investment advice for a friend of mine who has c. €1m to invest in an ARF.

[North Star]

Good afternoon Dan,

You have got some very insightful feedback and firmly held viewpoints to date which is always a good start when trying to make an informed decision. I would like to offer a slightly different perspective. I apologise in advance for a long winded reply ....
Firstly in relation to your friend and investment advice, when dealing with clients and their investments we are firmly in the realm of behavioural finance i.e its difficult to separate the emotions and fears either rational or irrational that are associated with investment gains and losses. Your friend sounds like lots of clients we have, who were happy to earn 4-5% on long term bank deposits for investments and pension/ARFs etc and as they have gradually matured, they are now facing a challenge to try to deliver reasonable returns with a limited risk to their capital. ( They may not have realised it at the time but as events in Cyprus proved, bank deposits were never risk free ). Stephen is right in when he is saying that you cant examine risk appetite and loss tolerance re the ARF in isolation. An overall/holistic approach is important. Your friend needs to quantify the level of return required over the medium term to meet his/her financial objectives. They may well be making an equally serious mistake of not running enough risk, depending on their circumstances. Though I accept that if they have sufficient assets they may have no need to take on investment risk. For this purposes lets assume that your friend needs a 3% real return per annum after all costs.

Based on what you have said it appears that for your friend the marginal utility of a unit of gain is not equal to a marginal utility of a unit of loss, i.e they would be more concerned with a €100k loss compared to being satisfied with a €100k gain. If this is correct or confirmed by your friend we need to take this into account when looking at investment options. We would try to where possible moderate the downside risks even if that meant sacrificing some of the upside potential. We would advise your friend to avoid capital protected products even though they may seem alluring on a first viewing. There are plenty of threads on AAM which will explain why we hold this view.
In terms of investment styles and approaches, we arent champions of any one approach at the expense of all others i.e we can see the merit in low cost passive strategies, active mangement where it has a good track record in adding value and also some Absolute Return strategies. Costs do matter and we always look at net returns i.e after all costs when evaluating options. ( I will address the Absolute Return specific items later ). You can diversify across investment approaches as well as across asset classes. In our view valuations also matter, not as any timing indicator but a determinant of probable/potential future returns, so yes we confess that we bring our own bias to the table by liking a GMO type approach to investing

As risk and return are inextricably linked we need to see how we can get your friend at a position where they are more 'comfortable' taking on risk to deliver the required return with the associated risk of loss. We find that once clients have a reasonable profit buffer, then they are more comfortable with downside risks. Back to behavioural finance again, giving up some profit doesnt seem to hurt as much as losing part of your original capital, even if to many that is illogical. Therefore for your friend we would start with a very defensive approach and gradually step into higher risk/return levels as a profit buffer has been built up. This takes discipline and time, and in a rising market will sacrifice some upside potential. As bond yields and cash instruments are so low, we find that there is good reasons to use an Absolute Return approach as 'defensive asset' to help build up a profit buffer. We are concerned that bonds/fixed income are extremely expensive and the traditional 60% equities and 40% Bonds portfolio will struggle to meet historic return patterns and will show higher correlation than previously experienced. I could well be wrong but I have to call it as I see it.

Lets assume over time your friend has now built up a modest 10% to 15% profit buffer( taking income drawdowns into account). We can now explore a more balanced long term investment strategy along the following lines assuming that your friend doesnt have the inclination to directly hold a portfolio of equities and will favour a diversified ETF or fund strategy;

1. Lower cost globally diversified equity exposure

• - Exact percentage to be determined by max drawdown ( reasonable worst case ) figures your friend is comfortable with - lets say 30% of ARF
• The objective is to buy and hold this through all market cycles
• We suggest looking at Dimensional Fund Advisers (DFA) or Vanguard for ETFs
• Whilst no one can time markets, when moving from cash to this 30% holding as we have a value bias we would like to enter this portion when it is supported by favourable valuations ( which will annoy the efficient market disciples)

