The game of picking stocks is mirrored in a game of picking managers who pick stocks. The performance effects of playing the active management game are the sum of behavioural impacts at both levels: fund managers and the ‘end investor’ or his/her agent. 

Because most investors playing this game are doing so because they believe past performance is predictive of future performance, rather than random, they will naturally tend to select new holdings from the sample of managers/funds that have performed better than average over some recent period.  If, on the other hand, it really is random (or even much less predictable than they thought), there is a very high chance of disappointment – where disappointment is defined as the ‘unexpected’ slippage of the fund through the rankings table. Consistent with the beliefs they held when they bought, they will now tend to sell, because they will assume that they made a mistake or that the manager in question has lost his/her touch – in other words the new performance is predicting more of the same. Because they have not changed their beliefs, they then go through the same exercise to select the replacement fund. And so it goes on, turning random underperformance of holdings into a non-random string of portfolio underperformance – until they realise it is their beliefs that are wrong. 

This second behavioural effect is under-researched in academic studies, perhaps because the key insight itself has not attracted nearly as much attention as the effects at manager level. However, there are a number of industry firms that survey money-weighted returns in mutual funds (measuring client-experienced average returns): Dalbar, Vanguard and Morningstar. This analysis suggests playing the loser’s game costs up to 6% pa – far more than just the incremental costs of active funds (which in the UK we put at between 0.6 and 2% depending on the buyer’s agency relationships). 

The data available to researchers is fund performance (obviously) and fund flows. But when making a connection between the two there are some problems:

• Both are absolute – so if people sell after poor performance they could be making a market timing decision or a switching decision based on poor relative return but the data won’t tell them which. The two may of course be positively correlated. Given the evidence (in Dalbar’s annual surveys, for instance) that net flows are positively rather than inversely associated with market movements, it seems likely most of the effect is due to poor market timing rather than switching, so a reaction to absolute rather than relative performance.
• Flows are partly idiosyncratic decisions and partly regular contributions/withdrawals but the two are not distinguished.
• Money-weighted return calculations are affected by the sequential pattern of returns and flows – although I’m not convinced this methodology point ‘explains’ the apparent behaviour effect.

In ‘Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability’ (Friesen and Travis, 2007) the authors say this about the relative-return  impulses to trade funds:

In testimony to the United States Senate, investment guru John Bogle (2003) argued that the Dalbar (2003) study ignores an additional “selection cost” borne by investors, whereby investors place a disproportionate amount of money into actively managed funds that subsequently underperform the S&P 500 index. Bogle suggests that after accounting for this selection cost, the average mutual fund investor return over the 1984-2002 period is actually negative.

Whilst it may be difficult to measure actual effects for a universe of mutual fund investors, it is possible to model the behavioural effects to test for the likely scale of impact of the relative-return impulse, by applying some simple decision rules, based on rank orders, for both buying and selling.  This is a project for future research.

It is, however, possible to infer something today about the prevalence of this impact just from observation of a limited sample of portfolios. We have taken in new clients from a wide range of advisers/banks/wealth managers over the past six years. Because our clients have well above-average wealth, their previous agents are typically respected and popular firms, so we would expect them to be less prone than the average to systematic wealth-destroying behaviour. We also take on clients who are more experienced than average and so many have previously been wholly or partly self-directed. Our initial financial planning process for all new clients includes a critical appraisal of existing investment arrangements. We observe, in most cases, the same destructive behaviour by both agents and self-directed investors.

Even in the case of investors with agents, we suspect the investor’s own ‘predicted’ behaviour effectively encourages the agents to sell, because the agents think individuals think that poor performance tells them something about the agent’s skill.

When looking at agent behaviours, it is always sensible to consider whether incentives or game theory might explain them. Whilst I believe this is realistic in the case of fund managers, whose active-management payoffs are quite different from their investors, I do not think gaming validates the behaviour of agents selecting funds. Because both these agents and their clients are acting consistent with a set of beliefs (however false) about skill, it looks more like a case of the blind leading the blind.

‘It’s a miracle! I can see!’ cries Eddie Murphy in Trading Places when rumbled as a ‘blind’ beggar. In investing, miracles do happen and when an investor truly can see, their rumbled agents are unlikely to get away with it. They, rather than their clients, are the ones who should have known better.

Note: This article (in draft) was extensively quoted by Matthew Vincent, FT Money editor, in his Serious Money column on 30th July. It followed a piece the previous week about the first, manager, level of the active-management game titled How fund managers get paid for winning the lottery. You may need to be an FT subscriber to view these articles.

This is rarely the way ILGs are actually used in private client portfolios, even when managed by highly-qualified professionals. This is a testimony to the ubiquitous hold of money illusion but also to the intellectual arrogance of most professional money managers in the face of investment uncertainty. Arrogance is a form of behaviour conducive to higher fee generation when clients believe market risks can be successfully exploited for gain by skilled agents. But humility is more likely to be conducive to higher return generation when market risk is not easily exploitable or costs of trying are high. Both money illusion and skill illusion explain why so little use is made of ILGs as unique ‘power assets’, as distinct from just another asset class to throw into the diversification pot.  

Risk free or just another bet?

