It is important to play games. We view gameplay as imperative for children because it helps with cognitive and physical development. Competitions teach children patience, social skills, negotiation, strategy, confidence and how to win and lose. Games are also important for adults. As we age, these activities help relieve stress, maintain brain function, stimulate creativity and help us feel young and energetic. In addition, games enhance our professional development. For example, the military conducts war games to teach our soldiers the complexity of their craft and prevent catastrophic outcomes. Airlines make a significant investment in flight simulators so the 87,000 flights that cross our skies each day take us safely to our destinations. Lawyers hone their skills in mock trials to better advocate for their clients. Professional athletes go through preseason games so they can deliver more victories to their fans. Throughout our lives and across settings, games benefit us in multiple dimensions.

In this spirit, the $14.5 billion Public Employees Retirement Association of New Mexico (PERA) investment division has an internal investment competition. Each member of the team constructs a hypothetical portfolio based on agreed-upon criteria. The portfolios run throughout the calendar year, with weekly checkpoints. This annual exercise began in January 2015 as a way to facilitate an esprit de corps and instil incremental investment acumen and discipline. It is a highly productive exercise, as it creates an environment in which all members of the team can challenge one another’s hypotheses. Moreover, this atmosphere facilitates constructive feedback in which people formulate ideas and defend their positions. Improving investment knowledge, skill and discipline across the team benefits PERA’s 100,000 members, as we continually strive to improve the processes through which we administer the pension trust fund. As we near the end of this year’s competition, several themes and behaviours have emerged that are similar to those we see in the institutional investment marketplace. Thus, our friendly simulation has become a microcosm of the asset management space. This virtual reality helps flag behavioural biases across PERA’s roster of money managers and allows us to minimise the impact of potential adverse influences.

 

 

The rules

Each participant begins the investment period with a fictional $10,000 portfolio. A virtual exchange prices securities and processes trades. Accounts must contain at least three distinct asset categories, hold 10 positions of 5 per cent, have no single holding greater than 20 per cent and have one-third of assets invested internationally. Eligible investments include indices over stocks, bonds, real estate, real assets and commodities. Team members can invest in publicly traded securities and exchange-traded funds (ETFs). Players must choose their own portfolios and cannot adopt actively managed mutual funds. In addition, portfolio rebalancing is required each month. To create a dynamic competition, the portfolios must change by at least 10 per cent as part of this monthly rebalancing exercise. Moreover, the competition does not allow borrowing funds against assets. The group serves as its own watchdog and monitors compliance.

Performance

Observing how fluctuations in the markets affect each player’s portfolio teaches a great lesson about investing. The year 2016 had a horrific start. The broad MSCI All Country World Index was down more than 10 per cent through the first six weeks of the year. Markets also exhibited dramatic drawdowns across most asset categories in June, with British voters’ unanticipated decision to leave the European Union. In addition, there was volatility on either side of the US presidential election. Due in part to these and other market gyrations during 2016, the investment challenge highlighted the benefits of broad asset category diversification.

Recalling the guidelines, portfolios could have no position greater than 20 per cent (including cash) and had to maintain diversification across asset categories and geographies. As a result of these guidelines, the virtual portfolios weathered the difficult environment. The philosophy behind the guidelines is consistent with that of the real-world PERA fund. PERA diversifies its investments across asset categories and geographies. The fund does not try to time markets; asset category diversification provides risk mitigation across cycles.

The rebalancing the game requires is another critical element to success in uncertain markets. It is the process of realigning the weightings of a portfolio of assets. This involves periodically buying or selling assets in a portfolio to maintain a desired asset allocation and risk tolerance. Specifically, an investor would sell above-weight investment strategies in order to buy those that are below the target amount. This is another key investment tenet of the PERA fund. As the virtual portfolios generated gains following market downturns, so too does the PERA fund benefit from rebalancing over the course of a full cycle.

Investment operations emerged as another key element in the competition. For example, the virtual exchange we used to manage our friendly competition failed to account for stock splits. It also did not properly return cash for an ETF that was delisted. These operational flaws affected the reported values of several portfolios in the simulation. As our team is quick to note, investment operations should be front and centre. It is naïve to refer to these important functions as back-office; they are critical to the proper function of a complex institutional investment program. Good investment performance is dependent upon the right operational infrastructure.

 

Observations and lessons

Many patterns emerged from the 2016 investment competition. These items stimulated much debate among the group. Here are some of the issues we discussed, our observations on them, and lessons they taught us.

