Inflation The Bank of England has raised its 2017 inflation estimate to 2.7%, from the current rate of 1%. The Bank does not expect inflation to return to its 2% target until 2020. The rise in inflation expectations was explained by the decline in the pound since the EU referendum, which is driving up prices of imported goods. Fig 1. Projections for UK CPI based on market interest rate expectations Source: http://www.bankofengland.co.uk/publications/Pages/inflationreport/2016/nov.aspx Growth The economic growth rate forecast was also raised from 0.8% to 1.4% for 2017, whilst expectations were cut for 2018 from 1.8% to 1.5%, signalling that the Brexit impact will be felt later than originally expected. Further interest rates considered in August have been clearly ruled out. Fig 2. Projections for UK GDP based on market interest rate expectations Source: http://www.bankofengland.co.uk/publications/Pages/inflationreport/2016/nov.aspx
NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: N/A; Chart credit:Bank of England; Table credit: N/A Private clients and families wanting wealth advice, typically want holistic wealth advice.
That's why it's worth remembering that investment capital is only one form of capital. Client fact finding should go well beyond understanding an investment portfolio, to account for other forms of capital - what it is and how it's structured. What are the other key forms of client capital to consider: Land: the oldest capital of all, since "they just don't make it anymore" - how is it held, how is it managed. In the UK agricultural yields nose-dived when the US prairies got going and crisis-related spikes aside, have never fully recovered. But "green gold" remains a resilient, and tax-efficient, store of value, and a source of collateral where productive. Property: principal, residential, and commercial property all require attention and management. Providing a store of value, an income yield and a source of collateral, it's no wonder that bricks and mortar continues to play such an important role in overall wealth. It's all the easiest "immovable" thing to tax. In the UK, taxation for properties has tightened for offshore owners, and now residential buy-to-let properties. Staying on top of the changing tax position is key for any type of property - whether owned for lifestyle or investment. Business: operating businesses can continue to provide an engine for family wealth. Again how it's owned and managed is key, as well as a picture of its capital intensity and capital requirements. How and whether returns are paid out or re-invested all form part of the broader financial landscape. Chattels: chattels are subject to their own esoteric tax treatment, and are a source of pleasure as well as a store of value. Inventorying, maintaining and insuring them are the larger headaches, with different experts needed in different fields. Trust capital: is the client a settlor or beneficiary of discretionary, life interest trust: if so, what are the terms of the trust, who are the trustees, how is it managed, and what is the tax position. Like personal capital, trust capital could simply be an investment portfolio, or itself made up of a mixture of the different types of capital outlined here. Charitable capital: whether supporting a historic, or creating a new charitable fund or trust, ensuring charitable capital is efficiently managed requires a keen eye on economies of scale. Ensuring it is properly and transparently deployed requires commensurate due diligence. Human capital: most of all, there's not much point to well-managed wealth if it can't be modeled to suit client objectives and needs - be these material or emotional. After all, you can't take it with you. Balancing this with an intergenerational view and succession plan is probably the hardest part for an adviser. So whilst there is no shortage of investment portfolio managers to choose from (and selecting, monitoring and reviewing one is another whole challenge), a holistic approach requires much greater scope and a flexible coalition of expertise. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Additional disclosure: This article has been written for a UK audience. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information on Elston’s research, products and services, please see www.elstonconsulting.co.uk Photo credit: Google Images; Chart credit: N/A; Table credit: N/A
Big dreams The cuddly caption announcing the move says “Smaller Fees means Bigger Dreams”, which is warm-hearted. But it’s also sort of fair. Today’s retail investor has more access to breadth and depth of international markets than our parents ever dreamed of (if they ever dreamed of that sort of thing). What does this mean, apart from being cheaper? Well firstly, Moore’s law applies to ETF pricing & capacity as much as it does to semiconductors. That’s not new or surprising. But the sustained deflationary pressure on fund fees is forcing the convergence of institutional and retail investment offers. This will create pressures on asset managers that do not adapt. Adapt to what? The quest for elusive alpha from security selection looks like the right way of solving the wrong puzzle. The puzzle to solve is how to design asset allocation strategies to help investors achieve their desired or required outcome. Put differently, investment houses need to offer solutions (or “dreams”?), not products (“funds, OEICs, ETFs”). Who are the winners? Market access has basically become commoditised, so the only value in the value chain is in distribution (having customers), and solution design (giving them what they want). Asset managers and financial adviser that embrace this new reality should flourish. Those that linger on in yesteryear’s product based world will gradually lose momentum. NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. For more information see www.elstonconsulting.co.uk Photo credit: coinquest.com Chart & Table credit: N/A
