Professor Zvi Bodie of Boston University is an influential academic, familiar to all who used Bodie Kane & Marcus as a text book for investment theory and practice. He is also a bit of a conspiracy theorist. He thinks the personal wealth management and advice industry in the US (and by implication the UK) is so addicted to risky assets, as a necessary part of its ’asset-gathering’ business model, that it cannot afford to offer an investment approach which substitutes risky exposures by a true risk free asset: government-issue inflation-indexed bonds – TIPs in America, ILGs in the UK.

Pauline Skypala, formerly the scourge of the retail investment industry when on the FT Money team, and now FTfm editor, usually focuses on institutional investment but in her Opinion piece last week she referred to a recent interview with Zvi Bodie in a US financial planning journal in which he argues that individuals would choose to hold inflation-indexed bonds in preference to equity-based investments if they were only told the ‘true’ risks of equities and were offered investment services that implemented a ’safety first’ approach.

As this post deals with a fundamental principle of modern planning and portfolio management, it forms a new part of our Research Resource. It accompanies my Feedback response published in FTfm today.

 In this post we

• explain the approach advocated by Prof Bodie and implemented in our Outcomes Driven portfolios
• provide a technical explanation without assuming technical knowledge
• observe what clients actually do when given complete information in an unbiased way. 

It is written for the three categories of people we know read our posts:

• professionals, both pure financial planners and wealth managers, who should feel challenged by this simple and robust alternative to conventional asset allocation techniques
• individual investors, who (with the exception of No Monkey Business clients) are not being offered this powerful alternative
• financial writers.

So No Monkey Business

Because we

• adopt the risk management technique for portfolio construction that Bodie Kane and Marcus (amongst others) set out
• base portfolios on personal outcome targets defined and set by clients with our help but not our direction
• charge flat fees loosely related to wealth levels but not to particular asset values or asset types

therefore we can

• tell clients the truth about risk and what it costs (in resources, outcomes or certainty) to avoid it 
• be economically indifferent to what risk they then choose to embrace or avoid

the consequences of which are

• the process leads where it leads
• if 36% of total holdings are now in inflation-proofed government securities that largely reflects the average age and risk preferences of our clients.

The FTfm article

We thought it would be interesting to share with FTfm readers where it actually leads. The answer appears to be that clients given complete and unbiased information take more risk, not less risk. This is not at all what Zvi Bodie expects or does himself (which he has made common knowledge).

This is not the article I most wanted to offer the FT. When Professor Blake of Cass Business School wrote a piece in FTfm recommending designing pensions from real spending outcomes back to resources and risk taking, FTfm published our response saying ‘clever us, that’s just what we do’. When Edhec Business School wrote a piece for FTfm saying it was time the private wealth management industry adopted the institutional techniques of asset liability modeling and liability driven investing, Pauline published a piece from us saying ‘clever us, we’ve been doing exactly that for the last five years’. So the article I would have like to write was ‘clever us, we did what Prof Bodie suggested and it works – for us and for our clients’. But we have limited bragging rights with the media so sharing practical insights about where it leads was a smaller ask.

Explaining the method

Like so much of what we do, the core of our portfolio construction approach is no longer innovative, if viewed in the wider context of institutional practice rather than retail investment services.  Its text-book definition is the Two Asset Portfolio, because it divides a portfolio into two independent components: risky and risk free.

Technical background:

The Two Asset Portfolio sits within the general theoretical framework of Modern Portfolio Theory (MPT) – the link opens Wikipedia in a new window – and the concepts captured by the Capital Asset Pricing Model (CAPM), the distinctive feature of which is the Capital Allocation Line. In imaginary space (usually depicted in a graph) defined by return and risk, it is the line which connects a risk free rate with the opportunity set of risky alternatives, such as different equity markets.

It does not, however, require you to assume that all the risky assets lie on the line. They could be distributed quite randomly in risk/return space in which case there are lots of ’optimal’ diversified combinations that share the characteristic of having the highest return per unit of risk, all of which maximum-effiency portfolios then mark out an Efficient Frontier. 

In a Two Portfolio approach, the optimal location on the Efficient Frontier is defined by the highest possible excess risk-adjusted return, which (graphically) is where the Capital Allocation Line anchored on the risk free rate is tangental to the frontier.