This debate, which rarely reaches the wide audience it deserves, burst into the open in the columns of the FT this month. The American finance professor Jeremy Siegel is well known as the author of ‘Stocks for the Long Run’, a book (now in its 4th edition) which has helped establish in both professionals’ and the public’s mind the essential characteristics of different asset classes that make them useful for investment objectives. Professor Siegel wrote a guest column for the FT titled ‘Inflation-linked bonds face a headwind of many risks’ in which he nodded towards the special benefit of ILGs, particularly in pension plans, but also listed reasons why they were over-priced (both in the UK and their equivalents in the USA) with real yields of barely 1% (’levels that would have been unimaginable just a few years ago’). He concluded by warning of large losses on the horizon for holders of such bonds as economic activity and inflation both picked up. Equities, he felt, offered ‘much better long term protection against inflation than today’s low-yielding inflation-linked bonds’.

Outrage from the ‘power asset’ camp! It provoked a  letter signed by another American finance professor, Zvi Bodie, three frequently-published consulting actuaries familiar to UK pension funds and ex-corporate finance head turned pension consultant, John Ralfe. They argued: ‘The conservative pension saver, especially those with little or no other capital, should avoid the worst outcomes in retirement by holding inflation-protected bonds, even if it means giving up the possibility of the best outcomes by holding equities.’

They also argued that the risk of equities is typically misrepresented by the investment industry, which (either out of mischief or ignorance) understates the risks and overstates the likely payoffs when investing in equities.

Much as I welcome the argument, as it helps to banish popular illusions about risk and the management of risk, I have to say there are fallacies on both sides of this debate, as well represented in these two FT pieces. The faults lie partly in the assumptions that lie behind the maths and partly in a disconnect with personal risk preferences in the real world.  In this Insight we will try to find the firm ground between these two camps and show how it can be used as a foundation for individual portfolio choices.

I am not particularly concerned with a less meaningful aspect of the debate which is that there will always be arbitrageurs in the market and investors with a particular opinion about future inflation who will trade between ILGs and conventional gilts as if both were risky assets. On a short term view, when the position taken is not matched to or defined by the maturity of the bond or the duration of the investor’s objective, they clearly both are bets, not hedges. If this is largely what Professor Siegel was referring to, he is right.

Assuming a non-random equity ’system’

The sort of historical evidence in support of equity investing made famous by Professor Siegel is broadly supportive of the view that equity returns are a fairly intuitive output of adaptive capitalist systems. They do broadly what you would expect as an economist, if you only knew that stock markets recorded the performance of publicly-traded companies in some form of ‘market economy’. However, it is important to distinguish between nominal returns, which are distorted by each country’s and each period’s inflation experience, and real returns, deflated by a national retail price index. Inflation is one of the externalities we expect market systems to adapt to, more or less well.

Interpreting behaviour from real returns, without separating between income and capital, it makes surprisingly little difference if the market economy is Anglo-Saxon, Swedish or Japanese. There is in fact (yet) no theory of why millions of individual decisions by real investors based on idiosyncratic views of personal welfare leads to either similar trends in equity ‘total’ returns (both income and capital) or why the very large deviations from trends that emerge in all the data histories are both bounded and also similar between countries, regions, different stages of economic development and different periods of history. There are many sources of differences, including how they behave together, at the same time, but these may contain less useful information (or none at all) compared with the similarities.

The absence of a theoretical explanation of sustainable trends and of reversion to the trend is a concern for many and a particular concern for academics. But even if there was a theoretical explanation, it would rely on the same data as the only practical basis of experiment. If you have little choice but to participate in the system, you might as well leave proof to others and work out for yourself what view of the world and the system you are willing to hang your hat on. I decided a long time ago that, with respect to real total returns from equities over long periods, it was not a random world.

If the system were random

This preamble is important because many of the critics of the representation of equity risk believe it is in fact a random world. These letter writers, for instance, argue that ‘the proper measure of equity risk is the cost of buying insurance against underperformance versus the risk-free return – a “put option” on a stock market index. If risk reduces over time the cost of equity put options against any shortfall should reduce. But the cost increases the longer the option period, reflecting increasing not decreasing risk. The theoretical price, based on a standard option pricing model and actual prices charged by banks, is about 25 per cent for 10 years and 30 per cent for 20 years.’

The mathematical truth in this statement, that risk expands, not shrinks, with time conceals an assumption that it expands at the rate of a random time series (the square root of time) rather than at the slower rate of a mean-reverting series. The ‘theoretical price’ of the risk derived from option markets is not a proff of anything because it extrapolates from short-period nominal return behaviour which is (probably) random. There is no market in 25 year equity options and, if there were, arbitrage from the physical equity market would cause it to reflect the same assumptions of mean reversion widely made by participants in that market.

ILGs and mean-reverting equity returns

Hanging your hat on a sustainable but uncertain trend in long-term real returns also means that you will assume that the mean expected equity return will rise faster than any risk free rate, such as the 1% real yield of ILGs. The insight that risk rises with time means the band of probable outcomes around the trend increases slightly for every year the investment is expected to be held. (This will still translate into a declining standard deviation of short-period returns the longer the expected holding period, which was the source of the widespread error that risk falls with time, as it does not compound each single-period standard deviation over the relevant length of time.)

