Articles of Interest October 2020

AMP fires AMP Capital to go passive with KiwiSaver, NZRT

Last week, Investment News reported on AMP's KiwiSaver overhaul. They have decided to replace "sister-firm" AMP Capital, the main current manager, with index titan BlackRock.

AMP is a default KiwiSaver provider, and the fourth largest in the space. While the well-established company offers a feeling of comfort for investors, the under-performance of their KiwiSaver funds has persisted for some time.

While the move was surprising for us, we see it as a win for KiwiSaver investors. AMP is not only moving away from active to a more efficient passive strategy, the change also moves away from the vertically integrated structure, where products and advice come from the same source.

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David Booth discusses investing and elections for the NYT

With the US election nearing it's conclusion, investors are again questioning the potential impacts for their portfolios. In this New York Times article, Dimensional's David Booth offers some insight into how markets work.

Things are rarely simple in the stock market, with many companies supported by Trump's presidency tumbling throughout the year. Others which should have been hindered have seen their share prices soar.

This all supports the idea that betting on election outcomes should not be part of a long-term investment strategy.

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Report shows short half-life for big fund brands in decade of change

This article opens with "Almost half of the top 500 global fund manager brands have disappeared over the last decade". This is all consistent with the overwhelming evidence that actively managed strategies don't stick around.

While some managers go under, many are bought out and merge with other brands. While this report covers the largest global managers, the trend applies also in NZ. For example, looking at MJW's popular investment surveys, the names in their September release have changed considerably from those in the 2009 survey.

The trouble with this pattern of change is the difficulty in assessing past performance. After all, when we look through the managers, we aren't seeing the performance of those funds merged or disestablished. Seeing the scope of this change globally raises questions about whether the future best performing funds will just be the last ones standing.

Balancing Act

It is good to see share prices back up, with the S&P 500 and NZX 50 at new highs. We do expect more volatility moving forward, with uncertainty surrounding the upcoming elections, COVID-19 and economic concerns.

With prices going up and down, you may find your portfolio drifting away from the allocations you originally chose. During times like these, we may have to rebalance more often.

This week, we wanted to shed some light on how rebalancing works, why we do it and the policies we use to make the most of it.

What is rebalancing?

Rebalancing is the process of buying and selling investments to bring your portfolio back to target.

For example, say you started with a portfolio with $100, invested half in shares and half in bonds. If the bonds didn't change in value (staying at $50) while the shares doubled in value (went up to $100), your portfolio would be invested 2/3s in shares, 1/3 in bonds.

While this would have been the result of very strong returns from shares, the risk of the portfolio has gone up considerably. To bring the portfolio back to 50:50, rebalancing would involve selling $25 worth of shares and buying $25 worth of bonds.

Portfolio drift

Rebalancing is necessary due to this drifting away from target. This tends to happen over a long period of time, with a portfolio that is never rebalancing slowing approaching a nearly 100% allocation to shares.

Looking at the performance of the S&P 500 and US Long-term Corporate Bonds, in USD since 1926, we can see how this plays out. We will ignore taxes and costs for simplicity's sake.

What would happen if we invested $100 as above, split 50:50 between shares and bonds? Over more more than 94 years, the $50 of bonds would have grown to $15,553. The shares would have grown to $472,867(!) and your portfolio is now allocated nearly 97% to shares.

Taking the average returns for these two investments, after 10 years you should expect your 50:50 portfolio to turn into a 60:40. During periods of volatile returns however, this can happen very quickly.

In the graph above, you can see the spike in share returns around 1932. If you had a 50:50 portfolio in July 1932, 12 months later it would be invested 70% in shares! Assuming there was good reason for your target allocation, it would be sensible to sell some shares and buy some bonds. 

What to consider when rebalancing

The three most important considerations are the same as with investing in general; risk, returns and costs. When you decide to rebalance should be based on balancing all three.

As shown above, not rebalancing leads to more risk and higher returns. But rebalancing too frequently can lead to a poor outcome, as the cost of trading eats into returns.

We should consider the risk of the portfolio before deciding to rebalance. If it has drifted far from the amount of risk we deem acceptable, then rebalancing is sensible.

Most good policies will define the range which is acceptable. For example, we could allow our 50:50 portfolio to become a 55:45 before we do anything.

Costs are associated with trading for even the most liquid investments, so this must also be considered. It can be difficult to weigh trading costs against an abstract concept like risk. 

Can rebalancing provide higher returns?

Through rebalancing, you will be regularly selling high and buying low. Many believe this leads to a "rebalancing premium", although this comes with the assumption that good returns are followed by bad returns and vice versa.

