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.
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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.
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By GlobalData“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.
