Aug 26

Real Return funds…lacking real-ity?

What a fascinating investment world its been over the past few months. We’ve had concerns about Greece exiting the Euro, commodity price crashes, a Chinese sharemarket crash and now some of the biggest developed economy sharemarket declines since the dark days of the GFC. Volatility has been somewhat benign for a long time thanks to QE3 and the money printing out of Japan and Europe but its come back with a vengeance.

One of the more recent trends in the product landscape resulting from the GFC has been objective based investing…most notably Real Return funds. The story goes that investors are looking for a decent return above inflation and don’t really want exposure to the nasty volatility of sharemarkets as this market exposure didn’t appear too aligned with their true investment goals….so these objective-based investments appeared (or at least most of them did) following the GFC and have been quite popular.

Today (and pretty much most of recent times), these products have a bit of a problem…unfortunately these products have dug a hole for themselves and will probably struggle to get out. The problem is they are real return plus “too much”….and it has turned them into investments that not only will struggle to meet their objectives, but have landed their investors back where they came from…that is, exposures that carried too much risk.

The most popular objective (at least that I’ve noticed) of Real Return funds is CPI + 5%. A few years ago, this wasn’t perceived as too big a problem….Cash rates during 2011 and 2012 were in the mid 4%s, term deposits were paying attractive premiums (150bps+) over government bond yields, as too were investment grade bonds (BBB rated bonds were 200-300 bps of government bonds) so with an expected CPI at the RBA target mid-point of 2.5%…scrambling for a few extra basis points didn’t require massive risk taking and a diversified portfolio of defensive and risky investments could do the trick.

Fast forward to today and its a completely different story…

  • RBA Cash rates are at 2%…below expected inflation…and priced to go lower
  • Government bond yields are yielding between 1.8% (for short term) and 3.2% (if you want 15+ year terms)
  • BBB rated bonds have premiums at less than 2% over government bonds with total yields for 3-5 securities at less than 4%

…meaning these traditional defensive securities are quite debilitating to any portfolio looking to achieve CPI + 5%. This can only mean that in order to achieve the desired objective requires loading up on risk and a fair bit of it. Risk from sharemarkets, junk bonds, and almost by default…illiquidity.

None of this should have come as too big a surprise when you consider the last 50 years…equity returns in Australia and Globally have produced real returns of only a little more than 5%…pretty much equaling these Real Return objectives, whilst bonds and cash have understandably fallen well short. So portfolios containing not much other than equities (& other risky assets) should have been expected.

So today, we are clearly in a position where these Real Return funds (or at least those with +5% real targets) require significant levels of risky assets to achieve objectives, and waddayaknow…we have badly behaving sharemarkets. Hopefully this bad behaviour is short-lived but either way, I have to wonder how these objective-focused or real-return investors will react when they discover, once again, their objectives are struggling to be met and/or they are carrying uncomfortable levels of risky assets. Unfortunately the main problem real return investors have failed to grasp is that there aren’t too many asset classes that actually provide real returns of a +5% magnitude…sure they might outperform inflation by 5% over long periods of time, but the returns are typically not highly correlated to inflation so real returns is quite the misnomer. Oh yeah…and inflation linked bonds don’t provide anything like CPI + 5%.

So the bottom line… real return investing isn’t too real at all with big targets like CPI + 5%…it is an objective that is not strongly linked to the reality of investment markets so prepare for another investment approach aligned with disappointment.

Fire away!

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Feb 21

A few simple thoughts on a few not so simple markets

Following are my recent thoughts around markets with many charts to support these views. These views are far from complete but do represent a reasonable summary at this point in time.

Income Assets

Aust Government Bond Yield Curve - 19 Feb 2015 - Version 2


Source: RBA, Delta Research & Advisory

  • The above left chart suggests the market believes the cash rate is heading towards 1.5% to 1.75% and there is likely to be continued weakening of the Australian economy
  • With cash rates currently at 2.25%, cash does appear to be slightly better value than conservative bonds where the yield is less than 2% around 4 to 5 year terms.