Give me a sign Just as high priests in Roman times, after slaughtering their offering, examined its entrails to gauge the Gods’ favour, so too have UK commentators been searching for any statistical insight or market data point to declare whether the shock Brexit result is likely to lead to economic success or failure. The data point phoney war The data that has come out since the EU Referendum on 23rd June 2016 is meaningless as we still don’t know what Brexit looks like. It’s been a phoney war for headlines, as stunned commentators search for a gauge to measure policymakers by. When politicians use statistics, it’s dangerous. When they co-opt data, it’s dynamite. First we had encouraging PMI Data. Brexiteers (those who want the UK to leave) read this as vindication, which is a stretch to any rational observer given the pace of transmission in the economy. Next we had Bremainers (Brits wanting the UK to remain in the EU) shouting “Pound Down/Told You So”, whilst Brexiteers shouting “Footsie Up/Told You So”. It took a while for pundits to figure out that both sides were right, because they were unknowingly saying the same thing. This is because the FTSE 100 (Footsie), consists of companies with predominantly overseas earnings. Hence the UK’s bell-weather index gains were more a function of the pound’s slide, rather than any inherent strength in the economy. Marmite makes it real But perhaps what has hit home hardest is the 24-hour Marmite price spatbetween two behemoths, Unilever (NYSEARCA:UN; LON:ULVR) and Tesco (LON:TSCO), which led to a tabloid induced panic. Marmite is the salty yeast-extract paste either loved or hated by Brits on their toast. Its main ingredient is the sludge left over from brewing beer, so it seemed odd that a UK product with UK input costs should be at risk from a price hike. But given Unilever’s equipment, cost of capital and investors are looking for Euro denominated returns, the impulse to raise prices was clear. So Unilever wanted to raise prices +10% to offset the -15% fall in the pound. Tesco, the UK’s largest grocery, with enlightened self-interest wanted to shield consumers and share the pain with their supplier. For the time being, retailers are shielding consumers from price rises. But that go on forever. The consumer pain from weaker currency will eventually be felt, and will have an inflationary impact. Where is Golidlocks? The true fear gauge for Brexit is therefore not currency alone, but currency and inflation expectations. UK inflation expectation are reflected in the market by the “breakeven rate” – the implied inflation rate derived from the difference between conventional and inflation-linked gilts of the same maturity. This is the UK’s “quiet fear gauge” for Brexit, as it is not referenced in the tabloids. On eve of Brexit vote, US & UK 5Y breakeven rate stood at 1.495% & 2.301% respectively. The lower level in the US reflecting their stronger and faster recovery, steering the US economy away from deflationary fears following the Global Financial Crisis. The UK has followed a broadly similar path since the Global Financial Crisis, albeit at a higher level. Chart 1: US and UK 5Y Breakeven Rates History Source: Bloomberg: USGGBE05 Index & UKGGBE05 Index, rebased 31-Dec-07=100 Whilst a long way from the Goldilocks dream of moderate growth with inflation that was ‘just right’, the chart shows that the big bad deflationary wolf of 2008 has been vanquished by the fairytale money created by Quantitative Easing, and inflation targeting is, broadly, back on track. For now. Hard Brexit is inflationary Since the UK’s EU Referendum on 23rd June 2016, relative inflation expectations have dramatically diverged. Whilst the US has notched up slightly to 1.584%, the UK has rocketed to 3.052%. Unhappily for the UK’s new Prime Minister Theresa May, the bulk of this uplift can be pinned to her ‘Hard Brexit’ reference in her speech at the Conservative Party Conference on 2nd October 2016. Chart 2: US and UK 5Y Breakeven Rates since UK’s EU Referendum Source: Bloomberg: USGGBE05 Index & UKGGBE05 Index, rebased 23-Jun-16=100
The logic for this is brutally consistent. Hard Brexit means harder trading conditions which means slower growth and weaker pound. Slower growth and rising inflation is a painful combination, and would prove a gruesome challenge for the Bank of England. Carney’s Mission Impossible? Whilst deflation loomed, and inflation remained subdued, the era of ultra-low or zero interest rates was a possible and necessary lever of support. If the Cabinet are hell-bent on hard Brexit, Governer Carney will face a near impossible mission: to defy gravity by keep rising inflation in check (around the 2% target) whilst propping up the economy (and the markets) with a 0.25% Base Rate. The Cabinet’s staunchest Brexiteers are still traumatised from ‘Project Fear’(when the machinery of Cameron’s government lined up behind “Remain”). There is therefore additional political risk if Carney’s apprehension at this impending challenge is construed as partisan, and his position is made – by coercion or insinuation – untenable. Personalities and emotions in the broken love triangle of Prime Minister, Chancellor and Governor will matter here. In that respect the venality of the post-Brexit reshuffle is not encouraging. Brexit: Hard or Soft? The referendum result was not expected. The change of the country’s and Conservative party’s leadership was not expected. The post-referendum realisation that Brexit would actually happen was not expected. The idea that the new Cabinet would go for a “hard” as opposed to “soft” Brexit takes the pain of this sequence of negative surprises to the limit. Wishful thinking would suggest that perhaps the Cabinet’s discussion of a hard Brexit is a cunning plan to fox our EU counterparts before negotiations start? Sadly, given the lack of preparation exhibited by the Brexiteers on their unexpected victory, that would ascribe too much credit, where none is due: whilst cunning was in abundance, there was no plan. Inflation-protecting a portfolio For US and UK portfolio investors, 1.5% and 3% respectively are now the hurdle rates if 5 year returns are to be ‘real’. For long-term multi-asset investors, it is worth considering how best to inflation protect each element of their portfolio
No clear plan Either a clear Remain vote, or a clear Leave vote with a prompt articulation of what Brexit means (the Norway model? the Turkish model? the Swiss model?) would have given UK markets the certainty investors crave. But now four months on, the Government is, it seems, simply making up what Brexit means as we go along, and trying to keep irreconcilable interest groups happy. There seems to be one message from the Government to Japanese car manufacturers, another to the City, another to the EU, and very little, of course, to the electorate: just that, with crypto-clarity “Brexit means Brexit”. A real fear gauge This lack of clarity and lack of direction is creating real economic costs, and will ultimately hit everyone in the pocket for more than just Marmite. The upward march of the UK breakeven rate is the fear gauge for that: watch it. NOTICES I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information on Elston’s research, products and services, please see www.elstonconsulting.co.uk Photo credit: Google Images; Chart credit: Bloomberg Professional; Table credit: N/A
