Traditional portfolio construction involves combining a mix of ‘defensive’ and ‘growth’ assets together, but there could be some serious flaws in this methodology.
Dan Miles from INNOVA and Josh Corrigan from Milliman have suggested a new way to look at portfolio construction that they say brings it back to the client.
“60/40 portfolios don’t work, and never have,” according to Miles and Corrigan in their paper A new approach to portfolio risk management – the use of risk factors to rebuild portfolio construction.
“We need to bring portfolio construction back to the client – what are their future liabilities, and what risks should we (and what shouldn’t we) expose them to? Not only do we need to understand how much risk a client may want to take on, we also need to assess their capacity to take on risk.”
Miles and Corrigan broadly categorise the risk factors that clients are exposed to in their daily lives – regardless of any financial capital that requires management – into two buckets:
Human Capital: Wage inflation, Employment, Mortality, Disability
Liabilities: Future consumption, Goods and services inflation, Longevity, Liquidity, Taxation
In the advice process it is also crucial to identify liability risk factors related to the capital markets, to understand whether an individual’s exposures to such risks are within their risk tolerances or not. However, they say that asset classes are “largely irrelevant”.
“Asset return behaviour is driven by a number of different risk factors. It is these factors that are relevant, not the asset class itself.”
In their paper, Miles and Corrigan say that advisers need to break down asset classes into their return drivers and this process will provide an expected return payoff profile for each asset class.
“So the role of portfolio construction is to now incorporate the client’s risk tolerance and expose them to those future payoff profiles that can help mitigate the risks that they are exposed to via their human capital and liabilities.”
For example, a client may not be able to handle any form of inflation risk, and so may need a portfolio immunised against inflation. They say that this is the role of the financial adviser – to flesh this out for each client and tailor the outcome specifically for them.
This is not very different to the strategies that some advisers take with their clients under the current advice framework, but Miles and Corrigan say the differences are the following:
This process starts with the client first and is focused on an outcome designed for them based on their future needs at an intimate level
The focus is on risk management and liability matching. Not only the clients’ risk tolerance, but also their risk capacity
It is grounded in robust testing and modeling, not simply based on rules-of-thumb
It aids in building the professional framework within which the adviser can operate, and helps them define their role and demonstrate the value they add in the process.
"No investment strategy is right for any single person – it needs to be tailored for the individual – this process brings that back to the heart of the advice process."