Con Keating | Comment
The arguments that a value-for-money met- ric should reflect the ex-ante risk-preferenc- es of the investor/fund manager are a canard. The implementation of strategies reflecting these preferences may, and usu- ally do, restrict the value for money achiev- able by a saver.
of good active fund management is the identification and avoidance or mitigation of those bad events which will occur from among those which may. Passive invest- ment is acceptance or tolerance of whatever comes to pass.
The IRR of a member’s savings reflects the strategies followed by the funds in which it was invested. This might be the passive ‘non-strategy’, or market-timing, or life- styling. Each have their own ex-ante risk exposures, but the IRR explicitly captures all those risks which eventuated. It also cap- tures the costs associated with risk avoid- ance and mitigation of those events which did not occur.
The expression ‘life-styling’ refers to portfo- lios which progressively move their asset allocation away from equity to debt as the member approaches retirement. The objec- tive is to minimise the volatility of the port- folio’s value at retirement, which of course, was previously the prime determinant of the member’s retirement income. There are difficulties with creating bench- marks for ‘life-styling’ in that this practice applies at the level of the member’s alloca- tion, not the overall consolidated fund. It is also far from clear why this strategy should be treated differently from any other strategy where comparison is made to the available investment opportunity set. The process of moving progressively to higher bond allocations will carry with it the prospect of a smaller ‘pot’ value at retirement than would be expected with the standard 80/20 portfolio. The question then becomes, is this lower pot value war- ranted by the risk avoided? This may be investigated quantitively. I set up a simple model, where debt securities have an expected return of 4% and volatility of 10%, with equities having an expected return of 7% and volatility of 20%. The cor- relation between them is 0.4. The returns distributions are assumed to be normal. The portfolio allocation is then modified from an initial 80/20 to all bonds in steps of 5% until it reaches 100% debt after 17 years. At this time the expected value of the 80/20 benchmark is some 20.45% higher than the ‘life-styled’ fund. The likelihood of the 80/20 benchmark delivering a return
below the ‘life-style’ expected value is 14.24% and the expected loss relative to that value is 7.63%. By contrast, the life-style fund has a 50% likelihood of a return below its expectation with a value of 6.74%. If we define risk as the product of the likelihood and magnitude of an event, then the risk of the ‘life-style’ strategy is 3.37% while that of the benchmark 80/20 portfolio is
just
1.08%. It appears that in this instance ‘life- styling’ is a case of reckless prudence in risk management.
The loss events of the ‘life-styling’ and benchmark portfolios are not independent of one another; they have a degree of dependence by construction. 32.8% of the benchmark portfolio’s problematic returns will be associated with underperformance by the ‘life-style’ portfolio; a case of damned if you did or damned if you did not follow the strategy.
In the vast majority of outcomes, the pen- sion saver is far better off invested in the 80/20 benchmark; the ‘lifestyle’ portfolio only exceeds the expected value of the benchmark 80/20 portfolio in 2.04% of circumstances.
Of course, this is one simple illustration and we might vary any or all of the model assumptions, the expected returns and vol- atility of debt or equity, their correlation or the speed at which ‘life-styling’ is intro- duced. We might even introduce more complex rules, path-dependent strategies, such as moving to bonds only after a strong equity return, but these will all bring with them only variations in degree of the prob- lem illustrated here.
If we add to this concerns that we may cur- rently be in a debt bubble induced by mon- etary and quantitative easing, with the implications of that for future debt returns and volatility, ‘life-styling’ appears to be far from conservative and, indeed, unlikely to deliver the benefits usually claimed for it.
Issue 87 | October 2019 | portfolio institutional | 17
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