Jun 28

A Few ESG Investment Thoughts

ES Investing

Possibly the biggest trend in investing today is the shift towards ES investing. No, that’s not a typo because it is the E (Environmental) and S (Social) factors of ESG investing that are experiencing the greatest focus as humankind faces existential threat from climate change (i.e. E) and numerous social issues, whether racism, sexism, corporate culture, et al, are getting the attention they deserve because, let’s face it, there is some bad behaviour that has persisted for way too long that needs to change. We’ll come back to the G (Governance) a little later.

Right now, Investors around the world are leading the thinking and action about climate change, whilst many governments are lagging (and we Australians don’t have to look very far). Whilst governments around the world fight about what year they want to reach net zero emissions and hang onto the fossil fuel industry in order to salvage some votes for the next election (and I promise I’m not just thinking locally), investors are allocating their dollars to companies which are already positioned for the future (think Tesla) and sending strong messages making it difficult to fund potential “dirty” companies (think Adani).

Dual Objective

When we construct investment portfolios, one of the first questions we ask is around the objective. This is generally in terms of return (e.g. CPI plus x% or to exceed a benchmark) but for the ES investor, the investment objective is a dual objective which is part quantitative and, somewhat unusally, part qualitative.

The quantitative objective remains the same or similar to always, and that is to achieve optimal investment return given defined constraints (For the ES investor these constraints include redefining the investment universe based on various defined ESG requirements). However the qualitative objective is about “the greater good” where there is hope and intention of changing the behaviour of individuals, corporations, and governments. Changing global behavour for the greater good is the ultimate goal of ES investing. Please note, this article doesn’t intend to go into the detail of what these behaviours should be but they are obviously about changing the current path of climate change, increasing diversity in the workplace, improving human rights in a range of scenarios, et al.

So what are the potential consequences of this dual objective?

Changing Global Behaviour

Capital markets are particularly good at changing bad or unwanted behaviour. It does this by simply increasing the cost of capital. If a company wants to raise capital for an unpopular purpose (e.g. Adani raising capital for its Queensland operations where many believe it could be damaging to the Great Barrier reef), investors will simply refuse to invest such that the company in question will have to increase its cost of capital (whether by increasing promised interest rates if raising debt or reducing its share price on offer if raising equity), until enough investors feel the additional return is attractive enough to provide the required funding. For some ES investors, this may seem hypocritical (i.e. owning a badly behaving company) so sometimes ES-focused investors will hope to change behaviour via direct engagement with management and the board. One limitation to direct engagement is that it generally requires massive investment to be effective however this does appear to be where companies like BlackRock, PIMCO, and other large fund managers are looking to make a difference.

Expected Return Dilemma

You may have already worked out that by increasing the cost of capital of a badly behaving company, by definition, means it now has a higher return expectation compared to a well behaving company (assuming all else equal). This may also mean, and perhaps naively, that badly behaving companies have lower valuations than well behaved companies. This return expectation difference creates a dillemma as it may compromise the return objective of the ES investor and for advisers who are speaking to their clients about ESG investing this must be part of the conversation. That is, the likelihood of underperformance by investing for the greater good may be higher than investing in the alternative … so ideally, the “greater good” should be the higher priority objective.

Many may argue that higher valuations for strong ESG rated companies means they have greater growth potential, as opposed to the lower rated companies, and this is definitely a reasonable possibility. Secondly, many existing ES investors would be currently exposed to the momentum of strong capital flows and would have seen strong investment returns that are supporting their investment thesis.

Possibly the company that encapsulates this momentum and high return experience is Tesla which has provided 5-year investors an average annual return of over 75%pa. Of fundamental concern may be that Tesla is yet to generate strong or consistent profits, and currently trades on a PE ratio of around 670. To justify this valuation requires massive revenue and earnings growth in the face of increasing competition and many must be wondering how much share price growth is truly available for a company’s whose market capitalisation is already around 650billion US dollars. On the flipside to the clean energy focused Tesla, we have fossill fuel dominant companies trading on low PE Ratios. So whilst Tesla has a PE Ratio of over 600 with revenues around 35billion USD, Toyota, Honda, and the recently ESG-challenged Volkswagen trade on PE Ratios that average around 10 to 12 with combined revenues of over 600 Billion USD at ~70% of Tesla’s market capitalisation (~460 Billion USD). This momentum and return potential for Tesla may continue, but there are clearly some future share price growth risks and also relative to some fossill fuel dominant car companies.

ES Investing will be G

So looking ahead there is little doubt that ES investing will continue … because it is the right thing to do and the consequences of doing nothing may be catastrophic. It is the right thing for the planet, and equality is the right thing for all people. This will ultimately mean that governments will get on board the ES train in a much bigger way than they have so far. As Governments observe this trend towards ES investing and the movements that go with it, they will increasingly shift their policies towards favourable ES outcomes. If they don’t, over time the people currently in power will lose their jobs and they certainly won’t want that. These shifts in policies mean that governments will ultimately change laws to stop or reduce bad E and S behaviours and also adding to badly behaving companies’ cost of capital with higher taxes, tariffs, et al. It may take a few more years yet but the E and S of ESG will likely fold into law such that ESG investing may morph int G investing as bad E and S practices will disappear under law.

Summary Thoughts

ES investing is the biggest trend in investing today and will continue for many many years to come until the governments around the world are in a position or forced to make stronger laws that radically change their behaviour and those of many corporations of today. Either way, investors will continue to lead the charge by increasing the cost of capital of the badly behaving corporations but this may come at the cost of lower relative returns over the long run as expected returns for badly behaving corporations may increase from higher cost of capital. Changing the cost of capital is how real change occurs on a massive scale, and this means investors must be prepared to alter their objectives such that the “greater good” becomes the primary objective over “expected return”. Of course, this may not happen but it is an important part of understanding the risks of ESG investing.

Of course, this leads to expectations of superannuation fund performance and particularly given the new mandated performance tests … but perhaps another day.