2. Active management where it adds value

• Smaller companies is the sector where active management has a higher probability of adding value after costs, maybe as a side effect of the swing to passive investing, which leaves an opportunity for stock pickers to add value
• This sector has a long track record of superior risk return characteristics which isnt to say it outperforms all the time, but over the medium to long term its track record is appealing
• As above ideally would like to step into this gradually in a favourable valuation environment even if that takes time.
• Allocation up to 20% if built up gradually

3. Defensive assets - 50%

• This includes Absolute Return type funds, and if/when rates start to normalise will also include cash, bonds, corporate bonds, gold etc in small allocations
• The objective is to produce reasonably stable but modest returns with lower correlation to equities

Some may view the above as too adventurous for a 3% real return agenda but I am taking into account that it may take some time to build up this exposure. If more suitable defensive assets were available to meet the return agenda then we can scale back the higher risk/return allocations.


Specific issues re Absolute Return strategies as Hedge funds and associated risks for retail investors

• We have and will probably continue to recommend some Absolute Return type funds, and our clients employ us to in effect do their due diligence work for them
• There is no alchemy and no risk free return, these type of funds replace asset class risk with investment manager risk and as Sarenco says you can diversify across several managers to mitigate some of this risk
  
• In a previous life I have 20 years capital markets trading experience and would be at least quite familiar with the type of strategies used
• Whenever we give a client a written recommendation we take on a regulatory and ultimately a legal risk and we are very conscious of this. We take our responsibility to clients seriously.
• We have reviewed various Absolute Return Funds including Std Life GARs fund. In fairness to Std Life they were good in granting me access to fund mangers in private meetings here and in small group meetings in Edinburgh where we could ask as many questions as we felt were required to be satisfied with our due diligence
  
• Jim raises some very good points re LTCM type risks, and we have and continue to be aware of these risks
• As the guys say Macro driven hedge funds can often work in crowded trades and be exposed to extreme volatility when the market thins and there is limited or no liquidity. There have been several episodes where Macro Hege funds have been hit by this crowding effect e.g the 2008 bear maket, the correction in 2011, JP Morgan 'London Whale' in credit deivatives and perhaps even this summers correction. During all these episodes GARS performance was much more stable than the average 'Balanced Managed Fund' available to Irish retail clients
  
• We take some comfort from this historic performance under stressed conditions
• In addition the GARS appoach to having 30 to 40 different strategies hopefully mitigates some of the risks Jim mentions
  
• The other factors which also provide comfort are the daily liquidity, the fact that there is no bonus payable for beating a hurdle target, an element of risk sharing via Std Life investing their DB pension in the fund, the lower costs compared to hedge funds, the strong investment team and the risk management delivered to date
• Our primary concern would be if corelations all move to 1, but in that scenario we would expect all risk assets to be hit
  
• To conclude, there is no risk free return or investment panacea but our opinion is that some Absoute Return funds are worth considering as clients would be in general be satisfied IF a cash plus 5% can be dlivered with lower volatility. We fully accept that others are free to disagree.
• Apologies again for length of reply All the best Vincent

 

[Dan Murray]

Thanks JPD and Vincent

I wish to applaud Vincent for taking the time to make such a weighty contribution - especially as it must be a particularly busy time of the year for practitioners. I note that Steven from Bluewater said he would share his views also - when time permits. For practitioners to make clear public recommendations is laudable - as there must be a temptation (for obvious enough reasons) to sit on the fence on this one.

Regarding the substantive issue, Vincent's comments resonate positively with me. I found much overlap with the suggestions made early on in this discussion by Elacsaplau - that is, some exposure to equities and absolute return funds, the current unattractiveness of bonds, the merits of progressively moving towards the target portfolio mix, etc.

 

[Dan Murray]

Institutional and ultra high net worth investors employ highly qualified staff to carry out extensive due diligence on a hedge fund before allocating any of their capital to a manager. Retail investors obviously don't have that luxury.

