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Portfolios after the fun

Portfolios after the fun. Peter Holland Fidelity. It’s the people, stupid!. We are very clever Large spreadsheets Information overload But also very dumb (greed/fear) The origins of today’s problems What will the “industry” do? What ought the “industry” do? The “Octopus” solution.

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Portfolios after the fun

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  1. Portfolios after the fun Peter Holland Fidelity

  2. It’s the people, stupid! • We are very clever • Large spreadsheets • Information overload • But also very dumb (greed/fear) • The origins of today’s problems • What will the “industry” do? • What ought the “industry” do? • The “Octopus” solution

  3. A Glorious Bull Market

  4. The Bull Market • Valuation driven • Transition to low inflation world • Equities became the asset class of choice • Bonds & Property were for wimps • “Greed” took over • Benchmarking became the norm • Ownership replaced by derivatives, “vehicles”, “products” • Timescales contracted • Confidence increased

  5. The New World

  6. What went wrong? • Sub-Prime, credit etc • The “engine” was forgotten • The “back testing” was unrealistic • Investors were confused by complexity • Risk was moved, not eliminated (moved to the ignorant) • Economic or Behavioural? • Incentives – bankers – “products” not loans • Front end fees/profits preferred to sound lending • Rating agencies – paid by the “product” generators • The short term “rear mirror” view of risk • The great fee conspiracy (fees change behaviour, risk perception) • The world of investment management couldn’t cope with lower nominal returns. 4% from bonds; 7/8% equities – inadequate!

  7. The benchmarking cancer • Benchmarks drive manager behaviour • Incentives – “benchmark risk” takes over • Timescales shrink • Losing money is irrelevant • All judgements are relative • The economic driver is lost • Managers become obsessed with the “big bets” • Pensions: • Liability calculation change – benchmark – portfolio • “Process costs” are high • Why does conservatism appear after markets fall?

  8. Turnover . . .

  9. Fixing it? • Identify the cash generative capacity of asset classes. • Align expectations (no free lunch) • Get real on fees • Total return of 8% minus 1.5-2% fees??? • Fix incentive issues • Bank loan officers, rating agencies, fee-greed • Fix the rear view mirror! • LTCM modelling, eg • The world changes – annoying but true • Benchmarking behaviour should change • Measurement role only • Investment timescale; asset ownership

  10. The reality . . . • Regulatory expansion & conservatism • Based on the recent past (not the future risks) • Portfolios will become more “conservative” • Equities, Property, Bonds • Hedge Funds/Private Equity • The DB trend (vs DC) • New asset classes (commodities, weather/carbon/forex trading!) • Fees will remain too high in relation to actual returns • Absolute Return investing? • The Philosopher’s Stone – a portfolio for all times? • Ownership & economic driven investment? • Fees, vested interest, complexity?

  11. The Octopus’ Assumptions • Macro driven • Economic returns (the “engine”) matter • The AWFUL TRUTH – cheap, simple, long term is GOOD. • Cash income matters • Past correlations, little help • Economics behind correlations matter • Current & future correlations matter • No “long term” asset profile (the world changes) • Major asset moves needed occasionally • Cash/Benchmark for measurement only • Asset ranges set • Equities, 25-75%, Bonds, 0-50%, Property, 0-50%, Cash, 0-25% etc • Continuous review (not quarterly)

  12. Octopus contd • Today’s world • Global ($) growth driver is “new world” not “old world” • Em market equities are less risky than generally perceived • Material shortages will remain for a while • “Old world” inflation is picking up • Developed mkts – inflation linked bonds are good (fixed, bad) • Equities are good value • Geographical approach to equities is ill conceived • Sectors, types, stock specific, balance sheet etc matter • Utilities, resources, infrastructure • Currency – I have no skill • Humility

  13. So far . . . • Octopus benchmarks – Cash plus 3.5% and my “Institutional” benchmark: • 25% UK equities, 20% ex UK equities, 20% fixed interest, 20% index linked, 15% property • Vehicles: ETFs, closed end funds, stocks (for “tilts”), cash • Outcome (since inception) +3.6% ve benchmark & +6.1% vs cash. Since July 2004. Very early days!

  14. Conclusions • Markets are dealing with the excesses • Root problems are human not statistical • Dealing with greed, poor incentives, high fees is TOUGH. Losses and chaos will purge some of this but far from all • Conservatism (voluntary and regulatory) will increase till markets do better • Many liability driven funds will (and ought to) close down the risks (DB>DC; buy-outs)

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