creating more efficient portfolios

Transcription

1 Investing for growth - creating more efficient portfolios First weigh the considerations, then take the risks. Helmuth van Moltke 42 towerswatson.com

2 DC members have historically been heavily invested in equity markets throughout the accumulation phase of retirement plans. This heavy reliance on the equity risk premium, often coupled with use of active management, has created member investment strategies which lack the benefi ts of diversifi cation and also bring a heavy governance burden to the fi duciary which is often not lived up to and all too often destroys, rather than adds, value to the member. In this article we look at the design of investment portfolios aiming to deliver growth, within a reasonable risk framework, through the accumulation phase of a DC member s savings life. We consider how a more diversifi ed approach can create more effi cient solutions than the all-equities approach used by many DC plans at present. We also look at the relative merits and implications of using active or passive management in these portfolios. Throughout, our theme is based on appropriate portfolio design for a given level of governance budget and member risk tolerance. Understanding and managing investment risk to members Members objectives in a DC plan are defi ned by three factors: the epected outcome (the amount of fund or level of pension and age at retirement), the potential variability of that outcome, and the volatility of the journey to retirement. Risk can then be defi ned as the chance of not achieving the objectives set with reference to these three factors. This means that fi duciaries need to be clear as to their intentions around these three factors and then to build investment strategies which have risk levels consistent with those intentions. Investment risk is one lever that members can use as they steer their journey towards retirement. The other levers are changing the contribution rate, or accepting a different outcome (by retiring at a different age or with a different level of pension). Investment risk levels should therefore be determined by the amount of fl eibility that the member has with respect to these other levers. Those willing to fl e contribution rates or change retirement plans are in a position to accept higher investment risk (which they will do in the hope of securing a higher level of outcome). Journey well, arrive better redefi ning DC investment 43

3 Building a portfolio to accumulate There are three steps to creating an investment portfolio designed to deliver growth through the accumulation phase of a DC member s lifecycle: The design of the glide-path the evolving mi of growth and safe assets through the working life of the individual 1. The growth portfolio slots into this glide-path. Determine the risk/return objectives and asset mi of the growth portfolio itself. Fiduciaries need to consider the implementation route within asset classes and in particular the etent to which active or passive management is appropriate. Successful investing requires consideration of return and risk. Adding value in the investment proposition can therefore be achieved through: Better glide-path design incorporating awareness of members liabilities and circumstances. More diversifi cation in the asset mi used to generate growth. Appropriate use of active or passive management. However, each comes with an increasing governance burden (time, cost and skill required to eecute). The benefi ts of diversifi cation Successful investing requires consideration of return and risk. We look to achieve the best possible return per unit of risk within the constraints of the governance available 2. Historically, many DC schemes have a glide-path design where the growth portfolio is invested entirely in equities. This leaves members heavily eposed to equity risk and not well diversifi ed. This can be improved (in the sense that a better return per unit of risk can be achieved) by adding a number of other return drivers (see Figure 01). Figure 01. Diversity of return drivers Equity risk premium Equities Absolute return equities Emerging markets Tactical asset allocation Skill premium Private equity Hedge funds Currency Credit/insurance premium High yield debt Emerging market debt Securitised loans Absolute return property PFI Infrastructure Property Timberland Commodities Liquidity premium 44 towerswatson.com

4 Risk is reduced by adding assets in which return patterns are not entirely correlated with those from equities. This will also introduce alternative return drivers into the portfolio such as credit and illiquidity, bringing more diversity to the growth assets. For this reason, Diversified Growth Funds (DGFs) are gaining in popularity amongst DC plans, replacing global equity options as the default growth fund. Risk is reduced by adding assets in which return patterns are not entirely correlated with those from equities. Results of asset allocation modelling We can illustrate diversification benefits through modelling using Towers Watson s long-term return, volatility and correlation assumptions for various asset classes. Figure 02 highlights the benefits of moving to a more diversified approach utilising small allocations to currency hedging, emerging market, infrastructure, private equity and property, alongside bonds/equities, and away from a 50/50 equity and bond allocation. One useful measure of investment efficiency is the performance and tracking error relative to the cash return. Moving from a 50/50 equity and bond portfolio to the eample diversified growth fund with 12 different asset classes, increases the investment efficiency measure by nearly a third from 0.35 to This is achieved by a small reduction in epected return being outweighed by a significant reduction in risk through the benefits of diversification. Figure 02. The benefits of greater diversification Epected outperformance (% pa) Diversified portfolio 50% equity/50% bond 100% equity % bond Tracking error (% pa) Journey well, arrive better redefining DC investment 45