Post-Brexit fears around commercial property values has led to managers of three UK property funds locking investors in. They fear a potential rush of investors to sell units following the Brexit result in the EU Referendum. Decisions to suspend will typically reviewed every 28 days. The funds affected are those managed by Standard Life, Aviva and M&G, totalling some £9bn of assets (see table). While the justification given – to “protect the interests of all investors in the fund” – is fair and reasonable, some investors may not be too happy to be locked in for potentially quite a scary ride. The paternalistic reading is that investors are being protected from themselves, as they are denied the temptation to panic sell. Funds that locked in investors in 2008 eventually “came good”. But while investors may agree that “buy and hold” is right for the long run, that’s not the same deal as “buy and be held prisoner at the manager’s will”. This episode shines a much needed spotlight on the opacity around the underlying liquidity within funds that trade in less liquid assets. As always, investment funds are only as liquid as their underlying holdings. One of the main reasons advisers give for using funds over ETFs is that daily liquidity is not necessarily important as their investors take a long-term view. This does however deny the opportunity to make tactical adjustments to changing economic circumstances, particularly event-driven ones such as the UK referendum. What this episode illustrates that by contrast to funds, ETFs benefit from better internal liquidity (they typically invest only in liquid securities), from better daily external liquidity (as they are both OTC and exchange-traded), and from active liquidity management (the creation and redemption of units through capital markets activity by the issuer). For UK investors whose property exposure was through ETFs which such as iShares UK Property UCITS ETF (LSE:IUKP) which tracks the FTSE EPRA/NAREIT UK Property Index, the flexibility remains whether to adjust exposure or to the ride this out. And for portfolio management, flexibility counts. In terms of underlying exposure, Property ETFs and Property Funds are similar but different. Whereas property funds may have direct exposure to commercial or residential property, property ETFs typically own shares in listed real estate companies. As Property ETFs are by nature “equity only”, they can be expected to have higher volatility than property funds that which have exposure to bond-like steady streams of net rental income from less liquid direct holdings. So if risk is defined by standard deviation, it is clearly higher for a property ETF. If risk is defined by liquidity, it is clearly higher for a fund. Aside from volatility, the level of yield from property ETFs relative to funds is comparable, while the overall fee level is of course much lower. Table: Fee Comparison For investors seeking exposure to UK property as an asset class, then exchange-traded liquid ETFs that provide that from a portfolio construction perspective. But importantly, property ETFs won’t share the underlying liquidity risk that is (now) all too apparent.
NOTE Funds compared are iShares UK Property UCITS ETF (GBP), Standard Life Investments UK Real Estate Fund Retail Acc, Aviva Investors Property Trust 1 GBP Acc, M&G Feeder of Property Portfolio Sterling A Acc. Returns data as of 5th July 2016 (except M&G as of 4th July 2016). Standard deviationfigures as of 30th June 2016 for all funds. NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. For more information see www.elstonconsulting.co.uk Photo credit: pictogram-free.com. Table credit: Elston Consulting
Brexit it is The U.K. public has voted to leave the European Union after 43 years in yesterday's referendum. Leave has 51.7% of votes so far with 71.8% turnout (higher than previous general election) suggests a vote for Brexit by a narrow margin. The leaving process could take a minimum of two years, and even Leave campaigners don't expect the process to complete until 2020. Opinion polls were too close to call Polling pointed to a closer result and recent momentum for the Remain campaign which had given markets an element of (false) security: the final poll put 45% Leave, 44% Remain, 11% Don't Know. While the binary nature of the debate suggested that those undecided might abstain, turnout has been high at 72%, despite (you guessed it) bad weather. Source: BBC Article 50 The Prime Minister, David Cameron, must now decide whether invoke Article 50 of the Treaty of Lisbon (to leave the EU) which starts a 2-year exit negotiation process. If not invoked, there is potentially more time for negotiation, but it would create additional uncertainty, in terms of direction, timing and mandate. Experts ignored The Remain campaign was able to rely on the expertise of economists, business leaders, and international bodies such as the IMF, all warning of dire economic and security consequences under a Brexit scenario. The Leave camp, in rebellious vein, dismissed this as "project fear" being rolled out by a self-serving elite. Ultimately, the vote was as much about emotions as it was about argument. U.K. fragmentation One of the second-order risks that the Referendum has unleashed is the risk of the U.K. finding itself regionally split. At present, England is 53.2% Leave on 72.9% turnout and Wales is 52.5% Leave on 71.7% turnout. By contrast, Scotland is 62.0% Remain on 67.2% turnout, and Northern Ireland is 55.8% Remain on 62.9% turnout. One of the unintended consequences of a "Brexit" from the EU could be an independent Scotland remaining part of the EU. How Northern Ireland would be affected if it is outwith the EU with an open border with the Republic of Ireland that is within the EU is also going to require focus. Legend: Blue - Leave, Yellow - Remain
Source: BBC EU angst With the U.K. being the first country to leave the EU, a precedent will now be set. Remaining members of the bloc may also start to "think the unthinkable." Brexit will shake the foundations of the European project and trigger introspection in Brussels and, possibly, reform. Ironically, a reformed EU (focusing on trade only, without ambitions of statehood) is something that many Leave campaigners would want. But the vote suggests that expectations in the ability of the EU to reform are low. Markets Whereas a Remain vote would have enabled a business as usual relief rally, the Brexit vote means prolonged uncertainty as the U.K. attempts to shape what its future looks like outwith the EU. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credits: BBC Photo credit: George Hodan
