Archive for category: Lonsec Retirement Perspectives

According to a report in Bloomberg recently, while Vanguard data show a portfolio with 60 equities/fixed income mix returned an average 9.1% a year from 1926 to 2020, JP Morgan Asset Management recently estimated it will return just 3.7% over the next decade. Why? In a world where 85% of developed-market government bonds are yielding below 1%, the likely returns from the fixed income component of the portfolio has plunged, as shown in Figures 1 and 2.

Figure 1

Figure 2

So, this raises a question that we are getting asked by our clients – why even bother having fixed income within my portfolio?

When answering this question, it is important to think about what the reasons were for including fixed income in your portfolio in the first place.

At Lonsec, we believe that fixed income generally can play three roles in a portfolio:

1. As a diversifier to equities – bonds dampen overall portfolio volatility when held in a portfolio with riskier assets such as equities;
2. As a defensive asset that “will not go down” – so may be suitable for the risk averse investor with a primary objective being the preservation of capital; and
3. As a provider of a steady income stream – regular income payments from bonds provide a stable income stream for retirees

Figure 3 shows the rolling three year returns for global equities and global bonds and serves to highlight the relatively low volatility of global bonds compared to global equities.

Figure 3

However, when faced with the prospect of challenging returns, the reasons for inclusion tend to fall by the wayside and we start to focus on where to find better returns. As a result, we have seen many investors move out of fixed interest securities, especially longer term government bonds, in favour of equities or a taking a bar bell approach by investing in the extremes of lower quality investment grade bonds and short duration cash like securities. This is a dangerous proposition especially for those in retirement.

Becoming a victim of short-termism and negative momentum can shift your portfolio greatly to one that effectively eradicates each of those objectives we listed above. Why?

1. When we increase our allocation to equities or riskier assets, we are reducing our diversification. This will significantly increase the volatility of the portfolio.
2. Whilst the short duration assets will act has a buffer during times of market volatility, we have seen time and time again, that lower quality investment bonds will typically have their correlation to equities rise to 1 during periods of market stress and produce a very significant negative return that effectively wipes out any ‘buffering’ that the short duration assets may have provided.
3. During periods of economic stress, the stability of income from equities can change quickly. We saw this last year when many banks cut their dividends for a short period of time to ensure their books were able to withstand the changing economic landscape.
4. For retirees, unless the income provided through dividends and higher yielding fixed income securities is sufficient enough to live on, the impact of falling markets when in drawdown can be catastrophic to the long term viability of a retirement portfolio.

The question around the validity of longer duration bonds in portfolios is a valid one. Fund managers have been able to lean on these as performance enhancers as dovish central banks have overseen 20 years of falling interest rates. This, coupled with the relentless demand for safe haven assets from investors, especially during times of equity market stress, has seen abnormally high returns being achieved in this end of the market.

A fact that we all quickly forget about volatility is that with riskier assets not only do you have a greater probability of producing higher returns, you also have a greater probability of producing lower returns.

Whilst historically it has been easy to forget about fixed interest as the asset class has taken a backseat to the action packed excitement of the sharemarket, we cannot do this anymore, especially if you are approaching or in retirement. This is the stage where preservation of capital with a guaranteed income stream becomes the most important goal.

For those especially, bond investors now have three choices:

1. Take on more risk to generate higher yields;
2. Lower return expectations for the short to medium term; or
3. Accept low rates as something they cannot change.

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The biggest challenge for investors in an environment such as the one we are experiencing now is that there is a lot of information, the environment is changing rapidly and there are many unknowns. In the past several weeks we have witnessed one of the fastest drops in markets in history, bond market liquidity has dried up, unemployment is rising, robust business models have unraveled with businesses such as Virgin Australia forced into administration and we have seen unprecedented levels of government stimulus. This follows an extended period where equity market returns were strong and volatility was at historically low levels.

Whether you are running an investment committee or speaking to clients in such an environment, going back to basics is warranted. Referring to your investment philosophy and the investment framework that underpins it is fundamental in periods such as this. Importantly, it will assist in avoiding making reactive investment decisions that can have an adverse impact on the long-term outcomes of your portfolios. This is particularly important in the current environment where there is a proliferation of news flow. On a client level, dusting off the investment philosophy and refocusing your client’s attention on your fundamental investment beliefs will help you deal with nervous clients and aid in preventing them from making kneejerk decisions relating to their investments.  If we cast our minds back to the GFC, we know that clients that were reactive and cashed out from a typical balanced portfolio locked in a loss of about 8.5% on average, whereas those that remained invested, benefitted from the subsequent rebound in markets.

At the core of Lonsec’s investment philosophy is our belief in a diversified portfolio approach across asset classes and investment strategies with a strong focus on risk management. We aim to do this through a combination of active asset allocation decisions focused on managing risk and active bottom-up investment selection focused on ensuring portfolio are diversified not only by asset class but also investment strategies. As a practical example, in the current environment our focus within asset allocation remains on valuation, cyclical and liquidity factors and market sentiment. This provides us a starting point for assessing the current environment.

From a bottom-up fund selection perspective, we remain focused on understanding the role that every fund plays in the portfolio recognising that during periods of severe market dislocation, our ‘risk control’ funds should provide some dampening against this volatility, whereas our ‘growth’ funds will more than likely suffer the full extent of any market moves.