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May 22

Approaching the Zero bound

I’m always fascinated by the various changes in financial market behaviour and this economic lockdown has created some new behaviours in the cash or money markets not seen before (or that I’m aware of).

The chart below shows the performance of 3 cash benchmarks:

  1. RBA Cash Rate Target … currently 25bps (Green)
  2. RBA Cash Overnight Rate … currently 13bps (White), and
  3. 1 month Bank Bill… currently 9bps (Yellow)
Source: Bloomberg

Since the RBA announced its last 25bps cash rate decrease on 20 March, the RBA’s overnight rate has been trading at a much lower rate, whereas before, it traded at exactly the same level as the Cash target … at 13bps and almost half the target rate, this is a statement that 0% cash has a very strong chance … and negative rates are not out of the question at all.

An even stronger statement comes from the current price of 1 month bank bills that are trading at a record low 9bps…that’s 0.09%! With the exception of some very short term anticipation of the RBA lowering its cash rates, the 1-month bank bill rate has always traded at a premium to the RBA Cash (as far as I’m aware considering my 5 minute long term history chart check didn’t yield anything). The fact the RBA Cash Target is a premium to bank bills is another strong statement that zero rates are strong chance … and potentially negative … and bank bills are clearly not as strong a credit as the government.

So for those who think bond yields are too low and no longer offer protection, hopefully the recent pricing on these cash instruments provides some food for thought as this current record low interest rate environment may well be lower than you think and may well get lower than you think.

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Apr 24

Worry about Valuations??? … yeah, a bit …

The biggest market in the world, often represented by the S&P 500 index, crashed pretty quickly from 24 February reaching its bottom on 23 March. This fall, in US Dollars, was around 34%. Since then, it has bounced back by around 25% after almost 5 weeks … not a bad turnaround, but obviously not back to the pre-coronavirus crisis highs yet.

The following chart shows the current PE Ratio of the S&P 500 but going back to early 2008 which was near the start of the GFC recession.

Now, I don’t know about you, but if I thought at the start of the year that unemployment in the US was heading towards 20%, China would produce a real GDP first quarter result of negative 10%, and the global economy would effectively be shut down and likely for a fairly unknown period, I wouldn’t have thought the current PE Ratio of the S&P 500 would be above its long-term average going back to the start of 2008. (Please ntoe, this is an arbitrary start date as opposed to a data-mined start date).

The current PE Ratio of the S&P 500 represents an earnings yield of 5.4% … I’m not sure that’s particularly appealing considering the enormous expected decline in some very unknown future earnings as well as the enormous market volatility we are still likely to experience (the Vix hasn’t been below 35 since this began!) … let’s face it, the risk is high and the earnings yield isn’t that flash.

Now, of course there has been a lot of US Government stimulus (let’s be super positive for the economy and expect $3 trillion this year) and the Federal Reserve has reduced rates and is undertaking some quantitative easing. But considering this stimulus probably equates to around 10% of the valuation in the S&P 500 at the start of this crisis … its doesn’t quite add up to justify an above average PE Ratio.

So, my guess is that the market doesn’t care about valuations very much any more and/or believes there is a V-shaped recovery coming, we’ll be back to normal, and back to good growth in no time. The market appears to shrug off the prospects of a 20% unemployment figure and its long term effects and we’ll be fine in no time.

Now I know this is all probably over-simplified analysis but then I do always to reduce my error by reducing the number of variables in my calculations … but I digress!

So what should we expect from sharemarkets? I have no idea but the risks appear quite high and the rewards appear … not so high … and it doesn’t make too much sense to me.

We all get things wrong all of the time and I certainly know I am no different. The old saying that the more I know, the more I don’t know has never been truer for me than now … and it kind of sucks. There are many variables that go into these markets and market behaviour appears to be getting more complex and nuanced all of the time. So should I back this view that markets are expensive and don’t justify their current valuations? … to a degree, but I have to keep an eye on the log term, know that markets can stay irrational longer than I can stay solvent, markets are smarter than me, and …

price momentum with news that is the opposite of my expectations is a powerful force and why I diversify.

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Mar 19

The decline of the Aussie … almost halved in value since July 2011

The above interactive chart shows what the latest crisis events have invoked on the Aussie dollar. At the time of writing trading around $0.57US which is down from a high in July 2011 around $1.10US … so almost half.

Unfortunately for our currency this is what happens when crises occur … investors run to the safe havens of the US Dollar, which is still the global reserve currency.

That said, considering Iron Ore is still high at around $100USD, there is strengthening potential … just our near zero interest rates serves as a brake.

Chart 2 – Iron Ore Prices in USD – since 2012 and to 19 Mar 2020 – 4pm AEST

Iron Ore - 19 Mar 2020

Source: Bloomberg

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Mar 19

RBA announces 3yr target of 0.25% and drops cash to 0.25% … & a very strange yield curve

Reaction to 3 year bond price in the first chart below … that’s still a 0.5% yield to maturity. So the RBA are saying they want 0.25% yield to maturity which is a high bond price but only  little bit of interest in the first 5 minutes or so off the bat.

3yr bond yield - Rba announcementSource: Bloomberg

A little bit later the following chart shows what the Australian Government Yield curve looks like. To me, this is bizarre (or an inefficient market).

It confirms what I believe is a complete mis-pricing at the longer end of the curve (see last post) … 10 year bond yields are now trading at 1.7% which appears way too high given the recession we are currently in … and the shorter end of the curve is heading towards the RBA’s 0.25% target where buying commences tomorrow on the 3-year bond. Currently (3.11pm ADST) the 3 year bond is yielding 0.34% so is on the way down from the initial 0.5% … as you’d expect.

Aust Gov Yield Curve - 19 March 2020Source: Delta Research & Advisory, Bloomberg

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Mar 19

Most markets are mostly efficient most of the time … maybe not so much now

Its clearly been a long time since I updated this blog and perhaps this current crisis makes most sense to make a comeback; particularly given I started this blog not long after the worst of the GFC (Jan 2009 to be precise).