A panel session at the Inside ETFs Europe 2016 Conference examined the renewed interest in Liquid Alternatives. This article draws out and expands on some of the key findings from the panel discussion of the same title. The role of alternatives in portfolio construction The role of “alternative” asset classes in portfolio construction has traditionally been to provide differentiated asset returns that reduce overall portfolio volatility through diversification. Alternative asset classes can be broadly defined as non-equity and non-bonds, so typically includes hedge funds, property, commodities, infrastructure and private equity, and subsets of those groups. Lessons from the global financial crisis This classic Markowitz-style portfolio construction approach, based on single period mean variance optimised models was severely challenged in the global financial crisis, when diversification failed to protect assets in the short run (correlations trended to one), and risk-return opportunities became more binary (risk-on/risk-off). Assumptions challenged More specifically, some key assumptions on correlation, liquidity and time horizons that underpin portfolio construction theory required closer scrutiny. Firstly, correlations are unstable, particularly over shorter time horizons. This means that while a static approach to a diversified asset allocation may be adequate in the long run for the long run, in the short run diversification can fail to provide any protection to a portfolio. Hence the need for a tactical asset allocation approach that is dynamic. Dynamic means adapting to the fact that correlations between asset classes are different in the short run to how they are in the long run, and remain in constant flux. It’s therefore important to understand the role and correlation of alternatives to other asset classes across a time horizon that is relevant to an investor, as not all (in fact very few) investors are endowments with infinite time horizons. Secondly, liquidity matters, and matters more when needed most. While portfolio theory assumes perfect liquidity to move between asset classes, the relevance of liquidity became all too apparent in the financial crisis both from a timing perspective and a counterparty perspective. From a timing perspective, the gating of investors in certain hedge funds, and the relevance of redemption notice periods – whether daily, monthly, quarterly or annually – became all too relevant. From a counterparty perspective, solvency, capital structure and legal title became a primary concern. Finally, time horizon matters. For investors with a long-run time horizon who had no need to access capital and could weather extreme market volatility, there was sufficient risk budget not to worry about near-term correlations and liquidity constraints. But for those that needed to access capital in the near to medium term, or wished to dial-down their exposure to all risk assets in the face of potential market dislocation, these factors could not matter more. Industry response Once the dust settled, the industry response to client concerns was to consider how to offer alternative strategies (for the same diversification reasons as before), but with some hard lessons learned. Strategies had to be sufficiently flexible to be adaptive to changing market circumstances, and sufficiently liquid to be bought and sold on a daily basis. “Liquid alternatives” therefore became a buzzword for strategies that can 1) from a portfolio construction perspective, provide uncorrelated returns to traditional asset classes; and 2) from a portfolio implementation perspective, provide daily liquidity. Put differently, liquid alternatives are products that enable investors to trade “anything other than conventional beta”, according to Jean-René Giraud, CEO of Trackinsight, a European ETF research provider that is part of Koris International. Liquid Alts – delivered as mutual funds The growth in “liquid alt” was focused initially in the US mutual fund space (and were sometimes known as 40 Act funds as they were governed by the US Investment Company Act of 1940). The nature of investment strategies offered was therefore governed by what was permissible under the 1940 legislation – for example the requirement to offer daily liquidity, and to calculate a daily NAV. However, this also meant constraints around concentration, excessive leverage and short-selling. While these constraints were more restrictive than private/non-registered hedge funds, this sub-optimality was considered outweighed by investor demand for daily liquidity. Following the financial crisis, there was explosive growth in liquid alt funds, as illustrated in Fig. 1, below: Figure 1: Growth in Liquid Alt Mutual Funds (US) Note: The chart combines the Morningstar Alternative Mutual Funds and Morningstar Non-Traditional Bond Funds sectors to represent a Liquid Alt mutual fund sector.
Source: Spouting Rock, Morningstar Direct, as at 31st October 2015. Morningstar subdivides liquid alt funds into the following sub-sectors: Managed Futures, Long-Short Equity, Multi-Alternative, Market Neutral, Nontraditional Bond, Multicurrency, Bear Market. Managers of liquid alt funds ranged from specialist boutiques to retail versions of established hedge fund managers. Growth in AUM in liquid alt mutual funds has since tapered off possibly because the liquid alt exposure is becoming more readily available – to institutional and retail investors alike – through Exchange Traded Products (ETPs). Liquid Alts – delivered as ETPs The growth in Liquid Alts continues in the ETP space which has enabled rapid innovation in the breadth and depth of the range of strategies available. With TERs of 0.20% to 0.60% for ETPs, compared to TERs of approximately 2.00% for 40 Act funds, there is a compelling cost efficiency too. This is a key reason that institutional investors are looking at liquid alt ETPs as a lower cost alternative to hedge funds with a similar portfolio function, according to Jay Pelosky of J2ZAdvisory a New York-based global investment advisory firm. The number of liquid alt (including Smart Beta) index strategies available to fulfil the role of of providing differentiated returns to traditional asset classes is expanding rapidly on both sides of the pond:
