Academic endorsement for outcomes-driven investment
The French business school EDHEC’s investment faculty and research institute makes it a world leader in investment theory and innovative practice. In a new research paper EDHEC promotes the application of Liability Driven Investment techniques (which is the fast-spreading leading edge in asset-liability modeling, or ALM, for occupational pension funds) to private wealth management.
The following extract from the Executive Summary of Asset-Liability Management in Private Wealth Management highlights a gap the authors see between what customers are led to believe advisers do and what they actually do. In the UK market, I think it applies as much to IFAs and private client stockbrokers and discretionary managers as it does to private banks.
Our analysis has great potential implications for the wealth management industry. Indeed, it is often said that proximity to investors is the main raison d’être of private wealth managers and a key source of competitive advantages. Building on this proximity, private bankers should be ideally placed to better account for their clients’ specific liability constraints when engineering an investment solution for them. Most private bankers actually implicitly promote an ALM approach to wealth management. In particular, they claim to account for the investor’s goals and constraints. The technical tools involved, however, are often inappropriate. While the private client is routinely asked all kinds of questions about his current situation, goals, preferences, constraints, etc., the resulting service and product offering mostly boil down to a rather basic classification in terms of risk profiles. In this paper, we provide a formal framework suggesting that asset-liability management can ensure that private wealth managers are able to offer their clients investment programmes and asset allocation advice that truly meet their needs.
In the paper the authors demonstrate why advisers’ traditional portfolio construction techniques, which are semi-customised to a series of standard, single time-period, optimal portfolios, are suboptimal in meeting goal-specific outcome targets. They are suboptimal because
the target outcomes are not correctly defined (such as ignoring what it is that defines the goal itself, eg retirement spending or a property purchase)
the time-period risk and return estimates are not representative, given evidence of the long-horizon, real-return charcteristics of different asset classes
they cannot reflect idiosyncratic preferences and ‘utility functions’ (eg how each individual trades off competing objectives, such as maximising spending versus leaving a bequest, or thinks differently about exposure to different sources of risk, such as inflation versus capital-market verus longevity risks).
Our clients, and professional firms familiar with our ‘Defined Outcome’ approach to complete customisation, will be able to tick off virtually every attribute they describe. The specific model the authors define uses the same ‘separation theorem’ we do, as between a ‘hedge portfolio’ (which they also suggest for retirement plans is a duration-matched index linked gilt portfolio) and a ‘return-seeking portfolio’ of diversified risky assets. When they define the assets that best match long-horizon goal outcomes, they are dominated by equities because of the post-inflation risk and return evidence, including mean reversion in real returns. Their suggested building blocks for the risky asset portfolio may be broader than ours are, but that is a minor difference.
EDHEC note the very slow uptake of techniques already applied elsewhere. We might reasonably date LDI’s arrival, as a serious contender against the traditional ‘balanced management’ solution, to about a decade ago. Intriguingly, Chris Drew and I developed the mathematical model that allowed us to deliver mass-customisation of outcomes-driven portfolios with complex utility descriptions in 1998/9, while LDI was still in its infancy!
After a decade promoting outcomes-based planning and portfolio management, initially as consultants and software developers, Chris and I could be forgiven for being resigned to the market always undervaluing its technical superiority and its client benefits of clarity and confidence. But we are not resigned. Far from it, its practical demonstration in No Monkey Business is a completely realistic springboard for success. But generic endorsement from the likes of EDHEC, who carry far more weight than we do, is still a tremendous boost to our confidence and that of the team around us. I think it should be to our clients too. Backing an innovator or early adopter does not always feel obviously right.
The EDHEC paper prompts us to produce a paper of our own. As well as focusing on the academic arguments supporting EDHEC’s proposal, we plan to address some of the practical constraints on its uptake:
the business economics that lead to resistance to genuine customisation
what it is in the mindset of both advisers and their clients that leads to the persistance of what we call ‘the factory model’
how finance journalists can raise the profile of what can seem a dry technical debate
what it suggests about the ‘raising skills’ excercise which is a key objective of the FSA’s RDR reform agenda.
You can read an abstract of the EDHEC paper here, on the EDHEC Risk website. There is a link on the page to the paper itself.