Why outcomes are the new alpha

This article was originally published in December 2013.

In its recent report, The Investment Management Industry: Outcomes Are the New Alpha, McKinsey & Company attributes the industry’s slow growth prospects to demographics, recent memories of volatility and a decade of flat equity returns. Three key areas, however, hold promise for growth over the next several years:

• passive investing
• alternatives
• outcome-oriented solutions

Low returns are forcing more investors to look beyond relative return strategies like actively managed equity and bond funds, and money market vehicles. Chart 1 (this page) shows U.S. asset flows from 2008 to June 2013.

Passive investing

The trend toward passive investing (including indexing, index mutual funds and ETFs) is a logical development, given that active management has not consistently added value to passive benchmarks and lower-cost products are now more widely available. The shift toward fee-based advice, encouraged by the elimination of trailing commissions in the U.K. and Australia, also promotes flows into index products.

In Canada, regulators recognize part of the problem is many advisors’ increasing dependence upon trailing commissions (CSA Discussion Paper 81-407 Mutual Fund Fees). It’s encouraging that about 15% of advisors have moved to a fee-based model, aligning their interests with clients rather than product providers. It’s a big trend in the U.S., where advisors are driving the fee-based movement and are using ETFs.

Alternatives

This category encompasses a broad array of products, including real estate, private equity and the full range of hedge fund strategies. Despite an inconsistent track re-cord during major market collapses—when fear makes everything decline—broad diversification has been an effective way to deal with volatility. ETFs representing alternative approaches allow more investors to access these specialized asset classes that otherwise come with obstacles, such as minimum investment, illiquidity and layered fees.

Outcome-oriented solutions

The McKinsey report notes a key concern for investors is outliving retirement savings. Defined contribution (DC) pension plan members need to accumulate sufficient capital to provide replacement income in retirement, but they lack the expertise to manage their portfolios. Target date funds, which automatically adjust the asset mix of a balanced portfolio to become more conservative as retirement approaches, are a common but unsophisticated solution. The new trend in benchmarks is outcomes.

Pension outcomes

In a 2011 paper for the Rotman International Journal of Pension Management, my colleague Ioulia Tretiakova and I described a risk-based glide path that increases or reduces portfolio risk based on how an investor is progressing towards her capital accumulation goal. If she falls behind (see “A” and “C” in Chart 2, below), risk is modestly increased. If she’s ahead (see “B”), it’s reduced.

After adopting this approach, one of the first things a $45-billion Australian superannuation plan did was remove itself from league tables: it no longer publicly compares its portfolio’s performance to a benchmark of indexes or to other superannuation plans. The only benchmark that matters is progress towards target capital for plan members. This is a good example of the shift to outcomes.

The table (see “Annual net flows,” below) shows estimated growth or decline for selected asset classes from 2012 to 2016. Growth for ETFs, alternatives and multi-asset solutions are highlighted in green. (DC plans aren’t included; they would add $400 billion to multi-asset class solutions if recent history is any guide.) Advisors can still use relative return strategies to win assets from other advisors, but providing an outcome-based solution is a far more powerful value proposition.

McKinsey states that, within five years, 70% of investable assets will be in the hands of retirees or those close to retirement. Next month we’ll review a post-retirement investment approach that aims to minimize the risk of running out of money.

Annual net flows 2012-2016

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.