While the range of products available is far greater in the US than in Europe at this stage there is potential for Europe to “leapfrog” and catch up in terms of innovation and development given the high level of research in alternative strategies from institutional investors, index providers and academia, according to Mr Giraud. Liquid Alts – delivered as Model Portfolios Retail investors are not limited to alternative mutual funds, or alternative ETPs. Liquid Alt strategies can be made available via managed accounts which are unconstrained by the parameters of the 1940 Act or individual ETP construction. One of the key enablers for this was the investment into platform technology by North American brokerages that made Model Portfolios readily manageable, according to Suzanne Alexander of Cougar Global Investments, a tactical ETF global investment strategist focusing on portfolio construction with downside risk management. So whether as an investment strategy in itself, or an alternative part of traditional strategy, liquid alternatives are helping to redefine portfolio construction. In this respect, Europe is lagging with platform providers slow to offer ETFs, let alone ETF Model Portfolios (“EMPs"), according to Giraud. UK Platforms – ETF Ready? In the UK, platform providers remain focused on mutual funds as a way of delivering investment allocation to clients, and the bulk of investment research is skewed to fund manager research, rather than ETF research. Novia Financial is one of the few platforms to offer not only traditional fund services, but is actively seeking to improve adviser access to ETFs, through technology upgrades. Platforms that are “ETF enabled” can provide advisers the tools, products, and cost structure they need to compete on like for like terms with robo-advisers which typically use ETF Portfolios, aggregated trading, and fractional dealing to deliver low-cost scalable investment solutions. With this technological parity, advisers can then differentiate themselves on the core services that robos can’t offer: financial planning/wealth structuring (typically more material than investment allocation), face to face support and a relationship based on trust. Broadening the portfolio construction toolkit Retail investors continue to seek ways to diversify their portfolios. Institutional investors are losing patience with Hedge Funds’ lack of “value for quality” evidenced by the material redemptions from hedge funds (some $14.3bn net outflows in 1q16 alone, according to Preqin). This means there is growing demand for liquid alts both from the top down and the bottom up, according to Pelosky. Funds formerly allocated to hedge funds will have to find a home, and a reinvigorated lower cost liquid alt ETP sector could be in the running to capture part of it. Notes: Participants in the panel discussion on this topic included: Henry Cobbe, Elston Consulting (moderator) Susanne Alexander, Cougar Global Investments Jean-René Giraud, Trackinsight Jay Pelosky, J2Z Advisory NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: Elston Consulting. Chart credit: Spouting Rock
A survey published this week of 250 institutional asset owners with AUM in excess of USD2 trillion suggests that there is continued growth of interest in reviewing Smart Beta strategies. The survey is published by FTSE Russell and is available here. It suggests that 36% of institutional asset owners are currently evaluating smart beta, up from 15% in 2014. This implies the potential for large inflows into smart beta strategies over the coming 12-24 months. What is smart beta? From an index construction perspective, if beta is defined as index-based investment strategy constructed using a cap-weighted approach (size factor), smart beta can be defined as an index-based investment strategy using an alternatively weighted approach (any factor other than size). From a portfolio construction perspective, smart beta can be defined as an asset allocation strategy constructed using different optimisation techniques to combine a range of index-based investment strategies. What the factor? Risk and return can be broken down into many contributing factors. Analysing factors requires the ability to statistically distil, isolate, and observe a factor for significance. There are therefore potentially thousands of factors, depending on your ability to analyse them, which could include aside from the obvious (size and volatility), quality, momentum, value, liquidity, profits, dividend yield, leverage, etc which make up the components of earnings and/or the cost of capital which classically define a company’s value. The broadening and deepening of data availability and accelerating computing power is facilitating the growth in this quantitative approach. How do factors help? Buying the (cap-weighted) index for an asset-class (e.g. S&P 500 NYSEARCA:SPY, NYSEARCA:IVV (US); LON:CSPX (UK)) could be seen as a straightforward “passive” approach. Through a factor lense, however, it looks like a blind overweight of a size factor. Size factor may outperform in some market conditions and underperform in others. So while asset owners traditionally thought of asset allocation in terms of geographies and asset classes, they are starting to consider portfolio analysis and construction from a factor perspective. It’s no secret that sovereign wealth funds have been early adopters of smart beta investing: the transparency of a rules-based approach is additionally attractive. Is “smartie” the new “hedgie”? Like the original attraction of hedge fund, return enhancement and risk reduction are the primary motivations for reviewing Smart Beta strategies, according to the FTSE Russell report. Unlike hedge funds, cost savings are an attraction too. Sounds familiar? One of the original motivations for including hedge funds in a portfolio was for return enhancement and portfolio risk reduction through the inclusion of an uncorrelated asset. This ostensibly required exceptional skill, and hence exceptionally high fees. But the mantra supported the exponential growth in hedge funds from niche to mainstream from the early 2000s. Arguably, smart beta strategies can serve the same purpose from a portfolio construction perspective, but using a systematic rules-based approach that replaces manager risk (unpredictable, rarely consistent), with model risk (predictable, consistent). Combined with ego-free fees, it’s no wonder that there is so much interest in this investment approach. Flexible delivery? Furthermore, unlike hedge funds, smart beta strategies can be delivered to in-house managers, segregated accounts,– the equivalent of being able to “enjoy in your own home” – as well as ETPs and CITs (Collective Investment Trusts). Relative to hedge funds, this creates greater transparency about the counterparty risk you are taking. Has the switch started already? As if on cue, two stories on the same day this week illustrate the point. In the UK, some listed hedge funds are reported as losing two-thirds of their assets as performance disappoints and expensive alpha proves elusive. Separately, in the US there are reports of further M&A activity in the smart beta space with Hartford Funds, a $74bn asset manager acquiring Lattice Strategies, a San Francisco-based smart boutique with $215m AUM. This is the latest in a series of acquisitions by large asset managers of quantitative