The concept of a rising and expanding range of possible real wealth outcomes around a known risk free rate with a lower slope is expressed in the diagram below. The principle to which the letter refers, of both lifting the floor or worst-case outcome but at the cost of a lower slope for wealth generation, is illustrated here by substituting half the equity portfolio by a risk free ILG. Depending on the values assumed, there is a point at which the distribution of outcomes lies entirely above the risk free rate. At any point, you can adjust the level of substitution of equity risk by ILGs to achieve a tolerable worst-case outcome. You would find the same general principles explained in Professor Bodie’s widely-used text book ‘Investments’.

Choosing between risk free and equity bets

The FT letter writers express the opinion that ‘conservative’ investors, worried about the consequences for living standards of a bad outcome, should not make an equity bet at all but accept the certain but very low real return and outcome of ILGs. This is a massive over-simplification. If it has a paternalistic purpose, it is thoroughly misguided.

The question investors at any level of wealth, whatever their instincts about risk, need to ask is ’how much risk should I take, given the consequences of bad outcomes and the floor below which these become personally intolerable, and what will that cost me in resources?’

If, like other reluctant participants in the capitalist system, I want a certain standard of living but do not want to bear much risk to obtain it, I think I would like to know whether I could in fact afford to avoid risk. If the implications of building more certainty into my life was a mediocre living standard, either by making spending sacrifices whist still earning or in retirement (or even both), I might accept a bit of a capitalist gamble to lift most of my probable outcomes above the mediocre.

If, on the other hand, I were extremely wealthy and had no children, and was not hard-wired to keep creating wealth (as many enthusiastic participants in the capitalist system are), I can imagine I might decide to stop taking risk, or would only take enough to secure improvements in my spending power that I was likely to value. I have no need to gamble and no satisfaction from gambling. I can leave the table and live on gilt coupons (index linked, of course).

These practical examples of risk taking preferences, in a real-world context with particular personal consequences, illustrate an important role of ILGs in both financial planning and investment management as the market benchmark of the cost of avoiding risk, in both resources and outcomes.

Choices at retirement

The benchmark for avoiding all risk at retirement is the income provided by an index linked annuity, as this deals with longevity risk as well as capital market and inflation risks. Using a retirement plan as an example:

• On the basis of current real yields, a capital sum of £1,000,000 will produce an annuity income before tax (for a 60 year old male with two-thirds spouse benefit) of £25,250pa. This illustration ignores the practicality that, if it were in a pension plan, you would apply the tax free cash to a purchased life annuity which unfortunately does not come with full indexation. Being an annuity the real payments will be level each year, even though you might prefer higher spending targets early in retirement and less later, but with equivalent real outcome certainty.
• With controlled risk taking, in current equity market conditions, the same sum might generate a profile of preferred spending starting with a gross equivalent draw of  of £40,000 pa at the start of retirement. Depending on the payoffs from risk taking and how quickly or slowly they emerge, the starting rate might increase to a mean expected rate of £90,000 pa in real terms, sustainable to age 95. On worst-case real investment returns, the rate of draw might taper, in line with the time preferences, from age 75 to about £26,000, so never less than the level real annuity.   
• At retirement, it would be illogical to hold ILGs and draw down from them instead of buying an inflation-indexed annuity. More of the resource would need to be assigned to funding the extra years of life beyond the actuarial expectancy of the pool of lives in the annuity fund – the illustrations above assume 35 years instead of about 27 years.  To match the same worst-case gross draw as above holding only maturity-matched ILGs would require £400,000 more capital and to match the median draw would require a further £600,000.

No free lunch

An important insight of the FT letter writers is that equity investing is typically presented as a free lunch. They say: ‘The higher expected return of equities over inflation-protected bonds is simply a reward for the risk of holding equities; it is not a “free lunch” or a “loyalty bonus” for long-term investors.’

Provided the trade off between resources, certainty of outcome and risk taking is properly explained and quantified, there is no illusion involved in making a case for equity investing. On the contrary, it avoids the illusion that avoiding risk is cost free and affordable. In the example above, the actual rate of sustainable draw is consistent with 99% confidence of not breaching the floor, there is no spending of payoffs from risk taking before they have been earned and the cost of avoiding different forms of risk is explicit.

ILGs perform an invaluable and indispensible role both in communicating the principles and quantifying the trade offs. They should feature in every financial plan and every portfolio review. But they should also be the main method of risk control in the portfolio itself.

Benefits of planning

All of these new clients undertook an Initial Review: a collaborative approach to defining the ways in which they wished to benefit from their wealth, including soft attributes, such as confidence and control, as well as specific measurable results, such as a lifetime spending plan immune to the worst that the economic gods might throw at it.

Good financial planning delivers its own benefits. Some are immediate in the sense of the clarity that comes from giving money different tasks to perform or the confidence that comes from stress testing the household economy. Others emerge gradually, such as the ease of decision making that comes when there is a plan to refer to, or are only apparent if and when stress actually happens. But the real test, whether they are able to look back in later years and decide they did get satisfaction from their wealth and avoided regrets, is one they have to wait for.

In 80% of cases, clients undertaking planning went on to retain us to manage their assets, which suggests the planning delivered some immediate or expected benefits. In several cases the clients who did not go on did not retain another manager and preferred to be self-directed (including financial professionals who valued the planning but had access to good investment solutions).

In no case did we end up managing part of the assets in conjunction with or competition with other managers – possibly because we are flexible about retaining good products or privileged access to products but largely because clients value having a single ‘ringmaster’ when multiple investment solutions are being used.

Why did they talk to No Monkey Business?

