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November 20, 2009updated 05 Jun 2017 11:39am

Back to the drawing board

Investment strategies and theories are being reconsidered after a decade in which global equity markets declined, throwing into question the buy-and-hold doctrine advocated by many academics and commentators Will Cain looks at some examples of passive, absolute and asset allocation strategies. Portfolio management has been put under the microscope after last years meltdown across all but the most conservative asset classes.

By Will Cain

Investment strategies and theories are being reconsidered after a decade in which global equity markets declined, throwing into question the buy-and-hold doctrine advocated by many academics and commentators. Will Cain looks at some examples of passive, absolute and asset allocation strategies.

Portfolio management has been put under the microscope after last year’s meltdown across all but the most conservative asset classes.

As the financial crisis peaked in the third and fourth quarters of 2008, wealth managers suffered huge declines in client assets under management (AuM). AuM at the top 10 wealth managers declined 23.6 percent according to Private Banker International research (see PBI 246), while globally, high net worth individuals’ (HNWIs) assets fell by 14.9 percent in 2008 according to Merrill Lynch/CapGemini figures.

Wealth managers which were well diversified were hit by a market crash in which virtually all asset classes and regions became correlated. This has led many to reconsider investment strategies and allowed a select few to claim success for processes which delivered outperformance at a time of volatility in investment markets and stress for clients.

One of these was Iveagh, the family office of the UK’s Guinness family, which used an asset allocation model to generate a 4 percent compound annual return between the start of 2007 and midway through 2009. This compared to the 2 percent loss of the FTSE/Association of Private Investment Managers and Stockbrokers Index.

Speaking to Private Banker International, John Ricciardi, head of asset allocation at Iveagh, said the main goal of the fund was to transfer the wealth from the seventh generation to the eighth using a globally diversified approach with asset allocation at its core.

“The global investment portfolio is constructed to match our return and risk requirements over a five to seven year horizon, using proprietary analytics,” Ricciardi said.

“The strategic asset allocation is reviewed annually with an assessment of all asset classes on the five to seven year horizon.

Ricciardi said it was important to have high levels of liquidity to enable tactical moves, and said Iveagh used “the most boring, plain vanilla ETFs” from a range of providers formed a large part of the strategy.

“It is long only, and our intention is to drive the returns from the asset allocation,” he said.

“We focus on funds and ETFs that deliver that market return with the least volatility possible.”

This allowed Iveagh the flexibility to trade very little when markets were quiet – it made no trades at all in 2007 – or more frequently and aggressively at times of high volatility during 2008 and 2009 (see chart above).

“At the start of 2008, we were looking at a bear market scenario, and changed from 60 percent equities to 5 percent. The strategy is about significant changes to asset allocation. We moved up fixed income to about one-third of the portfolio.”

Ricciardi said equity exposure was increased prior to the first vote in the US House of Representatives on the Troubled Asset Relief Programme because it was seen as a strategy to save the global banking system.

When it was voted down the equity markets crashed, but Ricciardi said increased exposure to fixed income helped balance out the declines.

“It is a strategy which makes sense and protects capital on the downside and participates on the up side,” Ricciardi said.

“We have the advantage of the geometry of returns – if you go from 100 percent to 50 percent it costs you 100 percent to go back up. So why doesn’t everyone use it?

“The simple reason is because it was not really necessary from 1981 to 2000, because there was a seven-fold increase in the markets and everyone was buy and hold. But for this generation, it’s a broken paradigm. All of the major pension funds are reducing their equity exposure.

“Buy and hold might be the best approach, but you have to wait 50 years which might be a bit long for some people.”

Ricciardi pointed out alternatives were an interesting proposition for the first seven years of the decade, but that government bonds had offered the only real diversification after the financial crisis.

There were some exceptions to this – managed futures proved an effective hedge during the financial crisis, registering a 5 percent return. But all of the other popular hedge fund management styles – equity market neutral, macro, multi-strategy and convertible arbitrage – all registered negative returns in 2008.

