Delivering Investment Outcomes
Since the global financial crisis, many of the assumptions that underpin traditional wealth portfolios have been brought into question.
For example, targeting a growth and defensive mix implicity relies on volatility as the risk measure, assuming that returns will be approximately normally distributed. However, we know that not to be the case. Returns show significant left-tail skew, particularly during times of market stress.
There are many different approaches that can be described as a “lifecycle” framework. A common trait is that the time horizon of the investment portfolio is the dominant consideration when determining the appropriate risk tolerance.
- Short-term consumption goals should be hedged, to provide the maximum certainty that the portfolio will have the required value at the horizon.
- Medium-term goals should be insured, to allow for the possibility of benefitting from market moves, while reducing the impact of adverse moves.
- For long-term goals, the cost of hedging and insurance is likely to be too high to be justified. Long-term portfolios should be structured to allow the strategic asset class drivers to produce returns while minimising cost drag.
Managing portfolios across different time-horizons requires the ability to measure and manage risk in more terms than volatility alone.
To modify the lifecycle approach, we expressly consider the differences in objectives and savings characteristics inside and outside of superannuation. One of the most obvious differences is that the tax rate inside superannuation is likely to be much lower, limiting the preference for growth assets over income-producing assets. The time horizon is also reasonably certain, whereas consumption goals outside superannuation may be more fluid. Regular cash flows into a superannuation account imply that the performance drag from volatility should be reduced, in contrast to using volatility simply as a risk measure. At the end of the accumulation period, the assets are likely to be used to provide an income stream where inflation becomes a principal risk, rather than a single bullet redemption.
In order to account for these differences, we construct superannuation and pension models differently to non-super investments, leading to higher number of models. However, we also add non-super models that have absolute return targets and income targets to meet different investor needs, as well as models that target capital returns and high levels of franking for higher marginal tax-payers.
Targeting a broader range of objectives results, therefore, in a broader range of models than simply five or six risk profiles. A wider range creates more flexibility to achieve specific client objectives. For example, an individual client may be invested in one portfolio for superannuation savings, an income portfolio outside superannuation, and an absolute return portfolio for an as yet undetermined goal. Our experience suggests that this approach resonates with both advisers and clients that are looking for a more specialised and tailored service.