This general principle is adaptable to specific definitions of risk and return, which will in turn suggest the appropriate risk free asset. In most applications of MPT today, including the ‘factory model’ of standardised asset allocation, risk is defined as short-period variance in returns in nominal terms (usually monthly or quarterly standard deviation, annualised) and, consistent with that, the risk free asset is usually cash or Treasury bills.  However, if the portfolio utility is better defined by long-period purchasing-power outcomes, because of the nature of the client’s goal and how the client will measure satisfaction, the returns, risk and risk free asset should all be redefined to ensure they fit that definition of the utility.  

The Two Asset approach is often described by the term used in corporate finance: the Separation Theorem, because it treats the risky asset (or venture) as capable of being optimised separately from the identity and risk preferences of its owner. In the context of the ‘factory model’, which for convenience treats all portfolio utilities as identical and uses the same nominal short-period risk and returns, the idea that all clients could hold the same risky component of their overall portfolio is logical. In fact, however, the ’factory model’ treats the risky portfolio as the entire portfolio. This is what firms would be tempted to do if they could only raise fees for managing the risky portfolio and not for cash, hence the conspiracy theory.

We have established that the risk free asset and the optimal risky portfolio are the two separate building blocks. Therefore:

• how they are combined determines the overall risk of the portfolio 
• and becomes the way of personalising the risk exposures and managing them.

The theoretical solution for working out the right combination is indifference. It refers to being ‘equally satisfied’ by the prospect of earning exactly the known risk free return or the range of probable returns provided by the risky portfolio. You would be indifferent between the certain return and the uncertain returns. 

But we like the implication too that it is a choice that the professional advising you is indifferent to:

• we have no interest in what you choose
• and only you can choose.

Planning in plain English

The trick when translating a choice described by algebra into one clients understand is this:

• keep with numbers
• but apply them to outcomes, not returns
• and make them outcomes that they can relate to and are relevant (or maybe even vital) to them. 

With retirement planning this is usually dead easy (thanks, Prof Blake): it is sustainable real rates of annual gross ‘income’ or drawdown, where the probabilistic range of outcomes reflects both inflation and capital market uncertainty and how they each develop with longer time horizons. At some blended tax rate (depending on how the asset are held and taxed), gross draw translates into sustainable spending. ‘Sustainable’ means all of three things: it does not need to alter with changes in stock market levels but can be increased with inflation and the capital will not run our before the job is done.

Not only do clients understand this language but they can also control the conversation and take it on. They can elaborate their target outcomes, such as wanting more early in retirement, then less but allowing for more again at the end. They can talk about conflicts, such as between their own spending and benefiting children or charities. They can resolve them in terms they understand, such as gifting (or reserving) only as much capital as would leave sufficient to meet tolerable worst-case spending outcomes at a chosen level of risk taking.

The meaning of ‘risk free’

This solves the problem of a shared language but it requires one other thing, a unique risk free asset (thanks, Prof Bodie): inflation-indexed bonds. This is because most goals that individuals plan for have ‘natural’ outcomes, as the clients think about them (not as advisers do, note), that are defined by purchasing power at some future date.

Dealing with real outcomes at different horizons immediately tells us advisers that we have to deal with two risks, arguably equally momentous: capital markets and inflation. As noted in our technical explanation, most applications of portfolio theory, including the ‘factory model’, ignore the different effects of inflation at non-standardised horizons.

In the special case of drawing down capital for lifetime spending, the uncertain duration of the plan is a third source of risk, because we do not  know how long we will live. 

Why ILGs, not bonds

Because index linked gilts have a fixed duration and are inflation-proofed, and because they bear only the principal risk of the British government, they can be described as ‘risk free’ in terms of both inflation risk and equity risks (in a previous Insight we explained how most risky assets share the same sources of risk as equities and are derivatives of equity, as loosely implied by ’business risk’).

Non-indexed bonds, whether corporate or government issue, cannot perform this risk free role. Though bonds are the conventional ‘balancing’ asset in what we call the standard ‘factory model’ of diversified, multi-purpose portfolios, they only serve to transfer the risk exposure from business risks (which are actually positively linked to general inflation) to naked inflation bets. In the same way that a ‘level’ annuity without inflation protection is a gamble on the predictability of inflation, fixed income is not only not risk free, it is a big bet. It is also a bad bet.

