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



## Dan Murray (7 Oct 2015)

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

He's looking for a low/lowish risk investment.

What charging structure can a fee based advisor get?

What charging structure can a commission based advisor get? (i.e. is paying a fee a no-brainer?)

What are the investment options?

What options would you recommend for someone who would be happy with c.3% p.a. net return on average (with minimal capital risk)?

What are your views of Absolute Return Funds? Which of these is the best?!

Anything else obvious that I'm missing?!


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## Steven Barrett (7 Oct 2015)

Hi Dan

What is his definition of low risk? How much could it fall before he gets the jitters? What other assets does he have? How long does this money have to last him? Too low a risk coupled with too high a draw down and there is a danger of the fund running out too early. 

There are at least 22 charging structures available in the market. He could probably get as high as an additional 5%/ 6% allocation but he'd be paying a higher management fee. Or you could go with a lower management fee and lower allocation. In the long run, the lower management fee is better value for money.  

Again, investment options are extremely broad. With platform providers, there are literally thousands of funds available in the market. 

If he's happy with .3%, he should be looking for cash i.e no risk at all. At those kind of returns, if he took out €40,000 a year, the fund would last him 26 years.

The absolute return funds are more expensive and they all do different things. Standard Life's one has got the most press and done very well. It is extremely complex though and uses a lot of different strategies to achieve it's returns. It came to the Irish market after the last crash. Haven't seen it in a market crash scenario yet. 

Your friend needs to know what he wants from his money. What does he want to spend it on? What is the cost of his life at present. Then he can work out what level of risk he needs to take to make sure he has enough money to do it. He can then assess whether the risk is within his comfort zone and whether he can afford to ride out the next crash. 

Steven
www.bluewaterfp.ie


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## Dan Murray (8 Oct 2015)

Thank you Steven for your response

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.

He is currently invested in Cash - and wants to move slightly up the risk curve and understands that as one moves up the curve, increased risk is involved.

So - our question is what options are available for someone in the early sixties targeting a 3% return (in an ARF).

My sense is that to achieve 3% on average, he is looking at:
(a) some combination of cash/bonds/equities
or
(b) an absolute return type product

The fact that there are "literally thousands of funds available" is accepted - nonetheless, won't a solution for a regular client be (a) or (b) above, or a combination of the two? I feel it would be way more helpful if we can move away from "the thousands of available funds" to the asset classes that are likely to deliver on his target return. Is this fair?

Put another way, what is the least risk (or optimal strategy) option to target a average annual return of c.3% p.a.?

Also, what do people recommend?! Like, there's a little bit of the.....on the one hand going on in the quote below! Are you broadly in favour or against?!



SBarrett said:


> The absolute return funds are more expensive and they all do different things. Standard Life's one has got the most press and done very well. It is extremely complex though and uses a lot of different strategies to achieve it's returns. It came to the Irish market after the last crash. Haven't seen it in a market crash scenario yet.



For the avoidance of doubt, he is not "happy" with any risk. But he is even less happy with practically zero return. So what is the least risk way of targeting a realistic 3% return. If the answer to this involves too much risk to capital, he may have to dial back down the risk curve and satisfy himself with a 1.5%/2% return.

Thanks for any input.


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## elacsaplau (10 Oct 2015)

Hi Dan

I'm broadly in agreement with your thinking. My tuppence worth is:

He could reasonably expect to achieve his target return of c. 3% over the long period by splitting his funds equally between cash, equities and absolute return funds. For equities, I would suggest passive global equities (ideally partially hedged) and for absolute return funds, he may want to divide his investment between 2 products in order to increase diversification.

He _may_ also want to euro cost average (I'm not sure if this is a real expression) but hopefully you know what I mean. It might be no harm for him to move to the suggested asset allocation over a period of time. The reason for this is that he may not be yet ready for the emotional rollercoaster that is equities.

Others may question the absence of bonds in the portfolio that I'm suggesting. Personally, I just can't get excited with bonds at current yields and would probably prefer some property exposure instead (say 10 to 15% of overall fund) - but only if your friend was not already over-exposed to property.

Finally, getting low charges is very important. Also, I'd be inclined to place the money with 2 or 3 institutions - so long as this does not cost too much in additional charges.


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## Jim2007 (10 Oct 2015)

Absolute return funds are hedge funds by another name and the are fastest growing product in asset management these days.  Which means that it is highly likely to be the big looser in the coming years.  Alternative strategies only work when they are executed by a few players and as this is no longer the case it is very likely that they will turn out to be very high risk vehicles.

A 3% return is a modest expectation and there is no reason to expect that it can be achieved using bog standard investing strategies.  A mix of blue chip dividend paying equities, bonds and perhaps about 5% properties should be able to achieve this.


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## Sarenco (10 Oct 2015)

I certainly agree with Jim that absolute return funds are hedge funds by another name and have no place in the portfolio of any retail investor, in my humble opinion.

However, I wouldn't necessarily agree that a real rate of return of 3% per annum, after fees and charges, is a particularly modest expectation from a balanced portfolio of stocks and bonds.

Obviously nobody knows what the future holds and forecasting returns on publicly traded securities is a fraught exercise.  What we do know is that stocks are riskier (more volatile) than bonds and bonds are riskier than cash.  Therefore, over the long term, the expected return on stocks is higher than the expected return on bonds and the expected return on bonds is higher than the expected return on cash - most of the time!

At current valuations, some of the more optimistic commentators are forecasting that the real (after inflation) return on large-cap developed market stocks, over a 30 year investment horizon, will be around 5% per annum and the real return on short term government bonds or cash will essentially be zero.  On the basis of these forecasted returns, an allocation of 60% to large cap developed market stocks (with the balance of the portfolio in cash) would be required to achieve a real return of 3% per annum _before_ fees and charges.  If fees and charges (including portfolio trading costs) amount to 1% per annum, the required allocation to developed market large cap stocks jumps to 75% to achieve the desired 3% real rate of return.

A portfolio with a 75% allocation to equities would obviously be volatile - the pattern of returns from one year to the next is likely to be as smooth as sandpaper.  A reasonable compromise might be to hold 50% of the ARF in a global equity fund and 50% in an intermediate term euro government bond fund and to simply accept whatever returns the market provides.

Ultimately, every investor has to balance his need or desire for return with his tolerance for the risk required to achieve that return.  This is very much an individual decision that must be made with regard for an investor's overall financial circumstances.  Investing is all about trading off risk and reward - there is no way around this simple fact.


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## Dan Murray (11 Oct 2015)

Hi All

Firstly, thank you all very much for taking the time to comment. It is very much appreciated. I've been mulling the question over and my own, somewhat random, thoughts at this stage are:

1. There seems to be some form of Chinese whispers in relation to the return I am trying to target! Steven picked up 0.3% p.a. and Sarenco picked up 3% p.a. net of inflation! For the avoidance of doubt, I am trying to target a 3% annual return - net of fees!! - and promise to try to be more clear in my writing style _as seo amach!_

2. It strikes me, yet again, how dysfunctional/idiotic the regulations to do with pensions are in Ireland. Steven mentioned a drawdown of €40k p.a. - but of course, the regulations effectively _demand_ that one draws-down €50k - giving us the wonderful contradictory position of requiring folk to have an AMRF so that they don't run out of money and forcing such same folk to withdraw at rates which mean that they could run out of money. Or - to take on inappropriate/uncomfortable levels of risk. Holy, holy....

