I have to admit it is widely held belief that stockpickers/share managers should be able to produce positive returns and that they should be judged (or benchmarked) based on cash returns instead of broad sharemarket benchmarks such as the S&P/ASX200 or All Ords. I’m afraid if you are a long only share fund manager and your mandate is such that you are only to invest in the sharemarket (and cash), then your benchmark should be based on the sharemarket and your returns will fluctuate just like the market. The broader market (or market beta) is more than likely to be most responsible for your returns, both good and bad, and your market timing and stock selection will hardly result in consistent positive returns no matter how good you are.

That then leads me onto Market Neutral funds and they should be benchmarked to Cash…but my next peeve are from those that imply it is easy to add value by simply investing in cheap shares and shorting overvalued shares such that this outperformance can be easily added to the cash return for a easily gained cash plus return…its not easy and never will be.

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Jan 13

Longer duration looking less risky…relatively speaking

Aust Government Bond Yield Curve - 13 Jan 2014Source: RBA & Delta Research & Advisory

Its definitely been a long time since I posted anything and hopefully this post will at least be a little interesting…I haven’t read a great deal of anything financial over the past few weeks so I apologise if this is old news….but I digress!!

Now, the above chart is the usual Australian Government Bond Yield curve that I always post…why? because it normally says a lot about what’s going on in the world and particularly Australia. In the short terms, i.e. out to 2 Years, it suggests thta the Reserve Bank is more than likely going to keep rates low…that makes a lot of sense whilst the economy is transitioning from a Resources investment boom creating a lot of growth to a relatively unknown economic growth driver. The Reserve Bank definitely want the Australian dollar to be much lower (~85 US cents) but there are other economists believe that it really should be 80cents or lower again.

Beyond that, this curve has steepened and today is very steep…and I really do mean very steep…this typically means that the long run economic expectations are pretty strong. I’m not 100% sure why as locally there are many uncertainties but it is true the global economy is looking much stronger than it has in many years or put another way…the major developed economies are not looking like blowing up…so that should help Australia (although I do believe we are a very complacent nation after 22 or 23 years of economic growth).

OK…how steep is the yield curve?

10Yr - 3Yr Aust Gov Bonds

Source: Delta Research & Advisory

The above chart shows that the difference between the 10 year and the 3 year Australian government bond yields is the highest it has been since the start of 1995 (I haven’t looked for data before then as I’m guessing this is sufficient to make my point). So given this statistical rarity, there’s a very strong chance this relationship is unlikely to hold so the expectation of 3 year bonds to increase more than 10 year bonds is reasonably likely over the next 12 months or so.

That doesn’t necessarily make the investment strategy simple because if 3 year bond yields increase and the 10 year bond yield stays the same your bond fund may still have poor returns. However, if the reverse occurs, whereby the 10 year bond yield decreases and the 3 year bond yield stays the same then the returns will be pretty reasonable. Either way, simplistically I do believe a longer duration portfolio is not such a bad thing at the moment…even better if you believe duration may be a reasonable hedge to a falling sharemarket…perhaps the better strategy for the bond manager today may be to short 3 year bonds to buy 10 year bonds. 




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Nov 25

How the economic machine works…by Ray Dalio

Source: www.economicprinciples.org

The above video (hopefully its working) is easily the best description I’ve seen on how economies operate and an absolutely must see for anyone interested.

In the context of the Australian economy it certainly does sound a few bells…perhaps alarm bells…particularly when you consider that the Australian economy has not experienced particularly good productivity growth over the last 10 years, has been deleveraging somewhat (e.g. double digit household savings ratios) over the past few years, has had record level income growth (best in the developed world), and now faces an uncertain future as the resources investment boom is finished and unemployment is expected to climb as the unwinding begins

The requirement for Australia is a lower exchange rate, increased productivity growth, and a government with a long term vision and credible plan for a weaker Australia…oh well, looks like we’ll be in for tough time over the next few years economically. Either way, there is still a bit of fuel in the policy fuel tanks but I’m still backing volatile markets and not the complacent bull markets Australians have almost come to expect over the past few decades.

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