In addition and importantly - I was speaking yesterday with an actuary from a leading actuarial consultancy who told me that his company includes GARS as part of its standard suite of fund options (5 or 6 funds) offered to members of the DC plans it manages. His view was that GARS possibly has a higher risk than suggested by its objective rating of 3 (on the ESMA scale) but that it is not an inevitable accident waiting to happen.

 

[elacsaplau]

Interesting debate. Just to clarify one point, when I mentioned absolute return funds, I wasn't specifically referring to GARS. Personally, I have money invested in an absolute return fund to do with my pension plan at work. It's managed by Mercer and has a target return of 4% p.a. nominal.

I would be very interested in seeing any studies that appropriately evaluate the performance of hedge funds whose target annual return is in the 2% to 4% ballpark. [The only reports that I can find in relation to hedge fund performance are similar to that linked to earlier in this thread. According to the linked report, for example, the typical fee structure of the funds under review combined both an annual management charge and an average performance fee of 20%. It's very easy to understand the attractiveness of pure speculation to the hedge fund proprietors in such a reward structure.]

 

[Steven Barrett]

There have been a lot of good points made in this discussion.

Standard Life's GARS gets the most mentions because it is an obvious success story. My reservations on it is that it is extremely complex

It will achieve this objective by investing in a portfolio of permitted derivative contracts (including futures, options, swaps, forward currency contracts and other derivatives), fixed interest securities, equities and cash. Additionally the Sub-fund may invest in (other forms of) transferable securities, deposits, money market instruments and collective investment schemes

I believe that clients should understand what they are investing in. Strategies involving a hedge of Swiss Pharmaceuticals against German Luxury goods isn't what most are looking for.

Another issue for me is that it hasn't really been tested. I want to see if it delivers what it promises to after going all the way through a bear market.

Otherwise, the figures stack up well for the fund, good returns and reduced levels of risk.

I place a lot of business with Dimensional Fund Advisors and I would be suggesting one of their lower risk portfolios for someone looking at a 3% return. Their portfolio of 80% bonds (short dated) and 20% equity has an average return of 4.22% over the last 13 years. The worst return in that period was -0.73% in 2008.

I've attached a risk v return chart for the GARS fund with the Dimensional Defensive (80% bonds/ 20% equity) and Balanced (50% bonds/ 50% equity).

Steven
www.bluewaterfp.ie

 

[Dan Murray]

Thanks for taking the time to reply Stephen.

I believe your suggested asset allocation has only a very remote prospect of achieving the target return of 3% p.a. net on average over the next few (say 3 to 5) years.

5 year Euro Bonds (composite high grade) are yielding zero - with negative nominal returns for shorter periods; and if we assume, say a 6% return from equities, we get (80% x 0 plus 20% x 6%) or a total gross return of 1.2%. If we assume fund management charges of 0.30% p.a., this gives a net return of less than 1%.

Do you agree with my calculations?

 

[Steven Barrett]

I don't know Dan. I have no idea what's going to happen over the next few years.

Using historical data going back to 2002, that asset mix has generated the following annualised average rolling returns:

1. 1 Year - 4.70%
2. 3 years - 4.63%
3. 5 years - 4.39%
4. 10 years - 4.56%

Of course, past performance is no indication of future performance.


Steven
www.bluewaterfp.ie

 

[Dan Murray]

I'm, frankly, amazed by your posts today. In the latter one, you say that past performance is no indication of future performance - yet your soul justification in both posts is the past performance of your chosen mixture. Was it the great JK Galbraith who said "past performance is a lantern over the stern. It shows you where you have been not where you are going."?

 

[mercman]

After reading the posts already put up on this subject, I would like to throw in my opinion into the mix. Some of the replies you have received are from market professionals, some are from ordinary members of the Investment Comm. With every respect to AAM and Brendan I really think that your friend should be looking for direction from persons who they would recommend and their company's name. It is a pointless exercise reading dribble as to what happened previously -- look to the future, there's lkittle point in looking back.