In our opinion, conventional bonds do not even belong in the risky portfolio, once risk is being managed by dilution or substitution, because the weak diversification value of bonds is then redundant. The reduction in real outcome uncertainty relative to equities is small (unless you want to assume the historical instability and unpredictability of the inflation process is not relevant) and the reduction in expected return is very large. A bizarre product of traditional planning is that individual investors for most of their life hold conventional bonds and at the same time mortgage debt but without ever making any connection between the two. 

The power of the method

Our application of the Two Asset Portfolio follows  Zvi Bodie’s idea of a ‘ladder’ of stepped, horizon-matched ILGs combined with an optimal combination of global equity markets (using trackers - why blow all the good work on risk and cost control done so far?) where risk tolerance or indifference is directly exhibited by the way clients choose between different ‘model runs’ illustrating different combinations of 

1. resources assigned to the goal 
2. ranges of real outcomes at different dates 
3. the thing that makes them balance at any required level of confidence: a level of risk tolerance.  

The power of the method lies in the fact that clients do not need to know what #3 means, or what it looks like when dropped into risk/return space so it cuts the Capital Allocation Line (pretty though that is). They only need to know what changing #3 does to #1 and #2, as in its effects on the certainty of achieving the target outcomes for a given level of resources (present capital plus future contributions). These effects they see. They can see as many runs as they want till they get to a solution for each goal, and between competing goals, that gets the job done in the way most satisfactory for them.

The evidence about equity risk

Using a financial model, clients will only be confident about the numbers you show them if they can see where they come from. Here, Pauline Skypala and Zvi Bodie are both right that the industry does not seem to want you to know how bad real outcomes can be, even with long expected holding periods. They have used every trick in the book to disguise risk. Although this partly carried over from an early tradition of paternalism, I do not believe this excuse holds any more and therefore lean towards conspiracy (otherwise No Monkey Business would have been a dishonest title for my book).

The Feedback article describes a process we use of walking new clients through a set of charts that show the cumulative real returns of the major equity indices for up to a century of data. We point out the long periods of flat or even negative returns, which are the real product of equities dealing badly with the inflation or business environment and investors making bad decisions about discounting the continuation of bad times. This is the flip side of the long bull market phases that selective memory (and advertising) might otherwise bias towards.

Here is one example, for the US market, used in a recent post discussing the valuation of the S&P.

Fig 1 Real total returns and fitted trend: S&P 500 (semilog)

The trend for the entire data history from 1925 (the unbroken orange line) is 7% pa. This is the ‘engine’ driving the funding of future financial goals using equity investments. But this underlying driver is literally overwhelmed over short periods by the scale of the deviations from it. Note how frequently real returns are flat for decades at a time. If you bought at the height of the ‘nifty fifty’ growth-stock boom in the 1960s you had to wait over 20 years to get you money back, when inflation is taken into account. Talk of a double dip if market falls again now is not quite accurate. If we look at the period since the dot com bubble burst in 1999, another dip will be the third in a long ‘correction’. We are already over 10 years in.

You hardly need our gruesome charts for Japan to see that equity returns can be negative or flat in real terms for very long periods and that you will almost certainly experience extreme disappointment in a lifetime of investing. Welcome to the world of true risk. 

Feedback: what clients actually choose

Zvi Bodie’s point is appealing: why would anyone run these kind of risks? The answer is simple: if they cannot afford, or do not like, the alternative.

Emphasising the risk is itself a bias unless we are also careful to explain and illustrate the cost of avoiding risk. It is the high cost of avoiding risk, in possible outcomes permanently given up or inefficient use of capital, that leads our clients to opt for a higher level of risk taking than is assumed by academics.