Active v passive strategies

Observation: The principal difference in the portfolio models employed by the group was the use of active versus passive investment strategies. Active strategies try to beat a market benchmark through skilful security selection. Passive or indexed strategies embrace a benchmark predicated upon the belief that markets are efficient over time, especially when adjusted for risk and fees. Many people invested in a collection of passive indices. Others created concentrated portfolios of individual securities. The latter group embraced volatility and the former shied from it. There were nuances across implementations. Some of the participants were active within their asset category specialty and passive across other strategies. Others took the opposite approach and embraced risk in the areas outside their subject matter expertise.

Lesson: We believe asset allocation is the principal driver of the variance in performance for diversified portfolios. While picking an individual security may be more exciting, it is not the winning solution over an extended period for a public pension plan. Absent proprietary research, broad exposure to multiple asset categories is a better long-term investment approach for an institution such as PERA. Our mandate is to distribute benefit payments today and into the future. Accordingly, spreading capital across various asset category indices or betas provides better downside protection. The decision to invest in an index versus picking individual securities provides valuable insight into the actual marketplace. For efficient asset categories, such as large-capitalisation US public equities, active managers have trouble beating the comparable passive strategy. Moreover, those managers who beat the index in a given period often trail it in subsequent ones. Yet, active managers have an allure that is akin to a good story. From a marketing perspective, these story-based strategies attract much attention because they are fun and appeal to the adventurer in all of us. We all want to win and active strategies give us a chance to beat the odds. At the same time, many of these stories belittle passive strategies as boring and pedestrian. The manager’s challenge is to rise above the noise by optimising the expected return per measure of expected risk. Adventures are fun, but for the most efficient asset categories over extended periods, indexing may be the optimal strategy.

Crowding

Observation: Another behavioural theme relates to crowding. Each portfolio in the competition is transparent and visible to every participant. Crowding exists when many people invest in similar securities and strategies. With similar trades come like outcomes. Like outcomes yield blurry information and a lack of differentiation. Said differently, there is safety in numbers.

Lesson: As we see with commonplace trades in the money-management space, crowding benefits money managers through consistent peer performance. As a positive, this may allow someone to win by not losing. Alternatively, this is akin to benchmark hugging (when an active manager closely mimics its underlying index) or survival through conformity. One motivation for such risk-averse professional portfolios is asset and fee maximisation. Specifically, managers that move with the herd may have a better survival rate. Clients may not fire them based on undifferentiated peer comparisons.

From the perspective of the PERA portfolio, our most significant form of risk management is diversification. In addition to diversifying our investment strategies, we also employ multiple money managers to avoid organisational risk within a single investment firm. Our money managers’ peer rankings are not particularly relevant. We do not benefit from overlap or crowding within like mandates. Crowding helps only our money managers. It shifts the focus from what is an optimal investment structure to what is safe in the context of peers and universe rankings. Where we employ active money management, we expect our managers to express an educated point of view and develop the best collection of securities in a category. We encourage our managers to think and execute, as opposed to just surviving against their peers. We want our managers to be hungry and motivated to generate appropriate risk-adjusted returns for PERA. We are vigilant towards this end. We structure tight investment guidelines with each money manager. Investment guidelines are a list of do’s and don’ts for them. We also hold the vast majority of our investment securities at PERA’s custody bank. This account structure gives us greater visibility throughout the whole PERA fund and helps us avoid unintentional positional biases such as crowded trades.

Quartile rankings

Observation: In contrast to the crowded portfolios, some within the investment challenge went their own way and tended to perform at either the high or the low end of the spectrum. People in this group changed in the standings throughout the year and readily moved from top 25 per cent to bottom 25 per cent and vice versa. It is noteworthy that some within the go-it-alone cohort tended to reduce risk and join the benchmark huggers after periods of success.

Lesson: Once again, this is a common observation in money management. Managers often gain attention subsequent to a period of outperformance. Asset owners and their advisers flock to investment managers based on historical performance. However, mediocre performance often follows success, as a manager may have incentives to play it safe. We see this in sport when a team with a large lead starts playing less aggressively and taking fewer risks. In investing, like sport, there may be a victory despite a change from successful tactics. Specifically, the money manager may gain additional investors. With additional clients come additional wealth and fame. Losing this source of income would not be a rational action by a money manager. Unfortunately for incremental investors, the desired outcome may be disappointing, as the previous success often yields mean reversion. S&P Global publishes data on this in its persistence scorecard. This report details the lack of consistent placement in the top quartile by money managers. In many cases, the passive strategy produces the most reliable performance.

