Inv sting for growth -
creating more effi cient portfolios
First weigh the considerations,
“
then take the risks.”
Helmuth van Moltke
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 expected 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 exibility that the member has with respect to these other levers.
Those willing to fl ex contribution rates or change retirement plans are in a position to accept higher investment risk (which
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 mix
•
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
•
mix of the growth portfolio itself.
Fiduciaries need to consider the implementation
•
route within asset classes and in particular the extent to which active or passive management is appropriate.
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 mix 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 execute).
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 available2. Historically, many DC schemes have a glide-path design where the growth portfolio is invested entirely in equities. This leaves members heavily exposed 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
Credit/insurance premium
Liquidity premium Equity risk premium
Equities
Absolute return equities
Skill premium Emerging markets
Tactical asset allocation
Private equity Hedge
funds Currency
Infrastructure Absolute return
property Property
Timberland Commodities PFI
High yield debt
Securitised loans Emerging
market debt
Successful investing
“
requires consideration
of return and risk.”
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.
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 example diversified growth fund with 12 different asset classes, increases the investment efficiency measure by nearly a third from 0.35 to 0.46. This is achieved by a small reduction in expected return being outweighed by a significant reduction in risk through the benefits of diversification.
x
50% equity/50% bond100% bond
Diversified portfolio
100% equity
Expected outperformance (% pa)
5 10 15 20 25 30 35
9 10
8 7 6 5 4 3 2 1 0
x
x x x x
x x
x x x x
Figure 02. The benefits of greater diversification
Risk is reduced by
“
adding assets in which
return patterns are not
entirely correlated with
those from equities.”
What makes a good diversified growth fund?
To be attractive in a DC context, diversified funds need to exhibit 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.
Figure 03. Options for delivering diversified growth strategies
Actual
diversity Liquidity Transparent price
Best in class asset
managers Fiduciary
control Governance cost
Create your own Yes Yes Yes Yes Yes High
Delegated
implementation Yes Yes Yes Yes Some Medium
Buy off-the-shelf Some Yes Maybe No No Medium
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 existing ‘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 expected returns are lower. Allowing leverage in the diversified growth fund can alleviate the expected return deficit, although this further adds to the complexity 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 Governance cost
Create your own Yes Yes Yes Yes Yes High
Delegated
implementation Yes Yes Yes Yes Some Medium
Buy off-the-shelf Some Yes Maybe No No Medium
Figure 04. Beliefs required for the use of active management
Fiduciary’s beliefs DC member’s beliefs
Skill exists (manager performance is not random, markets are not perfectly efficient)
Skill exists (manager performance is not random, markets are not perfectly efficient) Skill can be identified through some
system of analysis
Skill can be identified through some system of analysis The fiduciary has access to such a system
and can identify managers with skill
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
The benefits of active management justify the additional fees
Active versus passive
We have already discussed2 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 index-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 index fund with the same benchmark3. 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 existence and identification of skill as well as sufficient governance resources. In a DC context, 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 05. Time diversification of investment risk
■ Equity VaR ■ Constant VaR
Age
25 30 35 40 45 50 55 60
VaR
65 Need to take more risk
Need to take less risk
Spreading risk over the accumulation phase
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 index products (for example, wealth-weighted or risk-weighted index 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.
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 exponentially 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 flexibility 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.
Segmenting contributions
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.
is minimised4. 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.
Notes
1 Glide path design: building a de-risking strategy, Watson Wyatt, October 2009.
2 Investment governance: enhancing the value chain on page 13.
3 Standard & Poor’s estimate that 70 per cent of active managers will do no better than the index 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 context of asset allocation decisions see J Campbell and L Viceira, Strategic Asset Allocation: portfolio choice for long term investors, OUP, 2002.
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 example, 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 Index Linked Gilts) so that the risk of failing to generate the subsistence level income
Figure 06. Example of notional accounts
High risk growth assets to exploit return potential
Low risk growth assets following glide-path design
Safe assets to generate subsistence level income Second 30% of the
employee contribution
First 70% of the employee contribution
Employer contribution
