The following is a guest post (of sorts). Its a speech delivered to an industry audience by a friend of mine back in 2009.
Some of the specifics may be a little dated after 8 years (e.g. whatever happened to Intech?) but each of the 27 question’s posed by my friend’s “mum” remain as relevant as ever. They remain pertinent because, after 8 year, most superannuation funds still invest this way.
My friend’s mum doesn’t have to worry about any of those things. All she has to worry about is achieving a total return after taxes without taking any unnecessary risk.
Some reader’s may find these views provocative (to say the least). That is understandable because they threaten the status quo. But sometimes we need to ask the difficult questions. In the words of Socrates, “every great and noble steed who is tardy in his motions owing to his very size” requires a “gadfly” to be “stirred into life”.
Without further ado; here’s why my friend’s mum is a better investor than most CIOs.
Why my Mum Beats all CIOs
My initial view is that the way super is managed in Australia is not well aligned to members interests and that it doesn’t surprise me that the results are both ordinary and not necessarily what the members want. For example:
- A cash plus strategy to a layman means cash plus!
- Super returns over longer periods of time do not seem to have significantly outperformed cash.
- I’m pretty sure that most members would gladly accept lower returns in the good times for some protection in the bad times.
- It appears that there is very little excess return and what there is is unlikely to be true alpha
What I am going to highlight today is a number of issues that I have encountered and some potential solutions.
Even though I am expressing my concerns in a tongue-in-cheek manner and using my mum as a hypothetical retail investor, the issues in my view are nevertheless pertinent and real.
I warn you in advance that there are some very good reasons why you should take what I say with a grain of salt.
Not the ordinary disclaimer where I say that the views expressed are mine alone (which they are) and that I wasn’t here, you weren’t here and I didn’t say anything but more something like “my views are so aberrant that many think that I’m a complete crackpot”…
… Additionally, it is part of my job description to be negative. Whereas a business development manager is mostly telling a good story (maybe a fairy tale) suggesting that one should invest with his organisation my job is to say no to over 95% of the opportunities that are presented.
I wonder what came first, the chicken or the egg? Has my job made me a glass half empty kind of guy? Or was I always this way and therefore suited to being a CIO?
There is perhaps one good reason that you may want to hear what I have to say and that is that this. Sometimes my strategies do work and my record of investing over 30 years is pretty good…
… My mother is an excellent investor. She doesn’t listen to me but maybe does pay some attention to my dad…
… Sometimes she does some strange things, like buys shares in Arnotts just because she liked getting a large biscuit tin every Christmas.
But mostly she just makes sound, sensible, long-term investment decisions that are totally aligned to her needs and have worked in the past and in my view will continue to work.
My mother is a zoologist and a mathematician who has spent many years raising 4 children and helping with 10 grandchildren. She is layman in relation to finance.
So how come she had had much better results than most, if not all, superannuation funds?
Is it because she is so good or because the funds have just over-complicated and over-engineered something that should be straightforward.
I put forward the hypothesis that it’s the latter.
Here are a number of issues that I have identified where I think super funds could do better and the 20 (actually 27, my lucky number, buts what’s a few more between friends) questions that my mother might ask.
Why do most super funds look so similar, namely 70/30?
Surely a 70/30 fund is not appropriate for all that many members?
Surely one should have an eye on future retirement income (similar to liabilities for a DB fund) and employ some form of liability driven investing?
Maybe DB style investing with its longer term horizon is a better way of managing super?
Why do funds continue to use active managers in traditional asset classes when the data conclusively shows that at least 75% underperform before fees?
Why play a game when the odds are worse than even money?
In the case of some alternative asset classes despite the attraction of higher potential alpha the odds are even more stacked against you.
For example, only the top 10% of private equity managers achieve results that are superior to listed markets.
Why do funds emphasise relative returns?
After all, you can’t eat them!
More importantly, why do funds give out mandates where losing 40% of a client’s money when the index falls 50% is seen as good? (i.e. we can’t blame the manager in this instance who has lived up to his end of the bargain).
Why do funds classify high-yield credit as fixed interest and within ‘defensive assets’?
High yield credit is clearly a de facto equity bet and my data suggests a correlation (r-squared) of between 0.6 and 0.7.
So if one did like credit why not classify it as a ‘growth asset’? (Assuming of course positive returns!)
And, why not think about investing in equities instead of high-yield credit?
(Usually I think equities are a better bet but right now I prefer credit to equity on a risk-adjusted basis. Maybe credit will even outperform equities in an absolute sense over the next short while?).
If managers can tell cheap and expensive stocks then why can’t they tell cheap and expensive asset classes?
The Frank Russell used group used to say “Son, its time in the market, not market timing!”
Now, even they have a strategist to look at selective tilting.
Surely it makes sense to buy low, sell high and therefore not to buy high!
Why do super funds listen to mathematicians?
After all, they would say that on average we all have one testicle!
More importantly and seriously quantitative analysis suggested that high valuations (high equity prices and low credit spreads) were OK given low volatility and low default rates.
If only they had read a history book and realised that the period 2002-2007 was the outlier and that pre 2002 and post 2007 are more usual.
However, I am glad that pointy heads were embraced by funds management as how else would they get laid.
Why do funds pay active fees for portfolios that have large amounts of redundancy and are de facto at least 50% passive?
Our analysis of a standard multi-manager portfolio suggests that upwards of 50% is redundant. I’m sure you can understand why we would replace an expensive, underperforming, redundant portfolio with a large amount in a passive management style.
Why do funds invest in hedge fund-of-funds?
It was obvious that pre 2007 that most FOF exhibited an alarmingly close correlation with each other and with equities.
