Investors have been saddled with far greater responsibility in recent decades as defined contribution schemes replaced defined benefit schemes. Along with investors living longer, this creates a challenge for retirement planning.

CoreShares Asset Management took a fresh look at this challenge through a scientific lens. Evidence-based investing is an investment strategy that is not influenced by short-term market trends or predictions. Instead, it relies on accurate facts and credible analysis (published and peer-reviewed) – with which to make calculated, unbiased decisions. The result for an investor is a higher likelihood that they will achieve their investment goals.

Approaching the investment challenge

We started with the assumption that, in retirement planning, advisors must help investors work out the amount of income they can draw, and how much they can increase this each year to maintain their lifestyle (i.e. inflation protection). They must also help investors choose investments that are unlikely to result in permanent loss of capital. These investment goals are to:

  1. Create enough income
  2. Protect against inflation
  3. Protect capital

An evidence-based investor approaches this problem by starting with the ‘controllables’. These are decisions we make based on reliable data and history – such as asset allocation, diversification and fees.

We try to avoid making decisions based on the ‘uncontrollables’ or speculative forecasts, for example, trying to predict short-term market performance or macro events like the Covid-19 crisis. Here, we have explored an approach that is focused on key controllables across asset allocation, cost management and diversification and uses Smart Beta to align client goals with the portfolio.

The evidence: asset allocation

CoreShares assessed the inflation goal and converted it into a target of CPI+3%. We saw that across any rolling seven-year period over the last 118 years, equity outperforms this benchmark 76% of the time, while bonds only have a 37% chance of beating it.

We concluded that to provide inflation protection, a long-term asset allocation needs enough risky assets to deliver the required returns with a high level of probability. While equity is considered a ‘risky’ asset, and will certainly introduce higher levels of volatility into a portfolio in the short-term, the risk of having too little exposure to this ‘risky’ asset class is of failing to beat the benchmark and satisfy the goal of inflation protection over the long term.

We also weighed up the effectiveness of using tactical asset allocation (or ‘tilting’) to take advantage of short-term market trends to improve performance. We examined 15 years’ performance history in the (ASISA) Low Equity category and found that managers lowered their chances of beating a CPI+3% benchmark by using tactical asset allocation (only overthrowing the benchmark 32% of the time). Had they simply stuck to their long-term strategic asset allocation, they would have beaten this benchmark 48% of the time.

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The evidence shows that the goal of inflation protection can be met with greater certainty by using an appropriate asset allocation (enough risky assets) and sticking to it (only using strategic asset allocation and no tactical asset allocation).

The evidence: costs

There has been plenty of focus on costs in recent years, especially as local equity markets have delivered disappointing performance, with investors scrutinising where each basis point of their performance has gone.

Some investors still argue that they are happy to pay higher fees to a manager that delivers superior performance. But is this necessarily the case? Morningstar says that “the single largest determinant of a fund’s future success is the costs it charges” and our research shows that on average, the most expensive funds underperform.

In the chart, we divided the low equity managers into quartiles based on fees. The most expensive quartile only beat the benchmark 25% of the time, while the cheapest quartile beat the benchmark 46% of the time. This might look like a negative correlation, but it is a causal link and not a correlation. The higher fees erode the performance that investors receive.

We conclude that the most effective and efficient way for investors to implement the appropriate strategic asset allocation is to use low-cost funds as the building blocks, where indexation (aka passive investing) plays an important role.

This is particularly useful in the low-yield environment in which South Africans have found themselves in recent years: every basis point counts.

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The evidence shows that using low-cost passive funds that deliver better performance helps meet the goal of creating reliable income streams, as well as inflation protection.

The evidence: capital protection

Harry Markowitz claimed that “Diversification is the only free lunch in investing” and this certainly applies to capital protection in the world of multi-asset investing. By making sure portfolios are sufficiently diversified across geographies, industries and companies, we can limit exposure to any possible unforeseen company failure or event particular to a region or sector.

Using passive strategies as the building blocks to implement the asset allocation decision is a precise and accurate way to make sure you get the exact exposure you have chosen and remain well diversified. Using index strategies as the building blocks also brings a second benefit: added increased certainty. By using a passive fund, we avoid the risk that comes with selecting an active manager.

Harry Markowitz claimed that “Diversification is the only free lunch in investing” and this certainly applies to capital protection in the world of multi-asset investing.

The most recent S&P Index versus Active (SPIVA) reports that over 96% of active managers in South Africa have under-performed the Top 50 index over a five-year period ended 31 December 2019.[1] The difference between picking one of the top performers versus one of the bottom performers introduces unnecessary uncertainty into a multi-asset portfolio.

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The evidence shows that using reliable, well-diversified strategies (such as an index) as building blocks to implement the asset allocation helps meet the goal of capital protection.

Meeting the goal mechanically

Much work has been done to quantify the multi-faceted role that financial advisors play, from tax advice to withdrawal strategies and behavioural coaching, to name but a few. For example, helping investors to ‘stay the course’ and not panic-sell during volatile periods like the Covid-19 crisis, adds significant value to a client’s total return in the long term. Morningstar has termed this advisory role ‘gamma’ and calculates the value to be around 1.59% per year.[2]

Helping investors to ‘stay the course’ and not panic-sell during volatile periods like the Covid-19 crisis, adds significant value to a client’s total return in the long term.

Advisors must retain their margin and keep delivering a high-quality professional service in this way. Cutting fund fees is a simple and effective way to improve the investor’s bottom line, while the advisor retains a well-deserved margin. Advisors can bring more certainty to retirement planning by minimising the moving parts and using evidence-based investing principles to meet investment goals mechanically, with greater certainty.

CoreShares offers two multi-asset funds that employ the principles discussed in this article. Learn more about the CoreShares Wealth Accumulation and CoreShares Stable Income funds here.

Footnotes:

  1. According to SPIVA reports published from December 2014 to December 2019 (a total of 11 five-year review periods), active managers have, on average, underperformed the benchmark 87% of the time.
  2. Morningstar Report: “Alpha, Beta, and Now… Gamma” by David Blanchett, CFA, CFP & Paul Kaplan, Ph.D., CFA, published 28 August 2013.