Fred Astaire was a great dancer. But Ginger Rogers did everything Fred did, backwards and in high heels. While she made Astaire look good, Rogers took far more risks and often ended up with bleeding feet. She likely never got close to his compensation package, either.
In their approach to managing client assets, most advisors are like Rogers. Astaire represents the market, dancing to the rhythm of all available information. The primary goal of investment managers (i.e., Rogers) is staying with the market (i.e., Astaire) at any cost. In fact, most portfolios are benchmarked to market indexes, but only a minority are able to keep pace. Is this what investors really need?
Time horizon and risk tolerance are derived from KYC procedures. Objectives, like retirement or college for the kids, set future dollar targets. Advisors then proceed backwards by using historical rates of return to determine an asset mix that would have achieved the goal. Backward-looking correlations between asset classes establish diversification. But historical returns don’t have predictive power and past correlations aren’t consistent, particularly with frequently changing volatilities.
Value investors and other factor-based investment strategies purport to maintain a discipline that will beat the market. But their belief depends on history repeating itself. They make asset selections based on historical experience, hoping the market rewards the same things it did in the past. This describes smart or alternative beta.
What is the goal?
Why stay in step with the market? If the mandate is to beat an index (e.g., the S&P TSX Composite Total Return Index), the starting point may indeed be the market, with a focus on which sectors and holdings to under and overweight. Institutional investment briefs combine this absolute objective with a relative goal to be first quartile among like funds over some period. (The period is fixed but can vary based often on a consultant’s whim and is not always the same as the absolute return period.)
Individual investors are different. Each has goals specific to her needs—providing monthly income, growing capital but assuring enough money for grad school in six years, or providing an inflation-adjusted nest egg at retirement in 20 years. Personal objectives don’t relate to the market and have finite time horizons. As a result, benchmarking portfolio progress solely to an index becomes a misguided exercise. Unfortunately, most firms take an institutional, cookie-cutter approach to setting objectives to make compliance easier. Performance relative to the market has become more important than progress towards client goals. But easier is not necessarily better.
In high heels
After identifying a client’s particular risk tolerance, an asset allocation is typically determined. Regardless of market conditions, advisors are encouraged to rebalance to the policy asset mix. If 60% equities is the riskiest a client’s portfolio can be, advisors insist on keeping it as risky as possible all the time. This makes little sense.
During bull markets, as the market heads off a cliff, advisors rebalance to the riskiest portfolio mix a client can tolerate (60/40, for instance). At bottoms that advisors recognize usually only in hindsight, they buy the falling asset all the way down. Rebalancing to maintain diversification has benefits, but these behaviours may lose client confidence.
Exit stage right
Benchmarks should reflect client goals. Goals-based investing (see AER, February 2016) needs to be developed so that objectives can be viewed as liabilities and portfolios are consolidated by risk, rather than by buckets of returns. Liability-driven investing (LDI) is not new.
Defined-benefit pension funds have liabilities against which they are measured and LDI keeps all parties informed when there are imbalances.
Managing assets towards individuals’ goals makes sense too. If we enter downstage left and the objective is to exit upstage right, we can plot our path before we start. If the market leads advisors to territory too far away from our intended path, they need to be able to go solo.
Allowing the market to lead advisors across the stage is fine, as long as the path and pace are consistent with client risk tolerances and intended goals.
But benchmarks need to be more client-specific and less related to market indexes (e.g., if a client needs a 5% annual rate of return to earn enough to buy an investment property, that’s her benchmark return, even if the market is returning more or less). So advisors should consider liability-driven investing approaches that focus on client goals, rather than always trying to maximize returns.
Managing the risk of portfolios to the risk of liabilities can help (e.g., if the required 5% is below what the market is returning, advisors can ratchet down risk appropriately). Advisors can strap on high-heeled shoes and follow Fred, or put on their sneakers and make their way to their objectives.
Next time, we’ll look at LDI strategies for retail investing and introduce the idea of smart personal alpha to harvest risk premia for clients.
by Mark Yamada, president of PUR Investing Inc., a registered portfolio manager and software development firm. Disclosure: PUR Investing Inc. sub-advises for, and provides risk-based model portfolios to, Horizons ETFs.