Distribution

Observation: The dispersion of portfolio returns over the course of the year is somewhat related to the preceding theme, yet this observation is different. Typically, the majority of balances resided in a tight band throughout the year. The median portfolio (the middle one) moved up and down based on overall market conditions and at of the year it generated a positive return. The concentrated nature of the set of portfolios is representative of a distribution curve taught in an introductory statistics class. The shape, however, was not normally distributed. There was a significant difference between the median and the mean (average). In our case, more people performed above the average. The underperformance was greater than the outperformance, indicating the risk-taking incentives for those in the bottom quartile.

Lesson: Our virtual world is instructive as an analogue for the real one. The existence of a distribution curve is also highly relevant for institutional investors. Too many mangers and institutions refer to their portfolios as being in the top quartile. Mathematically, not everyone can even be above the median, let alone in the top quartile. There is excessive marketing accompanying peer standings. Institutional investment mandates are too important to award participation trophies to all managers. Balancing qualitative and quantitative factors in an unemotional manner enables investors to better position a portfolio.

Risk-taking incentives

Observation – As illustrated above and much like the ending scene in Thelma & Louise, team members with diminishing chances of winning the competition took uncompensated risks as we neared the end of the year. Whether it was panic or a refusal to accept defeat, this group dramatically increased risk. By investing in higher beta strategies such as IPOs, companies in crisis and countries with geopolitical turmoil, these participants hoped for a big pay-off. These last-chance strategies had mixed success, but were arguably rational decisions from the point of view of game theory.

Lesson – In a simulation, it is easy to adopt the mantra “go big or go home”. The PERA investment team realises that we cannot take this type of cavalier approach to managing a portfolio as important as the PERA fund. The lessons from the investment competition are vital to remaining humble, focused and disciplined. As for the takeaway, it is imperative to understand manager or strategy underperformance and evaluate it in the context of a larger portfolio. Underperformance can be a result of an out-of-favour strategy detracting from returns, such as energy in 2015. Alternatively, poor performance can be an indicator of excessive risk within a strategy. Judgement based on experience and collaboration is necessary to recognise that out-of-favour strategies may be attractive in the future. This is the premise behind rebalancing programs that foster a buy-low/sell-high philosophy. In contrast, it is prudent to avoid managers that incur excessive risk, like Thelma and Louise, in trying to elude a bad outcome. Hope is not an investment strategy and may lead to unintended consequences. At PERA, our systems and processes help determine the positive and negative contributors to performance. We recognise that positive returns require the same level of review as negative ones. Specifically, a true performance evaluation requires a comprehensive analysis that evaluates both risks and returns. This multi-dimensional framework helps us flag and eliminate excessive risk-taking motivations among our managers.

Conclusion

We are nearing the end of our second annual investment competition. With a minimal commitment of time, the exercise yields impressive results. The challenge helps us better interact as a group. We find common ground around our core function as stewards for PERA members. Investments should occupy the majority of our discourse and the challenge enhances that commonality of purpose. It also creates a healthy desire and discipline to be the best at what we do by enabling us to identify behavioural biases that exist in the broader investment world. The resulting awareness improves our overall skill and judgement as a team. We look forward to continuing this competition in 2017 and beyond.

Jon Grabel is the chief investment officer of the Public Employees Retirement Association of New Mexico.

Any discussion of fees and costs for pension funds should be within the context of “value for money” and not in absolute terms, Keith Ambachtsheer says.

“It is value for money that matters in pension fund management, not whether costs are high or low relative to those of a comparable group of peers,” Ambachtsheer argues. Are the benefits of scale being passed through to better member outcomes? This is the type of question that should be asked of the pension industry, he says, rather than focusing on fees.

In the February issue of The Ambachtsheer Letter, he quotes a report Australia’s Productivity Commission recently handed down that outlines criteria for assessing how efficient and competitive the superannuation system is at delivering the best outcomes for members.

He summarises the “sensible pension efficiency benchmarking proposals of the Australian Productivity Commission and offers a fast-track route to their implementation around the world”.

How the commission did it

The Productivity Commission’s approach was to define system-level objectives and formulate assessment criteria based on these objectives, then identify indicators to facilitate the assessment.

In other words, it asked, as Ambachtsheer puts it, “What are relevant…criteria? Or, stated differently, ‘How should pension system performance be benchmarked relative to the goals of adequate long-term net returns and pension protection?’ ”

The commission’s search for a suite of performance benchmarks led to five system-level objectives and 22 assessment criteria, supported by 89 unique indicators.

Assessing how competition affects efficiency is challenging. On the supply side, one must determine whether market concentration is a good thing or a bad thing. Meanwhile, on the demand side, competition is often driven by irrelevant information and unhelpful product proliferation.