3. I think this is a really important debate and likely to be of huge importance to many people so if it's ok, I'd like to tease out a little further please....

(a) Elacsaplau does not like bonds at current prices whereas Sarenco feels a "reasonable compromise might be to hold 50%....in an intermediate term euro government bond fund".

We know the yield on Euro bonds, say of 10 years duration, is just over 0.6% p.a. gross - so net of fund charges, there is very little return expectation if yields remain at current levels. There is also the very real prospect of investment losses, if yields were to tick up. So, personally, I'm more of Elacsaplau's viewpoint - but I'd really like to understand Sarenco's justifications better please!

(b) Absolute return funds

I know that absolute return funds are hedge funds. So what? Hedge funds are not all homogeneous and do not have to mean BAD or HIGH RISK - indeed, the original meaning of financial hedging was all about controlling risk.

I want to understand why the risk adjusted return expectation of, say, a GARS fund is worse than putting €500k into an intermediate term euro bond fund. I really want to understand your arguments - you may very well be right and save my friend, myself and others money! However, Jim's point about hedge funds (which encompasses such a broad spectrum) being the fasting growing product....."which means it is highly likely to be the big loser in coming years"......may be true but not necessarily so; and Sarenco has not given any reason why he is so against a GARS type product.

Please take the above points in the spirit of getting to a better understanding. Three years ago, there was a long thread on this site - in large measure, effectively rubbishing the merits of GARS. The logic of those contributors may have been right - I don't fully understand the technical points and many of the explanatory links are now defunct - nonetheless GARS has continued to deliver in line with its benchmark since then. Accordingly, I need convincing as to why GARS is a less attractive "bet" than mid-term European bonds - for at least part of someone's portfolio. You will be doing me and others a big favour if you can explain why it is as inappropriate as you believe. It would be great if Steven could give the practitioner's view on this question also.

Thanks again for all your contributions, insights and time...


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## Jim2007 (11 Oct 2015)

Dan Murray said:


> However, Jim's point about hedge funds (which encompasses such a broad spectrum) being the fasting growing product....."which means it is highly likely to be the big loser in coming years"......may be true but not necessarily so;



So what are the factors you believe would not make it so?  As I have already pointed out hedge fund strategies only work if there are a small number of players and this would appear to no longer be the case which means that sooner rather than later they will become the market as Long-Term Capital Management did in the past.  And once that happens there is only going to be one outcome.  Almost all hedge funds are successful in the short term so the fact that GARS has done well over the past few years is meaningless in long term.

As for the bonds question, you are not buying bonds now for their current yields but as a counter balance to the equites risk, which GARS is not.


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## Sarenco (11 Oct 2015)

Duplicate post.


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## Sarenco (11 Oct 2015)

Hi Dan

Happy to debate these issues, which will hopefully be of interest to others.

1.  You are quite correct that I assumed you were trying to target a real rate of return of 3% because, frankly, the nominal rate of return is meaningless.  Would you still be happy with a 3% rate of return if the annual inflation rate was 6%?

2.  From 1 January 2015 the yearly drawdown requirement was reduced from 5% to 4% for those aged under 71 with a fund of less than €2 million.  The pension framework of most countries incorporates a minimum drawdown requirement in order to avoid a situation where funds are locked up indefinitely in a tax free environment.  There is no requirement to actually spend any amount drawn down.

3.  The main reason I don't think hedge funds should be included in the portfolio of any retail investor is because the long term performance of individual hedge funds has often been horrific.  Less than 25% of hedge funds established in 1996 were still in existence 8 years later.  Long Term Capital Management (a giant hedge fund) managed to lose over 90% of its investors' capital - what makes you so confident that GARS will not be the next LTCM?  Hope is not a good investment strategy.

Also the available historic data simply does not show that hedge funds have, on average, meaningfully outperformed a traditional portfolio of stocks and bonds, notwithstanding the more complex risk exposure inherent in hedge fund strategies.

As Jim says, the primary role of fixed-income investments in a portfolio is to dilute the risks associated with holding equities.  If you are concerned about rising yields, then by all means stick with cash or short term government bonds but you have to accept that you are then taking a view that the deepest, most liquid market in the world is misprising longer term bonds.


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## Dan Murray (11 Oct 2015)

Thanks Jim and Sarenco

I find your comments very interesting - although _at this stage!!_, regarding the substantive investment question, I only accept some but not all of your points......will explain later.......need now to get myself to a high stool for the evening!

In the meantime, sincere apologies to all re the mix-up regarding the 5% draw-down requirement. I'm actually very happy that I was wrong!


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## Dan Murray (12 Oct 2015)

Hi Sarenco

I feel a bit like Thomas, the doubting apostle here

The hedge fund Jim mentioned and you again referenced seems to me to have been a high risk hedge fund. The type of hedge fund that I am talking about are low risk hedge funds - i.e. GARS is classified as risk rating of 3 on the ESMA profile. If, for example, you examine the chart in the link provided by Jim, the targeted return from GARS is closer to the yellow line - and is very far removed from the blue line with which it is being compared. My essential blockage is that Jim and yourself have not sufficiently differentiated between the pool of hedge funds. It seems to me that evaluating the risk characteristics of a hedge fund at one end of the risk scale by the outcome of a hedge fund at the other end of the scale is not appropriate.



Sarenco said:


> Also the available historic data simply does not show that hedge funds have, on average, meaningfully outperformed a traditional portfolio of stocks and bonds, notwithstanding the more complex risk exposure inherent in hedge fund strategies.



So, here's my questions....(a) do you accept that hedge funds do not all share the same risk profile? and (b) what studies can you point to that evaluate the performance of hedge funds at the lower range of the risk scale?

Thanks for your time _and patience!_


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## Sarenco (12 Oct 2015)

Well, I certainly wouldn't regard a target return of LIBOR + 5% as being at the lower range of any risk scale, whatever the fund's marketing material might suggest.  There are any number of absolute return funds with a target return of LIBOR + 4% or lower (although I take the point that hedge funds are certainly not homogenous).

Here's a link to a fairly recent academic paper that contains a pretty comprehensive review of the available data on hedge fund performance.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2637007


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## Jim2007 (12 Oct 2015)

Dan Murray said:


> The hedge fund Jim mentioned and you again referenced seems to me to have been a high risk hedge fund.



I gave the reference to LTCM because I have a history with it.  I was in the room on more that one occasion where Meriwether and Scholes were peddling it and it certain was not seen as a high risk fund, it was sold as a sure thing and was bought on the same basis by some very sophisticated investment teams.  There is no such thing as a low risk hedge fund because by definition it's level of risk is dependent on the number of players running the same strategy, the more players, the higher the risk that you become the market or that other hedge funds being to bounce of you.


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## Dan Murray (12 Oct 2015)

Thanks Sarenco and Jim

I understand that the absolute funds in Ireland have risk control measures in place to protect against the calamitous outcomes you both seem to predict. Are you familiar with these measures and if so, why do you think they are ineffective?


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## Sarenco (12 Oct 2015)

Hi Dan

Maybe look at it this way, the GARS fund aims to provide equity-like returns while maintaining the volatility of cash.  Frankly, that's the holy grail of investing.

Does that sound achievable to you on a long term basis?  Do you understand the strategies being employed to achieve this wonderful result?  Do you really understand the manager's risk mitigation techniques?  Do you understand the how these strategies relate to your total portfolio?

