Aug 22

Low Beta Anomaly…mispricing or risk?…(a little technical)

At the Portfolio Construction Conference 2014 I had the good fortune of being on stage to discuss Ryan Taliaferro’s presentation on the Low Beta Anomaly. Now I know I’ve opened up with a lot of jargon, so in plain english…the low beta anomaly  more or less says, shares that exhibit low levels of price volatility, on average, outperform shares with high volatility. Its an anomaly because if we accept volatility as a proxy for risk (which we have done for decades), then you would expect highly volatile stocks to outperform, not the other way around, because investment theory says to get high returns requires high risk.

One of the presentation’s conclusions was that this anomaly is a mispricing and is likely to persist because fund managers are inclined to hug benchmarks and avoid the tracking error (that is, significant deviations from benchmark returns) from low volatility stocks, therefore highly volatile stocks are overpriced due to over-attention. The variability in most portfolios are primarily driven by the variability in the most volatile investments so it is plausible that avoiding highly volatile stocks could be perceived of increasing a fund manager’s chances of underperformance which obviously increase their chance of unemployment.

A second conclusion was that the anomaly cannot be explained as a risk…which I have to admit  is not easy to wrap your head around…but…this is where I have a slight disagreement. I say slight because whilst I do believe low volatility stocks carry a risk that does not exist in high volatility stocks, I don’t believe this risk explains all of the outperformance and is more of a contributing factor.

So here goes my explanation…

It is acknowledged that high volatility stocks have somewhat of a lottery preference amongst investors…in other words they are attractive because they have the most potential for that big win…lets face it, you have a better chance of tripling your money (or better) with a highly volatile stock than a low volatile stock. In fact, return analysis shows that highly volatile stocks have a positive skew which is a defining characteristic of lottery preference. On the flipside, the broader sharemarket and low volatile stocks have a negative skew…and investors do not desire a negative skew of returns. So increased likelihood of negative skewness is a “risk” and therefore should be compensated…hence compensation for negative skewness may be a contributing factor towards explaining the outperformance of low volatility stock compared to high volatility stocks.



Whilst buying a lottery ticket is an example of purchasing positive skewness (albeit also an irrational chance of a big return) lets not completely dismiss this phenomenon as an insane purchase as there are many positive skew purchases everyone makes that have an expected negative return…and it can be summed up in one word…insurance. Whether it be car insurance, life insurance, or any other, the expected return in the long run is negative but we still pay for it. In financial markets, the purchase of a put option (which may be an insurance contract on a poor performing market) is very expensive and is typically priced in favour of the seller and not the buyer…why?…because of the cost of positive skewness that the put option (or insurance) can bring to your investment portfolio (or circumstances). Positive skewness is a cost and that cost is applied to high volatile stocks and therefore contributes to their lower returns.

So whilst I don’t dispute the key empirical results…that low volatility stocks outperform highly volatile stocks (and this is common across many markets)…there is a deeper message to this discussion. It is, whilst volatility is a good measure of risk (and probably the best measure we have, particularly for liquid assets), it does not explain all of an asset’s risk. The stock market is not normally distributed and its volatility only tells part of the story. In fact, this is a significant factor to why the world got in trouble from the financial engineers that mispriced CDOs which ultimately led to the collapse of Lehman Brothers and others. The stock market is negatively skewed…that is not desirable; plus the stock market has many large positive and negative returns (which relates to the volatility of volatility and is called kurtosis)…that is also not desirable. The key message is that these higher moments, skewness and kurtosis, should be ignored at your peril when considering investment risk.

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Aug 07

The disappearing credit spread…US now at pre-GFC levels

US Bond Spreads - August 2014

Source: RBA

I know this probably an overly simplistic way of looking at investment grade credit markets…but…the above chart is currently showing that US investment Grade credit spreads have declined to be in the ballpark of pre-GFC levels. Personally, the US economy is still relatively weak, albeit getting stronger, but I no longer believe this type of credit risk appears as good value and today I would rather own safer US Treasuries than US Corporate debt…why…greater protection alongside of riskier assets such as equities, therefore as far as I’m concerned Treasuries have a better risk-adjusted expected return.

According to Moody’s the worst default rate of BBB rated securities over the last 30 years was a little over 1% which occurred in 2002. The current spread provides a little more than that so there is only a little compensation for other risks such as illiquidity if things go tech-crash pear shape.