Given these questions and considerations, Ambachtsheer says, the Productivity Commission suggests focusing on time series analysis – meaning asking questions such as whether competition is leading to a decline in industry fees and profit margins over time – or checking whether the benefits of economies of scale are being applied to benefit members.

The Productivity Commission report defines three types of efficiency in the development of performance indicators: operational, allocative and dynamic.

Ambachtsheer explains that net return is an example of a key system-level operational efficiency driver. Actual long-term net returns versus those of reference portfolios and CPI+X benchmarks are relevant indicators, and segmentation by member phase, asset class and geography are also relevant.

Another variable in operational efficiency is cost. Total costs should be captured and reported. They should also be separated into components, so the effects of such factors as fund size, investment policy and implementation strategies can be assessed and better understood when comparing efficiency.

Not reinventing the wheel

Ambachtsheer commends the Productivity Commission’s approach to the value-for-money question and explains that the wheel does not need to be reinvented in order to implement the commission’s recommendations.

CEM Benchmarking, of which Ambachtsheer is a co-founder and co-owner, has already designed and implemented many of the Productivity Commission’s recommendations. For example, on the cost side, CEM has extensive multinational net return, cost, organisational scale, structure/location, and reference portfolio databases, with information covering more than a decade for a group of 133 globally dispersed funds.

This data can be used to look at operational efficiency, which Ambachtsheer defines as net value added (NVA), or net return minus the reference portfolio return. Using the CEM data is revealing. For instance, when 10-year net value added is plotted against average operating costs, it reveals no correlation.

In other words, Ambachtsheer says, on average, paying more for asset management did not raise the net value added for the 133 funds measured in the database.

“Other recurrent research findings include a positive correlation between net value added and fund size, between NVA and proportion of assets managed internally (especially private-market assets), and between NVA and governance quality,” he says. “There is now a realistic opportunity to benchmark pension system efficiency – value for money – around the world, in a logical, consistent, comparable manner.”

In the week leading up to the 2016 US presidential election, members of UniSuper, Australia’s second-largest industry fund, made the biggest switch to cash the fund had seen since the panic at the height of the global financial crisis in 2008.

That was enormously frustrating for the chief investment officer of the A$54.7 billion ($42 billion) default fund for Australian university employees, John Pearce.

“The thing I always try to impart to members is that the best long-term strategy is to stay the course,” Pearce says. “To me, it is quite problematic positioning a portfolio for those big one-off type geopolitical events; even if you had perfect foresight of how the election was going to unfold, it would have been impossible to predict the impact on markets.”

Most members who switched in the GFC did so too late and, more vexingly, then left it too late to switch back to growth assets and missed the recovery. With the US elections, many of those members who ‘got it right’, and moved to cash in anticipation of Donald Trump’s win, might be feeling pretty smug. The problem is that, in terms of investment outcomes, they still got it wrong – they would have been better off sticking with their balanced or growth options.

The ‘risk-off’ sentiment in global markets following Trump’s surprise victory lasted just one day before many asset classes got a bump. US bank stocks, in which Pearce’s UniSuper had topped up its holdings throughout 2016, added 15 per cent in the three weeks following Trump’s victory.

Internal strength and ‘fortress assets’

UniSuper is Australia’s sixth-largest super fund overall. It consistently ranks as one of the best in terms of investment performance. Pearce’s tenure at the fund has been defined as much by his leadership skills as by his investment chops.

Most super funds complain about a lack of member engagement but UniSuper is dealing with a different set of challenges, stemming from a membership that is inquisitive and active. Engaging with members via investment updates over email and video is a growing part of Pearce’s remit.

Also, Pearce began insourcing investment management seven years ago, and today his internal team of 35 managers runs 55 per cent of UniSuper’s assets in-house. That ratio is tipped to swell.

“We have a very scalable operation so we could take on a lot more FUM [funds under management] without hiring a lot more people,” Pearce says.

The internal team is focused on “mainstream domestic assets”, such as its large-cap Australian shares portfolio. Local small-cap mandates are delegated to external managers and most global stock picks are also outsourced.

At the core of the in-house strategy are what Pearce refers to as UniSuper’s “fortress assets”, which include major holdings in toll road operator Transurban, Sydney Airport, and various shopping centres.

Recent target reductions

In early November last year, UniSuper lowered the return target on a number of its conservative investment options, including dropping the five-year target on its capital stable option from CPI +2 per cent to CPI +1.5 per cent.

