Benchmarking is a standard tool for investors and investment professionals to evaluate the results of an investment manager. In a world of investing within asset classes and style boxes, the benchmarking process is relatively straightforward – any particular investment offering can be easily matched to an appropriate benchmark. In a world of unconstrained, “go-anywhere” style managers, though, the benchmarking process is less certain. Common methods to determine an appropriate benchmark – such as an ex-post regression of what the fund was invested in – can obscure the actions of the manager, for better or for worse. Is the only solution to simply select an arbitrary benchmark and proceed accordingly? Can we eschew a benchmark altogether?
As baby boomers continue into their retirement transition, two portfolio-based strategies are increasingly popular to generate retirement income: the systematic withdrawal strategy, and the bucket strategy. While the former is still the most common approach, the latter has become increasingly popular lately, viewed in part as a strategy to help work around difficult and volatile market environments. Yet while the two strategies approach portfolio construction very differently, the reality is that bucket strategies actually produce asset allocations almost exactly the same as systematic withdrawal strategies; their often-purported differences amount to little more than a mirage! Nonetheless, bucket strategies might actually still be a superior strategy, not because of the differences in portfolio construction, but due to the ways that the client psychologically connects with and understands the strategy!Read More...
As interest rates remain low, investors - especially retirees - struggle to find yield wherever they can. Unfortunately, though, the necessity of earning a required return to fund financial goals becomes the mother of invention for a wide range of investment strategies, both legitimate and fraudulent.
A recent offering of rising popularity is investing into structured settlement annuity contracts, which often claim to offer "no risk" rates of return in the 4% to 7% range. In general, the opportunity for "high yield" (at least relative to today's interest rates) and "no risk" is a red flag warning. But the reality is that with structured settlement annuity investing, the higher returns can legitimately be lower risk; the appealing return relative to other low-risk fixed income investments is not due to increased risk, but instead due to very poor liquidity. Which means such investment offerings can potentially be a way to generate higher returns, not through a risk premium, but a liquidity premium.
The caveat to structured settlement annuities, however, is that the investments can be so illiquid and the cash flows so irregular, they probably should at best only ever be considered for a very small portion of a client's portfolio anyway!
One of the most common criticisms to the use of Monte Carlo in financial planning is its typical assumption that investment returns are normally distributed, when in reality the market appears to go through environments that may be more volatile than a normal distribution would predict, as highlighted by the events of the financial crisis. In the last four months of 2008 alone, the market experienced 20 high-volatility trading days with a standard deviation varying from 3.5 to almost 10... each of which should not have occurred more frequently than once per millenia to once per several billion years. Yet when we look at those returns on an annual basis, we see a very different picture - the one-year decline to the bottom in March of 2009 was a "mere" 2.5 standard deviation event, which is uncommon but entirely probable under a normal distribution. Which raises the question - are "black swans" just a short-term phenomenon that average out by the end of the year, and are we focusing too much on impossibly rare black swans instead of the rare-but-entirely-probable 2 standard deviation decline?Read More...
As the popularity of tactical asset allocation and using market valuation to inform investment decisions rises, so too do the criticisms to such methodologies. In the long run, this is part of a healthy dialogue that shapes the ongoing evolution of how we invest. But much of the recent criticism to being tactical in particular seems to suggest that if we can't get the timing exactly right, or calculate a valuation that works precisely to predict returns in all environments, that it should be rejected. In reality, though, even just participating in a few booms, or avoiding a handle of extreme busts, can still create significant long-term benefits for achieving client goals. Which raises the question - if we're really focused on the long term for clients, are we expecting too much from market valuation in the short term?Read More...
In the midst of volatile, ambiguous, and uncertain markets, it’s often difficult to know what to do. In such a high stakes environment, we look for any clues that we can find, to figure out whether what we’re doing is “right” or not. Unfortunately, though, this can lead to trouble, as research shows that the methods and tools our brains use to make decisions are not always rational. For instance, sometimes we look to what others around us are doing, to determine whether our own actions are appropriate or not, rather than doing our own due diligence. In many situations, this form of “social proof” can be an effective means to fit into society. In other situations, though, it can potentially lead to herd behavior. Which raises the question – to what extent are our investment decisions as planners influenced by what other planners are doing, instead of our own due diligence?
A common complaint about the use of tactical asset allocation strategies - which vary exposure to bonds, equities, and other asset classes over time - is that they are "risky" to the client's long-term success. What happens if you reduce exposure to equities and you are wrong, and the market goes up further? Are you gambling your client's long-term success?
Yet at the same time, the principles of market valuation are clear: an overvalued market eventually falls in line, and like a rubber band, the worse it's stretched, the more volatile the snapback tends to be. Which means an overvalued market that goes up just generates an even more inferior return thereafter. However, greedy clients may not always be so patient; there's a risk that the planner may get fired before valuation proves the results right.
Which raises the question: is NOT reducing equity exposure in overvalued markets about managing the CLIENT'S risk, or the PLANNER'S?Read More...
A common debate in the financial planning world is what we can do to make clients less focused on the short-term volatility of the markets. As the viewpoint goes, if we can help clients to pay less attention to the markets, they won't be so stressed in times of turmoil and will be less likely to make rash, impulsive decisions like bailing out in the midst of a downturn.
Accordingly, one common conclusion is that as planners, we should send statements to clients less often; after all, if we don't want clients to look at the markets so much, why do we keep sending them so many reports about what's going on in their portfolio?
Yet a recent new service for advisors, that in part provides even more regular reporting for clients, is discovering that the opposite may be true: that in fact, the best way to calm clients is not less reporting and information, it's more... as long as it's clear and relevant and puts the situation in context. Read More...
In the ongoing search for more diversification - and especially, low correlations as a potential for stabilizing returns in a difficult stock environment - advisors have increasingly shifted in recent years towards "alternative" investments. From real estate and REITs to gold and other commodities to more, a recent FPA survey on Alternative Investments found that 91% of advisors are using some form of alternative investments. Sadly, though, the focus on finding investments that have a low correlation - according to FPA's survey, the number one criteria for choosing an alternative investment - has grown to such an obsession, that we're willing to name anything that has a low correlation as "a new asset class." But the reality is that while some alternatives really are investments that truly have their own investment characteristics unique from stocks and bonds as asset classes, others alternatives - like managed futures - simply represent an active manager buying and selling existing asset classes. Which means it's about time for us to start distinguishing between a real alternative asset classes (e.g., commodities or real estate), and the real value of managed futures.
Diversification is a fundamental principle of investing - examples of the concept date back as far as Talmudic texts estimated to have been written over 3,000 years ago, stating "Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve." The diversification principle received a further boost in the recent era when Harry Markowitz's Modern Portfolio Theory supported the notion that the volatility of a portfolio may be less than the volatility of its parts, such that the introduction of even a high-return high-risk asset to the portfolio may improve the portfolio's risk-adjusted return (or even outright reduce its volatility). Yet at the same time, both the rabbis of the Talmud and Markowitz would probably agree that the first step of investing your assets is even more basic: make sure you own stuff that has a reasonable expectation of providing a useful return in the first place. Unfortunately, though, we seem to have lost sight of this rule in recent years!Read More...