Our analysis suggests that only 10% of new investment clients were actually ’selling’, in the sense that they were keen to talk to other firms because they were fed up with their existing advisers.  We find this surprising and it contrasts with the first two years of our existence when many prospects cited problems with banks and IFAs over particular types of product and their assessment of risk.

Of the 90% who we say were ‘buying’ rather than selling, 40% had a specific event-based need, such as stopping work, selling up or needing pension-specific guidance. (The proportion looking for pension advice is down dramatically from the peak around A-Day.) That leaves 50% who were willing to talk to us just because it sounded like we might have a better mousetrap.

What did they leave behind?

Where they came from reflects the focus of our marketing in this period on high-earning professionals, where the well-entrenched advisers include Ruffer, UBS, Towry Law, Andersen Charnley and Saunderson House.

With the exception of Ruffer, which manages money with a bias to a single risk tolerance consistent with its own investment philosophy, the other firms seek to meet varying client risk preferences by matching them to a small range of standardised ‘balanced’ asset allocations. They therefore conform to what we call ‘factory wealth management’ which emphasises economies of scale and production-line processes. These are features common to most asset-gathering business models, whether discretionary or advisory, whether in a bank, an IFA or a pure wealth management firm.

In the factory model, productivity is maximised by channeling the very wide diversity of individual needs and constraints and idiosyncratic risk preferences into a narrow range of standard portfolios. In practice, the asset classes used as building blocks are common to all and the main difference between them is the weighting in fixed-interest bonds – an asset we think is extravagantly wasteful of a limited risk budget.

Nowhere is this manufacturing model more inappropriate than in ‘drawdown’, by which we mean a financial goal which requires a stream of cash flows to be generated and sustained from capital resources. Drawdown goals have quantifiable outcomes as date-stamped amounts, usually in real terms, after inflation. The most common is funding retirement spending (whether consuming pension or non-pension capital). In our market, where defined benefit pensions are not so common, self-funded retirement spending is a key objective.

The second common attribute of their previous managers was an implied belief in the active management bet. I say ‘implied’ because many investment professionals do not believe they can sell anything else even if they realise that active management is a loser’s game, so conditioned is the investing public to playing the game.

What did we do differently?

For planning clients who retained us as manager, our fully-customised Defined Outcome portfolio approach replaced the standard variants of balanced management they were used to. That is a big change.

Apart from altering the approach itself, the effect was never to validate the same level of risk taking and we either increased or reduced the overall level of risk, making it consistent with planning-based preferences. What planning typically revealed was that people were not taking enough risk to achieve the benefits they most valued. We do not find this insight became a source of blame for the previous adviser. A common tendency was for people to have accumulated cash from high earnings due to a lack of investment relationships they had confidence in or to avoid having an asset-based fee attached to that money.

Changes in risk levels were implemented not by altering the mix of standard diversified asset classes but by a ‘new’ mix of risky assets and risk free assets (’dilution’ not ‘diversification’).  Until clients undertook an Initial Review, virtually none was at all familiar with the institutional approach of Liability Driven Investment that ‘matches’ assets to liabilities either by hedging (duration-matched risk free assets) or making risky bets with uncertain outcomes.

When all risk sources were separately identified, the main change in risk budgets was the avoidance of inflation bets, achieved by getting rid of conventional fixed income exposure and replacing risk free assets that do not have inflation indexation with those that do (index linked gilts and National Savings & Investments). 

Where clients have different goals, every asset (including property), held by different owners in different accounts or wrappers, is assigned to a specific goal. Each is managed differently. Other than sibling children, no two clients have the same portfolio. This was a telling difference from clients’ previous experience.

At our clients’ typical wealth levels, substantial non-investment property holdings in the UK or abroad form an important part of the consumption benefits conferred by wealth. However, a common factor is that for lifetime wealth benefits to be maximised, some of this capital will need to come back into the funding of other goals, including retirement spending. We were able to incorporate this into the matching of assets to goal requirements and into the quantification of goal outcomes that otherwise depends on modelling financial asset returns. Clients valued, but had not previously encountered, such a holistic approach to lifetime efficiency of economic capital.

In most cases, after an Initial Review new clients gave up on ‘alternatives’ like hedge funds and private equity, although we often have to nurse holdings until they can be worked out appropriately. In some cases we organised new complementary investments but these used third-party products more often than third-party relationships.

Across the board, we have also substituted active funds by index trackers, using both unit trusts and Exchange Traded Funds (ETFs).

In many cases we changed clients’ thinking about pensions. Sometimes this was just based on the maths: the quantification of present values of cash streams inside and outside pension wrappers. This takes into account not just tax breaks going into pensions but also the high taxation of pension income and the penal taxation of undrawn inherited benefits. Some new clients regret listening to pension salesmen as they realise the tax benefits are not what they thought and they now have to live with the inflexibility of their capital.

How have we altered their costs?

We have introduced total transparency of all costs and defined a cost budget with every new client. We have radically changed the way their costs are allocated. This brings into better balance:

• the amount of charges 
• their importance in terms of explaining outcomes or probability of obtaining value.

‘Implementation’ costs – for obtaining exposure to the market risks and returns sought – are typically cut from about 1.6% to 0.35% for equities and are virtually eliminated for the risk free assets that take over from ‘balanced’ diversification the job of risk control. This saving is mainly achieved by giving up active funds or active security selection as the means of implementing desired market exposure.