Two sources of research which have guided our own policies are Vanguard's Best Practices for Portfolio Rebalancing and Marleena Lee from Dimensional's Rebalancing and Returns. They share the same conclusions regarding returns. From the Vanguard paper:

“Vanguard research has found that there is no optimal frequency or threshold for rebalancing, since risk-adjusted returns do not differ meaningfully from one rebalancing strategy to another.”

The problem for investors in chasing a rebalancing premium is the difficulty in choosing the right strategy to capture it. Some may have outperformed over some historic period, but none consistently. From Marlena Lee's paper:

"One must be cautious when interpreting reported benefits of rebalancing strategies that are formulated using historical returns because noise in realized returns will make certain strategies look good over certain periods, especially if researchers try hard enough to find good results.

How confident should one be that this strategy will continue to be the best performer in all periods and for all allocations? There are multitudes of trading rules that work well in the historical data from which they were mined but fail to continue their performance out of sample. It is unlikely that rebalancing rules are any exception."

These conclusions are actually quite useful for investors, as we can shift our focus to managing risk and costs.

Our rebalancing policy

In order to balance risks and costs, our rebalancing policy is based upon the following practices:

• We set a tolerance for how far each investment asset can drift from target, currently 10%. This means an investment making up 50% of your portfolio can drift between 45% and 55% without necessitating a purchase or sale.

• When rebalancing, we purchase/sell assets in order to bring allocations to the edge of tolerance, instead of back to target. If the asset above drifted to 57%, we would sell enough to bring this back to 55%.

• Whenever there is an excess of cash, we will use this to purchase underweight assets.

• We check portfolios are within tolerance once each week.

• When quarterly distributions are paid out, we use these funds to purchase underweight assets.

This policy aims to reduce unnecessary trading while managing portfolio risk.

The Need for Problem-Solvers

When I was a teenager, I was facing the dilemma of which career I would pursue upon leaving school.

I still believe this is a difficult decision for teenagers. When they are about 15 years old, they must decide which subjects to continue for their last years at school. The subjects they choose should be based around their strengths and interests, but also potential career paths and university studies. Choosing the wrong courses could mean an extra year at uni to catch up.

Think back to when you were 15, or maybe remember what your kids were like at that age. Some people already had their dreams laid out; I remember me and my mates having no clue. I did take maths, stats and chemistry because that was what I was good at. At the same time, my ideal job title was still "rockstar" and anything else was just a backup plan.

During this time, my parents suggested I speak with my friend's father. He was working in the engineering department at AUT back then. My parents thought engineering would suit me, so they had him round for dinner.

I remember what he told me now because of how he described his profession, as a problem-solver. He told me a story about a client approaching a product designer, asking for a steel trap to be produced. They described a small box, with a spring trigger linked to a heavy bar. When the spring was triggered, the bar would snap down on the bottom of the trap. The product designer took down the dimensions and promised to produce the trap.

He then described what would happen if the client approached an engineer instead. The client begins explaining what he wants, when the engineer interrupts: "Why do you need this trap?" The client explains his problem with rats in their factory, their dissatisfaction with previous mouse traps and their need for something sturdier. The engineer thinks for some time before telling them "I have considered your problem, and I believe you need a cat".

Why am I sharing this story now? I remembered it after reading an article, KiwiSaver's Achilles' Heel by Scott Alman. He discusses the impact of the Haynes Royal Commission in Australia and the following exodus of big players from financial advice. The commission shone a light on the conflicts of interests, cookie-cutter services and poor results for clients.

All this reminded me of the story above. With a focus on only products, clients needs are not fully understood. The results are inefficient, unsuitable, and often expensive solutions offered to clients. While the factory owner may not need an expensive trap to solve his rat problem, the products offered by banks may not be the best solution for every client walking through the door.

I recommend giving Scott Alman's article a read, as he describes the changes in the Australian advice sector and the parallels with New Zealand's. He also discusses vertical integration, where an institution offers products and advice at the same time.

The idea of vertical integration makes sense for a bank. If you can provide both products and advice to clients, you can get a bigger share of their wallets. The trouble comes from the lack of independence and conflicts of interest. Clearly the advisers would recommend the products of their employers even if they may not be the most suitable for clients.

Many of the advisers in NZ are known as QFE advisers. This allows employees, without becoming financial advisers, to offer financial advice around only the products of their employers.

We, and many others in the industry, have argued against this title. Maybe more appropriate would be "agent" or "salesperson". This makes clear the role these employees play. With the new regime coming in 2021, this role will be replaced by "nominated representatives" instead following push-back from the big end of town.

Scott Alman mentions how this is a problem with KiwiSaver. Can you remember a time where you weren't ask to switch KiwiSaver when visiting the bank? But the same is true in the overall investment space.

We believe independent advice is crucial to good client outcomes. Like with the engineer story above, clients need problem-solvers, not product providers. We believe keeping advice and products separate is the only way to ensure clients get the best results.