I did not have room in the FT article to illustrate this but I show below an example we have used in retirement seminars. It uses numbers (real or purchasing-power pounds) to show the cost in resources applied or in consumption enjoyed of replacing all equity bets with index linked gilts (’taking bets off the table’) and the further cost of removing the longevity risk by buying an index linked annuity (’leaving the casino’). The resources assigned are £2m; the resources have to last for 35 years at least and the client values higher spending early in retirement. The three alternatives are:

1. Sustainable draw with optimised risk taking: you could start at £125,000 pa with a 50% chance it will need to taper down to £105,000, and a 99% chance of not breaching a worst-case floor draw tapering from £125,000 to £57,000 in the client’s late 80s if markets are consistently bad.
2. Allocating 100% to ILGs throughout the plan: to match the worst-case outcome above takes capital of £2.2m and to match the better possible outcomes at 50% confidence (the median with optimised risk taking) takes £3.2m – a ‘resource cost’ of £1m.
3. Avoiding all risks including longevity: £2m buys a real income of £64,000 pa – an ‘outcome cost’ of £61,000 pa in the early years and £41,000 pa at the end.

The point is, the numbers speak for themselves. Given complete information about both the scale of the risk and the cost of insuring or avoiding them, as factors in this realistic practical example of half or twice, you are likely to stay at the table.

Incidentally, the multiple of two that describes the value of an inflation-proofed annuity applies also to the value of final salary scheme pensions. This is what it would cost you to replace what is effectively a large ILG ladder on your personal balance sheet. It means that one of the hardest decisions high-earners often face is whether to bear the risk that their pension scheme and its sponsor will both collapse under the intolerable burden of meeting its over-generous promises, with the consequence that a pension of £150,000 a year drops to the ‘insured’ level of £30,000. Up to the insured level, it is a risk free asset but above it there is a very small chance of catastrophe. Some advisers believe that even the insured level, being underwritten only by scheme levies to build up a protection fund, could be reneged on if the fund is overwhelmed by system-wide failures.

Are our clients representative?

This is not a controlled experiment: most of our clients are in the top 1% by wealth and income. Other investors and other advisers might assume they can afford to embrace more risk. This misses an important point. People take bets instead of laying them off because they value the payoffs. They think about the possible payoffs in terms of consequences. For goals such as retirement spending, the resources may be higher but so are the levels of spending at which the consequences look unpleasant or even intolerable. It is all relative. Rich people as well as poor people make rational gambles. It is mainly when you drop below the typical IFA target customer that the gambles are not constrained by own resources and are framed largely in terms of externalities, such as social security. 

In my Feedback piece I also suggested that the wealthiest, who could actually afford to live off the cash streams, capital or interest, from their ILGs (like their Victorian forebears who ‘clipped coupons’ on their Consols and never thought to work), choose to to take risk instead. A common motivation we see is that ‘capital should work hard’, because they worked hard to get it. Less common but just as important is that playing the game is its own reward, so satisfaction or success is measured as replacing (through return on investments) the money consumed. 

Is it more expensive?

In another important respect our clients may not look representative because they can afford the economic cost associated with planning goal-based portfolios where resources, risks and outcomes are the product of interaction with sophisticated technology (which is expensive to develop or license) and where confidence in the process calls for education and explanation as well as illustration (which is time consuming).

Our answer to this has always been simple: pay for it with the savings you make by opting out of the industry’s deeply conflicted factory model and its dependence on active management. These pile up the costs but have no economic worth.

The ILGs cost between £9.50 and £12 to buy and nothing to hold; the equity ETFs or tracker funds cost between 0.2% and 0.5% pa to hold.  At our average ILG holding of 36% (reflecting the sum of all customised combinations) for Defined Outcome portfolios, we cut typical implementation costs to 0.24%. This compares with published charges from industry giants like Towry Law of 1.6% (on which may be loaded asset-based fees for new contributions and tax wrappers). Many smaller IFAs will apply total costs of 2% or more, by loading up portfolios with expensive active products they cannot discount, and private banks load them up with their own products where they have no incentive to discount. Savings of 1.36% to 1.76% pa pay for an awful lot of unbiased, high-quality advice and education.

This example demonstrates that there is very high umbrella of inefficient charges resulting from traditional industry structures and investment processes. There is no reason why modern, technically-proficient firms should not compete successfully under this umbrella, offering better solutions at a lower price at a decent profit for themselves.

TAGS: equities, index linked gilts, modern portfolio theory, Risk, separation theorem