These savings free up cost capacity for what really counts:

• dynamic asset allocation 
• continuous risk management
• reporting focused on forward-looking outcome probabilities
• continuous planning in the light of actual goal progress.

In most cases, because of the size of the client’s assets, we managed to reduce total costs by several thousands each year and for the wealthiest, because our fees are much flatter than value-based fees, it is measured in tens of thousands. 

Providing insights into true cost levels and waste has sometimes affected how new clients feel about their previous managers! This suggests the industry is still a long way from being open and transparent but also that customers are not particularly discerning about value until something jogs them.

Service

Generally, clients spoke quite favourably of the service they were receiving from their previous advisers although when it goes wrong it is a killer for the relationship. This was rarely the reason prospects cited. Our competitors are not stupid and employ personable people and expect them to stick close to their clients.

I see no reason to expect us to perform the basic functions better. But we do expect to deliver more of value in the relationship, by making portfolio management a continuous process of financial planning. Defined Outcome portfolios generate a different form of reporting that is much more forward-looking than traditional reports.

I would also like to think, as some of the clients’ comments testify, that we can match any of our competitors when it comes to intelligent obervations about the financial world.

The challenge for private clients our title alludes to has two dimensions: giving them the right job and ensuring they do the right job well. The typical portfolio approaches for private clients focus on short-term constraints that are not consistent with maximum satisfaction with horizon-specific outcomes.

Using as an example No Monkey Business portfolio returns over the last two years of large falls and rises in markets, we illustrate how to set objectives and assess performance better. Because all our portfolios are different, for reasons that will be obvious from reading this Insight, we reference the same two portfolios as we did in an earlier Insight, Anatomy of a bear, one in ‘accumulation’ and one in ‘drawdown’.

Performance and confidence

Performance appears to be an important reason, perhaps the most important, for individual investors deciding to change their investment arrangements. This is not because they have a lot of information about their managers’ performance and are able to assess it rationally. In fact, they probably only get to see their own returns, compared with benchmarks, every three or possibly six months. Even then, without a lot more data history than their patience may tolerate, and without attribution (was it policy choices, market timing or selection choices?), there is limited information to be extracted from the reports.

If it is not continuous well-informed appraisal that leads clients to change manager, what aspects of performance do? It is usually because they are surprised by what has happened and in the absence of proper explanation they lose confidence that their adviser has understood the constraints or the objective or both. The surprise is all about expectations but the interpretation is all about confidence.

In other cases, however, investors will realise that the adviser or manager they appointed did a good job given the mandate but the mandate was wrong. It can be hard to leave a manager who has done a good job against the wrong mandate. In selecting us many clients have moved their money from managers with very good performance as well as from those with disappointing performance.

Wrong job, right job

We identify five common causes of disappointed expectations and mismatched mandates that are prevalent today:

1. The spread of a ‘factory’ approach to portfolio organisation that lacks close links to relevant personal objectives
2. The fact that equity returns over the past decade have not typically delivered the ‘risk premium’ professionals led clients to expect
3. The failure of diversification across the traditional asset classes to smooth portfolio volatility as portfolio theory apparently posited
4. The failure of ‘alternative’ asset classes to perform as expected, in terms of absolute returns, correlations and premiums for illiquidity
5. The ‘false prospectus’ that the fad of ‘absolute return investing’ turned out to be for many of its followers.

What all five have in common is that they are policy choices: high-level decisions about the general approach to how your money is to be managed. They belong to the client, who makes that policy choice. This is not to say the industry is blameless in adopting the easy sale in preference to a more exacting route to developing optimal investment solutions. The easy sale not so long ago was, after, all unitised with-profits.

We suggest that ‘outcomes driven’ investing, which Chris Drew and I developed ten years ago in parallel with the emergence of Liability Driven Investment in the institutional market, has avoided these problems and allowed for much clearer expectations and therefore more stability and consistency in following a planned and appropriate strategy.

The expectations effect works by being more explicit about what can happen, with more quantification of risks. But is also works via a feedback from greater confidence about outcomes to greater tolerance of short-term volatility. Consistency on the part of our clients means we are free to follow a model-driven discipline which is likely to increase wealth outcomes. Inconsistency means investors tend to raise their risk tolerance when times are good and lower it when markets and the economy are doing badly. This destroys wealth.

To illustrate how our clients can assess the job we are doing we reference our two actual portfolio examples. We do this in terms of three key questions we think all clients should want answers to:

• How is my portfolio structured to deliver what I want?
• How is risk being controlled?
• Are both evidenced by the activity in the period?

How is my portfolio structured to deliver what I want?

‘Delivering what I want’ translates, in investment theory, to ‘maximising the benefits I want to get from my money in the form I specify’. In this context, ‘benefits’ translate into ‘utility’ or (as sometimes expressed in the theory) as ‘welfare’. Utility is specific to a goal not general to an ‘investment personality’, assuming such a thing even exists.

In practice, utility is mainly about the consequences of uncertainty and how individuals express preferences in response to those consequences. In the factory model, the presumption has to be that these are common to everyone, not idiosyncratic. In reality, we make value judgements that are highly specific, such as:

• preferring to push possible bad outcomes further into the future, where we think we can better bear the consequences, or nearer where we can deal with them through adjustments to behaviour (such as a household budget change)
• setting explicit constraints on the consequences, such as a minimum spending level in retirement which no incremental potential spending chance should put at risk
• preferences that are dependent on progress in funding an objective that calls for a particular pot of money, which (whether the progress is good or bad) could invite taking either more risk or less risk.