No?

Well, that comes back to my opinion that hedge funds have no place in the portfolio of any retail investor.  If you don't understand something, then don't invest in it.

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.

And all the risk management techniques in the world don't stop hedge funds blowing up on a regular basis.  We are talking about retirement savings here - this is not an area where you want to take a punt.

For what it's worth, I actually don't take an ideological position on hedge funds.  I am of the view that the hedge funds can actually have a role in an institutional portfolio with an indefinite investment horizon.  I simply don't believe that they have any role in any retail investor's portfolio.

If you are still unconvinced, then I would suggest that you limit your investment in the GARS fund to, perhaps, 5% of your total portfolio.  Of course, this brings you right back to your original question - how to achieve your desired return without taking undue risk?

Nobody said this was going to be easy!


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## Jim2007 (12 Oct 2015)

Start by understanding why LTCM got into trouble - it became the market! It does not matter what risk control measures you put in place once you become the market they are about as useful as a chocolate teapot - the risk comes from outside.  Once you have a large number of players using the same strategy you can no longer unravel a derivative, liquidate a position or whatever because everyone else is trying to do the same.  Even worse is when other players running different strategies realise you are toast and begin to hammer you to make their return.  The more new funds are added the more likely such a situation can occur.

The bottom line is that you do not need this kind of risk to get the returns you need.  Stick to the basics over the long term and you will do fine.  If you set yourself the task of picking up say 15 large cap high yield stocks over the next 18 months, you are likely to do fine because you are likely to be buying undervalued stocks and so in addition to a solid dividend you should get a nice capital bounce as well.


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## Dan Murray (12 Oct 2015)

Thanks Sarenco and Jim

I have no doubt that you believe strongly in what you are saying - and thanks for your time and patience with me on this. Rather than me commenting further now - I think I need to reflect now on all you have said.

Whilst I do my ruminations, it would be great if others in the AAM community could share their views. If your views are correct, there must be very many people taking horrendous risks, probably without knowing, with their retirement savings.


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## Steven Barrett (13 Oct 2015)

Hi Dan

I've a lot on at the moment and haven't had a chance to reply in detail. I'll try to get around to it this week. 

Steven
www.bluewaterfp.ie


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## jpd (13 Oct 2015)

I have no doubt that some hedge funds will meet and beat your target of 3% but it would be next to impossible to say which one. So Sarenco's  & Jim's comments are very pertinent and accurate.

Your original post said your friend was looking for a low/lowish risk investment with 3% return net - imho, this is not possible in today's market (I assume your friend considers shares and equivalent funds as a medium/high risk)


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## North Star (13 Oct 2015)

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;


 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


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## Dan Murray (14 Oct 2015)

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.


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## Dan Murray (14 Oct 2015)

Sarenco said:


> 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.


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## elacsaplau (17 Oct 2015)

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.]


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## Steven Barrett (20 Oct 2015)

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 (i*ncluding 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


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## Dan Murray (20 Oct 2015)

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?


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## Steven Barrett (20 Oct 2015)

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 Year - 4.70%
3 years - 4.63%
5 years - 4.39%
10 years - 4.56%
Of course, past performance is no indication of future performance. 


Steven
www.bluewaterfp.ie


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## Dan Murray (20 Oct 2015)

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."?


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## mercman (20 Oct 2015)

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.


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## Marc (20 Oct 2015)

.


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## Marc (21 Oct 2015)

Dan

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


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## Dan Murray (21 Oct 2015)

Hi Marc

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

So desired return is 3% net of fees nominal.


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## Marc (21 Oct 2015)

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.


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## Dan Murray (21 Oct 2015)

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?


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## Dan Murray (21 Oct 2015)

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.


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## Sarenco (21 Oct 2015)

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?


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## Dan Murray (21 Oct 2015)

Hey Sarenco and thanks....

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


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## Sarenco (21 Oct 2015)

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.


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## Marc (21 Oct 2015)

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.


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## Dan Murray (22 Oct 2015)

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.



Dan Murray said:


> 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?!


Dan Murray said:


> 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?


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## North Star (22 Oct 2015)

Hi Dan, 

Do I take it that you didnt find our asset allocation strategy convincing? 

Though being serious, the fixed income/bond challenge is going to be very difficult for us all to navigate through at some point in the near future, and especially so for the more cautious investor who may not realise that bond investments especially long duration ones can go significantly under water, before gradually gliding back to par at effective maturity.


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## Dan Murray (22 Oct 2015)

Sincere apologies Vincent - my last post was inexcusably sloppy - worst thing is that I kind of knew it but I was trying to multi-task!!

I am genuinely impressed by and grateful for your post. What I was trying to get across in my last post is that whilst both of us believe, to an extent, that there is some place for absolute return strategies; others in this debate do not share this view for various reasons. That's all I meant by "convincing" (....it was linked - in my mind - to the reference of "dividing the jury"). I started off wanting to believe in absolute strategies but Sarenco, in particular, made some points that didn't suit my argument which I am struggling to discount! Also, I am having a hard time understanding the nature of the risk involved in absolute return funds and if I can't understand it, I can't honestly evaluate it. AAAaaaggghhh!!!!



North Star said:


> Though being serious, the fixed income/bond challenge is going to be very difficult for us all to navigate through at some point in the near future, and especially so for the more cautious investor who may not realise that bond investments especially long duration ones can go significantly under water, before gradually gliding back to par at effective maturity.



Now - that's CONVINCING.........nobody can argue with that


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## Marc (22 Oct 2015)

Dan,

I would have to sack myself as a Financial Planner if I was to agree that I thought you are asking the right question here. Hence all my observations around this being more complex than the question you are asking.

However, as I'm giving a lecture on this tonight at DBS let me put on my asset management hat for moment.

Here is a graphic from Asset Management Company Vanguard which I think gets to the crux of your question.




This is simply saying that the average return of a portfolio between 2000 and 2012 has been lower than the average return between 1926 and 2012. In other words investors should prepare themselves for lower returns in the future than they have received in the past. I think it is helpful to put some real evidence in to support statements that are fundamental to the debate.

The real question is surely this: "well, how much lower and how do we estimated it?"

So, again I produced a guide which I have already referenced called "realistic expectations" and in this I turned the question on its head and asked these questions:

Do I know what the average return from "cash" (I'm using the German 3 Month Money market rate as a proxy for the risk free rate) has been over some long time horizon? - answer yes
Do I know what the equity risk premium has averaged? - answer yes
Do I know what cash is paying today? - answer yes

So, if I am willing to assume that the equity risk premium will stay reasonably constant over time (happy to debate this), then all I need to do is assume a lower risk free rate going forward and solve for the portfolio that matches my expected return given a lower risk free rate.

Now in reality these assumptions are fed into the Black Litterman model to generate the actual asset allocation, but in order to simplify the problem a lot, let's work with historical data to calculate the realized excess return of a given portfolio and simply work out what part of that can be considered risk premium and what part is risk free rate and we are in business.


*Assumptions:*
We are willing to use some proxy for the Euro prior to 1999. I am using the German Mark in order to extend my analysis back to 1970.
We know our costs from my earlier post are around 1.25%. (Happy to debate paying extra in fund management fees in order to buy Ferraris for fund managers. )
Your target is 3% nominal (I see no reference to inflation in your question - another huge concern)

So your target gross nominal return needs to be 4.25%pa and gross real needs to be 6.25% assuming ECB inflation target of 2%pa.

