Leptokurtosis and the Elephant in the Room
At first glance, it may not seem obvious what a statistical term such as leptokurtosis and elephants have to do with retirement income. However, I will try and tie these two together over the next few paragraphs as both can have an impact on one’s retirement income and the quality of retirement.
Before we get to Leptokurtosis, early January is a good time to look ahead and try to determine what the markets have in store for us in 2011.
To do this, cast your mind back to your Economics 101 Varsity days when you were introduced to:
GDP = G + C + (S-I) – (X-M)
G = Government; C = Consumption; S = Savings; I = Investment; X = Exports and M = Imports
For illustrative purposes let us consider how the probability of returns can be impacted by one of the components of the formula, namely ‘G’. For simplicity, we will divide the world into three: the US, Europe and Emerging Markets.
Taking each region in turn:
US:
The Federal Reserve successfully supported the housing market in addition to propping up the banking system through Quantitative Easing (QE). However, with the second round, known as QE2 the primary objective will be to assist with the budget deficit. So in terms of the above formula, G is expanding as the Fed tries to ignite the inflation flame to douse the fear of deflation. Further, it appears a strong dollar is no longer a policy objective. The effect of a weak dollar has been one of the contributors to commodity prices, not to mention countries such as Japan, Brazil, China and other emerging markets resorting to ‘protectionist strategies’ to curb the strength of their currencies. Therefore the ‘G’ effect has supported both the US equity and bond market. However, for how much longer is up for debate and is likely to depend on the strength of the inflation flame.
Europe:
In contrast to the US, Japan and UK, the Eurozone is opting for austerity measures. To date, the influence of the ‘G’ in this region seems to be placing them in good stead, essentially driven by Germany resulting in a moderate slowdown. Having said that, the Eurozone still has its fair share of irregularity with the PIIGS (Portugal, Ireland, Italy and Spain) struggling to come to terms with their indebtedness and a strained welfare system, which is stoked by an agitated electorate protecting their ingrained right to unsustainable benefits. With this in mind, the Euro is still volatile and the divergence of government policy could pave the way for further variance in market returns within the region.
Emerging Markets:
Strong foreign flows, a weak dollar and strong commodity prices have provided the necessary boost to EM returns. As a consequence, South Africa, amongst others have had to deal with a strengthening currency. The impact of ‘G’ may be low as monetary policy tries to curb inflation, however rate increases can have a ‘double edged sword’ effect as higher rates draw in additional foreign flows, strengthening the currency thereby making exports more expensive (most EM countries are export driven).
So what does this tell us – essentially, the de-synchronization of policy may be a primary contributor to leptokurtosis. Essentially, this is a fancy word that describes the fact the upside and downside tail events are much more frequent than predicted by the normal distribution within market returns. Hence, the central peak is narrower, but the tails are significantly longer and fatter.
As a consequence, at SMMI we believe that managers of assets will need to ‘get the tails right’. This may mean that investors will need to deploy their risk budget more frequently and look to take full advantage of their Tactical Asset Allocation. This also begs the question: Who is best placed to actively make these TAA / rebalancing decisions? Specifically, we are of the opinion financial advisors should be looking to advise their clients to rather invest in actively managed solutions where the investment objectives of the solutions are closely aligned to the investment objectives of their clients. In essence they should be informing their clients that the outsourcing of the risk management and day-to-day investment management activity is in the client best interest. The risk of delivering sub-par investment returns by virtue of not having a full toolbox (or as a result of not having the ability to be dedicated to investment management on a full-time basis) has risen and the consequences are far more serious.
By now, you must be wondering what happened to the elephant. Much has been written on the sorry state of retirement savings in South Africa and how many will face hardship in their twilight years. The national saving ratio, or the ratio of gross saving to gross domestic product, (‘S’ in the equation) declined slightly from 17,0 percent in the second quarter of 2010 to 16,7 percent in the third quarter. Slightly stronger growth was observed in the gross saving of corporate business enterprises, which was offset by the deterioration in the dissaving by general government. The gross saving rate of the household sector declined marginally from 1,6 percent in the second quarter of 2010 to 1,5 percent in the third quarter. This was the result of increased household disposable income, which was neutralised by strong growth in final consumption (SARB Dec 2010).
Clearly a low Savings Ratio will have a detrimental economic impact. Moreover, on an individual level, a low savings ratio will more than likely contribute to the level of one’s retirement pot, however what is more sobering are the growing structural disparities between the ‘haves’ and the ‘have nots’. To illustrate this point, a few somber statistics:
-More than 13.8 m SA, roughly a quarter of the country’s population now receive some form of social grant (Sanlam BER, Sept-Oct 2010)
-The shortage of the number of people with the necessary human capital – the expertise and skills to support society and have the capability to pay taxes, namely too few to carry the burden of the numbers in need ie 5.3 million tax payers, with 1.2 million of them paying 75% of all personal and company tax (Dr Jan Du Plessis, South Africa: Detailed Analysis:2010:Collapsing into a Failed State, 12-Oct-2010)
-The debt burden is increasing, despite interest rates and inflation at historic lows. More than 11 million SA consumers struggling with their debt (Sanlam BER, Sept-Oct 2010)
-The unemployment rate of young people (15-24) increased from 44.2% in 2000 to 51.3% in 2010 (SAIRR 09/10)
-The prevalence of HIV in SA is 181 per 1000 adults aged 15 -49 yrs. The African average is 49/1000 and global average is 8/1000 (WHO – 090910)
This brings me to the Elephant in the room. Congratulations to those 2010 learners who passed Matric under challenging conditions. However, despite the recent controversy surrounding actual percentage increases / decreases, what is more sobering are the statistics provided by a Stanlib insight paper, whereby in 1998, 1.444 million Grade 1 students enrolled, by 2009 (Class of 1998), 580 937 students wrote Matric which is a 60% drop out relative to Grade 1 enrollment. Further, of those that wrote Matric, 334 718 passed. Only 23.2% of students who enrolled in 1998 obtained a Matric in 2009. That means around 1.1 million extra students do not have a Matric. It would be interesting to compare these results with that of Class of 2010. If we believe in the correlation between education and employment, we must wonder how these results will further impact the Net Replacement Ratio, which is currently around an industry average of 40%, despite the target being 75%. No doubt, strain will be placed on the Social Security System. A result of this may in turn lead to further tax burdens, prescribed investment to overcome the socio economic disconnect, all with a net effect of negatively impacting ones quality of life in retirement. Therefore, there are some daunting variables besides pure investment return that face the retirement industry. There is no doubt that this is a tricky situation, but SMMI is working with some of the brightest minds to ensure we grow our clients’ wealth throughout 2011.
