Methodology document. Objective based asset allocation. Individual goals differ greatly. We incorporate behavioural finance. Our allocations are not set-and-forget. We continually assess returns. An important part of our wealth creation and preservation activities is to educate our clients, and those deciding to be come clients, on the methods we deploy. By taking a leadership role in wealth management this education is a vital part of our ongoing communication activities. Version 1.1. Telephone +61 2 9239 9333.
Contents manifest. Activity summary. Section No1. Introduction. Section No2. Idea Development. Traditional Asset Allocation. Behavioural Finance. Section No3. Client Objectives. Aspiration. Income. Security. Legacy. Opportunistic. Section No4. Model Assumptions. Asset Classes. Return Expectations. Section No5. Examples. Example 1. Example 2. Section No6. Conclusion.
Section No1. Introduction. Providence appreciates that the goals of each individual investor will differ greatly regardless of the similarity of typical industry risk valuation metrics such as age, stage in life and financial position. It is for this reason we move away from these risk metric frameworks towards a method that incorporates the findings of behavioural finance. We have always been prepared to back our tactical view regarding risk and have a significant deviation from traditional portfolios or benchmarks. More specifically our focus has shifted towards focusing on each investor goals and then determining the appropriate asset allocation to satisfy these goals. While we are aware that various return assumptions will drive the output of any goalbased asset allocation strategy, our model is run with our clients to allow for education surrounding the impact of various asset allocation decisions. Finally, the client s portfolio is not a set and forget investment, we continuously assess the return considerations of the various asset classes and re-run the model to determine any necessary asset weighting changes.
Section No2. Idea Development. Traditional Asset Allocation Traditionally the asset allocation process has been developed based on the findings of Harry Markowitz s paper Portfolio Selection 1, first published in 1952. Markowitz s paper suggested that an investor should diversify and that he should maximize expected return, it identified that there is a rate at which the investor can gain expected return by taking on variance, or reduce variance by giving up expected returns. This theory was based on research done on the negative correlation between equities and bonds whereby bonds provide minimal return but provided capital security and equities provided larger capital returns with less security. As a result, the industry has used historical averages of return (mean), volatility (standard deviation) and correlation as inputs to the determination of an appropriate asset allocation. Based on either the desired return of the investor or the maximum willingness to take risk, the investor would determine the weighting to Equities and Bonds. This idea is the basis for the standard 1 Harry Markowitz. The Journal of Finance. Vol. 7, No. 1 (Mar., 1952), pp. 77-91. Published by: Wiley
growth, balanced or defensive fund, although asset allocation is slightly more complex these days given the ease of investing in a larger number of asset classes. Providence s concern with this traditional asset allocation approach is fivefold: 1. The returns are based on historical data only and have forgotten about the need to add judgments. Markowitz himself claims these procedures, I believe, should combine statistical techniques and judgment should then be used in increasing or decreasing some of these inputs 2. 2. The required return does not distinguish between income and growth; this is a key concern for investors particularly in the retirement stage of life where income generated from the portfolio provides the required funds to live, without having to sell assets at an inopportune time. Some growth assets however are still required in order to maintain the real value of an investment portfolio due to inflation. 2 Harry Markowitz. Portfolio Selection. The Journal of Finance. Vol. 7, No. 1 (Mar., 1952), pp. 77-91. Published by: Wiley
3. The required returns are based on a set and forget investment over a long time period so does not take into account the path to achieving the required return or volatility in assets at any prolonged period of time. 4. More alarmingly, it has been proven during significant financial market downturns that the correlation between asset classes may move closer to 1. This means that the diversification of the portfolio no longer provides the protection that it was implemented for. 5. This allocation method forces a client into a portfolio that is the best fit rather than an individually tailored portfolio specifically addressing the clients individual requirements or objectives. Behavioural Finance. Behavioral Finance moves away from traditional finance theory and introduces the concept that all investors act differently and demonstrate various behavioral biases. This counteracts Markowitz s key argument that all investors act rationally. Some of the more
common behavioral biases as defined by Nevins (2003) 3 include: Overconfidence An overestimation of an investor s ability to predict market events. This often results in taking larger risks without receiving the commensurate returns and overtrading resulting in large transaction costs. Hindsight Bias An investor believing they have predicted an event when in fact they had not. Overreaction This tends to result in investors buying high and selling low. Regret avoidance Not selling out of a bad investment in order to avoid admitting it was not a good decision. Providence believes that aligning a client s asset allocation decision with their objectives will make it more difficult for clients to fall victim to these behavioral biases and allow for strategy adjustments to be made not on the basis of these biases but on either a change in the client s goals or a change in forecast market conditions. 3 Daniel Nevins. Goals-based Investing: Integrating Traditional and Behavioural Finance. The Journal of Wealth Management, Vol. 6, No.4 (Spring 2004), pp. 8-23.