Referring to a graph on relative investment performance, Ricciardi said many investment houses had registered negative performance because they were ignoring the fact that 90 percent of their investment return came from decisions relating to asset allocation.

Iveagh has five main tactical asset allocation tools:

Leading indicators for global business cycles. The investment house has a proprietary indicator, and is currently predicting the biggest expansion in foreign trade for six years.

Models for key factors that will affect markets in each quarter. In particular, central banks are tracked in this process because they set the price of money. Ricciardi added a key current trend was the “decline in the rate of decline” of US house prices, indicating there was a some sense of recovery. But he questioned whether this sentiment had already been priced into the markets.

Market intelligence from specialist managers. Analysis showed current economic forecasts were particularly pessimistic compared to the actual recoveries experienced following previous recessions, Ricciardi said.

Valuation: relative and absolute. Ricciardi said there was a risk central banks lose control of inflation, but that valuations at current levels are reasonable compared to historical norms.

Technical analysis for every asset class and sub-category. Iveagh uses this discipline to tell them “how much, but not when”, focusing on longer-term trends (beyond six months). It was used to support its fundamental analysis in identifying inflection points.

“The whole thing together is what we call core management,” said Ricciardi.

“It requires access to daily dealing funds, highly liquid use of ETFs and acquiring asset class exposure as cheaply as possible and a flexible asset allocation. It helps you preserve capital and captures returns.”

Leo Drago, co-founder of AL Wealth Partners, an advisory boutique based in Singapore, said absolute returns were the best way to keep clients happy.

“What clients want and what they get is a very different thing,” Drago said.

“Clients in Asia will often say they want to buy a stock because their friend was talking about it at dinner and they think it will double in price. Our job as private bankers is to stop them doing that.

“I have seen portfolios that have under-performed cash for 15 years, and the clients will never admit that. They can make a lot of money and lose a lot of money year on year.”

He said clients generally had portfolios that had high correlation to equity markets, no downside protection, low liquidity in times of distress and products which were unsuited to the client.

What they wanted, however, was absolute returns in all market conditions, downside protection during bear markets, high levels of liquidity and “decent” upside performance.

Drago, speaking at the VRL/PBI Wealth Summit in Singapore in October, showed a slide with a 10 percent year-on-year return with very little volatility since 1991.

“Here is an example of what most would call the ideal portfolio,” he said.

“Clients look at it and say, ‘It’s perfect, that’s exactly what I want.’ There’s only one problem, and that is because it’s Madoff.”

The main target for AL Wealth was for their clients to be free of emotional distress, sleep comfortably at night and pursue what they really wanted to in life, Drago said. But that is hard to achieve if a buy-and-hold approach was adopted because of the huge fluctuations observed in most portfolios during the last 18 months.

“What clients are getting in most instances is a relative return, and we have basically had a decade of 20 percent loss according to the MSCI World Index,” he added.

One key distinction Drago made was the difference between compound returns and average return. A recurring rate of return over three years gave a higher finishing balance than a portfolio which averaged a 5 percent return but was more volatile.

Achieving these consistent returns is hard to achieve, according to Drago. He showed how it was difficult even to predict the direction of interest rate changes, using an analysis of consensus estimates of half-yearly interest rates and actual interest rates over a period of 26 years.

Of the 52 time periods, the consensus on direction of movement was correct on only 16 occasions.

Similarly, end-2008 S&P 500 forecasts for equity markets from 12 high-profile Wall Street strategists at banks including Deutsche Bank, Morgan Stanley, and Goldman Sachs, taken in early 2008, ranged from 4 percent in the most bearish case to 19 percent in the most bullish. The actual return was a 38 percent loss.

“We need a different approach,” said Drago.

“Should the success of private bankers be measured by their clients’ returns on their portfolio? Maybe yes, maybe no. But if it is one of the key things clients want then there is a fundamental problem in how things are done.”

Preserving capital was the top priority for Drago, along with stopping bad investments eroding wealth and producing consistent long-term performance.