The following table takes a range of portfolios from 80% Bonds/20% Equities to 98% Equities for the period 1970 to 2014


*Source*: Dimensional Fund Advisers

How to read the chart
1) Ignore everything except the first column
2) First Column has the Euro short term rate at the top. This is the return you would have earned from "cash" between 1970 and 2014. Over this period the return was 5.18%pa (source Deutsche Bundesbank) So, this is the "risk free rate" you could have had this for "free". Note that over this period inflation averaged 2.73%pa
3) What we are interested in is this. Cash isn't paying 5% today - more like zero. So, if I start with a lower interest rate, what should I expect from an investment portfolio.
4) The number shown in bold in the table is the risk premium for the portfolio above this "base" number. So top left hand corner, the number is 1.889.
That means that the conservative portfolio (80/20) averaged 1.889% above the Euro Short term rate of 5.18%pa over the period.
Note that the period include high inflation in the 70s, poor market returns, good market returns and both falling and rising interest rates.
5) The second number (T Stat) is 2.137 this is a measure of statistical significance and measure how confident we should be in the average premium (it was developed in Dublin incidentally) the test looks at the mean, the standard deviation of the mean and the number of observations. A T stat of 2 or more is generally taken to be statistically significant.

The table gives me the actual risk premium of each portfolio between 1970 and 2014 above the German Short Term Money Market Rate and my base currency is DMY/Euro. Note for the avoidance of doubt these are my research portfolios and not the off-the-shelf DFA portfolios referenced by Stephen earlier.

For forward planning purposes, if we assume a Euro short term rate of say 1% over the medium term then our Expected portfolio return is the Euro short term rate plus the average premium. So, putting it all together:

For a nominal target of 4.25%pa we need around 45%- 50% in Equities
For a real (inflation protected) return of 6.25%pa we need around 80% in equities.

Note that we also have T Statistics of more than 2 for each portfolio so we can be 95% confident that this is the real risk premium for the portfolio and not just background noise.

*Caveats*

Each portfolio is more complex than a simple MSCI or FTSE All World  Equity portfolio and a much lower equity risk premium would be obtained running the same analysis using just a developed equity index. In other words, some of the heavy lifting is being done here by taking more equity risk and less fixed interest risk. Overall this gives the portfolios a better sharpe ratio and better downside protection.


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## Marc (22 Oct 2015)

Just to address the point on absolute return

Standard Life GARs has exactly the same risk characteristics as the 40% risk portfolio before costs and lower realised returns since Sept 2008 net of costs.


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## Dan Murray (22 Oct 2015)

Thanks Marc

I appreciate you are spending a lot of time on this. Frankly, I don't understand either chart. My strong belief is that if I don't understand it, others will similarly be left 

For example, if we take the first one



Marc said:


> View attachment 930



What's your point? Is it that, in the long run, equities beat bonds but that the performance is less predictable over shorter timescales? If so, this is not news - and it doesn't advance the debate; if I have misunderstood, please advise....

The second chart - I simply don't understand the layout. It would be helpful to explain what precisely 1.889 on the first row and 3.761 & 1.321 on the 4th row mean. From this, presumably, I'll be able to work out the purpose of the chart.


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## Marc (22 Oct 2015)

This reminds me of the Hitchhikers  Guide to the Galaxy by Douglas Adams

"What is the answer to the ultimate question of life the universe and everything"
"42"
"42?"
"Maybe you didn't understand the question"

Let me go back over my post and add some notes


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## Dan Murray (22 Oct 2015)

_This is simply saying that the average return of a portfolio between 2000 and 2012 has been lower than the average return between 1926 and 2012. In other words investors should prepare themselves for lower returns in the future than they have received in the past. I think it is helpful to put some real evidence in to support statements that are fundamental to the debate_

Thanks for the clarification but in fairness Marc, my very strong sense is that every single poster to this thread is aware of this - and some have already said this explicitly. It's actually the genesis of the thread. Also, I have a strong aversion to over reliance of charting over randomly selected periods - i.e. the take-away from such charts would be different if you took a 5, 10, 20 and 30 year view to 2012. I take it you are ok with candid feedback.......not quite sure how to interpret your Hitchhikers reference?!




Marc said:


> How to read the chart
> 
> 1) Ignore everything except the first column
> 
> ...




Thanks for the explanation. Still unsure what exactly you are saying so before commenting, can you clarify please?


1. Are you saying that based on historic returns between 1970 and 2014, a fund made up of 80% bonds / 20% equities would have beaten cash by 1.889% and that an all equity fund would have beaten cash by 8.446%?

2. What equity and bond benchmarks are you using?

3. How are you using past performance to project future returns - are you saying that future performance will broadly replicate past (chosen) performance figures as seems to be implied by this?



Marc said:


> For forward planning purposes, if we assume a Euro short term rate of say 1% over the medium term then our Expected portfolio return is the Euro short term rate plus the average premium. So, putting it all together: For a nominal target of 4.25%pa we need around 45%- 50% in Equities. For a real (inflation protected) return of 6.25%pa we need around 80% in equities.


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## cremeegg (22 Oct 2015)

I can't help thinking that I am not alone in suggesting that the Emperor has no clothes.

Can I ask two questions.

Why should the equity risk premium between 1970 and 2014 tell us anything about the equity risk premium for 2016 onward.



Marc said:


> This is simply saying that the average return of a portfolio between 2000 and 2012 has been lower than the average return between 1926 and 2012. In other words investors should prepare themselves for lower returns in the future than they have received in the past. I think it is helpful to put some real evidence in to support statements that are fundamental to the debate.



Why is the second sentence in the above any more true than if it said. "In other words investors can expect higher returns in future because of mean reversion."


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## Marc (22 Oct 2015)

Dan,

I always work on the principle that Askaboutmoney posts are read by more than one person. This thread has now had over 1730 views!!

However, some people answer questions as if the only person on the thread is the original poster. I think that's dangerous as some people may infer that what is maybe right for one person may also be right for them.

Another one of my gripes is people posting "facts" without supporting evidence. If its a fact then provide the evidence.

I'm not disagreeing with you that many of the posters understand this debate. My concern is that many of the readers may not. I often get comments from people who read askaboutmoney and many of them point to the fact that many of the arguments are due to the failure to establish the difference between a fact and an opinion.

So, I included the data from Vanguard because it supports the main thrust of the argument. But it doesn't answer the question which is my second point. I also accept your point on data mining which is why my tests are both out-of-sample and over a longer period.

The reference to Douglas Adams is simply with reference to my point that I believe the thread is really asking the "wrong" question but I admire your tenacity to get an answer so happy to indulge.


To address your points


1. Are you saying that based on historic returns between 1970 and 2014, a fund made up of 80% bonds / 20% equities would have beaten cash by 1.889% and that an all equity fund would have beaten cash by 8.446%?

Yes, that's exactly what I'm saying. The average return of any portfolio is made up of the risk free rate plus the risk premium. I'm just isolating the part of the return that is made up of the risk premium, then taking a lower starting rate for cash and estimating the expected portfolio return going forward. I think this is exactly the question you are really asking.