The ideas of Statman (1999), an expert in the field of behavioral finance, helped form the basis of our objective based asset allocation with his behavioral portfolio theory as defined below: in the simple version of behavioral portfolio theory, investors divide their money into two layers of a portfolio pyramid, a downside protection layer designed to protect them from poverty and an upside potential layer designed to make them rich. In the complete version of the theory, investors divide their money into many layers each of which corresponds to a goal or aspiration 4. While we are not concerned with dividing the portfolio into numerous layers, we are concerned with satisfying the goals that relate to the various layers of the Statman pyramid. We have defined our client objectives as outlined below. 4 Meir Statman. The Diversification Puzzle. Financial Analysts Journal. Vol. 60, No.4 (2004), pp. 44-53
Section No3. Client Objectives. Building on these past studies and the last 12 years of working in wealth management, the Providence team has identified three common drivers that influence an investors satisfaction with regard to their investment decision; the income generated by the portfolio, capital security and capital appreciation. It can be contested that liquidity is often an additional concern however we don t believe this to be an objective but more of a necessity for a portion of the portfolio. In addition to these drivers, we have also learnt that the legacy of our clients is also very important, be that a contribution to philanthropic ventures or what may be available to beneficiaries of their will. Furthermore, clients generally have a high risk tolerance for a portion of their total assets. This portion varies significantly and may not be present at all for some; however it is the competitive nature in all of us that drives us to want to have the occasional high risk, high reward investment. As a result of these observations, Providence has developed an objectives based asset allocation model that aims to align the goals of each individual client with an
appropriate weighting to each asset class and stimulate discussion. In order to do this, we initially ask clients to prioritize and specify the following objectives: Aspiration - The overall portfolio returns that you would like to achieve. This may be represented as a margin over CPI, cash or a straight percentage. These are generally equity-like investments such as domestic shares, international shares, property, infrastructure and hedge funds. Income - The income that your portfolio needs to generate in order to meet your current and future living requirements. Generally income investments are heavily weighted to corporate bonds, cash and government bonds. High yielding equities or fully franked Australian equities may also be included to boost income. Security - The maximum level your portfolio could decrease in any one year. This is based on Heuristics 5 return estimates in a global recessionary environment. Asset classes that are likely to provide security include 5 Heuristic Investment Systems 2012. Strategy Engine Providence Asset Allocation & Investment Strategy chartpack. Issue 42. 9 July 2012.
government bonds, cash, inflation linked bonds and annuities. Legacy - Either the current amount the client would like to have available to invest across legacy assets such as their home, land bank or forestry. Or, the amount left over for these assets after all other objectives have been satisfied. Opportunistic - Funds available to invest in more speculative investments. Speculative securities can include things such as trading strategies (oil, commodities etc.) small to micro-cap equities and private equity direct investment. These funds should represent a portion of wealth that the client is willing to lose. As mentioned above, there may be some cross over between objectives. For example, the income generated from an equity investment will help satisfy the income objective however the growth related to these investments is apportioned to the aspirational objective. Furthermore at Providence s discretion, we may believe certain securities should be classified as a defensive security. For example gold has been seen to represent a
good inflation hedge during periods of significant money printing or quantitative easing. Furthermore, one or more of these objectives may not be applicable to each investor. For example, a client may have no desire to invest in any speculative investments. The purpose of prioritizing these is to individually discover what is most important for each client so we can best tailor a portfolio to achieve their specific objectives. Other than to prioritize the objectives, the purpose of having multiple objective categories is to segregate the client s financial needs and desires. This then allows Providence to better allocate their resources across the various asset classes in order to satisfy these. Traditional portfolio practice and funds management groups people together based on one of three categories; defensive, balanced or growth. This does not make explicit the reasons for the clients selection. Perhaps they are in a defensive Portfolio because they require regular income? Or maybe they are in a growth portfolio because of the stage in their life?