Anyway, no matter how you look at it the chase for yield from lower rated credit risk is definitely approaching its end and whilst Australian credit looks a little better or wider (see below chart), our unemployment rate didn’t increase to 6.4% for nothing…that is, our investment grade debt should have a wider spread as our economy is looking like doing nothing more in the next couple of years but weakening.

Aust Bond Spreads - August 2014

Source: RBA

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Aug 01

Ramblings about Unconstrained Debt Funds and Portfolio Construction…wonkish and a work in progress

I’ve just returned from a manager research trip in the UK where we visited a variety of strategies from a variety of managers and fortunately for me, with some of the leading thinkers and researchers in the advice industry (hat tip D&G … and I don’t mean Dolce and Gabbana). Several of the managers we visited spoke to their “unconstrained debt” strategies and amongst the research group it was largely agreed that these are flavour of the month, but there was differing opinion about their use in investment portfolios within the advice industry.


Firstly I think it’s appropriate to define what an unconstrained bond fund is. The key is obviously in the definition of unconstrained…typically, the fund is managed to an absolute return-like objective (e.g. Cash + 3% over rolling 3 years) and therefore independent of traditional bond benchmarks like Barclays Global Aggregate. As a result there is the ability to execute virtually any debt-like strategy or instrument whether it be long or short duration, credit/high yield, government, CDOs, ABS, swaps, etc…hence unconstrained. These basic characteristics don’t suggest they are accepting significant risk, particularly given there is often a secondary objective that is more like a Sharpe ratio (which may be excess return over cash divided by volatility)…so it’s more of a risk-adjusted benchmark which should make the punters happy with respect to risk-based objectives. There may be other characteristics and sometimes certain constraints that are common sense with respect to objectives (e.g. minimum liquidity) but in my opinion these are the core characteristics with the bottom line that managers of these strategies have numerous levers to pull to gain and protect depending on their view of the investment world.

Flavour of the month?

There are several factors that suggest these funds are likely to be very popular amongst investors today with the main ones being…

  • Potential for gain in rising interest rate market…It appears current market consensus is that interest rates around the world can’t stay near these historic lows and therefore can only go one way…up…this means the return expectations for traditional conservative bond funds are very low and investors are looking for an alternative.
  • Flexibility to avoid being caught in another credit crunch…Credit spreads have been tightening since the start of 2009 and the downside risk is also increasing so exposure to a strategy nimble enough to know when to get out of high yield can be quite handy…let’s face it, high yield bond funds had equity-like negative returns during the GFC and no one wants to experience that again so why not give a manager the chance to exercise their discretion?…well, perhaps there’s a few reasons but I digress.
  • Many believe bond benchmarks are flawed and should not be managed to… Rightly or wrongly there is a wide-held belief that debt benchmarks are poorly constructed as they have the highest weights to the most indebted companies and/or governments so benchmark risks are high…managing to an absolute return outcome that is independent of debt benchmarks may be attractive.

Given these unconstrained strategies are not “beta” or market-related strategies, they are very much pure “alpha” strategies and heavily reliant upon the pure security selection and/or market timing skill of the portfolio manager. Their performance has been short term and experienced a tightening of credit spreads combined with declining interest rates so irrespective of the portfolio position many bond funds have a reasonable track record if set up post GFC…and that appears to be the case. This relates to one of the major risks of these unconstrained bond funds and why it may be risky to fall in love with these strategies…they are yet to be truly stress tested by the markets.

Portfolio Construction

In terms of portfolio construction there was a lot of debate around where these funds should be allocated in a portfolio. The agreed options were quite obvious…either the debt (or bond/fixed income) or alternatives allocation.

The debt allocation centred on the fact that the returns come from that particular asset class, whilst the argument for alternatives is pretty much centred on the strategy’s complexity and its non-benchmark investment approach.

My personal belief is that they should sit in the Alternatives allocation but either way, current portfolio construction methodology in advice world is led by the asset allocation decision which is primarily a “beta” (or market-related) decision and these funds with their non-benchmark objectives have the potential of ruining the intentions of any recommended asset allocation. If the beta decision of the asset allocation is less of an issue than the allocation of unconstrained debt strategies is possibly a question of investment philosophy and how these funds are likely to satisfy associated investment beliefs…in other words… irrespective of strategy, a key question to answer is “what is the role of the debt investment in the broader portfolio?”…it is a diversifier to reduce portfolio risk, is it a pure income focus irrespective of correlations with other asset classes, or some combination?