2. What equity and bond benchmarks are you using?

These are our proprietary research portfolios. But they are comprised of robust index data. In other words the source of returns is simply market risk there is no requirement for repeatable fund manager skill to deliver these returns. This point is in the Caveat

3. How are you using past performance to project future returns - are you saying that future performance will broadly replicate past (chosen) performance figures as seems to be implied by this?

Yes, sort of. I am saying that the premium for taking equity risk should be fairly constant over time (not that the performance of a portfolio should be the same as in the past). They are different points. Again this is this point in my earlier post:

_"So, if I am willing to assume that the equity risk premium will stay reasonably constant over time (happy to debate this), then all I need to do is assume a lower risk free rate going forward and solve for the portfolio that matches my expected return given a lower risk free rate._"


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## Marc (22 Oct 2015)

Cremeegg,

1)Because it is consistent with the Barclays Equity Study from around 1900

If I came down from Mars and looked at the equity risk premium between say 2000 and 2008 I would probably conclude that people who invest in equities like to lose their money. Whereas in reality equities have a positive expected return so we need to be able to estimate how much more we should expect for taking on the risk

2) Because the issue at hand is not equity risk its low returns from defensive assets. In a conservative portfolio the dominant holding is cash and fixed interest. Therefore even if equities mean revert (my first point - what is a realistic equity risk premium) if you hold too little in equities you won't obtain the return you expect because the return on most of your money (the defensive part) is likely to be dire.


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## Dan Murray (22 Oct 2015)

Marc

I find your writing/communication style difficult to follow but I think what you are saying is that:
- you have in mind a bond portfolio and an equity portfolio that you believe can produce returns in excess of Cash
- you have defined Cash as German 3 month paper
- you have simulated the returns for your chosen equity and bond funds from 1970 - 2014 and have shown the composite return over Cash
- you believe that the proportion of equities and bonds will determine the composite premium over Cash
- you believe that the premium attained previously (i.e. 1970 to 1974) will broadly be replicated in the future and that this forms the basis in setting the equity / bond mix to achieve a given level of future return
- you are not prepared to state the asset make-up of your funds
- you believe that your equity fund has the same risk profile as say the MSCI but will produce greater returns

It would really be great if you could confirm each of the above as succinctly as possible please.

Also, at a point of detail, when you say that a 98% equity fund has an annual average return of 8.446% over Cash (where Cash = 5.18%)......do you mean this equity fund returned (a) (1.0518 + 0.08446)^45 or (b) (1.0518 * 1.08446)^45 ?

The above was just to confirm my understanding of what you are saying. Once I have this information, I will be better placed to comment on your posts.


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## Marc (22 Oct 2015)

Dan,

Apologies for your frustration but at this point most posters on askaboutmoney have already phoned me and called in for an appointment and are well on their way to getting sorted out.


you have in mind a bond portfolio and an equity portfolio (and real estate and cash) that you believe can produce returns in excess of Cash.

The evidence that these asset mixes have delivered an excess return since 1926 in the USA since 1955 in the UK and since 1970 globally is reasonably compelling, so yes I'm happy to say that i believe a portfolio of risk assets has an expected return greater than cash. However, I would also note that I need around 60 years of data to demonstrate with 95% confidence that I expect real assets to deliver a higher return than cash due to the inherent volatility of risk assets.

- you have defined Cash as German 3 month paper
I could use Libor or Euribor but we know that this data has been subject to price fixing. I also have a constraint that the Euro did not exist prior to 1999. So I'm not sure what other currency other than the German Mark we should use as a proxy for the Euro prior to 1999?

- you have simulated the returns for your chosen equity and bond funds from 1970 - 2014 and have shown the composite return over Cash

No, I have used commercial and research data for the various asset classes in a portfolio in order to estimate the expected risk premium over cash.

- you believe that the proportion of equities and bonds will determine the composite premium over Cash

No, I am trying to establish the realised return for different historic asset allocations over cash in order to be able to provide a rough estimate of the expected return for various asset allocations in the future. Remember that these estimated risk premiums also come with high levels of statistical confidence. I don't "believe", but rather the evidence strongly suggests.

- you believe that the premium attained previously (i.e. 1970 to 2014) will broadly be replicated in the future and that this forms the basis in setting the equity / bond mix to achieve a given level of future return

No, I said I was happy to debate this assumption. This was a necessary simplifying assumption in order to present the data in order to answer your question. As previously noted, in practice we actually use the Black-Litterman model to derive the actual asset allocation.

- you are not prepared to state the asset make-up of your funds

I didn't say that. The issue is (repeated elsewhere on askaboutmoney)  that we individually customise each portfolio to the particular needs of each client rather than shoehorning them into a limited range of static models. I therefore can't answer that question as I don't know the inputs.

- you believe that your equity fund has the same risk profile as say the MSCI but will produce greater returns

No, I categorically didn't say that. I said that the equity strategy is taking *more* risk than the MSCI which is why it has a higher expected return


Also, at a point of detail, when you say that a 98% equity fund has an annual average return of 8.446% over Cash (where Cash = 5.18%)......do you mean this equity fund returned (a) (1.0518 + 0.08446)^45 or (b) (1.0518 * 1.08446)^45 ?

The table is the realised risk premium over cash
So the total return from the equity strategy was cash 5.18% plus risk premium 8.446 = 13.626%pa

Just to give this last point some context for example
The average annual premium of Emerging Markets over Developed Markets since 1988 has been just over 5.5%pa


Hope that helps


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## Dan Murray (23 Oct 2015)

Marc

One additional question - the returns on the table provided are not consistent over the various portfolio ranges.

For example, if you take the equity return quoted above of 13.626% and use it in the 80% bond/20% equity portfolio, it gives a bond return of 5.371%.

And when we average these 2 returns, we get 9.4985 or a premium of 4.318. This compares with the stated premium for a 50/50 split of 3.761


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## Marc (23 Oct 2015)

Dan

That's right the composition of the portfolios varies as you move up and down the curve consistent with investor preferences in general.

This reflects the fact that we are working in one dimension here when in fact the asset allocation decision process is multi dimensional.

So if I start at the conservative end of the spectrum clients are generally more concerned with capital preservation so I will tend to underweight say emerging markets to reduce downside risk.

However, the conservative portfolio also has lots of fixed interest so there is a substantial duration (interest rate) and inflation risk. So I will tend to overweight inflation linked bonds and hold shorter duration bonds.

Higher up the curves the equity allocations will dominate the risk characteristics of the portfolio and these will naturally tend to be selected by investors with higher risk tolerances. So I can include more Emerging Markets Etc

But I stress these are research portfolios not live investor portfolios.

In reality I might have a client say, look id like 40% equity exposure but I want to dial up the equity risk and at the same time take less fixed interest risk.

Each portfolio is individually customised.


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## Dan Murray (23 Oct 2015)

Marc said:


> I didn't say that. The issue is (repeated elsewhere on askaboutmoney)  that we individually customise each portfolio to the particular needs of each client rather than shoehorning them into a limited range of static models. I therefore can't answer that question as I don't know the inputs.



Marc,

As I stated, I had understood that you were not prepared to share the asset make-up of your "funds". I tentatively take it this is not the case - as per the above - although, frankly, it's very hard to decipher what you actually mean. At least, your reply to this post will clarify things, either way, for once and for all. I take it also that you have come to some form of acceptance that this is an investment thread - not a financial advice thread. Accordingly, you can make whatever assumptions you feel you need - (the wording is intentional as other contributors, professional advisers and others, were happy to contribute to the investment question on its own merits) - to enable you establish your recommended investment strategy for someone seeking to obtain a nominal net average annual return of 3% over the next 5 years. Remember the client's dual objectives are to attain this return with the least risk possible. I'm happy for you to include whatever warnings you feel necessary.

