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

D

Dan Murray

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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?!
 
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
 
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?!;)

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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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.
 
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.
 
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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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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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.
 
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.
 
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!
 
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.

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!
 

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
 
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.
 
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?
 
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!
 
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.
 
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.
 
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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