The strength of having an investment framework will assist navigating through uncertain times as it helps understand performance drivers and ‘where to from here” scenarios. Additionally, it ensures that conversations we have with clients on expectations of portfolio performance are clear and easily understood.

For more information about how Lonsec can help you with your investment philosophy and process, please contact us on 1300 826 395 or info@lonsec.com.au.

Veronica Klaus Head of Lonsec Investment Consulting spoke on a panel at the Professional Planner Researcher Forum in Sydney last week.

Veronica discussed the inconsistency and confusion around asset class definitions, which is one of the biggest issues confronting the industry. The way in which assets are defined as growth, defensive, etc. often lacks transparency and ultimately makes it harder for financial advisers to make the right recommendations for their clients.

However, as Veronica explains, the superannuation funds aren’t necessarily the ones to blame for the problem.

 

Many behavioural studies have shown there are several traits and biases that can impede us from making reasonable decisions about everything from what to eat to how to invest. Understanding these biases and considering whether they may be negatively impacting decisions can be beneficial when implementing long-term investment plans. These studies show, in general, people have asymmetric risk profiles and fear losses more than the expectation of gains by at least a 2:1 margin[1]. Interestingly, and perhaps not surprisingly, this ratio increases substantially as people approach retirement.

American psychologist and economist, Daniel Kahneman, who won a Nobel Prize for his work challenging the prevailing assumption of human rationality in modern economic theory has stated, ‘If you have an individual whose objective is to maximise wealth at a certain future point in time, then loss aversion is very bad because loss aversion will cause that individual to miss out on many opportunities.’

This loss avoidance trait stands in contrast to a basic investment principal, that investors need to accept higher risk (and higher potential for near-term losses) in order to achieve higher returns over the long term, particularly during market sell-offs. When faced with losses, rational decision-making can become impaired by the emotional desire to avoid more losses.

There are a wide range of cognitive biases that can impact retirement plans, some are listed below:

Confirmation bias

Confirmation bias is the natural human tendency to seek information that confirms an existing point of view or hypothesis. This can lead to overconfidence if investors keep seeing data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, increasing the risk of being blindsided when something does go wrong.

Information bias

Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. Investors are exposed to an array of information daily, and it is difficult to filter through this and focus on the relevant information. In general, investors would make superior investment decisions if they ignored daily share price movements and focused on prices compared to the medium-term prospects for the investments. By ignoring daily share price commentary, investors would overcome a dangerous source of information bias in the investment decision making process.

Loss aversion bias

Loss aversion is the tendency for people to strongly prefer avoiding losses than obtaining gains. The loss aversion effect can lead to poor and irrational investment decisions, where investors refuse to sell loss-making investments in the hope of making their money back. Investors fixated on loss aversion can miss investment opportunities by failing to properly consider the opportunity cost of their investments.

Anchoring bias

Anchoring bias is the tendency to rely too heavily on, or anchor to, a past reference or one piece of information when making an investment decision. For example, if you were asked to forecast a stock’s price in three months’ time, many would start by looking at the price today and then make certain assumptions to arrive at a future price. That’s a form of anchoring bias – starting with a price today and building a sense of value based on that anchor.

How do we try and overcome the biases when building retirement portfolios?

The objective based nature of Lonsec’s Retirement portfolios means there is a greater focus on absolute rather than relative performance. Additionally, the portfolios have been constructed to manage risks, including:

• Market and sequencing risk
• Inflation risk
• Longevity risk

Some investment strategies that can assist in controlling for these risks include:

Variable beta strategies can vary equity market exposure by allocating to cash in periods where equity market opportunities are perceived to be limited due to expensive valuations, or where market downside risk is considered high.

Long / Short – Active Extension (also known as 130/30 funds) utilise a broad range of strategies including short selling and adjusting the net equity position for performance enhancement, risk management and hedging purposes.

Multi-asset real return funds invest in a wide range of asset classes, with the managers having considerable flexibility in the type and percentage of asset classes allocated to. Typically, these funds will seek to limit downside risk, while also targeting a real return i.e. a CPI + objective.

Real assets such as property and infrastructure, commodities and inflation linked bonds can assist in managing against inflation risk.

When constructing the Retirement portfolios, Lonsec takes a building block approach by assigning a role for each fund – yield generation, capital growth and risk control.

The yield component of the portfolios generate yield, or a certain level of income from investments that have differing risk return characteristics. The capital growth component is designed to generate long term capital growth, with limited focus on income, and is more suited to early retirees. The risk control component is critical for retirement portfolios and is designed to reduce some of the market risks in the yield and capital growth components. It is important to note that the risk control part of the portfolios will not eliminate these risks but aims to mitigate them. Asset allocation and diversification are also important ingredients in managing the overall volatility of the portfolios.

The Retirement portfolios can assist in managing the risks that impact retirees, however it is important to note that none of these strategies provide a guaranteed outcome. The range of products that offer certainty of income or capital protection such as annuities has increased in recent years, in recognition of Australia’s aging demographics and demand for greater certainty in retirement. Separate guidance on the use of annuities is available from Lonsec.

 

[1] Gachter, Johnson, Herrmann (2010). Individual – level loss aversion in riskless and risky choices. Columbia Business School