It will be informative to see what client variables you assume. If you want to choose 2 scenarios with 2 different suggested allocations, that would be great. The absolute key point is the client's investment goals. My belief is that the rest is just noise for current purposes - happy to acknowledge you have a different point of view. Also, please use current money market rates.


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## Marc (23 Oct 2015)

Dan,

I'm sure you are finding this process extremely frustrating. I have tried to engage you in a discussion about why you want this answer in order to establish if this is really the right question to ask. However, you are clear that you want the answer to *this specific question* rather than a discussion about your assumptions such as

why a 5 year term?
why 3%?
why not annuitise part of it as a proxy for cash and fixed interest?


Equally, I believe I have already answered your question with my analysis of Stephen's defensive portfolio which I agree with you is unsuitable to achieve the objective set.

I then set out an analysis of likely fees for managing an ARF - you have not commented on this analysis so I assume you are willing to accept the fee calculation as set out.

I then set out the required portfolio to meet the nominal target return of 3% net of fees i.e 4.25% Gross

I answered this here:
"For a nominal target of 4.25%pa we need around *45%- 50% in Equities*" and provided statistical analysis to back up my statement.

I also highlighted the fact that you are ignoring inflation and that
For a real (inflation protected) return of 6.25%pa we need around 80% in equities.

I would also point out that my analysis is entirely consistent with Sarenco's post



Sarenco said:


> I certainly agree with Jim that absolute return funds are hedge funds by another name and have no place in the portfolio of any retail investor, in my humble opinion.
> 
> However, I wouldn't necessarily agree that a real rate of return of 3% per annum, after fees and charges, is a particularly modest expectation from a balanced portfolio of stocks and bonds.
> 
> ...



In fact, Sarenco also agrees that asset allocation decisions cannot be made in a vacuum and that this is "a decision that must be made with regard for an investor's overall financial circumstances"

However, you are still looking for a more detailed answer

As previously noted I have virtually no information on either willingness or capacity for risk so the following cannot be considered advice and should not be relied upon for making personal decisions. The following analysis is for educational and information purposes only.

In order to generate an asset allocation I need to make certain assumptions:

Inputs
Style? You seem to have a preference to absolute return so I will select an active/passive style
Asset class restrictions? We know nothing about the client's preferences eg existing property portfolio so let's select unconstrained
Portfolio bias? We have no information on preferences so let's tilt 50% towards active management
Investment term? We do know this is 5 years but not why. Maybe the client intends to buy an annuity in 5 years

So now I need to set my expected return to 4.25% assuming 1.25% fees to bring me to my target of 3%
That results in portfolio 54 on this solution curve
Expected return 4.25%pa

Hope that helps.


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## cremeegg (23 Oct 2015)

I firmly believe that the future is unknowable, and the guy who can tell you what stock will out perform is a charlatan.

Marc,

You are suggesting that through a series of backtested asset allocations you can provide given levels of return at lower risk. I am sorry but snake oil is snake oil no matter how impressive the charts used to sell it.

I asked a simple question which addresses a fundamental aspect of your approach and you were completely unable to answer it.

My question was

Why should the equity risk premium between 1970 and 2014 tell us anything about the equity risk premium for 2016 onward.

to which you replied



Marc said:


> Cremeegg,
> 1)Because it is consistent with the Barclays Equity Study from around 1900



I'm sorry but the Barclays Equity study indicates that the real long term return for equities is consistently in the region of 6%. This *DESPITE *the significant change in equity risk premium that occurred in the 1950s.

Far for answering my simple question you are showing that you do not understand the basics of the sources you are relying on.


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## Marc (23 Oct 2015)

Cremeegg,

For the avoidance of doubt

Of course the future is unknowable. I'm not saying I can predict the future, but for planning purposes you need to make an assumption. But you are right, the one thing you do know for certain is that your assumptions will almost certainly be wrong with the benefit of hindsight.

I'm not saying I can identify which particular stock will outperform. I'm saying there is some strong empirical evidence that certain assets classes have higher expected returns. For example Emerging Markets are considered more risky than developed markets and have a higher expected return as compensation for higher risk. Do you disagree with this assumption?

I'm not saying I can provide given levels of return at lower risk at all. I'm saying that each allocation has an expected risk return characteristics. Just because the return is expected doesn't mean it is guaranteed. That is the nature of investment risk.

I did answer your simple question with a simple answer. Stocks have a positive expected return and a higher expected return than less risky assets. Of course we don't know for certain what the realised equity risk premium is going to be over any period. But again, we have to make some assumptions for planning purposes.

The observed risk premium for the Equity Portfolio was over 8% from 1970 to 2014. For planning purposes I am assuming a more conservative premium than this. Which is consistent with the long run average premium. What exactly is wrong with that approach?

You are perfectly free to hold whatever views you wish on that matter.


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## Dan Murray (23 Oct 2015)

Marc,

That's an excellent post. I had to be assertive earlier because I had felt that we had been going around in circles. I am very happy that you have answered my question (yes, _uno_!_)_ very clearly and provided me with charts that didn't give my poor head a migraine! I understand your need to be similarly robust in the initial section of your reply - you know the DON'T TRY THIS AT HOME CHILDREN bits!! 

Regarding the substantive issue, very broadly, my sense is that your proposed asset allocation is along the following lines:

High return seeking assets: 10% of portfolio with a target nominal return of 8% p.a.
Other return seeking assets: 43.2% of portfolio with a target nominal return of 6.5% p.a.
Defensive assets: 46.8% of portfolio with a target nominal return of 1.37% p.a.

I'll await your corrections/clarifications regarding this. I have overstated the total of the defensive assets by 0.1.% (compared with the pie chart) - presumably a rounding thing.

I will now reflect on what all this means. For the record, I am not saying that I agree with you - I just now clearly understand what you are saying! In the meantime, I just want to be sure we are being fair to Steven. We had used a much lower return on his Bond fund than is being assumed in your bond portfolio (if my sums are broadly accurate) and I don't have sufficient visibility of the fund suggested by Steven to consider if this differential is reasonable.


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## Marc (23 Oct 2015)

Thanks Dan,

Just a quick observation on your last sentence. I have worked with Dimensional for the last 10 years so I know exactly how their bond funds work.

I took the current Yield to Maturity of the Bond funds from the Dimensional website as my assumed return. The bonds are short 1-5, ultra short 1-2 or intermediate term inflation linkers so I'm happy that the assumptions I made are very reasonable.

The asset allocation of Stephen's portfolio is average AA+ and short duration whereas the comparison portfolio has more investment grade therefore (all things being equal) the assumed return will be higher.


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## Dan Murray (25 Oct 2015)

Hi Marc

I've been reflecting on your posts. I will share my own views when they are a little more evolved but in the meantime, I'd really appreciate some more clarifications please.

1. Are my calculations from Friday accurate or in need of correction?

2. The charts from Friday no longer appear. Do you know why?

3. What assumptions are made regarding currency movements in your portfolio? Is hedging involved and at what cost?

4. If certain equity classes have higher expected returns than other equity classes, how is this higher risk taken into account in your modelling?