5 What makes a good diversified growth fund? To be attractive in a DC contet, diversified funds need to ehibit genuine diversity rather than token moves away from all-equities. There should be a logical spread between different asset classes and, where appropriate, different investment strategies. DC product design and the requirement for daily dealing will place some constraints on the amount of diversity that can be achieved. In particular, there are requirements around liquidity of funds that may limit some alternative asset classes such as private equities. Funds should be liquid enough to realise investments in a reasonable timeframe with controlled transaction costs. Where active management is used, this needs to be best in class, which generally means the use of different managers in different asset classes. It is also important to try to create relationships where the interests of the investors and the managers are aligned. Well-designed performance-related fees are an important component of that alignment. Many eisting off-the-shelf diversified growth funds offered by investment managers do not score well on a number of these criteria. In particular, fees tend to be higher than those of many global equities funds whilst epected returns are lower. Allowing leverage in the diversified growth fund can alleviate the epected return deficit, although this further adds to the compleity of a product that already carries a much higher governance burden than equities funds. Delivering a diversified growth strategy When assembling a diversified growth strategy within a DC plan, fiduciaries have three different implementation options: creating their own (this would need at least 100 million of assets), using delegated implementation, or buying off the shelf from an investment manager. Figure 03 summarises the advantages and disadvantages of these options. Figure 03. Options for delivering diversified growth strategies Actual diversity Liquidity Transparent price Best in class asset managers Fiduciary control Create your own Yes Yes Yes Yes Yes High Governance cost Delegated implementation Yes Yes Yes Yes Some Medium Buy off-the-shelf Some Yes Maybe No No Medium 46 towerswatson.com

6 Active versus passive We have already discussed 2 the benefits of aligning a DC investment strategy with the underlying governance capability of the plan, as well as raised the prospect of skill diversification by using multiple active managers across different asset classes. DC plan fiduciaries need to carefully consider the conditions under which active rather than passive management is appropriate in DC. Successful active management requires superior judgements, insights or models which are capable of producing and sustaining competitive advantage. The passive or inde-tracking alternatives carry the advantage of much lower fees but require a manager with strong process, technology and understanding of investment indices. We know that active management is a zero sum game before costs. That is, before we take account of transaction costs and fees, for every winner there must be a loser. Trading costs and higher fees mean that the majority of actively managed funds will underperform the inde fund with the same benchmark 3. In addition, selecting good active managers is itself a competitive activity, and one which takes time and skill, placing demands on governance in both selection and monitoring. Beliefs Use of active managers requires certain investment beliefs about the eistence and identification of skill as well as sufficient governance resources. In a DC contet, we hold that both the fiduciary and the member need to essentially hold four (complementary but slightly different) beliefs before active management should be pursued (see Figure 04). We would suggest that these belief requirements, plus the governance burden, create a high barrier for the use of active management in DC arrangements and that the majority of schemes would be best placed using a predominance of passively-managed funds. This would turn the DGF into a DG(beta)F. Successful active management requires superior judgements, insights or models which are capable of producing and sustaining competitive advantage. Figure 04. Beliefs required for the use of active management Fiduciary s beliefs Skill eists (manager performance is not random, markets are not perfectly efficient) Skill can be identified through some system of analysis The fiduciary has access to such a system and can identify managers with skill The benefits of active management justify the time and effort required to identify the skilled ones DC member s beliefs Skill eists (manager performance is not random, markets are not perfectly efficient) Skill can be identified through some system of analysis The fiduciary has access to such a system and can identify managers with skill The benefits of active management justify the additional fees Journey well, arrive better redefining DC investment 47