Exchange-traded funds (ETFs) were cheap and offered daily liquidity, Drago said, but private banks were generally unwilling to offer them as part of portfolios.

“If you think gold is going to go up, what do you do?” he said.

“You can buy a gold ETF or in lots of other ways, but that is not what the private banks do. They say instead, ‘Let’s do a structured product.’ Sometimes they will do a simple one.

“But sometimes it is more complicated. They might go for 120 percent of the performance of gold over five years against the outperformance compared to silver, minus the outperformance of platinum linked to, I don’t know, Zimbabwe inflation. That is an exaggeration, but seriously, you get to the point where you have something that it really confusing for clients.”

A return to risky products

Even though clients were hit by losses on Lehman and AIG-linked structured products and equity “accumulators” during the financial crisis, there are signs they are attracting more interest again. Drago said clients should steer clear of such products and look instead at carefully selected hedge funds, coupled with exposure to fixed income, cash and some equities to deliver solid returns.

“Funds of hedge funds were down by more than 20 percent in 2008, but not every hedge fund went down,” said Drago.

“They are not all risky either – in fact they are designed to be less risky than other investments like equities when you build a proper hedge fund portfolio.”

He added that a dummy fund the business modelled was actually one of the best performing, though it did not invest in it. Between 1987 and 2009 it delivered an annualised return of 9.57 percent per annum.

He described it as a basic portfolio that had no trading or views, was rebalanced on an annual basis and he claimed it proved you do not necessarily need financial innovation to achieve a steady return.

James Sellon, co-founder and managing partner at Maseco Financial, a UK-based wealth manager set up in 2008, advocated a more passive approach, after studying different approaches prior to launching the business.

Sellon said education was an essential part of managing the client relationship and that it would help them not become scared out of the markets when they started to fall.

“We tried to work out what the future of wealth management would be and we came down on the side of a passive approach,” he said.

He quoted Eugene Fama, at the University of Chicago, who created the Efficient Markets Hypothesis, which concludes effectively that mispricings do occur in markets, but not in predictable patterns that can lead to consistent outperformance.

The implication of this is that active management strategies cannot consistently add value through security selection and market timing and that passive investment strategies reward investors with capital market returns.

“Active managers have been putting this theory to the test every day and most managers underperform their benchmarks after fees,” Sellon said. “By definition, active managers are an unreliable supplier of return. We as a result look to the index which should give you top-third returns relative to the average fund manager.”

Sellon said fund rating services were also not particularly good at predicting which funds would perform best, so provided little help to investors. He said the different systems employed by the rating services added an extra layer of uncertainty into the investment process.

“A client has to choose the right rating service, who has to choose the right fund manager, who has to choose the right stocks,” he said.

Sellon quoted a 1993 study by Fama and Kenneth French, which said investment structure determined performance, and the key drivers were down to changes in the overall market, the sensitivity to size – i.e. exposure to larger and smaller capitilised stocks and the exposure to value or growth stocks.

“The solution for investors who wanted to earn above average returns was to take more exposure to ‘value’ and more exposure to ‘small’,” he said.

“We think it makes sense to use these value and size dimensions when constructing portfolios, diversify away unsystematic risk and reduce beta through fixed income.”

Long-term discipline

Sellon added it was important to be committed to long-term discipline in investment strategy when pursuing this type of strategy. Over certain time periods, bonds have outperformed the index. Between 1965 and 1981, the S&P Index had an annualised compound return of 6.33, while US Treasury Bills returned 6.66 percent.

“Even so, it is hard to say whether year in, year out, whether there is an equity risk premium, but you do know that over the long term these premiums exist and we construct our portfolios to take advantage of these when they occur,” said Sellon.

“It is also important to rebalance portfolios, selling assets when they are deemed expensive and buying them when undervalued, back to the core strategic allocation.

“It is our belief that tactical allocation may well work, but it is hard for one investor to spot a manager ahead of him delivering that active outperformance.”

He added Maseco looked to use low-cost small cap and value funds that deliver the risk premium they are looking for and beta funds that deliver the beta of the market.


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