The investment management industry often views 'the client' as a faceless entity, which makes investment decisions part of a bureaucratic process. Although the client hires the investment manager and conducts the relationship with them, the reality is that the ultimate beneficiary of most of the manager's investment decisions is an individual investor with particular needs and requirements. This can encompass a wide variety of life planning decisions, such as ensuring one has sufficient funds for retirement, budgeting for health care needs, saving for a major purchase, or building a college/university fund for growing children.
This may sound obvious, but actually it often gets ignored in much of the investment management industry's product planning and asset allocation decisions. In our view, borrowing a simplified approach from the Liability Driven Investing (LDI) concept, which was popularised for insurance companies and pension plans, can provide a framework to better tailor products for individuals' investment needs.
LDI can better meet people's specific lifestage goals
LDI investment decisions are based on the goal of ensuring sufficient assets to meet the cash flows needed to fund all current and future liabilities. This form of investing is most prominent with insurance companies and pension plans, since their liabilities are large and require hedging, but are also reasonably predictable. However, LDI can also work for individuals since the future stream of our liabilities are also relatively predictable due to the major life stages that most individuals encounter, such as buying a house, having children, sending them to university, insuring for any health care issues that may arise and planning for retirement.
Most people have a fairly clear idea of their holding period for a specific investment decision, whether it be shorterterm budgeting for a house or college fund or longer-term for retirement provisioning. However, the investment management industry has focused most of its product offerings on perpetual fund structures in order to appeal to the broadest swathe of investor interest. This doesn't actually fit well with people's limited, sometimes well defined, investment horizons. Compounding this problem, portfolio managers tend to run these perpetual funds within their own investment horizons to best outperform their peers or a benchmark index. These investment horizons may not be clear to, or appropriate for, the end investors in the product.
Market benchmarks not always appropriate for individual investors
Let's illustrate the issue further by looking at bond funds. Bond funds are perpetual in design, even though each bond has a specific maturity date. Bond funds have interest rate risks, which can be measured by the concept of duration—the sensitivity of the price of a bond to a change in interest rates. Investment managers make decisions on the duration of their fund in an attempt to outperform a market index or a peer group. But for an investor with a clear investment horizon, matching their holding period with a bond investment of the same maturity should lead to the best outcome with least interest rate risk. This is a simple hedging strategy followed by insurance companies and pensions, called interest rate immunisation, or simply, duration matching. However, the dearth of target date or fixed maturity funds makes this strategy difficult to implement for investors. In the current environment where yield is much sought after and interest rates may rise in the near to medium term, matching an investment horizon with a fixed maturity may be the best way to maximise yield while minimising interest rate risk.
An investor has a 7-year investment horizon and buys a 7-year bond. The bond's value in the market will fall when interest rates rise and increase when interest rates fall. However, holding the bond to maturity means that (barring default), whatever happens to interest rates, at the end of the seven years the investor will receive back their initial capital investment plus the interest compounded to maturity.
Investing in a perpetual bond fund that continually reinvests and does not mature rather than a single bond that matches their particular investment horizon would expose the investor to two key risks, both interest raterelated. The first risk is that if interest rates were suddenly to rise just prior to the investor's 7-year investment horizon, the investor could be forced to sell their units in the fund at a loss in order to redeem them for the cash they require.
The second risk is if interest rates were to unexpectedly decline when the bond fund manager and the market expected them to rise. If bond managers are short duration, i.e. buying shorter-dated bonds because they expect rates to rise, but rates actually fall, the investor could be caught in the situation that they will have insufficient income to meet their cash flow requirements over their investment horizon. This has been observed in 2014 as rates have moved lower than the market consensus, pushing bond yields globally down to much lower levels than expected.
Matching the maturity of an investment portfolio with an investor's particular time horizon relieves the investor of any interim interest rate risks that they might be exposed to if they invested in a bond fund.
Another reason why LDI is appropriate for individuals is that they don't live and spend with a budget that looks like a market index. The concept of 'efficient market theory' has convinced millions of investors that equity investing according to a broad market index is the most efficient investment method. Such economic theories typically assume that the hypothetical consumer has an infinitely long investment horizon. However, not only do we not live forever, but we all have different lifestyles and goals so it's impossible for a market index to best serve the future spending needs of each individual investor.
The weightings of broad market indices also shift so that the composition of these indices varies greatly over time, encompassing the rise and fall of industries' fortunes (see chart). For example, broad market indices were heavily weighted towards the energy industry in the 1970-1980s, the technology sector in the 1990s and financials in the early 2000s leading up to the GFC. For an average investor looking to retire in the next 10 years, is the best advice for them to hitch their retirement savings to the fortunes of whatever industry happens to be in vogue in the particular market environment? We would suggest not.
Composition of MSCI AC Asia ex-Japan, S&P/ASX 200 and Nikkei 225 broad indices
MSCI Asia ex Japan
Source: S&P/ASX, Nikkei Indexes, MSCI Barra as at 14 Oct 2014
These graphs show the top three industry concentrations for Asia ex Japan, Australia and Japan. They highlight the fact that market indices reflect the industry composition of the country or region in which they are based, but this may not match how an investor should be constructing their portfolio to plan their life. Investors have a preference to overweight their domestic market in their equity allocation, but does it make sense that a Japanese investor and an Australian investor who will both retire in the next 5-10 years should have such different industry exposures purely based on where they happen to live?
LDI likely to become more prevalent in the investment management industry
Investing according to a person's future needs is a tricky strategy to put into practice. It may be easier to implement for a fixed income allocation, where matching the duration and risk profile of the investment goal with the investment product can lead to a better outcome. But what about future inflation, which can eat away the future purchasing power of our savings? This is where equity investing can be appropriate, although rather than buying an equity fund, which tends to be designed with a broad market index in mind, a superior alternative may be to follow an inflation-based target return strategy.
Neither of these strategies alone, however, is likely to deliver the best outcome for an investor. Creating a truly outcomeoriented investment fund requires the flexibility to employ a broad array of asset classes and the ability to manage downside protection. This is where multi-asset investing comes into its own. It is becoming increasingly popular because it can help fulfil varying investor needs, particularly a generation looking to plan its retirement decumulation phase. Spending patterns during retirement years will be very different than the wealth accumulation phase in younger years, particularly in terms of planning for discretionary as well as non-discretionary spending. More effective investment plans should take that into account. One problem is that many investment products don't address the rising costs of health care during the decumulation phase where achieving higher returns may not be as important as downside protection.
In our view, the investment management industry needs to better understand that individuals have specific and differing requirements, even in terms of retirement income. The LDI approach recognises the importance of not just focusing on asset growth when designing a portfolio, but also on future cash flows and expenses.
More customised, outcome-oriented investing could be the next big trend
Investment managers have become too focused on market indices and financial theories, with insufficient care and attention paid to what investors actually need for their life planning decisions. Deeper investigation into and understanding of the ultimate investors' needs will lead to much more effective product development. We expect to see an increasing number of products in the market that boast a more LDI-type approach. Some examples might be inflationbased target return funds, funds with target maturity dates or target risks, and funds with industry alignments that match investors' particular preferences. In our view, the development of outcome-oriented products that have an investment objective in line with an investor's real life goals will fill the current gap in the market for more customised and life stageappropriate investment solutions.