You will know personal utility was never addressed if you did not start with planning conversations that identified these preferences and described a portfolio solution that matched them.

You will also know it if the conversations about ‘risk tolerance’ did not address whether your utility was best expressed in terms of path risk, or the short-term volatility in the path of the portfolio in money terms (as measured by those performance reports) or outcome risk, as in the form in which you ultimately derive the benefits from your wealth, such a future level of real spending (after inflation) say 20 years out. The first is not a substitute for the second.

We find that in practice most investors, when encouraged to plan in terms of specific goals for their money, can see clearly when (and why) path risk or real outcome risk dominates. The investment solution will be radically different depending on which dominates.

For the client who owns our drawdown example, the goal is meeting a schedule of annual draw in real terms from capital (part in pension, part not) subject to the constraints of i) not running out of capital before age 95 and ii) sustaining the spending plan without being forced to cut it, except to the extent of a planned schedule of tapering minimum spending at different stages of retirement. In this plan, risk taking is constrained by the agreed range of tolerable outcomes, as ‘real’ money available in a cash account to meet the next three years spending, in a schedule of three-year time slices from 50 to 95. With known resources, risk is solved for by reference to the range of probable outcomes (which come from our model) and the consequences (which must come from the client).

The key element of our quarterly performance reporting is therefore where the client now stands in relation to the goal outcomes: is the ‘new’ portfolio value sufficient, with ‘new’ expected returns, to meet the agreed drawdown targets with the same confidence?

Because there is a degree of volatility in the ‘funding status’ (though as the return-generating element of the model is designed, this is much less than the volatility of ‘the market’), we report (as a monetary amount and as a percentage of the ‘fully-funded’ position) the ‘interim projected shortfall or surplus’. What the client wants to know is:

• Has the portfolio done so badly that I may now breach the plan constraints and therefore need (in this example) to cut spending, contrary to the objective of sustaining it a planned real rate?
• Have I done so well that I can change the targets or risk level or assign surplus assets to a different goal?
• Is the change just ‘noise’ I should not attach any significance to?

We provide this guidance in every report, every quarter, drawing on stochastic simulations of a long-term plan and its changing interim funding status. Usually we will be suggesting that no action is called for by the client, particularly in the first 6-10 years of a plan.

A secondary aspect of the portfolio progress report is that, because the target outcomes were planned in real terms, we need to adjust them each quarter by the actual inflation in the quarter before calculating the new funding position. We report that change too.

How is risk being controlled?

In the typical investment solutions that dominate the IFA, banking and wealth management business models, risk is managed by diversification. This is not a control. It was never put forward by theorists as a risk control. Its origin was in the separation of:

• diversifiable risks that provide no reward and therefore should be eliminated from a portfolio and
• systematic risks, common to any exposure to particular asset classes or markets however you select within them.

Relying on diversification between asset classes and markets reduces risk to the extent the returns from each are less than perfectly correlated and so for a given level of resulting risk there is a set of possible portfolios that will yield the highest expected return. These portfolios are ‘more efficient’ in using risk than portfolios that have lower returns per unit of risk. That is all it means.

To serve as a risk control, there would need to be sufficient of these asset classes and markets with both i) low or negative correlations (or co-movement) and ii) stable and predictable correlations to reduce portfolio risk reliably to acceptable proportions. As investors worshiping at the new altars of ‘absolute returns’ and ‘multi-asset classes’ discovered, correlations do not have these highly desired characteristics. And they converge when you most depend on them, such as when liquidity tightens up and asset prices are falling. Hence the disappointment.

In a liability-driven approach, risk is controlled by combining risky exposures and hedges. Hedges are assets that perfectly match a liability, or goal outcome. If the outcome is a target level of money in real terms 10 years out, for instance, that exact amount can be produced, on time, with certainty, by buying an index linked gilt with the same duration.

When investors have preferences for outcomes that involve trading off possible higher wealth against some minimum wealth, there has to be a range of probable outcomes, with risk taking, that is acceptable and efficient. The size of that range is controlled not by diversification, although that is part of an efficient solution, but by the mix of risky assets and hedges, or risk free assets.

What is the evidence?

So when we report our transaction activity for a client in the quarter, it should be seen to be consistent, at a high level, with the process of risk control as market values alter. It becomes the visible proof of a risk management discipline. It will be particularly seen as a discipline if the actual activity appears (at the time) counter-intuitive.

In Fig 1 we show the market returns from the start of 2008, just after the bear market began, up to the end of 2009. This describes the environment for each of cash returns, index linked gilts (the FTSE over 5-year index whose duration most closely corresponds to the time slice outcomes we hedge) and the four equity markets and regions (in sterling terms) we use as building blocks for the risky asset portfolio.

Fig 1 Index total returns in £ for portfolio building blocks

Two aspects are important to our model:

• The expected return on equities rises as markets fall in price, because we accept the evidence that equities generate a trend of positive real return over long horizons (capitalism requires it) and ’revert to the mean’
• The attraction of any expected equity return depends on the competition it faces from hedging assets, at their own ‘certain’ real return.