“The mandate for the capital stable option dictates it must be invested in 70 per cent defensive assets, so we can’t avoid having a lot of government bonds in there,” Pearce says.

With real interest rates at zero, it would be “both impractical and imprudent” to target a decent margin, so members have to be warned to lower their expectations. This is especially important for retired members who may have to adjust their spending habits.

The fund’s balanced and growth options have not been lowered, although they remain under ongoing review. A much longer time horizon on balanced and growth options, of between seven and 10 years, gives investment managers more opportunity to meet the average targets.

“People panic when they see market corrections, but these are healthy,” Pearce says. “If we didn’t have market downturns, we would have to keep adjusting expected returns because we would be in a bubble situation. I’ve been in the market for 30 years and you’ve just got to keep reminding yourself that things are never as good as they seem, and never as bad as they seem.”

Watch the housing market

As for 2017, the dominant force shaping global financial markets, “without a doubt”, will be what happens to US Treasury yields, Pearce predicts.

He also tips European politics to throw up “a fair bit” of volatility over the year ahead. Closer to home, he has a watchful eye on the local housing market.

“The question is whether we’ll see a correction or an orderly working through of the excess supply of apartments, particularly in [capital markets] Melbourne and Brisbane,” he says.

That is one of the reasons UniSuper reduced its holdings in Australian bank stocks over the past year, redeploying that capital into US bank stocks.

Over the past 12 months, UniSuper has also deployed more capital to its US-focused global healthcare share portfolio managed by Janus Capital Group, and to its global resources portfolio managed by Henderson Global Investors. It has also handed a new Indian equities mandate to a Schroders affiliate on the ground.

More recently, UniSuper has been researching how to invest in emerging-market Asian credit for the first time, and is in the final stages of reviewing a shortlist to select an external manager for the new mandate.

Pearce remains hungry for more good infrastructure assets but prefers to invest in listed vehicles.

“We tend to stay away from any of the big unlisted deals that look like they are going to get overly competitively bid,” he says, explaining why UniSuper didn’t lob bids in the recent auctions for the Port of Melbourne or electrical infrastructure company Ausgrid.

Looking after life savings

Not one for fancy mission statements, Pearce says the closest thing he has to an investment philosophy is simply that “superannuation equals life savings”.

“That sounds quite motherhood,” he squirms, but it has proven a valuable guiding principle. “It actually rules out a lot of things.”

It’s why UniSuper does not invest in opaque hedge funds, frontier markets, complex highly leveraged structures or private equity and venture capital funds, he explains.

The aversion to private-equity funds should not be misinterpreted as a lack of appetite for private assets. Far from it. Pearce just wants more control and transparency at a lower cost than is possible via a fund structure.

He also says he recently almost signed a “really exciting deal in the tech space” with an undisclosed “global business that just happens to be based locally”.

“Unfortunately it fell over; I mean, it’s not dead, but it’s a complex deal and there were a few details we couldn’t get our mind around,” he explained.

Having built a successful in-house team, Pearce is in a better position than ever to drive a hard bargain on fees.

UniSuper has external mandates with 14 Australian equity managers, 11 global equity managers, 11 property managers, eight fixed-income managers and a handful of managers across other asset classes.

“We have always had the scale to negotiate pretty sharp deals with external managers. I think the in-housing has just added to that competitive strength of ours,” he says. However, he thinks investment management fees in Australia are “pretty sharp” and “takes umbrage” with the finding of the David Murray-led 2014 Financial System Inquiry that superannuation is a high-cost industry.

George Clapham, managing partner at Australian boutique firm Arnhem Investment Management, has been doing business with Pearce for nearly a decade. He runs an Australian small-cap mandate for UniSuper and says the investment chief probes his fund managers on a lot more than fees.

“John is very active in talking to us about why we make the decisions we do about certain companies,” Clapham says. “He takes an active view on things like executive remuneration.”

UniSuper was one of the institutions that succeeded in putting pressure on Commonwealth Bank of Australia to dump controversial culture bonuses in its latest remuneration report.

Australian Securities Exchange-listed companies should consider themselves on notice that Pearce will continue to push back about executive pay structures that are not aligned with shareholder value.

This article first appeared in Investment Magazine, sister publication to conexust1f.flywheelstaging.com. 

 

Asset owners need to be more aware of the turnover in their equity managers’ portfolios, as it not only hides costs, but also acts as a proxy for the short- or long-term behaviour of managers.

A research paper produced by the 2° Investing Initiative, the Generation Foundation and Mercer analysed more than 3500 institutional long-only active equity funds in Mercer’s global investment database.