Personally after been very badly burnt with wonderful Investments from Irish companies, where my opportunity Loss amount to millions of €, I would never ever use the services of an Irish owned fund manager etc. Simply the rules aren't here for your money to be handled with due care and attention.
As a point of note ask any Irish fund what their TER (total expense ratio) is ? in 80% of cases trhgey will tell you that they are not obliged to tell you. the outstanding 20% of Irish funds are run by UK or continental or US managers who happily release the info. BTW, the TER is the total expenses which occur in a fund. And the largest Irish fund Managers (owned by an Irish Bank) will not tell you, as they don't have to. What a joke.

With €1 million to invest get International opinion, before the whole thing ends in tears.

I'm not a broker and have no affiliation to anybody. Just beware of the gangsters, and believe me there are many in Ireland who would love a piece of your money.

 

[Marc]

.

 

[Marc]

Dan

When you say 3% net do you mean net of tax or net of fees and expenses?

 

[Dan Murray]

Hi Marc

It's an ARF so fund growth is tax exempt, right?

So desired return is 3% net of fees nominal.

 

[Marc]

Ok it's just that the income from the ARF is taxable so I wasn't sure what you meant.

A couple of thoughts here:

Conservative investors should always consider and actively discount the option of buying an annuity for some or even all of their ARF.

The reason for this is that if your friend lives a long time and is forced to take 4%pa or 5%pa if over 71 and they target a conservative investment strategy, they could find out that they would have actually been better off buying an annuity at the start.

The problem here is no "best before date" on the birth certificate. I've written a detailed white paper on these issues.

In terms of costs you need to breakdown the typical costs associated with running an ARF.

You must have a qualifying fund manager or QFM ideally they shouldn't litterally be a "fund manager" or stockbroker. As Woody Allen says;"a stock broker is someone who invests your money until it's all gone"

Many people still use an insurance company to provide QFM/custody and fund management. There are much better options in Ireland now.

You shouldn't pay more than 0.25%pa for this service.

You also need an independent custodian who should be entirely separate from the QFM. Think Custom House Capital. Ideally you shouldn't be paying more than 0.1% to 0.2% pa for this service including execution in multiple currencies on multiple exchanges.

Taken together you should be able to get these services for around 0.40%pa

Fund manager costs are now more competitive than ever - just not here in Ireland. A suitable investment portfolio shouldn't cost you more than about 0.25%pa in fund manager fees. Pay anymore than that and remember Jack Bogle's comment when investing "you get to keep precisely what you don't pay for" or "money is like a bar of soap, the more you handle it, the smaller it gets" Gene Fama Jnr.

I was in London yesterday negotiating annual management fees (TER) for our clients for Global Equities of 0.15%pa.

Add in some additional risk factors to spice up expected Returns and you might end up paying around 0.3%pa

What benefit is there in adding absolute return funds? All returns are being driven by exposure to risk. That exposure either comes at low cost in the form of passive returns, or you pay a fund manger to try and add value through active management. But the underlying economics of low bond yields still apply. In order to generate returns, even in a long short fund like GARs the manger still lives in the real world. Returns are low so to generate additional returns over cash they have to bet repeatedly. But when you track the performance of GARS over time against a similar risk profile portfolio it tends to underperform by the difference in fees and expenses. GARs is more expensive so over time it loses.

It did well for a 2 week period in 2008. If you exclude this period the excess return (or alpha) vanishes.

The question one could reasonably ask is did it do well in 2008 due to luck or fund manager skill? To answer that question statistically with 95% confidence requires around 186 years of data.

A fund like Gars has net exposure to real assets of around 40%. If that's the right risk exposure here then just use a low cost investment solution to achieve that and keep the additional 60 or 70 basis points a year that Standard Life are spending on their marketing.

Targeting a (presumably nominal) 3% net of fees return but having to take 4% imputed distributions rising to 5% at age 71 would make for an interesting illustration for someone interested in capital preservation once inflation is also factored in especially if inflation averages more than the ECB target of 2% in future.