boutiques. What kind of smart beta equity strategies are available? Smart beta equity strategies for USA (NY-listed) and world markets (London-listed) include factor based strategies from BlackRock’s iShares® such as Quality (eg NYSEARCA:QUAL (US) & LON:IWQU (UK)), Value (eg NYSEARCA:VLUE (US) & LON:IWVL (UK)), Momentum (eg NYSEARCA:MTUM (US); LON:IWMO (UK)), and Size (eg NYSEARCA:SIZE (US); LON:IWSZ (UK)). What about multi-asset? Our approach has been to focus on risk-based portfolio construction which is why we launched our multi asset Global Max Sharpe Index (ticker ESBGMS) and multi-asset Global Min Volatility Index (ticker ESBGMV) back in December 2014. Our view is that smart beta is a new and powerful part of the portfolio construction toolkit. Conclusion We see smart beta as a diversifier for classically constructed portfolios and as a flexible tool for analysing and managing factor exposures at different stages of the market cycle. If the large institutional asset owners follow through their interest in smart beta with mandates, it will be an investment style that is impossible to ignore. NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. This article has been written for a US and UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers. For research purposes/market commentary only, does not constitute an investment recommendation or advice. For more information see www.elstonconsulting.co.uk Image credit: FTSE Russell
The portfolio puzzle The Rubik’s cube has become a popular metaphor for the marketing teams of ETF providers. With good reason. For each client there’s a portfolio construction puzzle to be solved with building blocks, representing geographies, sectors, asset classes, factors and styles. There has been rapid expansion from providers of ETFs tracking main-market indices, with the largest institutional providers capturing the lion’s share of flows, owing to their ability to deliver on four key ETF governance criteria – consistency, liquidity, transparency and, of course, price. This means that ETFs for main market cap-weighted indices are increasingly commoditised. After all, there doesn’t seem to be anything overly smart about replicating market beta, other than the smartness of saving on fees relative to 'closet-tracker' active funds. Traditional cap-weighted index investing is a preference: either out of philosophy or necessity. Innovation means smarter? Hence R&D of institutional investors, index providers and ETF manufacturers alike has focused more on “smart beta”. This has triggered a slew of innovation – both superficial and substantive. At a superficial end, age-old alternative weighting strategies (eg value indices that screen stocks for low book values, or dividend-weighted indices) have been rebranded as being “smart”. In these cases, for “smart” read “non-market-cap weighted”. In fairness, this rebranding is part of broadening of alternative weighting strategies that are factor-based. More substantively, research programmes such as EDHEC-Risk Institute’s Scientific Beta have been instrumental in promoting fresh thinking the field of both factor-based and risk-based smart beta strategies. Factor-based approach As a result, providers are focusing on making building blocks smarter. Instead of relying on the ‘traditional’ factor of market capitalisation for index inclusion, smart beta indices (and related ETFs) look at alternative factors: book value, dividend yield, volatility, for example. In that respect, the FTSE Russell 1000 Value Index launched in 1987 is probably the oldest factor index on the block. More recent factor indices are stylistic: Both iShares (Oct-14) and Vanguard (Dec-15) havelaunched global equity factor ETFs focusing on Liquidity, Min Volatility, Momentum and Value. The sophistication of factor-based index construction will continue to increase with the increase in data availability and computing power. Risk-based approach Portfolio strategists meanwhile can apply quantitative rules-based approaches to portfolio construction, creating static or dynamic asset allocation strategies from a growing universe of both cap-weighted and alternatively-weighted index tracking funds. These strategies – such as Maximum Sharpe, Minimum Variance, Equal Risk Contribution and Maximum Deconcentration – offer an alternative to the standard but troubled single period mean variance optimisation (“MVO”) approach. MVO’s limitations Single period MVO approach remains the traditional bedrock of very long-run investing in normal market conditions where the sequence of returns does not matter. However it runs into difficulty in the short-run when markets are non-normal and sequence of returns matters a lot. So unless you are a large endowment with an infinite time horizons, or perhaps can afford to invest for yourself and your family without ever needing to withdraw any capital, relying entirely on the MVO approach for asset allocation gives false comfort. For cases where there are constraints that challenge the MVO model - due to multiple or limited time horizons, expected capital withdrawals, risk budgets, and unstable risk/return/correlation profiles of asset classes (collectively known as real life) - portfolio construction requires a smarter, more adaptive approach that observes, isolates and captures the reward from shifting risk premia over time. Risk-based portfolio strategies attempt to achieve this and are designed to offer a liquid alternative approach to investing that is uncorrelated with traditional Single-Period MVO strategies. What’s the problem to solve? Whether assessing factor-based ETFs, or risk-based ETF strategies, at best these new developments seem all very smart. At worst it’s just a bit different. However, as ETFs get smarter and the strategies that combine them become more sophisticated, there’s a risk that the key question in all of this gets lost in an incomprehensible barrage of Greek. The key question for portfolio managers nonetheless remains the same. What client outcome am I targeting? What client need am I trying to solve? For portfolio strategy, whether using a discretionary manager that relies on judgement, or a systematic rules-based approach that relies on quantitative inputs, the key client considerations remain return objective, time horizon, capacity for loss, and diversification across asset classes and/or risk premia. Broadening the toolkit A portfolio strategy has little meaning without an objective that focuses on client outcomes. Factor-based ETFs and Risk-based ETF portfolio strategies offer an alternative or additional set of tools to help deliver on those outcomes, in a way that is systematic, liquid and efficient. "Asset allocation is not everything. It's the only thing."