Anyway, the current crisis has clearly required a global response to slow down the spread of COVID-19 because rapid global spread means the global health system collapses and many more people die, whether COVID-19 or anything else, than necessary. If the spread of COVID-19 continues to spread exponentially its only a matter of weeks before Australian hospitals will be unable to cope so here’s hoping we all take notice of our medical leaders and the spread slows sufficiently.

In terms of financial markets, the volatility across all markets is incredible, its horrible and includes some unexpected outcomes of which I’ll outline a few here:

  1. Gold hasn’t been the hedge to risk everyone expected … its down more than 7% in US Dollars and has performed worst in the wort of the equity markets

Gold USD - 19 Mar 2020
Source: Bloomberg

2. The 10 year Australian government bond (& other longer term Aussie bonds), is often an indicator of economic strength or weakness and has risen strongly over the last week or so … so much for its expected hedge to equity risk. Given Australia is facing its first economic recession since 1991 and given interest rates may be heading to zero, this is unusual and can only be explained by lots of foreign selling as the Australian dollar moves well below $0.60US.

Aust 10yr Bond - 19 Mar 2020Source: Bloomberg

3. If there is one industry where you would expect an increase in price during this horrible virus it is Healthcare. The following chart shows the MSCI World Health Care Index and its decline over the last month, whilst not as big as the MSCI World index, is still big at over 21% … this is possible some supporting evidence that diversification during stressed times can mean little within the asset class.

MSCI World Healthcare - 19 Mar 2020Source: Bloomberg

So the lesson from this is that just when you think your portfolio is diversified or you think you have picked the right bets at the right time, they still may move against your logic (or perhaps mine!). Many of us, thought bond yields would decline as equities decline, and perhaps gold would go up, and that a bet in the most in demand sector would be a sure thing … well it maybe not. Diversification across securities, sectors, industries, sectors, asset classes, currencies will be very important in these times but be very careful when it comes to making specific bets and ensure you stay within your risk budget.


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May 31

A Few Investment Selection Faux Pas

Over the years having worked in consulting and research I have been sent countless portfolios for opinion. Virtually all portfolios have followed a pre-defined asset allocation aligned to a specific risk profile but occasionally that is where the alignment ends. This is because the investments selected bear little to no relationship with their desired characteristics or asset class and the final portfolio ends up with risks and/or inefficiencies that may present more downside than expected or intended. This article touches on some of the more common and extreme examples that will hopefully be helpful in assessing your own portfolios.

Faux Pas 1 – Using Geared funds in Balanced Portfolios

This faux pas doesn’t just apply to “balanced” funds and applies to all portfolios where there is a significant defensive allocation to bonds and cash. The one exception is where cash is used for liquidity purposes as opposed to its otherwise defensive income characteristics.

From an asset allocation perspective, holding geared equity funds is the equivalent of holding an equity position of more than 100%, may be potentially 200%, plus a bond allocation that is negative such that it brings the net equity position back to 100%.

Having a negative bond allocation from gearing alongside the usual positive allocation of a balanced fund, not only may reduce the bond allocation to less than desired, it is also inefficient as the cost of borrowing is likely to be higher than the return on the bond allocation which is often dominated by low risk government bonds. If the bond allocation is cancelled by the geared allocation, the expected return on the net zero bond allocation may be negative!

For example, let’s say a 50% growth Asset Allocation portfolio has an allocation of investments that are 20% Cash, 30% Bonds, 20% Geared Equity Fund, 30% Equities. If the Geared Equity fund borrows $1 at 3.5%pa for every $1 invested (i.e. Loan to Value ratio of 50%), then the resulting asset allocation becomes:

  • Cash +20%
  • Bonds +30%
  • Cash/Bond allocation from Geared Equity Fund -20%
  • Total Cash/Bonds +30%
  • Equity allocation in Geared Equity Fund +40% (Two times 20%)
  • Equities +30%
  • Total Equities +70%

This results in a 70% growth asset portfolio and not the desired 50% hence creating greater risk than intended.

In terms of expected returns, if we assume a 2.5% long run expected return on Cash and 3% on Bonds, the expected return on the Cash/Bond allocation becomes:

(20%*2.5% + 30%*3% + -20%*3.5%)/30% = 2.3% … less than the expected return of Cash and Bonds!

Faux Pas 2 – Allocating High Yield Bond Funds to Defensive Bonds

We don’t often refer to high yield bonds as junk bonds nowadays but either way, below investment grade bonds, by definition, are not defensive. Chart 1 shows the comparison of default rates between investment grade and speculative Grade (non-investment grade), and whilst investment grade bonds have very few defaults, Speculative Grade bonds frequently have defaults of more than 1% to 2%, including almost 10% default rate as a result of the GFC in 2009.

Chart 1

From a performance perspective, the Bloomberg Barclays Global High Yield index, which broadly represents Global non-investment grade bonds, can often show equity like characteristics…usually in a down market. For example, during the worst performing calendar year of the GFC, this High Yield index (hedged to Australian dollars) returned negative 27.6% which was lower than the MSCI World which returned a negative 24.9%.
Given the dominance of equity risk on multi-asset class portfolios, one of the roles of the defensive asset class should be to cushion equity market risk. Unfortunately, during stressed equity markets, and not just the GFC, high yield bonds generally become highly correlated with equity markets and perform the complete opposite of what you would hope from a defensive investment. As Chart 1 shows, the worst years since 1981 for of Speculative Grade defaults were 1991, 2001, 2002, and 2009 … all associated with recessions and poor or stressed equity markets (Recession, Tech Wreck, and GFC).

