"Asset allocation is not everything. It's the only thing."
One of the harshest lessons of the Global Financial Crisis was that when the going gets tough, correlations trend to one, giving even diversified investors very few places to hide. It wasn't about whether or not you got burned, it was a more a question of degree. While there's a time and a place for active stock selection, from a portfolio construction perspective, it's the active management of the overall asset allocation that affects the outcome. Using ETFs for portfolio construction The growing popularity in Exchange Traded Funds is in part because of their elegance in providing broad, liquid, efficient and cost-effective market access to most major asset classes with a single trade. We now have a broad range of building blocks with which to construct a diversified portfolio. As a result, the problem for investors has shifted from "How best can I access a broad choice of markets?", to "How do I create a portfolio that suits my needs?" How many ETFs are needed to create a portfolio? To create a portfolio with too few ETFs would mean there is limited scope to create different asset allocation strategies. To create a portfolio with too many ETFs introduces additional complexity, oversight requirements, and a higher degree of trading costs if the portfolio is to be regularly rebalanced. So what is the minimum number of ETFs needed to create a well-diversified portfolio? A Strategic Core For a strategic portfolio for a UK investor with £100,000 to invest and a desire to keep trading and ongoing costs to a minimum, we believe that advisers can construct strategic asset allocation models using the following “Magnificent Seven” broad asset classes alongside cash: UK Government Bonds, UK Corporate Bonds, Global Corporate Bonds, UK Property, UK Equities, Global Equities and Emerging Market Equities. All 7 of these asset classes can be accessed through BlackRock's iShares range, mostly from their cost-efficient Core range. Importantly, these ETFs are 'cash-based' or 'physical' meaning that they actually own the underlying holdings (unlike some ‘swap-based’ or ‘synthetic’ ETFs). Liquidity and diversification The fund sizes of these ETFs ranges from approx £400m to £4bn meaning external liquidity is high. Internal liquidity is as good as the underlying securities the ETF and index holds. While investors see only seven holdings, a portfolio containing these 7 large and liquid ETF building blocks represents a diversified portfolio of some 6,901 individual securities, all of which are fully disclosed for each fund. Strategic or Tactical After creating a strategic asset allocation model, ETFs mean that tactical asset allocation changes can be executed in real-time, which can give significant implementation advantage in these volatile times. As a starting point for advisers look to provide low-cost portfolio construction, using ETF building blocks for these key seven asset classes are a helpful first step. www.elstonconsulting.co.uk NOTICE This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Elston Consulting to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Elston Consulting, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 Elston Consulting Limited. All rights reserved. BirthStar, Elston Gamma, and Elston Strategic Beta are registered trademarks of Elston Consulting Limited. All other marks are the property of their respective owners. The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected. In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity but more of a combination of each to match a client’s needs, requirements and aspirations.
When researching the solutions that could help advisers navigate the new retirement freedoms, we looked to the US where annuities have long ceased being the mainstay of retirement income to understand the innovations that can help create more durable retirement portfolios. From “to” to “through” Lifestyling pensions are managed to a retirement date typically targeting annuity conversion. Target date funds can be managed through retirement targeting sustainable withdrawals from a balance of stability and growth. The target date is not an end date but a start date for the drawdown phase. It is the turning point where investors move from making regular contributions, to making regular withdrawals. The investment objectives gradually pivot from making a pot grow before retirement, to making it last in retirement, sustaining a durable income. Flexible, not fixed In contrast to old-fashioned lifestyle strategies which follow a fixed investment plan, target date funds enable flexible asset allocation to adjust for the market and economic environment. This is the difference between being asleep or awake at the wheel: the journey looks similar, but it’s who’s driving that counts. This flexibility enables active risk management for a smoother ride for clients. Partial annuitisation Annuities’ key feature is to provide guaranteed income in old age until death. That was generous in 1928 when the pension age was 65 and the average age of death was 67, now it’s a stretch as, happily, we are all living longer. Partial annuitisation may have a role to play to top up other guaranteed incomes, like DB benefits and the state pension, to help cover a client’s essential spending in retirement. So while most retirees in the UK took 25% cash/75% annuity, about 19% of retirees in the US take some form of annuity with optimal allocation considered to be 25% annuity/75% drawdown on average. Deferred annuities Traditional annuities and enhanced annuities would both be termed in the US as “immediate” annuities as they start paying out at point of purchase. What we don’t have yet in the toolkit are “deferred” annuities, which start in the future to do what annuities were originally meant to do: to form a perfect hedge to longevity risk. By combining target date funds with a progressive purchase of deferred annuities, there is scope to get the best of both worlds: a managed portfolio to drawdown over time, and a longevity hedge for later life, when longevity risk is an insurance worth having. We encourage UK insurers to offer deferred annuities to broaden the retirement toolkit. A “bucket” approach One framework in the US for retirement portfolio construction is the “bucket approach”. Each bucket includes a cash component for short-term needs, a medium risk bucket for medium-term needs, and a higher risk bucket for longer-term growth. The allocation to each bucket changes as time goes on, as risk capacity changes with time. With target date funds, allocations to these different “buckets” is managed within the fund, for convenience, efficiency and value, and enables advisers to focus on more holistic planning decisions. Bringing it together Instead of considering a portfolio’s potential for risk and return, advisers are now having to consider retirement outcomes – income replacement and adequacy rates, sustainable withdrawal rates, life expectancy and legacy decisions. Our accredited CPD series for advisers around retirement investing examines the ‘lifecycle’ framework for combining future income, current portfolio, life insurance and annuity choices to optimise asset allocation over time to consider not only investment risk, but mortality risk and longevity risk too. Old problems, new answers While none of these considerations are new to advisers, the responsibility for managing them is. The innovation that target date funds provide for a managed drawdown portfolio forms part of the retirement planning toolkit alongside cash, guaranteed income, and insurance. It’s for advisers to combine these to create a plan that suits their client’s needs. It’s time to rethinking retirement investing and we are here to help. Regulatory changes in pensions and advisory markets are prompting a fresh look at age-based multi-asset funds, known as lifecycle or Target date Funds (TDFs). As part of a broader move towards packaged investment strategies, investment managers may need to reassess their product offering to become a wealth manager, a fund factory, or both.
Read the full article from CFA UK Professional Investor Magazine |
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