Global Bonds - Feb 2015

Source: RBA

  • Major global bond yields continue to trade near record lows with little sign of inflation or rising interest rates anywhere
  • Despite that, there is talk of an increasing cash rate in the US and too much too soon is likely to put significant strain on the US economy and therefore equity market also.

Credit Spreads - Feb 2015

Source: RBA

  • With BBB spreads only around 180 basis points above government bonds, then the expected return of the Australian Fixed interest market (~UBS Composite) over the next 3 to 5 years is only around 3%pa.
  • These spreads do represent slight value as traditional default rates are below these spreads suggesting a higher risk-adjusted return can be had if Australian credit is held for the long term
  • US Credit spreads appear to be at similar values to Australian credit also suggesting similar value.
  • However, a significant number of high yield corporates are energy companies and the collapse in oil prices (see below) do make the high yield sector somewhat riskier than usual

Oil Price 1

Source: Morningstar Direct

  • Oil’s recent price collapse is the second biggest over the last 30 years

Oil Price 2


Source: Morningstar Direct

  • Prefer Cash over Australian Bonds over Global Bonds but investment grade credit also has marginal appeal.
  • So overall preferred strategy is short duration, investment grade credit


  • As suggested above, Australian and major global economies continue to appear weak or fragile at best.
  • Forecast earning for Australian companies for 2015 and 2016 years have been in decline
  • Despite economic weakness everywhere, Australian sharemarket appears to be significantly better priced than global shares on a PE ratio basis by the biggest margin for over 10-12 yearsAustrlaian Earnings

Source: RBA

  • Supporting the lower valuation is also a superior dividend yield from Australian companies and when you add the “only available in Australia” franking credits, the simple view suggests much better value for Australian equities

Austrlaian Div and ToT

Source: RBA

  • However the key risk to the Australian market is the rapidly declining terms of trade lead by the decline of key export commodity prices which will flow into most aspects of the Australian economy.

Austrlaian Commodity Prices

Source: RBA

  • Other threats to the Australian market include a collapse in residential house prices which are at record highs in most cities, although are at threat should unemployment spike higher

 Australian Economic Risks

Source: RBA

  • Whilst Australian equities appear better value than global equities, Emerging Markets appear even better again with a PE Ratio significantly below global equities (13.4 vs 17.9). Other valuation metrics for Emerging Markets are also quite favourable including forward PE ratios, and price to book value.

EM Statistics


  • Emerging Markets equities have also performed quite poorly in recent years thanks to the slowdown in China which, like Australia, has been a dominant economic force.
  • The risks for investing in Emerging markets is the instability of their currencies which have been incredibly volatile over the last couple of years (since there was an original hint of the unwinding ofQE3).

EM Equity Perfroamcen

Source: Morningstar Direct

 Property & Infrastructure

Property & Infrastructure

Sources: ,

  • Australian property paying higher dividend yield by around 2% which is also around the carry received from hedging global property into Australian dollars
  • Price to Book value and forward PE suggests Australian property may be better value although return on equity has been lower which is most likely a reflection of the lower gearing levels in Australia
  • Greater diversification or less concentration in the Global Property market compared to the Australian market which is dominated by a few securities such as Westfield
  • The table below shows a current dividend yield of only 2.9% for developed infrastructure which is slightly lower than global property and a reflection of its recent strong performance
  • Value in all three sub-asset classes has diminished significantly
  • Current trend of chase for yield may assist these asset classes in a low interest rate environment but their value appears weak

Equity Styles

Value vs Growth

Value vs Growth - Feb 2015

Source: Morningstar Direct

  • Significantly stronger performance by Australian value over Australian growth during last 3 years…belief in mean reversion suggests a bias towards growth strategies
  • Very little difference between value and growth among global equities so preference remains value

Small vs Large

Small vs Large - Feb 2015

Source: Morningstar Direct

  • Similarly Australian smaller companies have significantly underperformed larger companies
  • Very little difference between large and small among global equities so given the high valuations a preference is to keep the typically more volatile small companies to a minimum
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Nov 13

Industry Super Funds, Transparency…and stretching the truth a little

One of the bigger frustrations for advisers is the lack of transparency of industry super funds. Advisers and researchers do not have deep access to their investment processes, often with little understanding as to what comprises an investment strategy beyond anything other than the asset allocation. As a result, in general advisers don’t recommend industry super funds as they struggle to satisfy the “know your product” part of their recommendations…there are exceptions and other reasons for recommending them, perhaps administrative efficiency, but advisers typically have concerns around the lack of transparency of investment risks.

