Most investors expect the management of their nest eggs to adjust as time passes to meet the fund’s objective.
Yet most superannuation and retirement money has traditionally been ‘actively’ managed via a process that involves a static allocation to each asset class that doesn’t necessarily consider the broader environment, risks or valuation levels. The ‘active’ strategy all came in the form of manager selection within each asset class.
The Global Financial Crisis (GFC) reminded us what risk really is and evidenced that too much focus was given to managing the wrong risks. That is, the great risk to investors is the asset allocation itself, not the underlying fund managers that sit within each asset class.
In the aftermath of 2008, a new breed of funds emerged that aim to be true to their stated objective (and in many cases have more relevant objectives), and to dynamically manage all levels of risk to meet client goals.
Historical asset allocation approaches
Multi-asset investing is carried out at two distinct levels. The first is the asset allocation process that determines the relative weighting of different investment types. The second is the actual portfolio management of the components that are defined by the asset allocation process.
Historically, investment managers typically oversaw ‘balanced’ portfolios of equity and fixed income assets, often on behalf of defined benefit (DB) superannuation funds, and the investment objective was firmly focussed on meeting or exceeding a benchmark. Value could be added through stock selection or by (often modest) adjustments to the bond-equity balance.
The demise of DB schemes led to the increased use of defined contribution (DC) saving. The process focussed on creating a static strategic asset allocation (SAA) mix that was deemed appropriate to meet the long-term investment goals of the client. This might be defined relative to inflation but would not be dynamically managed to meet the objective.
The strategy would then be implemented by portfolio managers that were awarded benchmark-orientated mandates. Value creation by the overall manager was brought about by oversight and re-selection of the selected managers and outperformance of a benchmark.
Importance of focusing on client goals
When approaching or in retirement, investors usually don’t have the time or risk appetite to wait out economic cycles to achieve their goal. They are more sensitive financially and emotionally to significant market falls – especially those with lower account balances. Seeking to meet their investment objective – in most cases, capital preservation with some growth and with the least amount of volatility - makes more sense for this segment.
Unfortunately though many investment managers still retain a mindset that focusses on managing risks which the industry has traditionally felt comfortable overseeing – such as benchmark, peer group and manager risk. This is despite these factors being weak indicators of whether investors’ long-term income and capital goals are reached.
Although few really believe that the short-term peer group or benchmark-aware mindset is helpful in predicting long-term investment outcomes, it does throw up easy comparisons. In a complex world this is often held to be a respectable proxy for rigorous analysis.
The rise of goals-based investment objectives
The GFC resulted in capital losses in funds that deviated far beyond the expectations of clients. This paved the way for the rise of goals-based multi-asset portfolios which focus on an outcome such as a specific income target, a CPI+ return with lower risk, or a return that reflects a decreasing market risk appetite as retirement approaches. The amount of money in these types of funds, although increasing in popularity, is disproportionately lower than the significant amount of money still invested in traditional benchmark-aware funds.
For goals-based funds, meeting or exceeding short-term peer group performance should be a low priority for the investment manager as it is a poor indicator of whether clients’ long-term targets will be satisfied. However, a proliferation of fund league tables has emerged which may divert manager’s attention away from the pure pursuit of their fund’s investment goals.
Some consultants and multi-asset managers have adapted the traditional SAA approach to goals-based investing which means that the governance risk budget is ‘spent’ in building an SAA model that delivers a static minimum risk. Manager risk is therefore controlled by outsourcing portfolio management across a large number of asset managers with a range of investment styles and approaches to risk management.
But basing an investment strategy upon a static SAA deprives the overall investment manager of the ability to dynamically manage volatility.
High levels of manager diversification imply that pre-fee returns will tend towards those of the market, as the number of managers increases. This re-engineers market risk back into the process. Moreover, it creates greater complexity risk as different strategies, manager risk appetites and governance arrangements must be understood, analysed and monitored.
Alternatively investing in direct assets tends to reduce perceived short-term market volatility and can play a positive role in multi-asset investing. However, increasing exposure to direct assets comes at the expense of rising liquidity risk, especially at times of elevated market stress – a particular issue for those approaching or in retirement.
Neither of these ‘risk management tools’ enable the investment manager to effectively manage downside market risk in light of an evolving external investment environment and changing client demographics.
A more dynamic approach to volatility management is required
Retirees face increased sequencing risk, have less flexible income requirements, are more sensitive to inflation risk, have a greater need for liquidity and may well face a changing taxation environment. We should therefore concentrate our efforts on how we manage these risks which genuinely determine the extent to which investment outcomes align with client needs.
This means managing investors’ longevity and inflation risk in a more dynamic way that maximises absolute returns within their appetite for downside market risk and evolves with life stages.
A dynamic asset allocation approach can deliver superior investment outcomes through adjusting the risk budget so that it is spent when it is most likely to be rewarded. This is based on analysis of the economic cycle and the relative value of different asset classes, currencies, investment styles and sectors at different points in the cycle. Such analysis can reveal opportunities as growth becomes unevenly synchronised, yields depart from norms, the cost of tail risk protection varies or inflation protection costs deviate across currencies. A static SAA approach cannot capitalise on such opportunities to manage volatility.
However, the resources of a typical financial planner to dynamically manage volatility in line with the client’s evolving risk appetite are limited, relative to a well-resourced institutional multi-manager.
Managers should focus on delivering investment goals
We believe the investment management industry is still largely concentrating on the risks that don’t truly determine if our clients’ investment objectives are met.
Managers should focus on delivering specific investment goals while dynamically managing market volatility with a view to controlling inflation risk and longevity risk. If they don’t and continue to focus on short-term factors such as benchmark and peer group risk, this may only lead to inferior investment outcomes for their clients.