Faux Pas 3 – Market Neutral Funds in Equity Asset Class

In terms of the effect on the portfolio’s asset allocation, this Faux Pas is the complete opposite of using Geared funds. That said, Market Neutral funds are a type of Geared Share fund, except instead of borrowing cash to invest, the market neutral fund borrows stock, but the same amount that it buys. This results is a net allocation to equities that equals zero. The fact that a market neutral fund, may implement their strategy in the Australian equities market (or US, or Asia, et al.) doesn’t make it representative of the Australian equities asset class. The asset allocation decision is expected to be a “long” market allocation decision (sometimes know as a beta decision).

Because the market neutral fund generally has a net allocation to its underlying asset class of zero, the return characteristics are more likely to resemble Cash plus Alpha, where Alpha represents the excess return of the fund’s long positions minus it’s short positions. If Alpha is greater than the fees charged then the return is likely to be Cash plus Alpha minus fees, otherwise the return will be less than Cash minus fees.

Charts 2 and 3 breaks up the risk of an Australian Equities focused market neutral fund and popular traditional active Australian equities fund show the proportion of total portfolio risk due to the Australian Market. As can be seen the Market Neutral fund bears has little to no Australian equities market (as defined by MSCI Australia) risk compared to the highly active long only Australian equities fund.

Chart 2 – Australian Equities Market Neutral Fund

Chart 3 – Popular Highly Active Australian Equities Fund

Because of this lack of relationship between the Market Neutral fund and the Australian equities market (or any market), the Market Neutral fund should generally be classified as an “Alternative”, as its Cash and Alpha performance outcome should be uncorrelated to Australian equities.

Final Thoughts

Having investments that don’t completely reflect their respective asset class is not always a problem. They may be playing specific roles to mitigate or capture desired risks. A high yield bond fund as part of the bond portfolio may be absolutely fine, as long as that bond portfolio does not play a purely defensive role to the equities portfolio and is positioned more as a higher income generator. A geared equities fund may be fine for a client, particularly for a high growth investor who has no long term defensive allocation in their recommended portfolio, or perhaps where the bond allocation is appropriately of the higher return/risk variety and therefore potentially earning more than the cost of gearing.

The key point to all of this is …. we are aware of the requirement to “know your product” but some of the riskier or more complex products will typically require a lot more analysis and understanding than the asset class source of their returns.

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Apr 27

From Asset Allocation to Risk Allocation


After capital market forecasts and assessing investor objectives, the current method for portfolio construction starts with the asset allocation decision followed by investment selection. In the Australian financial planning industry, it widely accepted that the asset allocation decision is responsible for most of the portfolio performance variability, and it is, rightly or wrongly, regarded as the most important investment decision. Asset classes are then populated with investments and the portfolio is recommended to a client.

Unfortunately, there is one major problem with this two-step approach. The investments chosen often do not reflect the required asset allocation and the asset allocation decision becomes compromised. This is because Asset Allocation is a “Market Beta” decision whilst the Investment Selection may introduce an “Alpha” component which can change the exposure to the desired asset classes. An investment manager looks to add value, loosely defined as “Alpha”, by designing portfolios that differ from the market. The size of these non-market bets may capture certain risks that are positively rewarded but it may also introduce unintended risks so that the final portfolio not only doesn’t represent the asset allocation, it might increase risks that result in a worse than market outcome in stressed times.

This portfolio construction problem can be summarised by the following equation:

Asset Allocation ≠ Investment Selection because Beta Alpha + Beta.

This problem can be solved in two ways:

  1. Remove the Alpha component of Investment Selection. This means the chosen investments are simply index funds that represent their respective asset classes. Many financial planners already do this, as they may believe markets are efficient and/or that active management does not add value amongst other reasons. This transforms the above equation to: Asset Allocation = Investment Selection because Beta = Beta
  2. Introduce a formal Alpha Allocation component to the process, changing the equation to be Alpha + Beta = Alpha + Beta. The goal is then to choose investments that specifically reflect the asset class and alpha allocation decisions.

This article discusses the introduction of the additional step of Alpha allocation and proposes one simple framework for its implementation. Considering today’ markets, whether bonds or equities, may be regarded as expensive with future (“Beta”) returns looking increasingly low, efficient purposeful Alpha allocation may become an essential component for adding that little bit of extra return.

Equity Risk matters most

The largest component of risk for all multi-asset portfolios comes from equity markets. It generally doesn’t matter whether a portfolio is 25% growth assets or 80% growth assets, most of the portfolio’s performance variability will come from equities. Therefore, active asset allocation approaches, must have greatest focus on the Equity Market allocation (or equity market Beta).

It’s often said when markets are running strongly, investors don’t really care whether they’re invested in index funds, benchmark-huggers, or highly active strategies. As long as they are receiving high returns they are likely to be happy. In strong markets, Alpha (or outperforming the market) matters less and it’s all about capturing the market (or “beta”).

Of course, when markets perform badly … investors don’t want “beta”, they want to be protected. They want uncorrelated assets, they want diversification away from equities risk, and they still want positive returns, and some clients may be more accepting than others, irrespective of their risk profile!

If equity markets are cheap, say based on simple, perhaps naïve metrics like Price/Book or PE Ratio measures, capturing equity market risk (or Beta) is desirable. On the other hand, if equity markets are expensive, well, it’s a lot more challenging.

But what if all asset classes have a weak return outlook and there appears little place to hide? This leads to an Alpha allocation (or non-market or specific risk allocation) decision.

Example Portfolio Construction Framework

Figure 1 shows one framework that can be used for allocating between Alpha and Beta which hopefully improves process around investment selection and their alignment to a formal view. In this context, Smart Beta (which are cheap systematic risks) are separated from pure “Skill” based Alpha allocation.

Figure 1 – Active Allocation Framework

Source: Delta Research & Advisory

It should be noted up front that this framework is no guarantee of success and is an attempt at putting probabilities in the investor’s favour. Active management success will always rely on good timing and assumptions coming true, and unfortunately there are never guarantees in investing.