One of the harshest lessons of the Global Financial Crisis was that when the going gets tough, correlations trend to one, giving even diversified investors very few places to hide. It wasn't about whether or not you got burned, it was a more a question of degree. While there's a time and a place for active stock selection, from a portfolio construction perspective, it's the active management of the overall asset allocation that affects the outcome. Using ETFs for portfolio construction The growing popularity in Exchange Traded Funds is in part because of their elegance in providing broad, liquid, efficient and cost-effective market access to most major asset classes with a single trade. We now have a broad range of building blocks with which to construct a diversified portfolio. As a result, the problem for investors has shifted from "How best can I access a broad choice of markets?", to "How do I create a portfolio that suits my needs?" How many ETFs are needed to create a portfolio? To create a portfolio with too few ETFs would mean there is limited scope to create different asset allocation strategies. To create a portfolio with too many ETFs introduces additional complexity, oversight requirements, and a higher degree of trading costs if the portfolio is to be regularly rebalanced. So what is the minimum number of ETFs needed to create a well-diversified portfolio? A Strategic Core For a strategic portfolio for a UK investor with £100,000 to invest and a desire to keep trading and ongoing costs to a minimum, we believe that advisers can construct strategic asset allocation models using the following “Magnificent Seven” broad asset classes alongside cash: UK Government Bonds, UK Corporate Bonds, Global Corporate Bonds, UK Property, UK Equities, Global Equities and Emerging Market Equities. All 7 of these asset classes can be accessed through BlackRock's iShares range, mostly from their cost-efficient Core range. Importantly, these ETFs are 'cash-based' or 'physical' meaning that they actually own the underlying holdings (unlike some ‘swap-based’ or ‘synthetic’ ETFs). Liquidity and diversification The fund sizes of these ETFs ranges from approx £400m to £4bn meaning external liquidity is high. Internal liquidity is as good as the underlying securities the ETF and index holds. While investors see only seven holdings, a portfolio containing these 7 large and liquid ETF building blocks represents a diversified portfolio of some 6,901 individual securities, all of which are fully disclosed for each fund. Strategic or Tactical After creating a strategic asset allocation model, ETFs mean that tactical asset allocation changes can be executed in real-time, which can give significant implementation advantage in these volatile times. As a starting point for advisers look to provide low-cost portfolio construction, using ETF building blocks for these key seven asset classes are a helpful first step. www.elstonconsulting.co.uk NOTICE This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Elston Consulting to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Elston Consulting, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 Elston Consulting Limited. All rights reserved. BirthStar, Elston Gamma, and Elston Strategic Beta are registered trademarks of Elston Consulting Limited. All other marks are the property of their respective owners.
The Japanese did it. The Europeans did it. Even the educated Swedes did it. So will the Fed ever lower interest rates below zero? Markets fell out of bed last week on fears the Fed might shift from a Zero-Interest Rate Policy ("ZIRP") that alleviated the pain of the financial crisis to a Negative Interest Rate Policy ("NIRP") to keep the monetary stimulus to the economy alive. Why does it matter The "feasibility study" being undertaken at this stage is a long way from a policy announcement, but would indicate a very different interest rate path to December's announcement. This volte face alone would query the Fed's credibility. Add to that the known unknown of how markets might operate in this Through the Looking Glass world where you pay to lend money to the lender of last resort, and some basic assumptions around the supply of, and return on, capital have to be adapted. How does it "work"? The short answer is: we'll see. In theory, by charging financial institutions to sit on surplus cash, they are forced to put that cash to work, for example lending to corporates to keep their wheels turning. In this way, negative rates act as a stimulus to the velocity of money, rather than the quantum of money supply. What are the issues? Issue number one is that it turns the fundamental relationship between providers and users of capital on its head. Aside from that are the legal and technical issues around how NIRP can be implemented in any jurisdiction. But, as we have seen so far - where there's a will there's a way. The sector most vulnerable is the banking sector as negative interest rates wreak havoc on Net Interest Margins - the spread between banks' borrowing and lending rates that is the cornerstone of their profitability. Hence the rather brutal round of price discovery that took place in the banking sector as a response to this new known unknown. From negative yields to negative rates Short-term real yields on government debt (i.e. nominal yields, adjusted for inflation) went negative in 2008 during the financial crisis. Short-term nominal yields on government bonds, issued by, for example, the US and Germany, have dipped in and out of negative territory thereafter, as a safety/fear trade signaling that those investors would rather pay governments to guarantee a return OF their capital, than demand corporates to promise a return ON their capital. So economically speaking, negative yields are not new. But what is new is that negative interest rates are being adopted as a central bank policy. How have markets reacted? Markets hates grappling with new concepts where there is no empirical data from the past on which to make hypotheses. Hence the "shock" increase in risk premia despite the ostensible further lowering of the cost of capital. Renewed interest in gold is the natural reflex for those scratching their head as monetary policy grows "curiouser and curiouser". What next? Central banks are adding NIRP to the armory of "unorthodox" levers at theirdisposal to achieve orthodox aims. To what extent this new weapon is deployed will depend on the underlying development in fundamentals around growth, jobless rates and inflation targeting. Those targets set the course to which monetary policy will steer. Whether the new policy levers have more efficacy than the old remains to be seen. Baked beans, anyone? The UK's baked bean price war of the mid 1990s, provides a parallel to the topsy turvey economics of negative pricing. To gain and retain customer market share, the big three British supermarkets slashed baked bean prices to around 10p a tin. Tesco's then broke ranks and slashed prices further to 3p a tin (subject to max 4 cans per customer per day). Not to be outdone by its bigger rivals, Chris Sanders of Sanders supermarket in Lympsham, Weston Super Mare made history by selling baked beans for MINUS Two Pence (subject to max 1 can per customer per day). Janet Yellen - you now know whom to call. While it didn't alter the fundamentals of the retail sector, it did mark the end of an irrational era of skewed economics. For the optimists out there, perhaps NIRP heralds the same? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. It's hard not to get emotional when markets get difficult.
