How goals based investing overcomes the limits of the traditional funds’ benchmark focus

Most investors understand that a traditional fund’s primary goal is to beat a benchmark. An Australian equities fund, for example, might define the ASX200 as its benchmark. In that case, its pure measure of success is whether it outperforms or underperforms the ASX200.

But as we saw during the global financial crisis (GFC), that benchmark approach can create a number of problems for investors.

Firstly, a portfolio manager may still beat the benchmark but deliver a poor outcome for investors.

The benchmark might fall 30 per cent. The fund could marginally beat that benchmark by recording a smaller 25 per cent fall.

That’s seen as a good outcome by the fund manager – they did ‘outperform’ the benchmark - but the investor has still suffered a significant portfolio loss.

The volatility within the benchmark itself is not seen as the responsibility of the fund manager to manage. The investor themselves ultimately must understand and manage this risk, which led to a big disconnect between investors’ expectations and outcomes in the GFC.

Who is the investor?

Perhaps the biggest problem is that, by focusing purely on outperforming benchmarks as their goal, the portfolio manager of a traditional fund may know very little about the type of investors they’re managing assets for, and what the investors are trying to achieve with those assets.

They may not know whether their investors are accumulating assets, or decumulating assets. They may not know their tolerance for certain risks like downside and inflation. And in some cases, they may not even know their tax status.

A deeper understanding

A goals based investing approach, by contrast, is designed to overcome the limitations of the traditional fund approach.

Under a goals based investing approach, rather than just simply beating a benchmark, a fund is defined by a particular goal it is trying to achieve.

A goal of the goals based fund, for example, might be to deliver a stable and steady return for a retiree in Australia drawing down cash flows.

All of a sudden, we know a whole lot more about the investor, in this case a retiree. We know typically the investor’s tax status, their low tolerance for large drawdowns and sensitivity to inflation, as well as their need for liquidity.

In turn, that opens up a lot more levers for the portfolio management team to add value.

Taking a view

When an investment manager switches to a goals based approach, it means they actually drop standard benchmarks and instead think holistically about their investors’ risks and needs.

Moving away from a benchmark, of course, can be challenging.

It means the portfolio manager has nowhere to hide. They must have a view and take risks in an absolute sense and define what the portfolio looks like as markets evolve and valuations change.

Defining risk

When the manager removes the benchmark, they need to rethink what risk is. Risk is no longer performance relative to a performance benchmark outcome. Risk is something else.

At AMP Capital, for our own goals based funds we try and align risk with how an investor would see it.

So, for our retirement funds and our goals based funds in general, we define risk by how much could be lost in a very distressed environment, such as the GFC.

We look at the portfolio today and see what it would have lost back then and manage that as the key risk for the end investor.

Reaching goals

Traditional funds have long focused on beating benchmarks.

But as we saw in the GFC, that approach had serious limitations. Investors suffered big falls. And their investments were not aligned to their personal goals, such as steady income during retirement.

The goals based approach enables fund managers to disconnect from the limitations of benchmarks.

It allows them to create funds where the goal is, not to beat a benchmark, but to deliver a clear outcome for investors. They can then invest their portfolios in a way that seeks to maximise the chances of those goals and outcomes being met, aiming to create greater certainty for investors.