The analysis showed the equity fund managers replace all of the names in their portfolio every two years, on average. That equates to a share replacement rate of 1.7 years.

While optimal turnover for investment performance is not a well-defined concept, the report states, a review of literature on the subject points to a four-year holding period (25 per cent turnover) as a reasonable estimate of what’s optimal. That is well below the average turnover rate identified in this analysis, which is 58 per cent.

The report did show that turnover has declined over time, but only gradually.

“The decrease in turnover suggests increasing demand for longer-term investments from asset owners,” the report states. “There remains more room for turnover levels to fall among long-only active equity managers, before reaching equilibrium.”

‘Tragedy of the Horizon’

The 2° Investing Initiative and the Generation Foundation have formed a multi-year partnership to explore and address the “Tragedy of the Horizon”, which they describe as the “potential sub-optimal allocation of capital for the long term due to the limited ability of the finance sector to capture long-term risks within short-term risk-assessment frameworks”.

Their project aims to assess artificial and natural factors that compress the horizons of market players, such that long-term risks get mispriced. Such a mispricing of long-term risks creates a void between the assets and liabilities of long-term asset owners and can eventually amount to an asset-liability mismatch.

Their report, The long and winding road: How long-only equity managers turn over their portfolios every 1.7 years, looks at the impact of turnover on long-term investing. Mercer provided data and analysis.

“High portfolio turnover makes the investors’ decision-making process full of twists and turns, obstructing their view of long-term performance and an optimal allocation of capital for the long term,” the report states. “Giving investors a straighter road, or [having them] hold assets longer, may make them more efficient drivers and better fiduciaries in the long term.”

The paper focuses on the role turnover plays in the asset owner-asset manager relationship and how a deeper understanding of this particular variable during fund evaluation can help investors. Findings show that turnover is going down in professionally managed long-only equity funds, on average, despite rising overall sharemarket turnover. Most equity managers appear to do a good job of keeping actual turnover within or near initial expected levels, the report states.

Other findings were that quantitative strategies, on average, exhibit higher turnover than fundamental and blended strategies; and there are cases where managers seem to make suboptimal decisions due to their belief that clients could not tolerate short-term volatility. Also, managers commonly view the turnover ratio as an outcome of their process, not an input or end they pursue.

Encourage optimal behaviour

The report has some clear messages for asset owners. In particular, they should improve how they monitor and communicate with investment managers if they wish to encourage optimal behaviour.

Asset owners should:

Be explicit about their time horizon and expectations for how it will affect asset-class exposures and the types of investment managers and strategies they’ll employ. This could include a behavioural policy statement, for example, incorporated as an appendix to the statement of investment beliefs document; ideally, the beliefs would establish a clear set of actions that specify how the asset owner would be expected to react to short- and medium-term manager underperformance

Avoid making short-term decisions by designing a reporting framework for monitoring managers that looks beyond short-term price performance

Develop and promote a process to check manager behaviour against expectations; this may include looking at areas such as portfolio characteristics, level of portfolio turnover and drivers of portfolio activity

Compare actual performance against the hypothetical buy-and-hold performance of the portfolio over a given period, to assess the benefit of portfolio turnover

Ask for more detail regarding frictional transaction costs managers incur and develop a process to check manager behaviour against initial expectations

Be explicit about managers’ time horizons and how they expect it to affect their decision-making, the design of employee compensation and incentives, and expectations for how they will interact with clients

Include greater discussion of turnover and management of transaction costs in the ongoing management of the portfolio.

At the outset of 2017 – the Chinese Year of the Rooster – chief investment officers are acutely aware of the potential for the world’s politicians to wreak havoc with their plans. After a turbulent 2016, this could be the year when the risks of an unbalanced portfolio truly come home to roost.

This January, the world heard a promise by British Prime Minister Theresa May to implement a clean and hard Brexit from the European Union, followed by an incendiary inauguration speech from new US President Donald Trump. These two figures, who were at the centre of the biggest geopolitical shocks of 2016, are set to continue shaping global markets in the year ahead.

More worrying for investment chiefs is that there are so many potential geopolitical triggers for market upsets already pencilled in on the calendar.

Elections will be held in the Netherlands, France and Germany, and possibly in Italy and the UK. Far-right populist parties touting nationalistic, protectionist policies stand to gain ground in all those polls. A twice-a-decade leadership reshuffle in China, which is scheduled for the latter half of 2017, could throw up another wildcard.