In Fig 2. we show how we moved money between the hedge portfolio and the risky portfolio over the course of the market cycle, responding to both effects. The bars show the net addition to (positive) or sale (negative) of equities in each quarter of the two-year period.

Fig 2 Net flow from risk free to risky assets as % risky

At the start of the bear market, equities fell but so did the risk free rate, so we added to the equity position. As this was followed by a reversal of the fall in risk free rates and slightly higher equity prices, we took some bets off the table and added to index linked gilts. As the bear market turned nasty, and the crisis in the banking sector spilled over into expectations of a global recession or new depression, additions to equities were mainly driven by falling price, rising expected returns, rather than by changes in risk free rates. More recently we have started taking bets off the table as both equities and index linked gilt prices have been very strong. Though mean expected equity real returns are still above average, the incentive to take risk is greater because index linked gilt yields are at record lows. However, the incentive has been lessening simply because of the scale of the recovery.

We suggest that few managers have shown such consistency in their risk taking approach during this market cycle. Looking at their activity will probably tell a clearer story than the performance they reported or the comparisons they showed. Over the long term, there is clear evidence that adopting a consistent attitude to risk, which is not at all the same as the same level of risk, produces higher returns because it avoids selling low and buying high.

Backward looking performance

Even on a pure accounting basis, we need to report what actually happened to our clients’ portfolios in each quarter and we do that too, in a fairly conventional way.

• We calculate the money weighted returns in each month (so adjusting for cash flows into or out of the portfolio during the month according to roughly when they arose) and multiplying them through to produce what is then very close to a time-weighted or internal rate of return for that quarter
• We show the returns for the assets we use a building blocks in the same period, so that the actual return can be viewed broadly in the context of the environment in which we were operating
• And from now on we plan to show something we have resisted hitherto: a measure of what clients might have earned with a more conventional approach, for which purpose there is nothing ‘better’ than the benchmarks developed to match the different version of the factory model by the Association of Private Client Investment Managers and Stockbrokers.

In a liability driven approach, the changing market values of the hedging assets are meaningless in terms of outcomes, as the two are perfectly matched: a rise in price will reduce the expected real return symmetrically leaving outcomes unchanged. So realistically it is only the risky portfolio whose volatility is meaningful, but in our view its meaning is in the impact on funding adequacy, and so requires a forward-looking measure. As a backward-facing measure of industry returns, the closest APCIMs benchmark for the risky portfolio is the Growth index although it is not still not representative of equity returns alone, as it includes cash, bonds, property and hedge funds (to the extent in full of 22.5%).

In Fig 3 we show the returns of two portfolios, one in drawdown (and so combining hedges and risky assets, the latter averaging about 55% over the period) and one in accumulation (with long enough horizons to have been fully invested in risky assets throughout the two-year period).

Fig 3 Quarterly portfolio and benchmark returns (indexed)

We can note, in terms of attribution, that we were helped by the extent of our diversification geograhically, as we tend to more equal weightings than conventional managers and have less of a bias to the UK as home market. This helped particularly in the bear market because of currency gains, although this was partially offset in the following year.  The returns to these structural characteristics, or policy features, in any particular period contain relatively little information except that diversification does not necessarily require lots of different assets. As the APCIMs benchmark shows, conventional diversification, even with the addition of 7.5% in hedge funds, did not produce either better performance or less volatility than our risky portfolio.

Though you can make comparisons with your own performance, we suggest the guidance in this Insight as to how to interpret what your manager is doing is probably much more important than a crude comparison of the numbers in a short period. As my book suggested, investment is best viewed as a journey not a race. You are not picking the winner so much as the best planner, navigator and driver, all rolled into one.

Lifetime Allowance
The Lifetime Allowance (LTA) will increase from £1.75m to £1.8m at the turn of the tax year. It will then be fixed at £1.8m until at least 2016 (unless reviewed by an incoming government).

As planned, individuals aged 50 that have opted for primary protection will have the allowable growth within their pension funds effectively capped for a period of 5 years.

By vesting the pension in full, the pension will not be subject to the LTA at a later date. The pension fund is not therefore restricted to any particular growth rate.

If further income is not required immediately, the income can be set at zero. And because the crystallisation of the pension triggered an ‘entitlement’ to pension benefits, the option for an income stream to commence before age 55 is retained.

What to do with the PCLS
On pension crystallisation, an individual can take a portion of their pension as a pension commencement lump sum (PCLS) or, as more commonly known, ’ tax free cash’. If there is not an immediate need for the capital, it can be reinvested outside the pension environment. If held in a taxable form, growth will be subject to capital gains tax (currently set at 18%) after the personal annual allowance of £10,100 has been used. This is a lower ‘effective tax rate’ on growth than experienced in a pension, 75% of which will effectively be subject to income tax at 40% or 50% for higher earners when extracted.

This presumes that the individual buys assets that attract capital gains. If on the other hand, index linked gilts (ILGs) were purchased the arrangement becomes even more tax efficient. ILGs are subject to minimal taxation when held directly (outside a tax wrapper). Most of the inflation compensation element of the return is in the form of tax-free capital uplift rather than taxed coupon uplift. This contrasts with nominal interest rates, where most of the rate paid is compensation for inflation and is then taxed as income, and with equity returns, where the inflation compensation is partly via income and partly gain, with both subject to taxation.

