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Comment: a modern approach to default portfolios

28 January 2020
Comment: a modern approach to default portfolios
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 What is the right level of risk for a workplace default?

This depends on a lot of factors including attitude to risk, time horizon, and objectives. Pension investors who are still in the savings phase need to maximise returns over a long time period, so they have to take a reasonable amount of risk. But this risk must be taken in an efficient way so that expected returns are as high as possible. By using modern portfolio theory workplace defaults can be designed to sit on the optimal point on the efficient frontier of risk and return.

How does modern portfolio theory help defaults find the right level of risk?

Modern portfolio theory enables default funds to optimise their expected returns by diversifying into a range of asset classes that give the best expected return for the risk taken. The efficient frontier has a distinctive shape – there is less expected return available for each incremental ‘unit’ of risk taken. As a general principle, diversification can help reduce risk with a relatively smaller sacrifice in terms of expected returns. However, as risk is increased there comes a point where the benefits of diversification start to diminish. So default need to be designed to sit at the optimal point on the efficient frontier.

How can schemes diversify effectively? The basic approach to diversification used in defaults is to use a portfolio combining equities and bonds. But it is possible to do much more. Unlike many other providers we have an allocation to property within our default portfolio. Our analysis shows that by including property we can achieve the same, or even higher, expected returns, while taking less risk.

What does this mean in terms of returns delivered and risk taken?

Our default has achieved broadly similar returns to the great majority of the 19 default funds presenting growth-phase 5-year risk/return data to www.capa-data.com. Yet while the returns are broadly similar, we have achieved this with considerably lower volatility. Only two funds in the data set have lower volatility than our default, yet both have failed to achieve the same level of returns.

Does diversification facilitate a tactical asset allocation approach?

Yes. A well-diversified portfolio means there is more flexibility to take advantage of short term market movements through a tactical asset allocation overlay. Access to a wider range of asset classes means we have more levers to pull, and more potential to generate returns.

Tactical asset allocation allows the fund to adjust weightings dependent on market conditions, to make tactical calls dependent on which asset classes are likely to perform best against a backdrop of different points in the economic cycle or in response to geopolitical events.

We think the impact of this can be significant – over the three years to June 2019 our popular Governed Portfolio 4 default delivered a return 2.6 per cent above its strategic benchmark. We calculate two-thirds of this was attributable to tactical asset allocation with the rest attributable to stock selection.

How does risk management change through the glidepath to retirement?

Volatility is a useful indicator of risk for investors in the growth phase. But as investors approach and pass into retirement the security and sustainability of income will become the priority. To maintain a sustainable level of income it’s important that investors understand why taking some risk is important, and how much risk they can afford to take. Establishing whether an investor’s income will remain secure is best achieved through stochastic modelling.

At this point it is also important to be aware of the investor’s objectives and wider circumstances. If the investor has secure income elsewhere this may mean they can afford to take more risk.

How should asset allocation change through the glidepath?

It is well established that, in general, risk should be reduced as the investor get closer to retirement. This is to manage the risk that a severe market downturn at the start of retirement would cause long-lasting harm to their pot.

This is usually done by moving out of risky assets such as equities and property, into more defensive assets such as bonds and cash. But it is not appropriate to completely de-risk. Exposure to risky assets is required to achieve the growth necessary to support a sustainable income plan.

Using stochastic modelling we model a highly sustainable income as one that can be maintained in 85 per cent of scenarios. A figure of 4 per cent is often quoted as a safe withdrawal rate, but this has to be regularly reviewed and balanced against changes in market conditions. The impact of charges also needs to be considered.

What role does governance play in default asset allocation?

Employers selecting a default fund need to know that their employees will be rewarded for the risk they are taking, and that the fund will do what it says on the tin. Most defaults will claim to offer a great return. But making sure this return is delivered in an efficient way, and that the default does what it is supposed to requires vigilant governance. This means having an experienced team that engages in regular reviews of investment strategy, monitors liquidity, cost and performance of underlying assets and considers the risk attributes of the population served by the default.

The post Comment: a modern approach to default portfolios appeared first on Corporate Adviser.

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