14/12/2011 - 11:17

Redesigning the architecture of investment

14/12/2011 - 11:17


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The market upheaval of recent years suggests we need to start thinking differently about how we invest.

The market upheaval of recent years suggests we need to start thinking differently about how we invest.

AFTER another year of crisis-driven volatility and wealth destruction – the ASX 200 down 10 per cent – investing will require the adoption of new architecture to regain ground in 2012 and beyond, particularly as the compulsory inflows to superannuation gather pace.

It is all about the architecture in the brave new world of investment.

If the GFC did one thing, it intensified the rigour required to achieve wealth creation; yet funds managers lag behind at the time they most need to abandon past practices.

This is particularly so because of the bipartisan commitment to increase compulsory superannuation contributions to 12 per cent between now and 2020 – an unavoidable essential if Australia is to meet the needs of an ageing population, because government alone will not be able to afford pension support at the required level.

Firmitas, utilitas, venustas – the foundations of architecture are required.

Two thousand years ago the Roman engineer and architect Vitruvius proclaimed these three elements to be the ultimate objectives of building; and, as they are to buildings, so they are to wealth creation today.

Buildings had to be durable (firmitas) to robustly meet the challenges of their environment; they had to function well (utilitas) to meet the needs of the people using them; and they needed a quality of beauty (venustas) to lift the spirits.

 If you replace the word ‘buildings’ with ‘investments’ the analogy is fitting.

Yet, as a more modern architect, Frank Lloyd Wright, noted: ‘The only thing wrong with architecture are the architects’. 

And so, too, it is in the Australian funds management industry, which will in the coming years – by government decree – be laden with trillions of dollars more in Australian superannuation monies.

In De Architectura, Vitruvius also revealed another natural analogy between architecture and investment: the infrastructure of function and excellence was more than a matter of bricks and mortar; it required consideration of a complex and diverse range of related disciplines.

So it is with future investment. The architecture of success requires the crafting of science and art. 

But these days the art of stock picking continues to outweigh the science, with the architects of funds management punting on their ability to match winners and timing, with way too little regard to risk mitigation and outcomes measured in absolute returns.

Unfortunately for investors, this default to past practices simply recycles the wealth building strategies that have been so spectacularly demolished in recent years. 

Funds management in Australia tends to involve allocations to actively managed, long only, big-branded shops that compete on price ... the cheaper the better.

The problem going forward is that, as reported by economist Burton Malkiel, professor emeritus at Princeton University, active equity management adds no value over normalised periods (say 20 years), and investors would have done better by investing via a broad-based market index. 

No ‘buy-and-hold’ investor has made money in US stocks for more than a decade now. The S&P 500 index was more than 1,500 points in March 2000; today, more than a decade later, it is 16 per cent down on that. The high-tech Nasdaq index is worse – today it is just over half of what it was in 2000.

Europe reflects the US. The drought is even longer in Japan, and here in Australia (home to the resources super-cycle and proxy to China) term deposits have matched it with equities. During the past decade, the RBA cash rate has averaged 5.41 per cent and, with term deposits generally pitched higher than that, they have essentially matched the ASX 200 averaged return of 6.45 per cent (dividends reinvested). 

Yet the foundation stone of the Australian wealth management industry has been large, and almost always long, allocations to domestic equities. The Orwellian chant has been that equities are the best long-term investments and that any deviation is merely cyclical.

No more; economic and investment issues are no longer cyclical, but structural. 

As Future Fund chairman David Murray noted in his portfolio update for the nine months to September 30: ‘‘The board is mindful that the uncertainty in financial markets can be expected to endure as the global economy continues to undergo significant structural adjustments over years to come.”

For some, though, there is nothing more elusive than that obvious fact highlighted by Mr Murray. 

Default investment practice has to be replaced with the rigorous new architecture of investment. That is, the adaptation and utilisation of the principles and analytics of the ‘endowment model’ of investing (EMI) – a complex mix which fully integrates the investment process and, ultimately, informs a better outcome.

Keys to it include the empirical assessment and weighting of direct and indirect risk factors, modelling them to strategies (whatever the asset class), before applying the same rigour of investigation into the processes, practices and risk mitigation of particular funds managers to be used.

The architecture is what we call ‘open’; that is, capable of absolute customisation, with the ability to model scenarios in allocation, performance and other variables critical to the rigour with which the EMI produces outperformance.

Particularly important is the modelling of all mandatory and discretionary expenditures while the investment continues to generate consistent earnings. For individual investors these expenditures can simply be the amount of money, regularly provided, to live on; while for charitable, cultural or educational foundations, for example, regular endowments may be required for capital purchases such as works of art, if it is a cultural foundation, or scholarship fees, etc., required by an educational endowment. 

The rigour of the architecture also models outcomes reflecting the consequences if investment outcomes are not met. The result is evidence-based decision making, utilising tools and structures for an all-weather portfolio. 

As the GFC meltdown so brutally illustrated, you cannot diversify away systemic risk. However, with the appropriate tools and processes, you can mitigate it.

It is interesting to note that the Future Fund, arguably Australia’s most sophisticated investor with its $73 billion under management, has committed 21 per cent of its asset allocations to alternatives (essentially, hedge funds) to meet the wildly evolving investment environment.

One can only wonder why, if the object of the fund is to strengthen the Australian government’s long term financial position by making provision for unfunded Commonwealth superannuation liabilities, its approach is not a model for the superannuation and wealth creation industry at large.

Unfortunately, reluctance has beget intransigence. The architects of Australian investment cling to old world equities philosophies that are virtually uninvestable today – and will continue to be so tomorrow. Regardless, fees will continue to flow their way while those invested with them will continue to suffer diminished days in retirement.

In conclusion, let me refer you with a very literal personal test: how do you see the shape of the investment world? As illustrated on this page (above), Edward Altman, professor of finance at New York University, frames five options.

I believe that only the new architecture innate to the EMI – with its analytics, flexibility and non-correlation to markets and market events – is capable of meeting all scenarios for future investment. After all, as Albert Einstein said: ‘We can’t solve problems by using the same kind of thinking we used when we created them’.

• Jon Horton is managing partner of Perth-based hedge funds company NWQ Capital Management, which manages the NWQ Diversified Fund.


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