These are just a few of the major geopolitical events investors are trying to plan for – what former US defense secretary Donald Rumsfeld would refer to as the “known unknowns”. But, of course, the biggest geopolitical shocks are always the unknown unknowns that no one sees coming.

“Any CIOs who think they have a handle on geopolitical risks are fooling themselves,” Statewide Super chief investment officer Con Michalakis warns. “The fact is, you can’t predict the future and history has shown that markets don’t price geopolitical risk well.”

What worries Michalakis is that in the current environment, with asset prices inflated from eight years of record low interest rates and extraordinary international monetary policy, even a small geopolitical shock might lead to major falls in global financial markets.

He has already re-positioned Statewide’s $7 billion portfolio to better withstand the inevitable volatility. This meant branching out into absolute returns and not being too reliant on equity risk, but still keeping some bonds for risk protection.

“At the moment, you want to be fairly diversified and take a little bit of risk off the table,” he says.

MLC chief investment officer Jonathan Armitage is also relying on diversification to protect the more than $100 billion portfolio he shepherds.

“Corporate profitability in the US and elsewhere will be subject to a number of different forces, which makes forecasting unusually challenging,” Armitage says. “The direction of government policy will also be an area that will be interesting, with a new administration in the US, presidential elections in France and the evolution of UK policy regarding Brexit.”

He says ensuring portfolios have adequate diversification will be especially important, given the heightened chance that both equity and bond markets could be set for a tumble.

“There is clearly an important question around whether the recent moves in bond markets, especially in the US, are temporary or reflect a more permanent shift in valuations,” he explains.

Armitage cites a well-timed shift out of long-dated US treasuries and into private credit as his best investment call of 2016.

Trump’s inauguration speech on January 20 painted a dystopian picture of the super power, with “rusted out factories scattered like tombstones across the landscape”, as he pledged to protect US borders from “the ravages of other countries”. Trump is spruiking a mantra to “make America great again” via a program to “buy American and hire American”.

However, Trump’s power over domestic reforms is dependent on having Congress on his side.

Geopolitical forecasters, including George Friedman and John Mauldin of Mauldin Economics, advise investors to pay attention to the actions of US Speaker of the House of Representatives Paul Ryan and the chair of the House Ways and Means Committee, Kevin Brady. Without these two Republicans onside, most of Trump’s domestic policies will be dead in the water.

Nevertheless, Trump remains a maverick with the potential to disrupt, as was demonstrated when a tweet he sent wiped $US4 billion ($5.3 billion) off Lockheed-Martin’s equity market valuation.

UniSuper head of global strategies and quant methods Rob Hogg is concerned about what Trump will do in the international realm, with his considerable power to reshape global trade policy.

“The question is whether we will see elements of protectionism, trade retaliation, or tariffs,” Hogg says. “Those sorts of elements are unambiguously negative for the growth of trade and also for investor sentiment.”

Hogg cautions that for all the geopolitical risks, investors should not forget that in the background there remain structural headwinds – such as baby boomers reaching retirement age and ongoing public and private debt – that need to be tackled as well.

In this stressed environment, China is emerging as the new international responsible citizen, supporting free trade and the Paris agreement on climate change.

With this in mind, Frontier Advisors director of capital markets and asset allocation, Chris Trevillyan, thinks that of all the geopolitical risks visible on the horizon, the one with the greatest potential to cause serious disruption for investors is the 19th National Congress of the Communist Party of China, slated for the second half of 2017.

The five-yearly congress marks a transition of leadership in the top ranks of China’s ruling Communist Party. In 2017, President Xi Jinping is almost certain to retain the top party spot of general secretary. However, there is much uncertainty over the other leadership positions.

“That could well be the most influential event, but it is the most opaque, so you don’t necessarily know in advance – or even afterwards – what has happened,” Trevillyan says. “Investors will have to wait to see how it plays out.”

The worry is that a desire to appear strong will lead China to take an even more aggressive stance in its territorial dispute with the US in the South China Sea, potentially sparking a war.

Trevillyan’s top piece of advice for institutional investors is to embrace portfolio diversification strategies.

Sunsuper listed shares manager Greg Barnes is also cautious about the potential fallout from trouble in the South China Sea.

The power struggle between Australia’s two largest trading partners could have big repercussions domestically, Barnes says. However, he is confident that Sunsuper’s $36 billion portfolio is well-positioned for these risks.

“We are in quite a reasonable period of market performance for equities, but it’s really about having a broadly diversified portfolio that can withstand the hiccups that invariably happen,” he says.

A significant allocation to high-quality unlisted assets, which have in recent times delivered both stronger returns and lower volatility than equity markets, is something Barnes tips to continue to pay off in 2017.