7 Fund design will still need to reflect governance limitations if private equity, infrastructure and hedge funds are to be delivered. What would DG(beta)F look like? A DG(beta)Fund looks to deliver multiple return drivers in a lower cost, lower governance form. This type of strategy would still retain a significant equity allocation. Skill is then delivered through smart inde products (for eample, wealth-weighted or risk-weighted inde funds) rather than through active managers. DC product design considerations will result in some limitations to diversity. In particular, illiquidity benefits are difficult to value in a daily-dealing environment. Fund design will still need to reflect governance limitations if private equities, infrastructure and hedge funds are to be delivered. Listed property, private equities and infrastructure and hedge fund replication strategies do offer practical options for those able to invest in a broad set of asset classes. Spreading risk over the accumulation phase The size of a DC member s account will grow substantially through their accumulation period. If we consider the amount of money at risk rather than investment risk in percentage terms, then risk grows with account size. In fact risk in value terms grows eponentially over time, peaking just prior to retirement. This is most marked with a 100 per cent equities growth fund, but the same phenomena occurs with lifecycle and DGF. However, we know that members human capital declines as they approach retirement and they have much less fleibility to absorb adverse circumstances with large amounts of value at risk (because they have little time before retirement to institute adjustment mechanisms). A more efficient profile for the individual would spread value at risk more evenly through the accumulation phase increasing in early years and reducing nearer retirement. To do this would mean introducing some form of leverage in early years when accounts are small but human capital large, and employing the de-risking techniques found in lifecycle funds as the member gets older and human capital reduces. Figure 05. Time diversification of investment risk VaR Need to take more risk Equity VaR Constant VaR Need to take less risk 65 Age 48 towerswatson.com

8 Segmenting contributions A further refinement to managing risk and return in a growth portfolio which recognises that different members will have different levels of risk tolerance broadly driven by their level of earnings uses the segmentation of a member s contributions. In this model, a member s contributions are allocated into separate buckets or notional accounts, each with its own investment strategy. For eample, the member could target a subsistence level of retirement income and allocate a certain proportion of contributions into funds invested in safe assets (such as Inde Linked Gilts) so that the risk of failing to generate the subsistence level income is minimised 4. The remainder of contributions can then be invested into a growth fund with more investment risk, with the aim of generating higher levels of retirement income. The sizes of these buckets will reflect the retirement needs of the individual member and their attitudes to risk. An illustration of this type of contribution segmentation is shown in Figure 06. Clearly, this approach would require a higher level of sophistication and governance from the plan s fiduciary and this additional cost should be weighed against the potential additional benefits of this approach. Figure 06. Eample of notional accounts Second 30% of the employee contribution High risk growth assets to eploit return potential First 70% of the employee contribution Low risk growth assets following glide-path design Employer contribution Safe assets to generate subsistence level income Conclusion Growth funds for DC members can be improved by adding diversity of asset classes and by ensuring that appropriate use is made of active or passive management given beliefs and governance. Diversified growth funds are found to be more investment efficient than portfolios relying entirely on equities returns as they deliver similar returns at noticeably lower risk levels. Allowing scope for leverage would further enhance the offering, particularly in the early years of accumulation. A good DGF brings genuine diversity whilst maintaining controls over costs and liquidity. Notes 1 Glide path design: building a de-risking strategy, Watson Wyatt, October Investment governance: enhancing the value chain on page Standard & Poor s estimate that 70 per cent of active managers will do no better than the inde in the market in which they operate, see Standard & Poor s Indices vs Active Funds Scorecard, Mid Year 2008 (12 November 2008). 4 For a more technical consideration of subsistence income in the contet of asset allocation decisions see J Campbell and L Viceira, Strategic Asset Allocation: portfolio choice for long term investors, OUP, Journey well, arrive better redefining DC investment 49