Now not all Industry Super funds are completely lacking in transparency. For example Rest Super provide good detail of their long term historic performance as well as a list of investment managers that underlie each investment strategy/asset class…fantastic. This means for Rest Super we may be able to get some understanding of what risks may exist…a step in the right direction.

One of the prevalent asset class definitions among Industry Super funds is “Defensive Alternatives”…personally, I tend to think this term is an oxymoron. There is little doubt that alternative strategies can and do provide diversification benefits to a portfolio with the ability of increasing return potential whilst lowering portfolio risk. But on their own, I believe their alternative risks can rarely be relied on when you need them most…particularly when most alternatives are defined as Hedge funds, Private Equity, Commodities, or perhaps Property & Infrastructure.

One of the strategies that is disclosed as part of Rest Super’s “Defensive Alternatives” is Jubilee Absolute Return Trust. Now its possible that Rest have a special mandate with Jubilee such that this investment is defensive, but when you consider the following performance chart of Jubilee versus cash and the near 20% drawdown towards the end of 2008, I’m pretty confident many would have a big question mark of its defensive status…certainly it wasn’t negatively correlated with risky assets during the worst of the GFC…and isn’t negatively correlation to risky assets what you want from a defensive investment???

Jubilee Absolute Return Trust

Source: Morningstar Direct

Anyway, the key message is that you should never believe what an investment manager says and one person or firm’s definition of defensive may differ to someone else’s. The “Know your Product” requirement is an essential one for good financial advice and significant care must always be taken when providing advice on asset allocation alone. Of course, none of this means that the strategy won’t work moving forward…its just investing requires an understanding of risks and whether they are worth accepting.

For Rest Super, the “Defensive Alternatives” asset class as expected is not regarded as a growth asset class so their default Core strategy is self-classified as having 75% of growth asset instead of 84% if you include the 9% allocation of Defensive Alternatives…I’m sure most would agree 75% is quite aggressive, but 84% is a step up again…so Buyer Beware.

My personal hope is that one day, Industry Super funds will move to the levels of transparency that many of the larger retail managers have provided over the year. There is little doubt Industry Super funds do have high quality investment strategies worthy of recommendation by financial planners, but it is difficult to do so whilst there are doubts about “knowing the product”.

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Nov 08

Merton’s Retirement Income Views…correct but its not a product solution…its an advice solution!!!

Nobel laureate economist Robert Merton says David Murray’s Financial System Inquiry must fundamentally shift how Australia thinks about superannuation. He says the desire to maximise lump-sum balances at retirement is excessively risky; the focus should be on ensuring retirement income is enough to meet a desired standing of living.

Source: AFR – 6 Nov 2014 (Paywalled)

I completely agree with this paragraph…in fact, I would say its worse than that as my recent personal experience working with advisers suggests there is still a strong culture of short termism with the focus on maximising returns today as opposed to between now and retirement. However, despite my agreement with the problem, the solution is definitely not a product or super fund, as alluded to by Merton…

…too many super funds are failing to de-risk balances as employees approach retirement, exposing them to market volatility which could slash their retirement incomes.

…But given this Nobel Prize winning Economist is currently consulting to a product provider then this view is not surprising.

The only solution to this retirement income problem comes from high quality, ongoing, personalised, financial planning. A product can never be personalised and efficiently consider their investor’s needs because they are all different. Investors have different net assets, different savings abilities, different lifestyle costs, and different risk tolerances, so any product solution looking to optimise these issues across a cohort of thousands is kidding themselves…but there is still opportunity for improvement so good luck to Merton and his clients.

So if providing high quality personalised financial planning can make a difference, why aren’t they doing so? I think the opening paragraph still gives the primary clue in that the financial planning focus in accumulation is not focused on providing an adequate retirement income to meet a desired standard of living.