This framework proposes the following deeper dive within each asset class with considerations of allocation to various alpha-driving risks:

  • Increased allocation to Alpha-focused strategies when equity markets are expensive
    • By definition the Alpha component of a strategy’s return is uncorrelated to the market (Beta) return so increasing Alpha potential when markets are expensive may be a simple, effective risk management strategy
  • Increased allocation to Beta-focused strategies (i.e. index or benchmark-hugging strategies) when equity markets are cheap
    • When markets are cheap, expected returns are high so diversification to markets matter less and capturing index returns can be best
  • Smart Beta (or Style/Factor biases have the potential for outperformance in all markets but it should be noted that factor timing is considered very difficult and different factors will perform better at different parts of the cycle.
  • If there are concerns about equity markets becoming stressed, some of the recent Risk Allocations that have provided some downside protection include:
    • Pure “Alpha” strategies focused on “market timing” and/or “security selection”. This may include Alternatives such as Hedge funds; or more specifically uncorrelated Alpha strategies such as Market Neutral or some Managed Futures strategies
    • US Dollars – this may be a currency hedging decision or could be a direct cash allocation using some ETFs. Often during stressed global equity markets, funds are flowing from the riskiness of equities to the safety of US Government bonds and cash. This increases the value of the US Dollar versus the Australian dollar. An unhedged Global equity position (which has a high proportion of US Dollars) can also be cushioned somewhat by this rising US Dollar.
    • Volatility – Volatility strategies do exist and are typically available via complex hedge funds, but equity market volatility increases during stressed times
    • Momentum – This is the “factor” that Managed Futures strategies generally capture and is largely about capturing the current trend. So for a downturn, like during the GFC in 2008, momentum capturing strategies can produce positive returns
    • Duration – This is interest rate risk. When equity markets are under stress, interest rates will sometimes decrease as equity markets are seen as a leading indicator to the economy. Declining interest rates means higher bond prices, but this applies to only the most secure or conservative bonds such as AAA-rated government bonds. Whilst Corporate bonds may have some duration risk, a stressed equity market often results in a declining corporate bond price as credit risk and equity market risk are generally highly correlated when you don’t want it to be.
    • Cash – This is the only asset class that can provide a buffer for a stressed equity market. Whilst Alternatives and Bonds can, it is only specific sub-classes of investment that may diversify the stressed equity market.

This simple framework provides a deeper dive beyond asset allocation, beyond market expectations, and towards some of the more specific risks that may be uncorrelated at certain times with the most important risk of all, equity market risk. Allocating to risks that provide greater diversification to an existing asset allocation, whilst no guarantee of superior return, hopefully provides for more efficient investment selection and fills a gap that has frequently created problems in the portfolio construction process … the asset allocation and investment selection mismatch.

Final Thoughts

Many pundits today see interest rates rising, decreasing bond prices, which may ultimately lead to decreasing equity valuations. All-in-all a recipe for lower asset class returns in the future. Many portfolios were not prepared for the GFC as they were chasing returns and had exposures that were considered defensive but ended up correlated with the equity market risk of 2007 to 2009. The GFC showed that asset allocation can fail, particularly if the investment selection is not aligned appropriately. This paper proposes an additional step that allocates to risks (non-market risks) depending upon equity market valuations. It proposes a step that provides a clearer recipe for investment selection. Whilst this does not provide guarantees of superior returns, it will hopefully provide greater diversification and improved ability to withstand volatility when its most needed and capture market returns efficiently.

Side note – It should be noted this framework requires the measurement of risks for investment and advisers frequently comment in various discussion forums of the inability to measure these portfolio risks. This is not true, and there are increasingly many more tools available for measuring and understanding the risks of investments available in Australia and they can definitely aid in building these more robust portfolios. And I’ll leave my conflict of interest at this point.

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Mar 14

Diversification … clearing up what it is and what it isn’t

Diversification is one of the central tenets of investment management and fundamental beliefs across the global financial planning industry. Its validity was set in stone by Harry Markowitz in his PhD dissertation and 1952 Journal of Finance article, Portfolio Selection, which demonstrated the effects of combining uncorrelated assets … i.e. improvement in the portfolio’s return per unit risk. This showed diversification to be the closest thing to the Holy Grail of investing and possibly the only “free lunch” (Rebalancing may be the free dessert) as it was possible to improve the return expectation of a portfolio without necessarily increasing risk (or vice versa … maintaining the expected return whilst decreasing risk).

Whilst, today, the concept of diversification may seem second nature to all of us in the investment industry, some of its fundamentals are often misused and sometimes misrepresented. Diversification is probably the most commonly used justification for investment recommendations and the word carries a sense of lower risk which is always appealing. Unfortunately some of its use appears to have shifted from Modern Portfolio Theory (MPT) definitions, originated by Markowitz, William Sharpe, et al., towards potentially misleading ways which may confuse.

The purpose of this article is to return to some of the (forgotten?) foundations of diversification, and hopefully address potential misconceptions or misunderstandings.

A simple example

It is not uncommon for investment advisers to recommend a portfolio that improves an investor’s existing portfolio on the basis of greater diversification. A simple example may be the investor who has a lot of their wealth tied up in a single stock, maybe because of an employee share scheme or inheritance, etc. The adviser would be concerned about the concentration risk of this single stock and would recommend a sell-down or reduced exposure to the stock to spread its risk across a portfolio of managed funds or perhaps a larger stock portfolio. The justification is the greater diversification because risk has been reduced away from the single stock to a broader portfolio and this has not necessarily compromised return potential.

This may be quite a valid recommendation with a valid justification. Spreading the risk from one stock to many others is a simple example of diversification but there is a little more to this than meets the eye…

Measuring Diversification

Modern Portfolio Theory (MPT) defines the completely diversified portfolio as the Market Portfolio. Without going into too much explanatory detail, because the Market Portfolio contains all assets, the market cannot be diversified away (except, by other markets). So increasing diversification is an exercise in shifting a portfolio to be more market-like. In the “simple example” this was a shift from the specific risk of one stock to many more stocks.