“[With] that kind of portfolio structuring, if there is a bump, we probably don’t go down as much; then we get back to compounding more quickly when the markets recover,” he says.

This article first appeared in the February print edition of Investment Magazine, sister publication to conexust1f.flywheelstaging.com. 

The dictionary definition of the word “optimal” is “best or most favourable”. While an investment strategy is hardly ever described as “the best” – perhaps for fear that this might sound somewhat hubristic or over-confident – it seems to be perfectly acceptable to describe a strategy as optimal, despite the same intended meaning.

So where did the over-use of optimal come from? Google’s chart of use over time shows that optimal was a word rarely used until around 1950, after which time its use grew exponentially. This supports the hypothesis that optimal entered the investment lexicon following the widespread adoption of mean-variance optimisation, which Harry Markowitz developed in the 1950s. Although the usage statistics for optimal have levelled off in recent years, the advent of robo-advice has given a fresh impetus for the use of mean-variance optimisation as a portfolio construction tool.

Mean-variance optimisation uses the expected returns, volatilities and correlations of a range of asset classes in order to arrive at an ‘efficient frontier’. Any strategy sitting on the efficient frontier maximises the expected return for a given level of volatility and is, therefore, described as efficient or optimal.

The problems with the term optimal as a descriptor of investment strategies are, therefore, intimately connected with the weaknesses of mean-variance optimisation as a portfolio construction tool. These include:

  • The use of volatility as the only measure of risk. As a result, volatility and risk have become synonymous, despite the fact that a highly volatile asset might be much less risky than one exhibiting low volatility if risk is viewed as the possibility of suffering a large drawdown or losing money in real terms, for example. This isn’t to say that volatility is useless as a measure of risk – far from it – simply that it shouldn’t be the only measure of risk.
  • Volatility and correlation inputs for a mean-variance optimisation process are typically backward-looking and assumed to be stable over time. The output based on such assumptions is, therefore, vulnerable to regime changes that materially alter correlation and volatility dynamics. Optimality based on backward-looking inputs is fragile when looking forward.
  • There are many possible approaches to setting the expected return assumptions that go into an optimisation, each with their own strengths and weaknesses. Different approaches can produce very different numbers but the high level of uncertainty in these assumptions is frequently ignored, with many of them often specified to an accuracy of two decimal places. Given the sensitivity of an optimisation to the input parameters and the high level of uncertainty inherent in the assumptions, to describe the output as optimal is misguided at best.

Mean-variance optimisation had not been invented when John Keynes wrote The General Theory of Employment, Interest and Money, yet the essence of the problem it has created is captured nicely in the following quote from the book: “Too large a proportion of recent mathematical economics are merely concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols”.

This is not to say that mean-variance optimisation should be avoided altogether. With a clear-sighted recognition of its limitations, optimisation can be used sensibly as one input within a wide-ranging investment strategy discussion. Such a discussion would seek to address the many unquantifiable trade-offs investors face: the attractions of investing in less liquid assets vs. the opportunity cost of reduced flexibility; the costs and benefits of leverage; a desire to diversify vs. a preference for simplicity, among many others. This discussion should make use of a mix of quantitative and qualitative inputs, with expert judgement playing an important role.

Bias towards quantitative tools widespread

Many investors already follow such an approach when setting strategy and may consider this tirade largely unnecessary. However, a bias towards quantitative and precise numerical tools remains prevalent in the investment industry, as highlighted in Andrew Lo and Mark Mueller’s fascinating 2010 paper “Warning: Physics envy can be hazardous to your wealth”. Perhaps more worryingly, a few minutes spent on the websites of some well-known robo-advisers demonstrates that efficient frontiers and optimal portfolios are very much alive and kicking.

In today’s environment of heightened political uncertainty, with monetary stimulus of a type and on a scale never seen before, and with structural trends such as climate change, global ageing and technological disruption likely to change the investing environment radically, we need thoughtful, constructive debate like never before. An over-reliance on simplistic quantitative tools will lead to naïve portfolio construction, wrapped in a comfort blanket of “optimality”.

Instead, we need to face the radical complexity of the real world. Rather than aiming for some quantitative definition of optimality, we should seek the more humble and realistic aim of robustness under a range of plausible scenarios. Stress testing and scenario analysis – straightforward deterministic tools – provide a useful, powerful alternative to the relatively complex stochastic and optimisation tools that are more frequently used.

Optimality is an illusion – it’s time we removed it from the investment lexicon.

 

Phil Edwards is European director of strategic research at Mercer.