Regardless, we believe that each individual is likely to have different needs and priorities. Once these objectives have been established and categorized the responses are fed into a model that aims to satisfy each objective. While this is still a model based approach, the model is run with the client so highly relevant education can be provided and amendments to a number of the inputs can be made.
Section No4. Model Assumptions. Asset Classes. The asset classes that we analyze are: 1. Australian Equities 2. International Equities - Hedged or unhedged depending on the purpose of the investment and/or our view on the currency 3. Listed Property - Australian listed Real Estate Investment Trusts 4. Unlisted Property - Direct property investments for example investment properties. Infrastructure is also included in this asset class. 5. Australian Government Bonds 6. International Government Bonds - Typically hedged as a weighting to this class is usually related to the yield only and is typically a defensive position 7. Credit - Corporate bonds 8. Cash - At call and term deposits. 9. Alternatives - Hedge funds and typically more speculative investments eg gold and commodities.
Providence uses a Strategic reference allocation as a basis for what the typical Australian balanced fund would have, we then apply our tactical range which represents our view on what we believe should be the maximum and minimum investment in each of these investments. As an example we have input 0 as the maximum and minimum weight for Australian and International bonds which suggests Providence currently believes there should be no weighting to these asset classes given current extreme valuations. Tactical Range Asset Class Strategic Reference 6 Minimum Maximum Australian Equities 35% 10% 50% International Equities 21% 5% 35% Listed Property 15% 5% 25% Unlisted Property 0% 0% 15% Australian Govt Bonds 23% 0% 0% International Govt Bonds 0% 0% 0% Credit 0% 0% 50% Cash 6% 0% 50% Alternatives 0% 5% 20% 6 Van Eyk Research 2012, Diversified Balanced Fund Strategic Asset Allocation. Van Eyk, Viewed 15 November 2012 <http://www.irate.vaneyk.com.au/index.cfm>
As previously mentioned, we believe it is prudent to have a minimum of 5% in cash available for an emergency which satisfies a client s need for liquidity. Should the client feel more comfortable with a slightly higher cash waiting, we can revise upward the minimum weighting for this asset class. Return Expectations Providence has an investment committee that meets informally once a month, with a formal committee meeting once a quarter. These meetings form the basis of our forecast return expectations and where we perceive to be portfolio risk. Providence relies on asset consultants to provide a framework of return expectations which we then apply a discount or premium to these assumptions depending on the investment committee member s views and experience. The key inputs that drive the model are below:
Asset Class Providence Base Case Downside Scenario Recession 7 Historic Volatility Australian Equities 8.4% -8.0% 15.5% International Equities 8.0% -12.0% 14.5% Listed Property 9.4% 3.0% 12.6% Unlisted Property 11.0% 3.0% 11.5% Australian Govt Bonds 2.5% 7.0% 4.0% International Govt Bonds 2.5% 5.0% 3.0% Credit 7.4% 3.5% 7.5% Cash 3.0% 2.5% 0.2% Alternatives 8.0% 5.0% 10.0% The Providence base case represents our current forecast return for each asset class, the downside scenario represents Heuristics return estimates in a global recessionary environment and the historic volatility is the standard deviation of returns. Providence also applies certain asset class grouping rules to ensure there is enough diversification. While our approach to asset allocation is now more behavior driven we do believe that Markowitz s analysis on diversification has significant statistical merit and hence 7 Heuristic Investment Systems 2012. Strategy Engine Providence Asset Allocation & Investment Strategy chartpack. Issue 42. 9 July 2012.
believe the following grouping rules should apply: Asset Grouping Parameters Minimum Parameter Maximum Total Equities 20% 60% Total Property 5% 30% Total Cash/Bonds/Credit 20% 60% Total Alternatives 5% 20% Total equities is a combination of Domestic and international equities, Total property is a combination of listed and unlisted property, Total Cash/Bonds/Credit combines Australian Government Bonds, International Government Bonds, Cash and Credit and Total alternatives represent the amount the client wishes to invest opportunistically as defined by their objectives. Like the Return Expectations Providence can adjust these asset grouping parameters to reflect our view on various asset class groupings.