This all means that to measure the level of diversification of a portfolio, consistent with MPT, means it should be measured in the context of the market or market risk. Measures commonly used include active share, tracking error, or systematic risk as defined by the R-Squared of the Capital Asset Pricing Model (CAPM).

Using the CAPM R-Squared measure, an index portfolio is close to 100% market risk, and active strategies will have variable market risk depending on how active and how diversified or concentrated they intend to be. The active strategy’s obvious goal is to ensure that non-market risk produces excess risk-adjusted returns (“Alpha”), but they will always have less diversification than the market.

As examples, the following three charts show the market (blue) and non-market risk (green) through time (using Markowitz defined risk) for:

  1. an Australian Equities index fund
  2. Popular actively managed Australian Equities fund, and
  3. Popular actively managed small-cap Australian Equities fund

Source: Delta Research & Advisory

The index fund, as expected, is all blue and therefore all market risk; the active strategy is dominated by market risk but with a substantial proportion of non-market risk (sometimes called active or idiosyncratic risk), and the restricted Small Cap strategy, expectedly, has an even higher proportion of green (or non-market risk) as it excludes the large-cap stocks from the market.

So when recommending changes based on diversification, it is possible to explicitly measure and demonstrate the changes and/or improvement in diversification using past performance risk measures.

Diversification Misrepresented

Many may argue that investment recommendations are sometimes looking to diversify away specific risks, as opposed to non-market risks, which may not result in the portfolio becoming more market-like. A popular example, is where an adviser recommends a Small Cap Australian Equities strategy to diversify away the large cap bias of the Australian equities market which is dominated by large banks and materials companies. Whilst, on the surface, this justification appears reasonable there are some issues of which advisers need to be aware.

Firstly, this is not diversification, but is actually the opposite.

Considering the first step of portfolio construction is Asset Allocation, which is designed based on market expectations of asset classes (i.e. “Beta”), a recommendation of a small companies strategy restricts the portfolio and therefore increases concentration risks to small caps and away from the market (or beta) recommendation. This shift away from the asset allocation decision potentially increases risks of market relative performance failure (i.e. compared to recommended asset allocation). Don’t forget, complete diversification contains all assets, which the restricted small cap strategy cannot.

The decision to move away from the market, dominated by large caps, is an active decision which is likely to carry the belief that small caps are likely to outperform large caps, so it is a decision designed to outperform the market and generate “Alpha Risk” (similar to tracking error) and therefore not based on diversification. Diversification is actually “Alpha Risk” minimisation. A portfolio that contains a single security is the simplest example of a massive “Alpha” bet whilst an index portfolio contains no “Alpha” bet whatsoever.


For the last 10 to 15 years, Alternatives have made appearances in more and more investment portfolios and often for reasons of diversification. Sometimes this is true and sometimes not. Alternatives can bring diversification benefits to a portfolio by accessing markets that do not exist within a portfolio. This may be true of soft and hard commodities, private equity, and maybe unlisted infrastructure. This is because these asset classes, or markets, are not represented in the traditional asset allocation of bonds and equities. “A market cannot be diversified away”, except by a different market.

Where Alternatives do not diversify but actually increase concentration or non-market risk, is for the various equity and bond strategies executed by many hedge funds. This includes long-short, variable beta, and potentially other arbitrage or concentrated strategies. Including these strategies does not increase diversification, as it is always possible these strategies have the same market exposure as an index fund, but increases the concentration risks linked to the success or otherwise of the specific strategy bets. Like the small cap recommendation, the inclusion of equity or bond “alternatives” is a recommendation based on capturing manager skill (Alpha) and ability to outperform a market and not one based on improving diversification and minimising non-market performance risk.

Quick word on Over-Diversification

Overdiversification is often mentioned amongst investment circles and in a cost-free world isn’t possible. Overdiversification occurs, when the costs of adding securities or investments to a portfolio detract from performance potential due to these costs. When costs are nil or very low, overdiversification is difficult or impossible to achieve.

For example, a portfolio of many index funds for the same asset class will only be detrimental to portfolio returns compared to one index fund if there are flat fees charged per investment. There is no overdiversification because there is no non-market risk to diversify and the return, irrespective of the number of funds, will be the market minus the average of the low management fees. Diversification and return impact is likely to be minimal … although there is rarely any value in having multiple index funds (of the same market).

Overdiversification most frequently occurs when combining active managers of the same asset class. This is because the more active managers in a portfolio, the more they diversify away the portfolio’s non-market risk (because you can’t diversify away market risk), potentially leaving a portfolio that resembles an index fund but at active manager costs. Measuring this is possible using historical data as already discussed and shown with Figures 1 through 3, but predicting the optimal number of strategies is difficult and can vary depending on how active and correlated each strategy is.

Final Thoughts

It seems diversification is used to justify more than it should. Diversification is a free lunch but only in the context of the market portfolio. It ceases to be free when concentration and greater specific risks are introduced. Diversification is a relative concept and is about reducing non-market risks and not increasing market outperformance potential.

There is no right or wrong level of diversification as there are many schools of thought and examples with reasonable evidence as to what works in markets and what doesn’t. Warren Buffet is quoted as saying that “Diversification is ignorance” and yet recommends most should invest in index funds. Lower levels of diversification may be safest when investment skill exists, but finding true skill is difficult, sometimes expensive, and persistent skill is rare.

Investment recommendations are designed to reflect one’s investment philosophy which help an investor achieve their financial goals. If you believe markets are efficient, you have defined the appropriate level of diversification, and will recommend market portfolios. If not, the portfolio construction question to be answered is, how much diversification is enough?