It's likely that the asset allocation that meets the required description would be a portfolio which assured capital depletion over time. Which would be a key consideration in the portfolio construction decision process.

The UK regulator coined a phrase for this "recklessly conservative"

Since the asset allocation is going to explain something like 90% of all of the future returns it's important to get it right.

I certainly wouldn't be ticking a box on a form with 3 or 4 models to choose from.

I'd also like to know where the 3% has come from in a world where 4%/5%pa must be taken.

The key drivers here are need to take risk to earn an expected return, capacity to take risk (a function of age, net worth income etc) and finally willingness to take risk.

A low willingness to take risk, as your friend clearly has needs to be properly considered in context. For example I'd be very concerned if your friend had a younger wife who needed to rely on the ARF pot for her income requirements.

In terms of phasing from cash to an investment portfolio there is some evidence that this helps maintain composure among cautious investors, but arguably simply delays increasing the return on the portfolio by keeping more cash for longer. Therefore under most conditions the combined effect of inflation and imputed distributions has a far greater downward effect on the value of a conservative portfolio than the markets. It's like having a 6%p fee being applied to the portfolio every year.

 

[Dan Murray]

Thanks Marc

It seems to me that achieving a net 3% p.a. return nominal is a reasonable hurdle over the next 5 years. I wouldn't call it recklessly conservative.

I understand the general points you are making but my objective is to focus on the investment return aspect of the question - otherwise the thread will lose focus. What would be most helpful if you could set out your proposed asset allocation to achieve a 3% net return p.a. please? Take it that I can do the math to dial up or down the risk curve thereafter.

Also, you seem to be saying that running an ARF costs more like 60 or 70 basis points, rather than the more modest 30 basis points I had conservatively allocated in my critique of Steven's proposed asset allocation. I would appreciate a clear response to this question: do you agree with me that Steven's proposed asset allocation is unlikely to achieve an average return of 3% p.a. on average over the next 5 years?

 

[Dan Murray]

Just had a look at Dimensional. I'm not sure what precise fund Steven is talking about but it may be a world bond fund, with a euro hedging which invests in sovereign, corporate bonds, FRNs, etc. Accordingly, there is a better chance of hitting the targeted return (because more risk is being taken). I would suggest fund descriptions (i.e. asset allocations!) are more helpful than reciting past performance stats.

 

[Sarenco]

Hi Dan

I'm not sure if it helps but the Norwegian Government Pension Fund (the world's largest sovereign wealth fund) targets a long term real rate of return of 4% per annum, with a target allocation of 60/35/5 equity/bonds/real estate. However, the Norwegian Central Bank Governor said a few months ago that he expects the Fund's return to fall "perhaps below 3%" due to low yields on long term government bonds. Who knows?

 

[Dan Murray]

Hey Sarenco and thanks....

What's this nonsense about a government setting up a pension fund??!! That would never work in these parts!!!!

 

[Sarenco]

Hah! Well I suppose all that money from North Sea oil and gas has to find a home somewhere.

The sheer scale of the Norwegian pension fund is pretty extraordinary - I believe they own something like 2% of all publicly traded European equities.

 

[Marc]

Dan,

I've worked through your calculations for the two models that Stephen referenced

You said;
"I believe your suggested asset allocation has only a very remote prospect of achieving the target return of 3% p.a. net on average over the next few (say 3 to 5) years.

5 year Euro Bonds (composite high grade) are yielding zero - with negative nominal returns for shorter periods; and if we assume, say a 6% return from equities, we get (80% x 0 plus 20% x 6%) or a total gross return of 1.2%. If we assume fund management charges of 0.30% p.a., this gives a net return of less than 1%.

Do you agree with my calculations?"

Stephen referenced the Dimensional Defensive and Balanced portfolios.