5. Similar question regarding bond investments - how is the added risk of higher yielding bonds taken into account?

6. Again regarding the modelling methodology used. Let's say:
- equities enjoy a stellar patch in 2015, 2016 and 2017 with returns in each of the three years of 15% p.a.;
- bonds returns and other variables do not change; and
- you were to update your model (at the start of 2018) so that it then examines the period 1970 to 2017

.......how would this impact on the model? Would it suggest that equities are more attractive than the model currently calculates?

I know it's the weekend - us pensioners never rest! - look forward to your clarifications when time permits.


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## Marc (25 Oct 2015)

Dan,

I'm happy to engage in this debate because I feel that you are covering an issue that I have had considerable concern about for some time now.

We know that many retirees in Ireland hold an ARF rather than an annuity and we know that the reasons for this are some combination of a desire on the part of retirees to "protect" the value of the pension and the incentive effects of commission payments on brokers (for the avoidance of doubt annuities pay less commission than an ARF). Note that you referenced fees vs commission in your original question.

We also know that many of the ARFs in Ireland hold a considerable amount on deposit (like your friend) in the belief that this a "conservative" strategy. As I have highlighted in this thread half of all retirees can be expected to live longer than the average and they may find out with the benefit of hindsight that such a strategy fails to preserve their income throughout their retirement. The reference I made to to "reckless conservatism"

As a point of reference the oldest known annuity payment in the world is an *American Civil War* pension that was being paid to a soldier who married a lady 50 years his junior and she is still alive today and continuing to receive the widow's pension - least anyone claims that an annuity is bad value! As an Actuary put it;"its an income for life, however long you live and if you die after 5 years, well it still did the job that it is *intended* to do"

So, the first observation I would make is that, all things being equal, the primary purpose of an ARF is to provide an income NOT  an Inheritance.

The reason for this preamble is because retirees clearly face a series of difficult choices with imperfect information and this is made worse because some advisers do not understand these issues fully (for full disclosure I teach advisers this subject) and they have the conflict of interest due to commissions. As Upton Sinclair said;"its difficult to get a man to understand something when his salary depends on his not understanding it"

My second observation is that, at the conservative end of the risk return continuum, a portfolio with less than 20% risk assets is currently unlikely to cover the additional costs of managing an investment portfolio. This is just simple addition, add up all the fees and they are more than the expected return. Implicit in this is that any additional investment return is being lost in investment costs yet the investor is still taking on some additional investment risk. This doesn't seem right to me.

Therefore, any adviser acting as the client's fiduciary should stress that there is probably very little additional expected benefit to the *client* of pursuing a very conservative investment strategy but there is additional risk to the client. Included in this would be insurance company "secure" or "cash/deposit" funds, With Profits funds, Structured Products (tracker bonds) and so on.

As I have already noted the primary objective of an ARF for most people should be to maintain the income and hence financial security of the pensioner and (if relevant) their spouse for the whole of the rest of their *combined* lives - however long they both might live. Under these conditions, longevity combined with inflation are in reality the biggest financial risks for ARF investors. Yet the focus of many ARF investors is on short-term volatility so there is a mismatch between the problem and the approach taken by many people.

Consider that Insurance Companies hedge their risks in both the Annuity and Life Assurance markets using Long-term bonds. Therefore both Annuities and Guaranteed Whole of Life Assurance can be thought of as an investment asset with predictable risk/return characteristics like an investment directly in a bond.

For illustration purposes only: consider a "balanced" retiree who invests half of their ARF in an Annuity with a guaranteed spouses pension and the other half in equities.

A 60 year old with a 60 year old spouse 10 year guarantee plus 100% spouses pension can currently obtain an annuity rate of 3.155%pa. Source Irish Life.

So, rather than put half of the ARF in cash and fixed interest with a very low expected return currently we could put half of the ARF into an annuity with a guaranteed return of 3.155%pa and have no longevity risk. We have swapped investment risk for default risk and we still have inflation risk.

Here is a calculation that I rarely see anyone make.

For an initial €100,000 annuity purchase what is my equivalent *future* interest rate at any point in time?
Annual pension is €3117.20pa
After 20 years I have received total payments of €62,344 so my remaining "fund" is €37,656 but my pension is still €3117.20pa so my "interest rate" is now 8.278%pa
After 30 years I have received total payments of €93,516 so my remaining "fund" is €6,484 but my pension is still €3117.2pa so my "interest rate" is now 48.07%pa

Compared to a deposit strategy this could look good value in the future if one or both spouses lives a long time, which in 50% of all cases is going to be true. You either live longer than average or you don't.

The inheritance aspect is protected to an extent by the 10 year guarantee (if both spouses die early the minimum value of the annuity to the estate is €31,172) plus the value of the other half of the ARF - €50,000 plus or minus market risk. By limiting the exposure of the ARF to 50% equities you still have a "balanced" portfolio, its just that the defensive part is now the annuity rather than cash and fixed interest.

For anyone who has less than say 40% to 50% exposure to risk assets, this sort of thinking might be a better option than a traditional cash, fixed interest and equity allocation.

Equally, if gives a sense of the "critical yield" that is to say the return the ARF *must* earn every year just in order to match the annuity income forgone.

What I hope I have shown is that for a 60 year old today, that number is very close to the 4.25% with charges differential target.

Now to address your questions:

1. Are my calculations from Friday accurate or in need of correction?

Here is a summary of the process for deriving the assumptions.

*Investment Objectives: Low Risk & High Return *

At its most basic level, the two key objectives in investing are to *maximise returns and minimise risk*. Unfortunately, when it comes to asset classes, these two objectives conflict with each other. Less risky asset classes, like cash or bonds, tend to have lower expected returns than riskier asset classes, like emerging markets equities. If you want higher returns then you’ll generally have to accept higher risk.

The key benefit of building portfolios is *diversification*. In essence, because asset classes aren’t perfectly correlated (i.e. they don’t always move up and down together), combining asset classes together allows us to build portfolios that have both lower risk and higher expected return than any single asset class by itself. There is, however, a great deal of art and science to how this is done.

*Traditional Mean Variance Optimisation *

Traditional Mean Variance Optimisation, as introduced by Harry Markowitz in 1952, is a method of attempting to maximise the benefit of diversification i.e. trying to get the portfolio with the maximum expected return for any defined level of risk.

Estimates of each asset class’s expected return, volatility (a proxy for risk) and correlation (how it is behaves in relation to other asset classes) are fed into a computer optimiser. The output is a suggestion of the optimal portfolio for every risk level - those portfolios for which there is no other possible portfolio that has the same risk and yet a higher expected return. Such portfolios are said to lie on the efficient frontier.

The main problem with this method is that forecasting future returns, volatilities and correlations is very difficult and that this traditional method doesn’t handle these uncertainties very well (particularly with regard to expected returns estimates). These weaknesses lead to portfolios that are:

·  unstable – for small changes in initial estimates of expected returns, the optimum portfolios change drastically

·  not as diversified as they should be (often most asset classes tend to fall out of the final recommendation)


The net result is that traditional mean variance analysis is almost never used in isolation by asset management practitioners.