Markowitz, Harry. 1951. “Portfolio Selection”, Journal of Finance 7, no 1 (March): 77-91

Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance”, The Financial Analysts Journal, July/August

Sharpe, William. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”. Journal of Finance 19, no 3 (September): 425:442

Reilly, Frank K & Keith C Brown. 2009. “Investment Analysis and Portfolio Management – Ninth Edition”. South-Western Cengage Learning

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Jan 14

Designing the rules of the game … Investment Policy Statement (IPS)

The following article was published by Professional planner Magazine a couple of months ago and whilst can be found on their website by clicking here … the original article follows.


One of the biggest trends in the financial planning today is the shift towards managed accounts. This is primarily an exercise in increasing efficiencies and lowering costs to serve clients, but it also has created other risks and shifted the financial planner closer to the role of fund manager. Whilst financial planners have always managed client investment portfolios, the managed account trend towards becoming more like fund managers requires a different set of skills, knowledge, and risks, that come with discretionary portfolio management.

The purpose of this article is to provide a guide to one of the foundations of quality funds management and to aid in this shift towards a more professional approach to all things investing … the Investment Policy Statement (IPS).

What is an Investment Policy Statement (IPS)

An Investment Policy Statement defines the rules of investment portfolio management. That said, it can easily apply to all investment decisions whether it be model portfolios, construction of approved product lists, or the management of a self-managed superannuation fund. Establishing a comprehensive IPS, irrespective of purpose, is a step towards stronger risk management and governance of all investment businesses whether implementing managed accounts or traditional investment advice approaches.

Chart 1 shows one version of the structure of an IPS. Central to the IPS are the objectives, with surrounding components designed to maximise the achievement of those objectives. Namely, Philosophy, Process, Implementation and the Ongoing Review. Covering all aspects of the IPS is a system of Governance focused on execution and accountability of all policies. Following are descriptions of each of these components. Please note, this article does not provide a comprehensive description of everything involved in the design and execution of the IPS and serves as an initial guide to lay the foundations towards better investment decisions and ultimately, investment portfolios.


Across the investment industry, the governance function is usually performed by the Investment Committee which is a specialist sub-committee of the business’s Australian Financial Services License (AFSL). The Investment Committee owns the IPS, is responsible for its creation, and ensures it is executed accordingly. Whilst there may be portfolio management, analysts, external consultants, and/or an internal Research department, the investment committee’s responsibility is to hold them accountable for the day-to-day running of investment activities.

The investment committee is typically established by way of an investment committee charter, that may for part of the IPS, that outlines the following:

  • Committee membership and voting rights. This may include:
    • Senior management
    • Compliance/Legal/Risk Management representation
    • Portfolio Management
    • Independent experts
  • Committee purpose – Ownership and implementation of the IPS which includes:
    • Strategy development
    • Due diligence procedures for investment selection
    • Investment performance review
    • Sometimes operational finance and business development review
  • Meetings are typically quarterly
  • Minutes and all procedures are documented
  • Investment and portfolio decisions are documented and communicated appropriately to stakeholders (advisers, staff, and investors)
  • The committee should ideally review the overall IPS on, at least, an annual basis

The investment committee plays the most crucial role of IPS due to its role in accountability and execution. So, whilst a well-functioning investment committee is no guarantee of strong investment returns, it is a leading indicator of a firm with a strong risk management culture which should reduce the likelihood of left-field investment disasters. Similarly, whilst an IPS may look good on paper, unless its rules and procedures are adhered to, it becomes worthless and a risk to any investment-related business.

Chart 1 – Investment Policy Statement (IPS) Design

Source: Delta Research & Advisory


Central to all investment decisions are the objectives. All investment decisions should be made with consideration of objectives and they should be defined based on the SMART principle:

  • Specific … may be absolute, such as 8%pa, or relative to a benchmark, such as to outperform the S&P/ASX200 by 2%pa over 3 years
  • Measurable … this seems simple enough as all investments produce performance, but when cashflows are involved it does get a little more complex and portfolio performance measurement is not perfect across managed account platforms, particularly with respect to Global Investment Performance Standards.
  • Achievable … Equity markets have outperformed cash and bonds in Australia by no more than 4%pa over the last 50 years. Aiming for high returns may be appealing to potential investors but if they are too ambitious and therefore not achievable, based on the investment strategy employed, then credibility and ultimately business may be at greater risk
  • Realistic … an achievable return objective does not mean it is realistic; particularly over the long term. For example, a 10%pa return objective may be achievable in any one year across most asset classes, but in this world of low interest rates and historically high valuations, setting any expectation that a consistent 10%pa can be achieved is not realistic and is setting up for failure
  • Time related … the more aggressive the return objective the more time may be required to achieve it due to the additional risk required. All investment objectives must be associated with a timeframe and rarely should that timeframe be less than 3 to 5 years unless dealing with lower risk strategies (such as conservative bonds)

More and more investment strategies are also including risk in their investment objectives. Risk can have multiple definitions, whether it is absolute (such as overall volatility) or relative (such as less risk than the S&P/ASX 200). It is worth noting that risk objectives should also follow the SMART principles as opposed to being vague, such as motherhood statements like, “low risk”.


The Investment Philosophy is an articulation of beliefs around what works and perhaps what doesn’t when it comes to investing. Investment markets are difficult to predict, highly competitive, and party to an array of beliefs and competing philosophies battle each other in the various markets with the goal of getting the best possible return.

The investment philosophy of a strategy or portfolio is typically what an investor is buying into. This is because the future is largely unpredictable so clear articulation of an Investment Philosophy can be a powerful client tool as well as setting guiding principles behind portfolio construction.

The Australian financial planning industry has embraced much of modern portfolio theory with core beliefs such as:

  • Diversification … spreading your eggs across the various baskets which may be asset classes, investment styles, and at the security level, and
  • Higher risk is required to achieve higher returns … hence there is the expectation that equities will outperform cash and bonds.

However, even these beliefs are challenged with strategies around increasing return potential from less diversification and more concentrated strategies. Then there is the market anomaly in certain markets that buying lower volatile securities having a tendency to outperform the more volatile or risky securities, which challenges the second belief around higher risk is required for higher return.