A desired standard of living can be calculated from a budget….its not hard but its rarely done. Taking the time to estimate a household budget can identify savings opportunities, insurance needs, and those non-discretionary expenses that are likely to endure into retirement…its a very powerful exercise which is too often left out of the financial planning process because its importance is underestimated. A superannuation fund is unlikely to ever collect this detailed information…if it did, the financial planning industry would be in deeper trouble than it is now as not enough financial planners collect it now.

So the budget will provide an indicative retirement income, throw in a few estimates of other likely costs in retirement and you have a reasonable estimate of the desired retirement income…providing for this should be the primary goal. This income estimate leads to the magical figure to provide financial security…or for some, financial independence.

To calculate what we need to provide this retirement income we simply look up lifetime inflation linked annuity rates. Currently a couple of around age 65 will get inflation linked income at around 4%…so to provide an inflation linked income of ~$60,000pa requires around $1.5million in today’s dollars. This is an example of the capital goal at retirement BUT it is in today’s dollars, so moving forward it must be adjusted for inflation, plus, it is using today’s interest rates, so will also adjust as interest rates go up and down…which therefore results in moving annuity rates. Finally, the desired lifestyle spend may change so this needs to stay updated also as part of the financial planning process.

Now, I know many investors and financial advisers will object to my use of inflation linked lifetime annuities from a life company because there is a belief that they offer returns that are poor and they can do better. I’ll be succinct…noone can do better without taking on some risk…therefore there is a risk of failure if you choose to ignore the inflation linked lifetime annuity rates so you probably need to increase the capital goal in today’s dollars above that of the annuitised value…just in case….happy to argue this point another time. Please note, I’m not saying inflation linked lifetime annuity rates are good…they’re just one of the closest investments we have representing the risk free inflation-linked rate for retirement…so by definition as a risk free rate approximation of course the returns should be low.

Finally, using a client’s net assets, and a conservative estimate for future net savings, the financial planner can calculate the desired real return for achieving the desired capital goal…this desired real return should then dictate the strategy or asset allocation of the investment portfolio and must adjust regularly based on changing goals, savings, and investment performance…much easier said than done…but definitely doable. The final point to the recommended strategy is that the desired real return must consider risk tolerance levels…and if the return goal is too high for tolerance levels…then so too may be the retirement income goals, so adjustments are a must.

What this all adds up to is a process that is personalised, objectives based, and adjusts according to client needs, circumstances, goals, market conditions, and clearly requires an ongoing advice relationship. In comparison, a product solution will always be sub-optimal and always reliant upon strong markets. This path dependency (i.e. market performance reliance) is why life-cycle solutions will never replace good financial planning and whilst they may be good solutions at a cohort level, will always be a poor solution for an individual.    Send article as PDF   

Oct 11

Australian Bonds and Equities…who would’ve thought?

Aust Shares vs Aust Bonds - Last 5 Years

Source: Morningstar Direct, Delta Research & Advisory

Over the last 5 years their performance has been pretty much the same…with the obvious exception that equities has bee a much much wilder ride. The reality of bonds in this global economy is that the outlook is still not that great from the major players (US, Japan, Europe, and in a sense, China) and so there has been and probably will continue to be, at least in the short term, a low interest rate environment. I say, in a sense china, because their rate of economic growth is slowing and that is clearly having a negative effect on the Australian economy.

Moving forward, whilst I do believe equities is a better place for higher returns than bonds, I’m not expecting the disastrous returns for bonds that so many commentators are talking about. The Australian economy is transitioning away from a resources-led economic boom and at this stage, there is still nothing there to replace it. Economic growth forecasts aren’t that high and neither should they be. Apart from what I’ve already mentioned, the government appears hardly likely to hand the economy any additional fiscal support and it all adds up to lower levels of average earnings growth too. There are a few other factors I won’t dwell on, but expectations over the next few years should be continued low inflation, low interest rates, low sharemarket returns, and a tough time for the baby boomers as they add fuel to the fire by selling their expensive properties to maintain their retirement lifestyle…so lower residential property returns too.

