Download Portfolios after the fun - Institute and Faculty of Actuaries

Portfolios after the fun
Peter Holland
Fidelity
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It’s the people, stupid!
• We are very clever
– Large spreadsheets
– Information overload
• But also very dumb (greed/fear)
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The origins of today’s problems
What will the “industry” do?
What ought the “industry” do?
The “Octopus” solution
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A Glorious Bull Market
1600
1400
1200
S&P 500 COM POSITE - PRICE INDEX
FROM 1/1/75 TO 31/12/99 MONTHLY
1000
800
600
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200
A Glorious Bull M arket
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197519771979198119831985198719891991199319951997
1 999
Sourc e: DATASTREAM
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The Bull Market
• Valuation driven
– Transition to low inflation world
• Equities became the asset class of choice
• Bonds & Property were for wimps
• “Greed” took over
– Benchmarking became the norm
– Ownership replaced by derivatives, “vehicles”,
“products”
– Timescales contracted
– Confidence increased
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The New World
S&P 500 COM POSITE - PRICE INDEX
FROM 4/1/00 TO 6/2/08 WEEKLY
1600
1500
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1300
1200
1100
1000
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700
2000
2001
2002
2003
2004
2005
2006 2007
2008
HIGH 1565.150 9/10/07 LOW 797.700 23/Sourc
7/02e:
LAST
1336.640
DATASTREAM
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What went wrong?
• Sub-Prime, credit etc
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The “engine” was forgotten
The “back testing” was unrealistic
Investors were confused by complexity
Risk was moved, not eliminated (moved to the ignorant)
• Economic or Behavioural?
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Incentives – bankers – “products” not loans
Front end fees/profits preferred to sound lending
Rating agencies – paid by the “product” generators
The short term “rear mirror” view of risk
The great fee conspiracy (fees change behaviour, risk perception)
• The world of investment management couldn’t cope with lower
nominal returns. 4% from bonds; 7/8% equities – inadequate!
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The benchmarking cancer
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Benchmarks drive manager behaviour
Incentives – “benchmark risk” takes over
Timescales shrink
Losing money is irrelevant
All judgements are relative
The economic driver is lost
Managers become obsessed with the “big bets”
Pensions:
– Liability calculation change – benchmark – portfolio
– “Process costs” are high
• Why does conservatism appear after markets fall?
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Turnover . . .
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Fixing it?
• Identify the cash generative capacity of asset classes.
– Align expectations (no free lunch)
• Get real on fees
– Total return of 8% minus 1.5-2% fees???
• Fix incentive issues
– Bank loan officers, rating agencies, fee-greed
• Fix the rear view mirror!
– LTCM modelling, eg
– The world changes – annoying but true
• Benchmarking behaviour should change
– Measurement role only
• Investment timescale; asset ownership
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The reality . . .
• Regulatory expansion & conservatism
– Based on the recent past (not the future risks)
– Portfolios will become more “conservative”
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Equities, Property, Bonds
Hedge Funds/Private Equity
The DB trend (vs DC)
New asset classes (commodities, weather/carbon/forex trading!)
Fees will remain too high in relation to actual returns
Absolute Return investing?
The Philosopher’s Stone – a portfolio for all times?
Ownership & economic driven investment?
Fees, vested interest, complexity?
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The Octopus’ Assumptions
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Macro driven
Economic returns (the “engine”) matter
The AWFUL TRUTH – cheap, simple, long term is GOOD.
Cash income matters
Past correlations, little help
– Economics behind correlations matter
– Current & future correlations matter
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No “long term” asset profile (the world changes)
Major asset moves needed occasionally
Cash/Benchmark for measurement only
Asset ranges set
– Equities, 25-75%, Bonds, 0-50%, Property, 0-50%, Cash, 0-25% etc
– Continuous review (not quarterly)
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Octopus contd
• Today’s world
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Global ($) growth driver is “new world” not “old world”
Em market equities are less risky than generally perceived
Material shortages will remain for a while
“Old world” inflation is picking up
Developed mkts – inflation linked bonds are good (fixed, bad)
Equities are good value
Geographical approach to equities is ill conceived
• Sectors, types, stock specific, balance sheet etc matter
• Utilities, resources, infrastructure
• Currency – I have no skill
• Humility
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So far . . .
• Octopus benchmarks – Cash plus 3.5%
and my “Institutional” benchmark:
– 25% UK equities, 20% ex UK equities, 20%
fixed interest, 20% index linked, 15% property
• Vehicles: ETFs, closed end funds, stocks
(for “tilts”), cash
• Outcome (since inception) +3.6% ve
benchmark & +6.1% vs cash. Since July
2004. Very early days!
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Conclusions
• Markets are dealing with the excesses
– Root problems are human not statistical
• Dealing with greed, poor incentives, high fees is
TOUGH. Losses and chaos will purge some of
this but far from all
• Conservatism (voluntary and regulatory) will
increase till markets do better
• Many liability driven funds will (and ought to)
close down the risks (DB>DC; buy-outs)
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