Irrespective of your belief around diversification and risk, the first question of philosophy typically comes down to a belief as to whether passive or active management is best, and whether it is applied to asset allocation, or security selection and in what asset classes.

Some of the more recent beliefs that are changing investment portfolios around the world include passive style investing (commonly called smart beta) and the re-embracing of skill as investors move away from traditional markets towards broader scope hedge fund-like strategies. On the flipside of this has been the biggest trend of all, which has seen enormous funds flow into passive market-cap index ETFs, suggesting many have stopped believing that active management can add value.

The best investment portfolios will have a clearly articulated investment philosophy which is understandable by investors, has evidence to support it, and is reflected in the chosen investments within. If an investor agrees with the investment philosophy, and the portfolio clearly reflects this, then investors are more likely to stay the course and are less likely to withdraw during the tough times that inevitably hit every investment portfolio.


This is the portfolio construction process and leading to the ultimate design of the investment portfolio. It is designed to achieve the stated objectives, and reflects the stated investment philosophy or beliefs around what works in markets. An example of some of the questions to answer in the process design include:

  1. What is the investment universe?
    1. Which asset classes are included or excluded?
    2. Which securities or investment types are included or excluded?
  2. What is the expected return and risk of those asset classes or investments within the universe?
    1. Depending on methodology this question may also include the more complex relationship between asset classes or investments (e.g. correlation or covariance)
  3. What are the investment vehicles used to access the investment universe?
    1. This could relate to:
      1. Platform availability/limitations
      2. AFSL limitations such as limited products (managed funds, securities)
    2. What are the required hurdles to be placed in the final portfolio?
      1. Qualitative factors
        1. Philosophy, People, Process
      2. Quantitative factors
        1. Performance, risks, style, added value (past/expected)
      3. Research/Consultant ratings
      4. Expected returns and/or returns/risk
      5. Alignment with philosophy
      6. Cost budget
      7. Risk Budget

The above is a relatively simple snapshot of some of the questions that could be answered to build the investment portfolio.

Most investment managers apply the above questions to a simple two-step portfolio construction approach:

  1. Asset Allocation, and
  2. Investment/Strategy selection

An investment philosophy with beliefs around market efficiency will lead towards passive index investing and beliefs of market inefficiency will bias strategies with various levels of non-market risk. Whilst this is relatively easy at the investment level, defining the “market” at the asset allocation level is rarely done and is often accepted as an industry average.

Investment objectives and philosophy will determine the type of process required which should also improve the efficiency of the design of the final investment portfolio. That said, implementing the investment process towards portfolio does require the greatest level of specialist investment expertise so its design should also consider capabilities of the key people involved.


The execution or transaction of the investment portfolio is often one of the most overlooked components of the investment process. Considerations include:

  • Cost of execution
    • Buy/Sell spreads or brokerage can be significant return reducers irrespective of the quality of underlying assets that may reduce the ability to achieve objectives. This is particularly the case for high turnover strategies
    • Managed account platforms may reduce costs of execution compared to other platforms when implementing complimentary strategies. For example, if one strategy is buying BHP whilst the other is selling BHP instead of 2 independent transactions there may be none or a reduced transaction savings numerous valuable basis points in cost
  • Timely execution
    • Portfolio return and risk expectations are made at a specific point in time and the time taken between the investment decision and time of execution may be costly
    • Some investments, such as IPOs or various corporate actions, have deadlines, and if they are not addressed appropriately may also have costly implications.
  • Rebalancing (which may also be part of Process)
    • Establishing clear rules around rebalancing, whether it be at the asset class level, investment level, frequency (e.g. quarterly or annually), and/or movement from desired allocations (e.g. +/-10%) creates transparency and clarity for appropriate execution of the ongoing investment management of an investment portfolio

Overall, good portfolio implementation with clear rules can add return via the reduction of performance drag caused by poor implementation. When decisions are made to invest today based on today’s information, ideally investments are transacted today instead of adding the risk of short term market timing which has very little evidence of adding value. Implementation guidelines should not be taken for granted.

Ongoing Review

The one constant about investing is that nothing is constant. Markets go up and down, styles go in and out of favour, beliefs are constantly challenged, and every investment or investment manager underperforms their objectives or benchmarks at one time or another.

The ongoing review looks at the portfolio with typical outcomes focused on:

  • Ensuring the portfolio is aligned to meet objectives and a reflection of investment philosophy
  • Is the asset allocation appropriate?
    • Capital market views and valuation considerations
  • Investment and Performance review
    • Are the investments doing what they are expected to do so?
    • Are investments still satisfying required ratings?
    • Are they invested according to stated styles?
    • Are the drivers of portfolio returns and risks aligned with intentions?

The answers to these questions re-start the portfolio construction cycle leading to new portfolio recommendations (which may be to do nothing) and the cycle continues.

Whilst investment teams will consider portfolios on a daily basis, the formal review presented at the investment committee and typically on a quarterly basis. That said, the frequency of the formal portfolio review should depend on investment style and/or level of expected activity. Sometimes portfolio reviews are undertaken more frequently, and many are monthly. An example, may be during highly volatile times when market valuations fluctuate and potentially creating opportunity for the highly active strategy.

One of the challenges of the ongoing review is to avoid shot-termism. Changes in monthly or quarterly (or even annual) performance is often too short a timeframe to make a meaningful assessment of the potential success of an investment or portfolio of investments as styles that are out of favour today may be in favour tomorrow (and vice versa). It is typically best to keep an eye on the bigger picture issues such as ensuring the portfolio is a reflection of beliefs than persistent alpha (or outperformance) generation.


What this article provides is a starting point for those looking to improve the risk management of their investment business. The IPS is a key part of all successful investment management businesses from the largest Sovereign Wealth funds to the smallest boutique fund managers or advisory firms. Creating the rules of the investment game, with IPS, is a step in the right direction of good governance and risk management that is becoming even more crucial in these increasingly complex investment times.

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