The weighted TER of the defensive portfolio is 0.27%
The weighted TER of the balanced portfolio is 0.35%

Source: Morningstar

On top of this you need to add the 0.40% or 0.50% for the ARF
Plus you need to add an adviser charge of typically 0.5%pa

So, total costs would be of the order of

Defensive 1.17%
Balanced 1.25%

Defensive Portfolio Expected Returns

As you correctly note, the yield to maturity explains around 92% of the expected return of a bond over the next decade. The YTM of the Global Short Fixed Interest Fund is currently 1% and the portfolio also includes inflation linked bonds so although its unrealistic to assume a 0% return for the defensive part of the portfolio, I would agree that somewhere between 0 and 1% would be reasonable based on starting yields.

Equities

The portfolio targets a higher return than developed equities through tilts to small and value stocks but the Global Core Equity fund has a TER of 0.37%. The portfolio is globally weighted which means that around 50% is invested in the USA. 75% of the US market is made up of the S&P 500 and you can buy this for as little as 0.04%pa. So by taking a more robust component approach to portfolio construction you can save a lot in fund fees and not give up anything in expected returns or tilts to the factors of expected returns.

Let's go with the consensus view of developed equities of around 6.5%pa and slightly more for Emerging Markets. I've written a detailed guide called "realistic expectations" which goes into detail on all these points.

So the expected return of the defensive portfolio would be currently something like 1.841% less costs of around 1.17% so a net return of 0.674% from which you would have to take imputed distributions of 4%pa. So, yes, you were bang on the money with your comments.

This is the point I made about being "recklessly conservative". There isn't a cat-in-hells chance that this kind of strategy is suitable for an ARF investor with even average life expectancy let alone a married couple.

Note here that the investor's attitude to risk is not really that relevant to this argument. The primary purpose of a pension is to provide income for the whole of the rest of one's life plus that of a spouse or partner. That should always be the overriding priority.

Individual circumstances might mean that the objective might change to say Estate planning, but in this instance we know nothing about this client.

I attended a Personal Finance Society conference in Northern Ireland today and one of the speakers was a senior Civil Servant from the UK Dept for Work and Pensions who gave this example: A married couple aged 65 today have a 74% chance of one of them still being alive aged 90!!!

So a "defensive" investor might think that they are being cautious and avoiding risk but in reality they are running a very substantial risk that they will literally run out of money. This circles back to my earlier argument around longevity and annuities. If you are genuinely this conservative, an ARF probably isn't the right product for you in the first place and you should consider buying an annuity instead at least to the point where you are providing a base guaranteed level of income that supports your essential needs.

 

[Dan Murray]

Thanks for a very comprehensive answer Marc. Your statistic re life expectation got me thinking - to the point that I'm going to set up a separate thread on it later today - need to do a little research first! YOU MAY HAVE JUST ADDED YEARS TO MY LIFE!!!!

I want to keep this thread on the investment question as I have been saying all along, as per below. Like, for example, of course there are merits to annuities - no one here has said otherwise - but debating the relative merits of annuities is not the purpose of this thread. Also, I don't fee comfortable providing specific personal details regarding my friend.

Firstly, I totally agree that investments should be viewed in context. For the purposes of this thread, however, can we limit the debate to the specific question please? I just want to focus on one key issue.

I am unsure whether you consciously or unconsciously didn't answer the primary question that I posed to you?!

I understand the general points you are making but my objective is to focus on the investment return aspect of the question - otherwise the thread will lose focus. What would be most helpful if you could set out your proposed asset allocation to achieve a 3% net return p.a. please?

That is, we know
(a) what strategy won't or is very unlikely to work; and
(b) what strategies might work but divide the jury

What I'm still looking for now is the least risk strategy that is likely to work?

The only fair conclusion to the debate to date is that no-one has suggested a convincing asset allocation strategy, likely to return 3% net p.a. with risk lower than suggested by a combination of equities and bonds. Say, for example, using the figures per your post, to achieve a 3% net return, we are looking at something like a 60% equity / 40% bond exposure. Is this the lowest risk approach to achieving average annual growth of 3% nominal?