As with any temper-tantrum, having a clear rules-based approach can help maintain investment discipline when emotions run high. One of the attractions of a multi-asset Smart Beta approach is that portfolios can dynamically adapt to "reflect the pulse" of the markets following clearly defined, systematic rules. While this may be short on art, and long on science, compared to smart Alpha managers, the scientific approach also benefits from the certainty of much lower fees. Furthermore, a dynamic approach can help mitigate tail-risk. For anyone except those with an infinite time horizon (endowments), relying on a traditional single-period mean variance optimisation model for asset allocation strategy is problematic, because the long-run assumptions on which they rely do not necessarily hold for the short-run. And when it comes to managing tail-risk, the short-run matters. This is why our portfolio construction approach is outcome-oriented, aiming to create for example a Max Sharpe portfolio or Min Volatility out of a broad opportunity set of liquid, physical ETFs representing a broad range of asset classes and geographies. We've just past the 1-year live-pricing anniversary of the Elston Strategic Beta indices - the Global Max Sharpe strategy (Ticker ESBGMS) and Global Min Volatility (Ticker ESBGMV) strategy. For asset-owners looking at alternative ways to manage risk beyond a long/short 2&20 approach, low-cost risk-based multi-asset strategies are becoming a compelling alternative. The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected. In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity but more of a combination of each to match a client’s needs, requirements and aspirations.
When researching the solutions that could help advisers navigate the new retirement freedoms, we looked to the US where annuities have long ceased being the mainstay of retirement income to understand the innovations that can help create more durable retirement portfolios. From “to” to “through” Lifestyling pensions are managed to a retirement date typically targeting annuity conversion. Target date funds can be managed through retirement targeting sustainable withdrawals from a balance of stability and growth. The target date is not an end date but a start date for the drawdown phase. It is the turning point where investors move from making regular contributions, to making regular withdrawals. The investment objectives gradually pivot from making a pot grow before retirement, to making it last in retirement, sustaining a durable income. Flexible, not fixed In contrast to old-fashioned lifestyle strategies which follow a fixed investment plan, target date funds enable flexible asset allocation to adjust for the market and economic environment. This is the difference between being asleep or awake at the wheel: the journey looks similar, but it’s who’s driving that counts. This flexibility enables active risk management for a smoother ride for clients. Partial annuitisation Annuities’ key feature is to provide guaranteed income in old age until death. That was generous in 1928 when the pension age was 65 and the average age of death was 67, now it’s a stretch as, happily, we are all living longer. Partial annuitisation may have a role to play to top up other guaranteed incomes, like DB benefits and the state pension, to help cover a client’s essential spending in retirement. So while most retirees in the UK took 25% cash/75% annuity, about 19% of retirees in the US take some form of annuity with optimal allocation considered to be 25% annuity/75% drawdown on average. Deferred annuities Traditional annuities and enhanced annuities would both be termed in the US as “immediate” annuities as they start paying out at point of purchase. What we don’t have yet in the toolkit are “deferred” annuities, which start in the future to do what annuities were originally meant to do: to form a perfect hedge to longevity risk. By combining target date funds with a progressive purchase of deferred annuities, there is scope to get the best of both worlds: a managed portfolio to drawdown over time, and a longevity hedge for later life, when longevity risk is an insurance worth having. We encourage UK insurers to offer deferred annuities to broaden the retirement toolkit. A “bucket” approach One framework in the US for retirement portfolio construction is the “bucket approach”. Each bucket includes a cash component for short-term needs, a medium risk bucket for medium-term needs, and a higher risk bucket for longer-term growth. The allocation to each bucket changes as time goes on, as risk capacity changes with time. With target date funds, allocations to these different “buckets” is managed within the fund, for convenience, efficiency and value, and enables advisers to focus on more holistic planning decisions. Bringing it together Instead of considering a portfolio’s potential for risk and return, advisers are now having to consider retirement outcomes – income replacement and adequacy rates, sustainable withdrawal rates, life expectancy and legacy decisions. Our accredited CPD series for advisers around retirement investing examines the ‘lifecycle’ framework for combining future income, current portfolio, life insurance and annuity choices to optimise asset allocation over time to consider not only investment risk, but mortality risk and longevity risk too. Old problems, new answers While none of these considerations are new to advisers, the responsibility for managing them is. The innovation that target date funds provide for a managed drawdown portfolio forms part of the retirement planning toolkit alongside cash, guaranteed income, and insurance. It’s for advisers to combine these to create a plan that suits their client’s needs. It’s time to rethinking retirement investing and we are here to help. The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected. In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity, but more of a combination of each to match a client’s needs, requirements and aspirations.
Read the full article in Employee Benefits The new pensions freedoms that came into force this April allow much more flexibility on how to invest for and in retirement.
This flexibility is welcome and overdue. It also means that advisers have a more important role than ever in helping their customers navigate the multi-dimensional world of retirement investing: both from a financial planning perspective and from an investment perspective. Read the full article in Money Marketing We believe there is scope for innovation in five key areas that could create greater choice, efficiency and transparency for at-retirement decisions.
Read the full article in FT Adviser Regulatory changes in pensions and advisory markets are prompting a fresh look at age-based multi-asset funds, known as lifecycle or Target date Funds (TDFs). As part of a broader move towards packaged investment strategies, investment managers may need to reassess their product offering to become a wealth manager, a fund factory, or both.
Read the full article from CFA UK Professional Investor Magazine |
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