Capital Extraction / Income Drawdown
Extracting the full ‘economic value’ in a personal pension fund is extremely difficult and in many cases impossible. Therefore, once a decision has been made to extract the tax free cash, a plan to extract the maximum amount of pension capital is likely to follow.

Throughout ‘decumulation’, the period of time during which individuals enjoy the accumulated capital, pensions are overly restrictive. Once the tax free lump sum has been drawn, the annual income that can be drawn from the pension is restricted to rigid government actuarial department (GAD) tables, influenced by the yield on 15 year Gilts, and taxed at marginal rates of income tax.

The after-tax benefits of savings in or out of a pension wrapper can be measured by comparing net present values (the total present value of a time series of cash flows minus the initial investment) of the two cash streams after their different tax treatment. We find many people who have previously focused on the tax advantages of accumulation are shocked to discover how small the net present value gain from their pension is. However, even this calculation ignores the uncertainty about the amount of capital that can be enjoyed either as lifetime spending or as a bequest. This is a serious oversight as there is in practice a large degree of inefficiency in the extraction of value from a pension account under current tax rules, aggravated by the penal taxation of residual funds after the deaths of both member and spouse. The rules are also designed to ensure that there is likely to be a residue if the second death occurs after age 75. The intention of these rules may have been to make the option of drawing down after age 75 unappealing.

The risk of not extracting all of the value from the pension fund can be avoided by buying, at some stage, an annuity. The potential loss of early death is offset by an equivalent gain from outliving one’s actuarial expectancy. However, this calculation is not a satisfactory explanation of the benefit of capital in or out of pensions where there are children and a significant value is placed on a bequest motive. Such an approach to the economic value of pensions is clearly dependent on individual levels of wealth relative to spending.

A critical source of loss of economic value in pensions is inflexibility. Pension rules generally do not allow an individual to access pension capital should it be needed. This is highly relevant when a large proportion of the assets assigned to retirement spending takes the form of pension capital, in which case it may be impossible to meet unexpected exceptional expenditures.

Pension Winners
When considering the whole duration of a pension, from commencement of contributions to the pensioners demise, the tax benefits are very difficult to calculate. The only group that can be confident that they benefited from the pension tax structure, ahead of other alternatives, are individuals that made contributions to pensions as higher rate tax payers, and then drew down income as a basic rate (or lower) tax payer.

Pension Losers
High earners who were able to make very large contributions to personal pension arrangements and based their actions on the tax benefits going in are those most likely, depending on later circumstances, to have destroyed value.

Their number will be significantly increased if, as many now fear, the pension commencement lump sum of, typically 25%, is axed by a future government desperate for tax revenues. We believe this fear is exaggerated because it would render savings in a pension fund economically irrational even for the majority of savers. But this concern has been described to us by one of our clients as a ‘monster under the bed’ which, once it had entered his mind, could not be ignored, and could only be assuaged by crystallising his pension to be certain of not losing out.

Potential for conflict?
You may now be wondering, why you have not been advised to consume capital or crystallise pensions early by other advisers?

It could be that that they have placed too great a value on the benefit of income tax deferral and gross roll up (less the 10% tax credit), ignoring the real (after inflation) value that can actually be extracted from the pension fund.

It could be that they enjoy the dependency that is created by using the complicated legislation and tax structure of pensions?

Or it could be that the majority of advisers are remunerated by the value of assets within the pension fund.
In practice these may play a part, but the most significant reason is that most advisers do not have the necessary investment expertise to manage what is, an extremely difficult investment challenge. On this basis they will be reluctant to advise, and will almost certainly refrain from drawing on your pension early, regardless of the level of assets an individual holds elsewhere. They may also advise clients to draw more conservatively from the pension than is sustainable so to avoid depletion of the fund.

Planning from a holistic perspective
Putting aside the previous considerations, the decision to crystallise pension benefits should really be made within the context of establishing a sustainable level of lifetime spending that a total portfolio can support. Most pensioners are likely to value higher spending when fit and active, with income tapering down later in life. They are also likely to prefer passing surplus wealth to beneficiaries by the method of regular gifting from income. Not only is it efficient with regards to inheritance tax but the client also values the gifting with ‘warm hands’.

This type of spending plan is likely to be funded not just by pension funds but various financial assets both in and out of tax wrappers, as well (perhaps) as real property or contingent assets such as inheritance. Only by considering the balance sheet as a whole and the existing arrangements for holding assets can one make a fully-informed decision.

In a context of holistic resource planning , retirement spending funded by non-pension sources may run up against a cultural attitude that differentiates between income and capital, as in ‘not consuming the seed corn’. In a pension fund, of course, this distinction clearly does not need to mean anything significant. The ‘income’ drawn in retirement or taken as an annuity is actually a conversion of accumulated ‘capital’ to a stream of cash flows. The ‘capital’ accumulated is itself the product of savings out of earned ‘income’. It is just money.

The important output of planning is how money is consumed. Freeing up attitudes about where the money should come from will also allow greater tax efficiency, as the tax code penalises income relative to capital. Consuming capital is a way of reducing one’s overall effective tax rate but this is only likely to be acted upon if there is confidence in the solution managing the sustainable level of income.

The underlying economic principle of a holistic approach is total capital efficiency, where after-tax outcomes are measured against the particular way in which clients expect to derive benefits from their wealth. This is the essence of outcomes-based investment, organised to deliver both client- and goal-specific planned outcomes.