The one major variable that could change it all is the Aussie dollar. Its currently around $0.88USD and if that continues towards a sustained $0.80USD or below, then the attraction for Australian investment and spending will go beyond the current attraction of higher interest rates and towards industries such as manufacturing, tourism, and our services (e.g. education). But until that happens the investment landscape is bound to be tough…unemployment will continue to increase, our wages will still be globally high, and the spending will continue to be low by recent historic standards.

Whilst I don’t believe we’re necessarily heading for any disastrous recession, far from it, I simply believe our complacent view of the Australian economy and expected market returns require an adjustment downwards. And, if you don’t believe me…perhaps you’ll agree with the bond market (see chart below) with government yields suggesting longer term growth expectations are lower than last year and the year before.

Aust Government Bond Yield Curve - 11 Oct 2014

Source: Delta Research & Advisory



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Oct 07

SPIVA Report…strong evidence supporting active management in small caps…not much else

My favourite simple performance report on active management came out today on the Australian market…it can be downloaded by clicking here. Unfortunately active management for the broad asset classes once again came up looking poor with an overwhelming proportion failing to outperform broad indices for Australian Shares, International Shares, Australian REITs, and Australian Bonds. An enormous proportion of active managers were successful in outperforming their Small Cap Australian shares benchmark thus providing some support for the widely held belief that markets are a little less efficient in small cap land.

Anyway, if you don’t want to download the report the result I’m talking to just look at Table 1 below….

Table 1 – Percentage of Funds Outperformed by the Index

SPIVA Australia Results - June 2014Source: SPIVA Australia Scorecard – Mid June 2014

This report is one of my favourites because it takes survivorship bias into consideration…it does this by only surveying funds that were around at the start of the survey period, as opposed to those at the end of the period (which obviously leaves only the good ones). Its also worth pointing out that this is a survey of retail unit trusts so they clearly come with higher fees but lets face it, access to wholesale funds for almost everyone still has platform fees on top.

Of course retail index managers still may cost up to 90bps in these various categories (which is quite appalling in my humble opinion) and they are guaranteed to underperform so its not necessarily as compelling a case for index funds as it appears…but those 3 and 5 year numbers are pretty bad (except for small cap).





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Sep 27

Bill Gross leaves PIMCO…might lead to a downgrade or two

Irrespective of the quality of the rest of the firm, and there is a lot of quality, with the departure of Mohammed El Erian at the start of the year and now Bill Gross, it doesn’t take much to guess there may be a little destabilisation at the PIMCO offices for a while. Whilst Bill was the manager of the world’s biggest fund, the $220billion+ Total Return Strategy, he is also the manager of the PIMCO Global Bond fund which is one of the more popular global bond funds in the Australian market…so things could get interesting locally too.

When purchasing a managed fund, as much as the funds try and sell you on their process and systems, the final investment decision rests with the chief portfolio manager and when he or she leaves, so will their performance…that’s not to say performance will be bad, but it will be different as each manager has their own style. Therefore the return behaviour of the PIMCO Global Bond fund will differ when the new manager, most likely the very competent Scott Mather, brings his new style to the table. Throw in the fact that Bill’s departure will destabilise the business somewhat, I’m pretty confident we will see a raft of HOLD, FUND WATCH ratings, and given the high institutional following maybe even some SELL ratings.

Why a SELL rating? There is every chance the outflows from the funds that Bill Gross managed will be enormous as it is likely many large institutions will show their loyalty to Bill and take their funds to his new home at Janus ro simply elsewhere. So this massive outflow may put some downward pressure on their funds that could be forced sellers…so from an investor’s perspective…it may be better to get out now than be locked up for an indefinite period. I hope I’m wrong, but I can’t really think of the last time a manager of a world’s largest fund quit and moved to another company so to be honest…I don’t really know.

No matter what happens this departure will provide somewhat of a prelude as to what may happen when the world’s greatest investor, Warren Buffett, is no longer at the helm of Berkshire Hathaway. Whilst Warren is the world’s greatest investor, please keep in mind that in the world of bonds there is no bigger name than Bill Gross.


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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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