“In the particular circumstances the world economy finds itself in, we clearly cannot exclude the possibility of either deflation or high inflation. One of the greatest bond bull markets ever has left conventional bonds extremely vulnerable to both risks. 

Governments may not be able to prevent the forced liquidation of excessive levels of debt, causing a vicious cycle of falling prices and incomes that mean debts cannot be serviced or repaid in full. Ten-year gilt yields of around 2% have almost never been this low. They imply a high probability of this ‘debt deflation’ but the additional 2-3% yield on the small population of high-grade, sterling-denominated corporate bonds is not enough to guard against its consequences. To the extent that monetary policies aimed at averting debt deflation eventually lead to high inflation and currency collapse, we might even experience both, in sequence.’

Bonds without guaranteed inflation protection cannot hold out these possibilities of high nominal and real loss and at the same time act as ’risk reducers’ in a portfolio.  Yet this is how bonds and bond funds are being used across the industry and by self-directed investors.

Related posts

Money Marketing Magazine : The bond illusion November 2011

New Position Paper: Bonds: a false market October 2011

In my recent article in Citywire Wealth Manager I explain that the FSA is handicapped by assuming the problem is uncomplicated when it isn’t. It therefore provides guidelines to firms that are likely to lead to inefficient risk choices by both agents and clients. We can only guess at whether this leads discretionary clients to take too much or too little risk and which would do the most harm.

Citywire’s title was Why wealth managers are to blame for suitability crackdown. I blame the industry rather than the FSA not because they are our regulator but because they take their cue from the industry. If we adopt, as standard practice, facile processes for assessing personal risk preferences, assessing portfolio risks and then for ensuring the two match up for each client, the FSA is likely to adopt facile guidelines for each and apply them in a facile way. If this is what the FSA has done, and if it has distorted in any way its shocking findings, and if we want to make sure the FSA does not undermine investors’ confidence (as this exercise may have done), we first have to make sure our processes are fit for purpose. Denial is not without a cost.

Obviously we think we have thought about the problem, we have come up with different ways of defining it and different solutions (heavily quantitative) for dealing with it. As regular followers of our blogs will know, both draw heavily on Liability Driven Investment techniques.

Click here to read the full article.

To read the full article click here (you may need to register for ft.com). I summarise the arguments below.

Target date funds are the basis of the default fund in the government-sponsored NEST auto-enrolled pension scheme, which is an important boost to their credibility. The next step in putting them on the retail investment map will be product launches from private providers. We expect Vanguard, a target date fund market leader in the US, to be amongst the first. This will allow anyone with a personal pension to match their capital and contributions to a specific retirement date or, if they plan to draw down in retirement, to a sequence of dates.

Target date funds make the risks taken by an investor and the expected payoffs specific to age, stage and the manner in which they expect to take pension benefits, whether as an annuity (with or without inflation protection) or drawdown. It can also make risk-taking activity specific to ‘utility’ or the way in which they value different attributes of the payoffs from risk taking. In personal retirement planning, utility or welfare is significantly defined by the adequacy of real purchasing-power outcomes at distant horizons and the consequences for spending of shortfalls in adequacy. Volatility does not explain utility well in pensions saving. Correctly defining utility, and allocating capital to maximise expected utility at the right time, represent important gains relative to the failed ‘balanced management’ paradigm that dominates investment management today.

In the article I examine whether these benefits can be delivered without the time-intensive personal financial planning or segregation of portfolios that we can achieve, working with very wealthy clients.  I believe this is exactly what is enabled by our adoption of the technique or ‘portfolio separation’: the separation of portfolios into a risky segment and a risk-free segment – risk free in terms of the nature of the outcome (real or nominal) and its date (or duration) supports. It will require, as it does for us, very high orders of systematic  decision processes. It is scalable to the mass market and target date funds supply the basic chassis if not the engine.

‘Wealth management firm No Monkey Business (NMB) believes the National Employment Savings Trust (NEST) should follow its lead and adopt the principles of Liability Driven Investment (LDI). According to NMB, NEST’s newly-published Statement of Investment Principles (SIP) makes ill-advised trade-offs in its target date funds between short-term, nominal volatility and long-term real outcome risk. The impact is that younger members will be irrationally conservative, middle-aged members will exchange equity risk with inflation risk and older members approaching retirement will be matched to the wrong kind of pension.’

Read the whole article here.

WealthAdviser is published by GFM, ’the largest online news publisher serving institutional investors/wealth managers and their investment managers/advisers across all asset classes’.

No Monkey Business has been a bit of a lone voice in private wealth management, arguing that diversification is not a risk management tool and that if you want to control risk you have to take risky bets off the table. Risk is about total risky exposures more than about the makeup of those exposures.  Over in the institutional space, however, a radical new approach to portfolio management, known as Liability Driven Investment, has been steadily gaining traction, helped by changes in accounting rules that made pension funds much more sensitive to the impact of diversification falling short. The key difference is that risk is managed largely by ‘hedging’ some or all of the liabilities.  Bets off the table. 

Amongst the leading academics behind this movement is  Edhec Business School. Monday’s edition of FTfm included an article written by Lionel Martellini, Professor of Finance at Edhec, titled A better approach to risk management. In it he says:  

“For a long-term investor facing consumption/liability objectives, risk management should not be understood in an absolute sense, but instead in relative terms with respect to the liabilities: this is the essence of the liability driven investing paradigm that has become the norm in institutional money management. Risk factors impacting pension liability values, notably interest rate and inflation risk, should be hedged away, not diversified away.”

Professor Martellini also says “investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing access to the highest possible performance potential while respecting such risk budgets.”

Do both statements read across to private wealth? Yes. Private clients’ risk budgets are more likely to be about long-term real spending power than short-term volatility, because the liability is usually future consumption, so it is inflation and equity risk that need to be partially hedged in order to squeeze into the risk budget. Step forward, index linked gilts: the private client’s natural hedge.

The article is available on the FT website (you will have to log in to view). It is timed to coincide with Professor Martellini’s new paper on LDI. This can be viewed on the EDHEC website. Not surprisingly, it is highly technical.