Goal-Driven Investing · 2011. 3. 8. · Construction Asset allocation to hedge life risks, not...

CONFIDENTIAL © 2011 Advisor Software, Inc.

Andrew Rudd, CEO & Founder

Nicolo Torre,Head of Research

S. Raj Rajagopal, Associate Portfolio Manager

Advisor Software, Inc.

www.advisorsoftware.com

Goal-Driven InvestingLDI for Households

San Francisco,

March 8, 2011

CONFIDENTIAL © 2011 Advisor Software, Inc. 2

Investing Household Funds: Conventional Approach

• Households allocate funds to investment accounts with varying tax treatmentsProcess

• Long-only allocation to cash, stocks and nominal bondsFund Strategy

• Grow nominal wealth subject to control on absolute volatilityMandate

• Markowitz and SharpeAcademic Basis

• Driven by risk tolerance or return needInvestment Plan


Is There A Better Way?

Can we learn from institutional practice? One possible answer

Liability-Driven Investing

• Jointly construct the asset and liability portfolios so that their risk characteristics are matchedIdea

• Liabilities represent both financial liabilities plus the goals for the householdDefinition

• If the assets and liabilities are matched then the difference (surplus/deficit) is likely to be small and remain small over time

Rationale


Aspects Better Approach

AimFocus on attaining lifetime sustainable income and consumption

• Beat the S&P 500 or afford your lifestyle and mortgage?

Framework Lifecycle investing, consumption smoothing

Academic basis Samuelson and Merton

RationaleRational investor will invest in risky asset to maximize lifetime utility of consumption

Construction Asset allocation to hedge life risks, not just portfolio risks

Investment Plan

Risk Capacity (household capacity to bear risk)

Goal Driven Investing: LDI for Household Investors

Pension Funds Endowments Insurance companies

Institutional Liability-Driven Investing

HouseholdGoal Driven Investing

You and Me


Aspects Of GDI

Consideration Example

Capacity to manage liabilities and assets

• Range of possible values in home purchase

• Choice of school and university (public or private) local or distant

Flexibility in timing of cash flows• Mortgage debt type and terms

• Lifestyle choice

Non-marketable assets

• Human capital (employment)

• Real estate and property

• Social security income

Tax Implications

• Nontransferable assets (tax loss carry forwards)

• Asset location between taxable and non-taxable portfolios

Options for risk management• Health, life and disability insurance

• Long-term care insurance

Intuitive in theory, but difficult in practice


What Does It Take?

We must:

Inventory the Household

Balance Sheet

• Liabilities

• Assets

Analyze

• Capacity for risk bearing

• Nature of risk exposures

Manage the portfolio

• Tax and risk efficiently


LiabilitiesCommitments

Low Priority

Medium Priority

High Priority

Liabilities

Benchmark

Essential spending

Controllable spending

Liabilities

Include both financial liabilities and goals, and both can be managed

Include both contractual (e.g., mortgage payments) and self-imposed (e.g., purchase vacation home) items

Represent the benchmark for optimization; goal structure defines investment risk and exposures

Are prioritized and defined in tranches

In the household context, liabilities

To prevent confusion, in the household context refer to them as Commitments


Assets

Requires comprehensive inventory

Includes employment income, social security, real assets such as a home, as well as savings and financial assets

Assets should include everything that can be used to fund the Commitments and affect risk characteristics:

To prevent confusion, in the household context refer to them as Resources

Resources

Fixed

Controllable ManagedInvestments

LockedInvestments

Social Security

Employment

Real Property


Balance Sheet Frames The Portfolio

Resources Commitments

Controllable ManagedInvestments

LockedInvestments

Real Property

Social Security

Employment

Low Priority

Medium Priority

High Priority

Liabilities

Benchmark


Balance Sheet Exhibits Risk As Impact Of Shortfall

Commitments

LockedInvestments

Real Property

SocialSecurity

Employment

Vacation, Car

Kids Education

Living and Retirement Expenses

Mortgage

Resources

ManagedInvestments

Margin of Safety


Balance Sheet Risk Exposures

Locked Investments

Real Property

SocialSecurity

Employment

Price Rationed Goods

Regular Goods

Financial Debts

Resources

Managed Investments

Nominal Interest Rates

Nominal GNP

Inflation Indexed

Commitments

Market Factors

Inflation + GNP

Multiple Factors

Inflation indexed


$0

$2,500,000

$5,000,000

1.30% 2.30% 3.30%

Inflation

Brokerage

IRA

Home Value

Social Security

Employment Income

$0

$2,500,000

$5,000,000

1.30% 2.30% 3.30%

Inflation

Retirement

Mortgage

0%

10%

20%

30%

40%

$0

$2,500,000

$5,000,000

1.30% 2.30% 3.30%

Inflation

Resources

Commitments

Margin of Safety

Example: Sensitivity To Inflation

Resources are less sensitive Commitments are more sensitive

Margin of Safety is quite sensitive to increases in the average inflation rate (measured in right axis)

Inflation Sensitivity is nonlinear and very high when the margin of safety is low

By implication controlling this risk is quite important to the financial stability of the household


How Do We Compute A GDI Portfolio?

Balance Sheet

Analysis

• Establishes benchmark for risk measurement and risk capacity

Dynamic Optimization

• Translates risk capacity into a tracking error budget for the next period

Mean-Variance

Optimization

• Builds the efficient portfolio meeting the tracking error budget

We use a three step procedure to construct the GDI portfolios


What Does a GDI Portfolio Look Like?

Immunize essential goals

Provide a secure floor on

consumption

Capture risk premium

Within risk budget constraint

Hedge for mortality risk

Secure consumption in face of

unexpected longevity

Qualitatively GDI portfolios have three components:

Changing market conditions and household circumstances cause the relative contributions of these components to evolve over time

By definition, the client is highly risk averse to any shortfall in essential goals, which influences TIPS exposure. Comparison between portfolio and goal structure motivates discussion between advisor and client


0%

50%

100%

Low Medium High

Margin of Safety

Fixed Income

TIPS

Equities

Margin of Safety Drives Asset Allocation

Note: In this and subsequent slides we use TIPS to represent the class of inflation hedging assets, which could also include certain real assets, commodities, etc.


Interpretation

Low

• Limited capacity to bear risk leads to selecting assets to minimize tracking error between Resources and Commitments.

• In many typical situations the result is a healthy allocation to TIPS.

Medium

• Moderate capacity to bear risk

• Results in equities partially displacing TIPS, increasing expected return at a cost of increased risk.

High

• A high capacity to bear risk

• Permits aggressive pursuit of return. Equities totally displace TIPS.

• Is primarily to hedge financial Commitments and near term spending. The allocation is little effected by the margin of safety.

Role Of Fixed Income In Portfolio

Margin of Safety


Time Dimension of Goal-Driven Investing

Age 20s/30s

Less financial assetsMore human capital

Contribution of financial assets to risk budget is low

Age 40s/50s

More financial assetsLess human capital

Contribution of financial assets to risk budget is high

Age 60s/70s

High actuarial risk

Mitigate risk by annuities

Margin Of Safety approximately constant with time, but may increase if Commitments burn down faster than Resources

Portfolio evolves in response to these drivers

Composition of Commitments and Nonfinancial Resources Evolves With Time


Example: Focus On TIPS Allocation

% Allocation to TIPS RetirementTIPS allocation is highest just before retirement(most exposure to inflation)

Human Capital Diminishes Faster Than Commitments, Financial Assets

Accumulate

Commitments Diminish Faster Than Financial Assets

0%

50%

100%

30 40 50 60 70 80


Representative Glide Paths Differ Markedly From Target Date Funds

0%

50%

100%

30 40 50 60 70 80Age

TIPS

Fixed Income

Equity

0%

50%

100%

30 40 50 60 70 80

Age

TIPS

Fixed Income

Equity

Vanguard Target Date Retirement Funds

Goal-Driven Model Portfolios

Deterministic glide path driven by age

Adaptive GDI portfolio driven by Balance Sheet

(100 – Age) in Equities %

(120 – Age) in Equities %


Simulation Analysis of Portfolio Strategies

Faced with a required payout, fix mix portfolios run out of money much of the time. The only cure for this problem is to dial risk taking down, so sacrificing substantial investment opportunity.