Debt Investment Philosophy

Traditionally, the debt asset class has a defensive role and equities the aggressive/return driving role. The unconstrained debt portfolio may significantly vary between traditional defensive and aggressive assets over time and the return success is therefore highly reliant upon the market timing skills and security selection skills of the manager…which is a risk in itself. This paradox is the first major challenge to assigning unconstrained debt funds to the debt allocation…that is, it potentially compromises the defensive role.

AS already mentioned, there is a widely held belief that interest rates around the world are more likely to increase than decrease in the coming years, and accompanying this is the belief that holding conservative bonds is the risky position. Therefore unconstrained debt strategies may actually reduce risk given an assumed improved return expectation in a rising interest rate market. Unfortunately there is one significant problem with this belief as is it is purely a return driven one and ignores broader portfolio risk. In other words, there is little or no consideration of the correlation with the other asset classes, and we should expect higher correlation to equities will increase portfolio risk significantly more than high correlation to bond indices. Certainly the possibility of low correlation in poor performing equity markets exists, but it requires the unconstrained bond manager to have that position as opposed to being a natural hedge like conservative bonds often are in times of stress.

The GFC was a wonderful exercise in understanding what true diversification was as certain debt investments (i.e. higher yielding) turned out to be highly correlated with equity markets and declined in value at the same time providing little to no diversification whatsoever.

Portfolio Construction Flaw

As mentioned, the current investment approach in retail advice is a two-step process. The first step is to assign an asset allocation based on an investor’s outcome needs and risk tolerances. The second step is to assign investments to the various asset allocations. Model portfolios aside, the flaw in this process in advice world is that these two steps are separate and the asset allocation decision, which is a beta or market-related decision, is often ruined by the investment allocations and using unconstrained debt funds is a case in point unless the asset allocation decision specifically provides for this type of strategy (and if it does then there is bound to be some arbitrary quality to the allocation as opposed to an objective return and risk focus).

For example, if the Strategic or Dynamic or Tactical asset allocation suggests a 30% allocation to debt strategies and the benchmarks for this allocation is the UBS Composite (in the case of Australian debt) and Barclays Global Aggregate (for Global debt), then allocating an Unconstrained debt fund will potentially reduce the required exposure to these asset classes…certainly the strategies we looked at had little to no correlation to these indices hence changing the asset allocation. This is the main reason why allocating to the debt asset class more often than not is inappropriate.

Alternatives Allocation

So what we are left with is the allocation of unconstrained debt strategies to the Alternatives asset class. However, this still creates some problems and the first problem relates to the definition and objective of Alternatives.

For most investors the alternatives asset class is the non-traditional asset class. It comprises anything that has little to no relationship with traditional debt and equity investments. It therefore comprises assets such as hard and soft commodities, illiquid assets like private equity, direct property and direct infrastructure, and complex hedge fund strategies like global macro, arbitrage, short selling, managed futures, and exotic derivatives like structured products. Given their complexity and perceived lack of relationship over time with traditional markets, unconstrained debt strategies appear to sit neatly amongst the complexity of hedge fund strategies.

However, an arbitrary allocation to the Alternatives should never occur…arbitrary allocation will obviously increase unnecessary risks as it is possible to create both a low risk alternatives portfolio and a high risk alternatives portfolio so constructing according to objectives is a must.

The design of the Alternatives portfolio is part of the broader portfolio so should have careful consideration of potential correlations with not just the remaining alternative investments but traditional asset classes too and particularly in times of stress.  Secondly, how will the unconstrained debt strategy likely contribute to the desired return and risk of the alternatives and overall portfolios?

Correcting the Portfolio Construction Flaw

The approach of considering an individual investment at the same time as the broader portfolio’s return and risk objectives should not just occur within the Alternatives Asset Class but at the overall portfolio level as well. Separating the beta decision from the alpha decision is an inefficient approach to portfolio construction and the decisions should be made together with portfolios return and risk objectives top of mind at all times.

This approach removes the two step approach to investing that the advice industry has embraced moving towards an integrated asset class and investment selection approach. The asset class allocation then becomes the output instead of the input.

Of course, all of this is perhaps easier said than done and it may produce other risks unstated and perhaps require tools or skills that are not available…but an integrated asset class and investment approach should increase the alignment with return and risk objectives instead of the current approach in which the investment decision often ruins the recommended asset allocation.

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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…

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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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