*Black-Litterman *

Black-Litterman (B-L) handles the problem of traditional MV optimisation by adding two extra steps. Risk and correlation numbers are still estimated (usually based on historic returns) but, instead of starting from a blank slate to estimate future returns on each asset class, B-L uses the views implicit in the market as a starting point. To a great extent this allows the portfolio manager the opportunity to identify asset classes where the historic return is unlikely to be a good estimate of the future return –such as in the Long-bond market.

The model then allows the portfolio manager to apply their own research to adjust these consensus views. Significantly each “view” must be assigned a confidence interval. Even so, the model weighs more heavily the consensus view of the market in recognition that markets are extremely efficient at pricing risk.

Using market consensus views of expected returns as our default starting point has a number of advantages. Firstly, knowing what the market/average investor “believes” is useful in challenging our own views. Secondly, where our own views differ from consensus, the B-L model provides a framework for combining our own views with market consensus, taking account of how confident we feel in our view. Overall this approach leads to portfolios that are:

·  more robust – they don’t change drastically if we slightly alter our views

·  very diversified – more asset classes are represented in the final portfolios

After we have the new adjusted expected returns we can follow the traditional MV analysis to create a set of efficient portfolios.


2. The charts from Friday no longer appear. Do you know why?

I am adding some warnings

3. What assumptions are made regarding currency movements in your portfolio? Is hedging involved and at what cost?

Historic volatilty of currency on average around 10 so it swamps fixed interest and cash. Therefore we always hedge currency risk in global bond portfolios. This is typically achieved through a one month forward currency swap between the fund manager and investment banks. The cost is negligible.

Equity volatility is greater than currency volatility so there is little or no benefit in hedging an equity fund.

4. If certain equity classes have higher expected returns than other equity classes, how is this higher risk taken into account in your modelling?

see 1

5. Similar question regarding bond investments - how is the added risk of higher yielding bonds taken into account?

see 1

6. Again regarding the modelling methodology used. Let's say:
- equities enjoy a stellar patch in 2015, 2016 and 2017 with returns in each of the three years of 15% p.a.;
- bonds returns and other variables do not change; and
- you were to update your model (at the start of 2018) so that it then examines the period 1970 to 2017

.......how would this impact on the model? Would it suggest that equities are more attractive than the model currently calculates?

There are two "models" that we use

1) Historic to determine the realised return of a given strategy in the PAST
2) Forward looking expectations using Black-Litterman

Of course as we have been in a 30 year bond bull market expected returns in the future are lower than returns in the past but that still doesn't mean you should declare that you expect no return from the bond market. Ask Bill Gross at Pimco!

Similarly, starting Shiller P/Es are probably the least worst predictor of equity returns in the future but they still only have around a 40% explanatory factor. There is still lots of room for uncertainty and we don't ever want to imply that we are certain of a particular course of events. Equities have a positive expected return and just because they are expensive or even very expensive relative to the average doesn't mean they won't go up more.

Remember Keynes line that; "the market can remain irrational longer than you can remain solvent"

See answer to 1


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## Sarenco (25 Oct 2015)

That's an excellent post Marc.

I think your observations on the value of annuitising a portion of the portfolio are very well made.

However, I have to confess that I am hugely sceptical of the value of any portfolio optimising software.  It looks to me like nothing more than a sophisticated way of replacing a manager's own opinion of individual asset classes for whatever is determined by the market.

I fully appreciate that you were not proposing the resulting portfolio for any individual investor.  Having said that, I was surprised at the very significant allocations to emerging market debt, junk bonds and even investment grade corporate debt in the resulting suggesting portfolio.  I personally wouldn't sleep well at night with that portfolio if I was relying on it for my income.

I think I'll stick with my old-fashioned way of determining an apprpriate asset allocation for my personal circumstances.  It wouldn't bother me unduly if that means leaving out various asset classes.


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## Marc (25 Oct 2015)

Sarenco

Thanks.

I totally agree with you. Each investor should have a portfolio customised to their particular circumstances and not be shoehorned into any particular model.

I may have already mentioned that I think this process is more informative about the problem than the solution and that I don't think this is the right way for Dan to go about it.

If I choose a different range of inputs and preferences I get a different portfolio. So I'm absolutely certain you would hold a different portfolio. Again I may have already mentioned that I believe all investors should hold a unique portfolio.

A different investor might select less bond risk and more equity risk as I set out in my earlier post.

But for this illustration I selected a weighted active manager view consistent with the view expressed by Dan on absolute return funds.

A different configuration would give a different portfolio.

The software is just solving the thousands of calculations to achieve that end.


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## Sarenco (25 Oct 2015)

Gotcha. 

I strongly suspected that was the case and I may have been adding (unnecessarily) to the chorus of health warnings. 

It's a useful exercise.  If nothing else, it highlights that there is no free lunch in investing - stretching for yield necessarily results in a riskier portfolio.


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## Dan Murray (26 Oct 2015)

Hi Marc

I believe you have not answered the following questions clearly. I am unsure whether this is intentional or otherwise - *please confirm.*

In relation to question 1, all I need is a Yes or a no, and if no, the corrected calculations.

In relation to question 6, all I need is a confirmation or otherwise to the point in bold.

1. Are my *calculations* from Friday accurate or in need of correction?

6. Again regarding the modelling methodology used. Let's say:
- equities enjoy a stellar patch in 2015, 2016 and 2017 with returns in each of the three years of 15% p.a.;
- bonds returns and other variables do not change; and
- you were to update your model (at the start of 2018) so that it then examines the period 1970 to 2017

.......how would this impact on the model? *Would it suggest that equities are more attractive than the model currently calculates?*


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## Marc (26 Oct 2015)

Dan,

I'm not being deliberately vague I just have other demands on my time. 

I would also note that I have made several substantive points that you have chosen to ignore.

In respect of your calculation where did you get the assumed 8%pa return from for higher risk assets?

In respect of your last question 

The black litterman process takes as its base assumption, the present market view of the expected return of all asset classes at any point in time. So if in 3 years time equities are higher then the market will most certainly hold a different view of the expected return than now.

Is that the question you are asking or are you trying to make a point about tactical asset allocation based on market valuations?

A higher P/E for example implies a lower expected return but it doesn't mean guaranteed negative returns from stocks.

It would be highly unlikely therefore that we would assume a higher expected return from equites in the circumstances you set out. Are you seeking to infer that good past performance implies high future performances?

I'm not sure why you are asking this question.


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## jpd (26 Oct 2015)

I've enjoyed following this thread but I feel it has run its course and will pass on it from now on.

Thanks to Marc & Sarenco for thoughtful replies - I hope all your clients are not as, I dunno - awkward, difficult, questioning? - as Dan


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## Dan Murray (26 Oct 2015)

jpd said:


> .......I feel it has run its course



I actually agree!

Time for me to wrap up and thank all contributors.


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## monagt (30 Mar 2016)

Marc said:


> Dan
> 
> That's right the composition of the portfolios varies as you move up and down the curve consistent with investor preferences in general.
> 
> ...



Where does one get  *“Inflation Linked Bonds"*


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## Steven Barrett (30 Mar 2016)

monagt said:


> Where does one get  *“Inflation Linked Bonds"*



Off the top of my head, Irish Life and Zurich Life have them. Some of the other insurance companies may also have them. You can also access them through platform providers. 


Steven
www.bluewaterfp.ie


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## monagt (27 Apr 2016)

Is that similiar to Rabo's Robeco Lux-o-rente and High Yield Bonds?


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