The GDI portfolio adapts to past results, so stabilizing outcomes. It rarely runs out of money and capitalizes on the substantial upside opportunity.

The non-adaptive glide path of target date funds delivers results similar to fix mix.

$0

$1

$10

$100

1 6 11 16 21 26 31 36 41

Millions

Number of Years

Value of Fixed Mix Portfolio(log value axis)

75th %ile

50th %ile

25th %ile

5th %ile

$0

$1

$10

$100

1 6 11 16 21 26 31 36 41

Millions

Number of Years

Value of GDI Portfolio(log value axis)

75th %ile

50th %ile

25th %ile

5th %ile


Preliminary Conclusions

GDI approach is

• Intuitive

• Genuinely different

• In some cases has compelling advantages

Is it implementable?

• How?

• For which clients?


Implementation: A Streamlined Process

Software Delivers This Investment Process Smoothly

• Permits delivery of the portfolio that is optimal for the client

• Implementation can maximize tax efficiency in rebalancing


Implementation: A Suite Of Model Portfolios

Suite Construction

Set up representative cohorts of target clients

Run software to generate the suite of model

portfolios

Suite Utilization

Map individual client to appropriate cohort

Assign appropriate model portfolio

Benefits• Trades full customization for a productized solution

• Easier adoption in some shops by aligning skills of relationship managers

• Cost effective for clients who do not gain much from full tax efficiency in implementation (i.e. the mass affluent segment of the market)


Example: Two Cohorts At Age 50

Age 50 Cohort

ResourcesLess

AffluentMore

Affluent

Assets

Home Value $350,000 $1,000,000

IRA, 401K $150,000 $750,000

Brokerage $1,000,000

Bank Savings $10,000 $10,000

Social Security per month $1,600 $1,800

Employment Income per year $100,000 $250,000

Commitments

Home Mortgage $125,000 $600,000

Pre/Post Retirement Expense per year

Scenario 1 $48,000 $142,000

Scenario 2 $40,000 $115,000

Scenario 3 $33,000 $94,000 Reference: Boston University, Center for Retirement Research

Source: Federal Reserve Survey of

Consumer Finance, 2007

Typical Household approaching retirement refers to the mean of the middle 10 percent of the sample

‘Typical Household’


Example Models For Age 50’s Cohorts

0%

50%

100%

Low Medium High

Margin of Safety

Less Affluent Age 50 Cohort

Fixed Income

TIPS

US Equity

International Equity

0%

50%

100%

Low Medium High

Margin of Safety

More Affluent Age 50 Cohort

Fixed Income

TIPS

US Equity

International Equity


Conclusion

GDI is a very powerful approach for

• Helping clients think through their priorities and identify their lifetime goals, which can be summarized in the Household Balance Sheet

• Keeping clients focused on what is important, namely achieving their goals efficiently rather than attempting to beat some irrelevant performance bogey

• Making financial planning more relevant, enabling the delivery of high-quality advice consistently within existing client service channels

Goal-Driven Investing: Assuring a sustainable standard of living in retirement

Patents awarded:

U.S. Patent No. 7,516,095 B1 “Stochastic Control System and Method for Multi Period Consumption” U.S. Patent No. 7,689,494 B2 “Simulation of Portfolios and Risk Budget Analysis”U.S. Patent No. 7,844,523 B2 “Automatic Mapping and Allocation of Beneficial Interests in Trusts for Portfolio Analysis”

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