Radical steps aim to soften slip-ups

18 January 2010 | By Andrew Wilkins

Andrew Wilkins, Executive director, Catalyst Investment Group

In the noughties, the investment styles of institutions began to grab the attention of high net worth investors eager to expand the choices available to them and better protect their wealth. In turn, the choice of products has expanded and filtered down to the wider retail investment market.

A comparison of asset allocation styles of retail investors and institutions is revealing. Between 2006 and 2008, institutional investors decreased their portfolio exposure to equities by 11.7 percentage points and increased bond holdings by 6.3 percentage points. Likewise, retail investors moved in a similar direction, decreasing their investment in equities by 14.3 percentage points and increasing their exposure to bonds by 5.4 percentage points.

Yet despite reducing their reliance on equities, retail investors have nonetheless remained heavily exposed to the asset class. By the end of 2008, institutional investment in equities comprised a mere 37.2% of the aggregate portfolio. Asset allocation was more evenly divided, and alternative investments had taken on an increasing significance. By contrast, retail investors’ exposure to equities still stood at 62% of portfolio allocation. In mimicking the institutions, retail investors still have some way to go. (article continues below)

The financial crisis revealed two key lessons, which will have an impact on investment portfolios. First, where investors had previously tried to move away from market risk by investing in alternative assets, these often compounded their risk by being more closely tied to the market than investors had appreciated. Second, as equities performed poorly, so did bonds, resulting in heavier, correlated losses.

 

These two factors have led to changes in the way that some institutions, that have pensions-related liabilities, plan to invest. In many cases, they are turning to more focused, liability driven investment (LDI) strategies, which concentrate on the ability of their portfolios to meet liabilities. As a result, many institutions have begun to seek out alternative assets that can mitigate the risk related to market volatility in a way that traditional alternatives failed to do.

Given the poor performance of retail portfolios in the financial crisis and the increasing choices available to retail investors, it is interesting to consider whether the time is right for such ordinary investors to follow suit. Could and should they start thinking about what they can borrow from LDI thinking for themselves? Is such a thing even possible?

Retail investors cannot define their liabilities with the precision that institutions achieve, and still face many barriers in terms of access to sophisticated financial instruments. As a result, a classic LDI strategy is difficult to apply to retail portfolio management.

”An asset relating to insurance cover means that there is no exposure to traditional investments and little market risk”

However, investors may face less exactly defined financial commitments or “liabilities”, such as mortgage repayments, insurance premiums, education costs and retirement funding. The need to meet these kinds of specific commitments has become more important as a consideration in financial planning, in the wake of the financial crisis.

Retail investors have their own liabilities that require either a lump sum payment or an income stream at predictable stages during their lifetimes. While the LDI strategies used by institutions may be beyond the grasp of lone investors, they should still consider what steps they might take to understand better the nature of their financial commitments, and how to structure their portfolios to meet them. Any investment strategy that has at its core a focus on managing and providing for liabilities is likely to be appealing.

Adopting such an approach would require investors to become much more holistic in building up an aggregate picture of their needs and liabilities. In turn, this poses an opportunity for advisers to deliver deeper, more valued advice. A variety of investment strategies would be required to meet the returns needed across investors’ lifetimes, leading in part to different asset class decisions and a greater emphasis on fixed income strategies. A root and branch review of investment portfolios would be essential.

In pooling their liabilities, investors would most likely allocate part of their portfolios to assets with low market correlation, to ensure their liabilities continue to be met during periods of poor market performance.

This thirst on the part of institutions has resulted in many institutional investors taking a particular interest in non-correlated assets. These might typically include several investment products such as senior life settlements (SLS) and structured settlements. SLS-backed investments in particular have gained ground as a viable alternative asset of choice, quietly gaining attention during the financial crisis among institutions, high net worth investors and retail investors alike.

Life settlement-backed products invest in diversified portfolios of American insurance policies no longer required by policyholders and sold on in the secondary market. Crucially, an asset relating to insurance cover means that there is no exposure to traditional investments and little market risk. As the value of the pooled insurance cover is known, and the likely maturity date of returns determined through rigorous life expectancy modelling, investors can anticipate yearly returns of about 8% over a stated investment term of typically 5-10 years, uninterrupted by the broader investment cycle. As part of adopting some of the principles behind LDI thinking, the advantage of having smooth and predictable returns from non-correlated asset sources is clear.

With the harsh lessons of the financial crisis still fresh in the minds of investors, and the nature of economic recovery still shrouded in uncertainty, it is a good time to consider the merits of more radical investment strategies. After all, who would have thought at the turn of the millennium that it would finish as the “lost decade” for beloved equities? Proper financial planning is required for retail investors to engage with their own needs or liabilities.