Section No5. Examples. Example 1 Let us assume a client with $1 million in assets has prioritized and defined their objectives as follows: 2 Aspirational The total return that you would like to achieve vs CPI, this includes the Income return achieved. CPI + 4% = 7% $70k 1 Income Certain level of income required to live. 3% $30k 3 Security Level of downside risk you are able to bear in worst case scenario -15% $150k 5 Legacy The amount you would like to invest in legacy assets or the amount available to invest across legacy assets after all other objectives have been satisfied. Remainder 4 Opportunistic The amount you would like to make available for speculative investments 5% $50k In this strategy, the client does not require specific funds for the legacy allocation so we will solve to achieve all other goals and what funds remain will be apportioned to this bucket. It is important to note that the income requirements assume no drawdown of capital in pension phase. Our return assumptions, inclusive of the Providence overlay are outlined below:
Tactical Range Asset Class Strategic Reference Minimum Maximum Providence Base Case Downside Scenario Recession Historic Volatility Gross Income Yield Australian Equities 35% 10% 50% 8.4% -8.0% 15.5% 5.7% International Equities 25% 5% 35% 8.0% -12.0% 14.5% 2.9% Listed Property 10% 5% 25% 9.4% 3.0% 12.6% 6.5% Unlisted Property 0% 0% 15% 11.0% 3.0% 11.5% 8.5% Australian Govt Bonds 25% 0% 0% 2.5% 7.0% 4.0% 2.5% International Govt Bonds 0% 0% 0% 2.5% 5.0% 3.0% 2.5% Credit 0% 0% 50% 7.4% 3.5% 7.5% 5.1% Cash 5% 0% 50% 3.0% 2.5% 0.2% 3.0% Alternatives 0% 5% 20% 8.0% 5.0% 10.0% 4.0% Additionally, we apply asset grouping parameters as outlined previously, these include: Asset Grouping Parameters Minimum Parameter Maximum Total Equities 20% 60% Total Property 5% 30% Total Cash/Bonds/Credit 20% 60% Total Alternatives 5% 20% With these rule as a basis, we solve to achieve all objectives. The asset allocation outcome is as follows:
Solving Asset Allocation % Australian Equities 40% International Equities 5% Listed Property 15% Unlisted Property 15% Australian Govt Bonds 0% International Govt Bonds 0% Credit 15% Cash 5% Alternatives 5% Total 100% Based on this allocation and our inputs, the forecast return and objectives are satisfied as follows: Total Investable Funds: $1m Total Legacy Funds $125k Total Invested Funds: $825k Total Opportunistic Funds: $50k Total Aspirational Return: $70k Total Income Return: $48k Total Growth Return: $20k Max Drawdown: -$20k
A comparison of the outcome to the objectives that this hypothetical client provided shows that all objectives have been satisfied based on this allocation. Providence in no way believes they can accurately predict the future and like all models, this relies on the quality of the inputs. What we will achieve is an ability to discuss with the client their objectives and the best ways to satisfy them. The tactical ranges can then be modified through discussion with the client if they are not satisfied with the results of the model. For example, if they do not want a large exposure to property as allocated in this example, we can modify the maximum amount for each of these asset classes. It is important to note, that changes to inputs may result in all or some objectives not being able to be satisfied. Again this provides important talking points for a client. For example, if a client was aiming to achieve a return of 10% per annum for the total portfolio with no risk to the downside there would be no possible outcome. Intuitively, one can understand that it is not possible to achieve such returns without having any capital at risk.
If it were possible, we think all investors would and should be invested in such an asset. Example 2 Let us assume a client with $1 million in assets has prioritized and defined their objectives as follows: 4 Aspirational The total return that you would like to achieve vs CPI, this includes the Income return achieved. CPI + 2% = 5% $50k 2 Income Certain level of income required to live 3% $30k 3 Security Level of downside risk you are able to bear in worst case scenario -0.5% $5k 1 Legacy The amount you would like to invest in legacy assets or the amount available to invest across legacy assets after all other objectives have been satisfied. 20% 200k 5 Opportunistic The amount you would like to make available for speculative investments 0% $0 As we can see from the inputs, this is a slightly more defensive outlook from the client however they have specified that they would like a more significant amount of funds available for legacy assets.
