Paraplanner Zone: New investment thinking

Andrew Wilkins, executive director of Catalyst Investment Group, says retail investors should make the most of investment choices previously only available to their institutional peers.

Retail investors would be forgiven for thinking now is the time to return to investment thinking of old. The determined rally in world stock markets from the lows witnessed last March has been truly remarkable. The FTSE 100 has retrenched an impressive 58% since then, yet a shadow of the 69% gain delivered by the S&P 500 and astonishing 97% of Asia-Pacific’s Hang Seng Index.

Nonetheless, investors would be wise to take stock and assess the options available. The shape and sustainability of continued recovery is not certain, and there are many more tools at their disposal than previously. In particular, the past decade has seen a gradual movement towards greater product and investment choices for the retail market. Areas of the market previously only open to institutions have become available to investors.

Retail investors should think about the growing number of options available and what strategies will deliver in the long term.

Liability-driven investment

One area of growing interest to institutions – the liability-driven investment strategy (LDI) – is worth considering. The notion of retail investors borrowing from LDI strategies may sound fanciful. LDI strategies, deployed by institutions with pensions-related liabilities, involve the careful mapping of assets to existing and future liabilities.

A deep and precise understanding of the nature of those liabilities is required, achieved through sophisticated actuarial modelling and typically complex investment decisions. Retail investors do not have anything like the liabilities institutions face, nor the variety of means by which to deal with them.

However, retail investors could certainly borrow from the thinking. For many, smoothing portfolio returns and insulating themselves from painful or unpredictable losses is paramount, as institutions have found  in the aftermath of the financial crisis.

For retail investors, this would mean thinking carefully about meeting and protecting their commitments. Headlines about delayed retirement plans for those burnt by investment losses provide just one example of the financial commitments retail investors face and their inability, on occasion, to take a long-term and more cautious view.

Many of the important milestones in our lives are defined through known, and significant, future commitments. Meeting children’s education costs, saving for a mortgage deposit, and meeting insurance premiums, are just a few of these ‘liabilities’.

Shifting to an investment planning approach that will deliver the returns needed over their lifetime could prove far more effective than betting on good returns in rising markets – and living with serious losses in the bad. It also presents a clear opportunity for advisers to engage more deeply with their clients.

Holistic approach

Borrowing from the principles of an LDI approach require retails investors to build a much more sophisticated and composite view of their financial needs.

Let us take the example of a first-time buyer. Traditionally, saving for a deposit might see an investor put aside some capital in a savings account a few years ahead of purchase. Separately, they may invest spare cash into equities to deliver a fairly generous return on investment.

However, considering their various financial commitments in the round, and in a low interest rate environment, that same investor should consider the overall level of return they require.

They would have some sense of when they would need to meet their various financial commitments, and build an investment strategy accordingly, dependent on the quantitative and temporal nature of the liabilities they face. They may opt for different asset classes entirely, or ones with different return properties to meet their needs.

The effect of deploying such a strategy would be a radical departure for retail investors, who remain heavily exposed to equities. IMA data shows that, while there has been a gradual shift from equities into bonds, cash, and other asset classes in recent years, equities still command a significant 62% share of retail investment portfolios, compared to only 37% of institutional holdings.

Deploying a more holistic strategy to their investments, would see retail investors most likely increase their exposure to fixed income securities, to more effectively meet their financial needs across the investment cycle.

They may also look more widely to newer income-generating assets, such as life insurance-backed products (known as life settlements), which can be structured to provide a source of fairly predictable annual income over a given investment horizon.

In addition to supporting an income generation strategy, these sorts of alternatives have the advantage of being lowly correlated with the market, helping to deliver the income investors need to meet their financial commitments even in the event of poor stock market performance.

While it may not be within the grasp of retail investors to take the sophisticated approach of institutions, they would be wise to take on board some of the lessons institutions have grappled with from the financial crisis, including the general principles behind LDI thinking.

Even if the market continues to rebound strongly, such a strategy has its merits in delivering the long-term protection of capital that many investors seek.