Was it that by some miracle that all of their uncorrelated alpha with large diversified portfolios yielded such similar results (a 1 in 6 million possibility) or was it that it was just some form of commoditised (exotic) beta?
You work it out!
Believe it or not, one of our managers still insists that there was no beta in its FOF!
Why do managers buy stocks that they don’t like?
Why did managers buy a lot of expensive alternate assets that didn’t really diversify risk?
As Keynes says, the only thing that rises in a crisis is correlations.
If one adjusts for timing of valuations its pretty clear that many so-called uncorrelated assets are not uncorrelated at all and all that was different was the timing of valuations.
Why do funds believe that assets that are revalued less frequently are less volatile?
How volatile would your home be if it were valued daily?
If you believe that assets with appraisal values are less volatile, have I got a deal for you!
I can provide you with ASX200 returns for no fee with half the volatility of the ASX Just buy into a Macquarie True Index fund and revalue monthly!
Why do managers use the indices that they do?
Why would one use the UBSA All Maturities Composite Bond Index that contains credit and that the more debt that a company or the government issues, the more that it is represented in the index. Does that mean as a company is going under I should buy more debt issued by it?
Why are cap weighted equity indices (where highly priced growth companies are overly represented) a good measure? No wonder value managers outperform these indices consistently.
Why are managers allowed to take lower quality, riskier, out-of-index bets and call any excess return ‘alpha’?
Isn’t it expected that a portfolio that includes small caps will outperform one without? So why do we applaud a manager that includes riskier, smaller cap assets and then pulls out his thumb and says “what a good boy am I?”
How come, managers rarely ask for a mandate to allow them to buy the less risky safer out-of-index assets? I’ve never seen a small cap manager ask to be allowed to buy large caps or an EM manager ask to buy developed market stocks!
Doesn’t it therefore follow that fixed interest managers are likely to add credit (and risk) to a portfolio in an attempt to beat their index?
Doesn’t it also follow that we can look back at past performance, suggest that bond managers are ‘one-trick-ponies’ and be sceptical as to whether they exhibited any real skill?
Why do funds invest in bonds with low duration?
How are bonds (often with credit attached) with an average modified duration of 3.21 years) useful in protecting the portfolio of a member with 25+ years to go until retirement?
Why do funds which supposedly manage for the long-term pay so much attention to short-term performance?
My mum has never heard of Mercer or Intech so is not bothered about league tables.
She does however care about her after tax performance relative to CPI & cash.
If one was genuinely a long-term investor then one might hold a value portfolio like DFA for the very long term.
But please remember when taking long-term bets, whether leveraged or not, that as Keynes says “the market can stay irrational longer than you can stay solvent!”
Why don’t super funds manage to an after-tax benchmark?
If the goal was to make CPI +4% after tax then why not lock that when it’s possible.
Why don’t funds differentiate more between mark-to-market and genuine under-performance?
If one holds a duration matched portfolio of semi-government securities with a spread of 100 bps to CGS, then if one holds until maturity then the portfolio will outperform govs by 1%.
Who cares about the marking to market?
Why use a sector specialist model that is so clearly sub-optimal?
It creates artificial barriers that lead to absurdities.
For example, if the situation was such that adding preferred stock improved portfolio outcomes it is very difficult for a sector specialist portfolio construction to accommodate it. The bond guys don’t like it because it has delta and is out-of-index and the equity guys don’t like it because its beta is too low. Go figure!
Additionally it rewards managing against an index (no matter how stupid the index is) without regard to absolute returns or the opportunities in other asset classes.
My job is not to buy any bargains but to buy the best bargains!
I suggest only two asst classes, growth and defensive.
So, why aren’t equity managers keen to buy preferred stock and convertible notes when appropriate?
My guess is that it’s just a bit hard for them to deal with anything outside their very narrow irrelevant view of the world.
Why do people think that when the ASX200 is at 6800 with past low vol it is less risky than when it’s at 3400 with recent high vol?
I think that risk is neither vol nor Var but something more related to valuations.
Accordingly, when prices are lower and spreads are higher I am inclined to add to holdings.
Why listen to some asset consultants?
I do accept that they provide some level of protection. (CYA)
However, recent implemented consulting results do not inspire confidence.
Why pay managers win, lose or draw? Why offer performance fees which give managers a free option?
Is it any surprise that those on performance fees routinely add risk and those on flat fees routinely index hug and gather assets?
I guess we reap what we sow!
Why hire outperforming managers and terminate underperforming managers?
Surely mean reversion would suggest doing the opposite?
There have been numerous studies which show that the only type of performance that persists is really bad performance. Otherwise past performance is a poor guide to future performance.
Isn’t it interesting that on average recently terminated managers outperform the replacement managers?
Why pay fees based on FUM? Especially if the strategy is not capacity constrained.
Surely it takes the same work to manage or advise upon or provide custody for $100m as for $1 billion.
PS I do accept that there are some additional fees and risks associated with size but do not accept that they are as linear as service providers do.
Why do funds spend 80% of their time looking at manger selection and 20% looking at Strategy and Strategic Asset Allocation?
Surely this is the 80/20 rule completely arse about?
After all, managing beta is risky but is 400x* better than alpha as a tool for increasing portfolio outcomes.
*20 times cheaper and 20 times more important.
So, why not just go back to an old fashioned balanced fund where alpha and beta are both properly managed?
“The more things change, the more they stay the same” or “plus ça change, plus c’est la même chose”
Finally, I’d like to leave you with two thoughts.
- If history revealed the path to riches, librarians would be in the Forbes 500 (Buffet); and
- Flat is the new up.