Leaving all other variables the same as in example one, the allocation output would be as follows: Solving Asset Allocation % Australian Equities 16.0% International Equities 6.5% Listed Property 16.5% Unlisted Property 13.5% Australian Govt Bonds 0.0% International Govt Bonds 0.0% Credit 25.0% Cash 10.5% Alternatives 12.0% Total 100% Based on this allocation and no change to the inputs from Example 1, we can see that all outcomes would be satisfied: Total Investable Funds: $1m Total Legacy Funds $200k Total Invested Funds: $800k Total Opportunistic Funds: $0 Total Aspirational Return: $64k Total Income Return: $43k Total Growth Return: $23k Max Drawdown: -$5k
Section No6. Conclusion. The objectives based allocation framework that we have outlined in this document includes rules that force diversification in the portfolio which draws on parts of Portfolio theory however our aim is to have the client s individual objectives to be the driver of any asset allocation decision. Providence has outlined that the asset allocation model does have its flaws given its exposure to various forecast assumptions, however we believe that through implementing this portfolio we will be able to facilitate better communication with clients and demonstrate the various risks and difficulties associated with trying to achieve their specific goals. Finally the process of assessing and prioritizing a client s objectives as well as analyzing various asset class returns should be continuous and the asset allocation process is therefore dynamic. Obviously, transaction costs should be considered here but again this creates opportunity to educate the client with regard to the impact of changing their goals or changing our asset class assumptions. Overall, Providence believes that aligning the individual objectives of the client to the
asset allocation decision provides a far better basis for developing an asset allocation for each individual client than by using the traditional asset allocation framework.
Document control. Preparation. Action. Name. Title. Date. Author. Grant Patterson. Managing Director. December 5, 2012. Written. William Porter. Research Analyst. December 5, 2012. Prepared. William Porter. Research Analyst. November 15, 2012. Distribution list. Name. Organisation. Title. Internal Providence Staff Authorised release. Authorised by. Title. Signature. Date. Version. Distribution list. Release date. Comments. Version 1.1. Internal. December 5, 2012. First Draft. Version 1.2. Internal December 6, 2012. Second Draft. Document history. Contact details. Enquires regarding this document, its content, or its scope should be directed to the following two staff members: Managing Director. Relationship Manager. Name. Grant Patterson. Name. Michael Ogg. Telephone. +61 2 9239 9333. Telephone. +61 2 9239 9333. Mobile. +61 0411 883 847. Mobile. +61 0408 628 792.
Providence Wealth Advisory Group Proprietary Limited. We are a wealth advisory firm with global skills in both wealth creation and preservation. Suite 7.02, Level 7, 55 Hunter Street, Sydney, New South Wales 2000. Telephone +61 2 9239 9333. Facsimile +61 2 9239 0355. Postal address is Post Office Box R536, Royal Exchange, New South Wales 1225. Providence Wealth Advisory Group has made every effort to ensure that the information in this report is accurate, however its accuracy, reliability or completeness is not guaranteed. This document contains general investment advice only and individuals should refer to their financial advisor as to the appropriateness of all recommendations. No warranty is made here to the accuracy or reliability of neither the information contained nor the specific recommendation for the recipient. Accordingly before making acting on any advice contained in this report, you should determine whether the advice is appropriate to your own financial objectives. Providence Wealth Advisory Group, its subsidiaries, affiliates, and its employees may have interests in the securities or the investment opportunities mentioned in this report. Providence Wealth Advisory Group, and its employees, disclaims both all liability, and all responsibility, for any direct or indirect loss or damage, which may be suffered by the recipient through relying on anything contained or omitted in this report. The text on these pages herein, page layout design, corporate style, corporate colours, and the Providence imagery may not be reproduced for any purpose, including educational, without prior written permission. Australian Business Number 42 003 224 904. Australian Financial Services Licence 245643. All rights are reserved. Copyright 2012.
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