Why objectives-based funds can’t work without good advice

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By Craig McCulloch | 03 November 2016

The goals of investors are unique, complex and often twisted by behavioural biases. Enter the global financial crisis, which further rewired investor attitudes towards risk and return.

The result? A perfect storm which exposed the financial services industry’s shortcomings.

Advice proved overly focused on investors’ risk tolerance– rather than their underlying goals– which drove the underlying investment strategies implemented on behalf of clients. Meanwhile, too many of those products were shown to underestimate the inherent risk they carried. This tenuous link between risk and objectives was cruelly exposed, forcing the industry to rethink its approach.

Complaints lodged with external dispute resolution schemes jumped to 197 at the top 20 advice licensees in 2009, up from 110 the previous year, according to the Australian Securities and Investments Commission (ASIC), which the industry put down to poor returns.

But the industry is slowly changing: the objectives of investors are now being incorporated into the financial advice process and a range of new products and approaches built from the ground up.

Objectives-based funds have quadrupled in size to about $10 billion over the past five years, according to Morningstar.

However, these products represent only a small part of the solution and have the potential to fail completely without a framework of good advice.

A new type of fund

The global financial crisis revealed the shortcomings of many traditional funds. For example, many balanced funds, which relied solely on diversification to manage risk, plummeted by around 20% in 2008.

The industry decided on a better path. Rather than confine portfolio managers to a strict strategic asset allocation, why not give them more freedom to invest in order to meet specific goals?

Real-return multi-asset funds have become a popular alternative to balanced funds. They have a similar goal, aiming to outperform inflation by 4.5% to 5.5% over rolling three- to five-year periods, but look radically different under the hood.

Morningstar’s survey of 44 objectives-based funds found wide-ranging approaches to asset allocation– highlighting that while many of these funds share a common stated goal, they employ very different approaches to achieving them.

But do they actually work?

Objectives-based funds: Only part of the story

While backing fund manager skill makes intuitive sense, the evidence to date shows that the relationship between risk and return has held steady.

Funds which achieved higher returns exhibited more volatility than the Vanguard Balanced fund while those which achieved lower returns were less volatile over the three years to April 30, 2016.

Only three of the 24 real-return objectives-based funds assessed by Morningstar outperformed the Vanguard Balanced fund over the same period, and those that did came with significantly more volatility.

Figure 1: Three-year risk/return: Objectives-based funds compared to Vanguard Balanced Index

However, this is about more than performance. It raises questions about what is an appropriate benchmark– one which includes both risk and return– as an appropriate measure. The broad range of approaches within the objectives-based fund sector combined with varying asset allocation approaches means that traditional comparisons against say, a pure equity benchmark, are no longer relevant.

S&P, in collaboration with Milliman, has recently launched more than 30 S&P Managed Risk Indices to assist in the effort to assess this rapidly growing sector. Each index measures equity market performance whilst making allowance for risk management as a core component.

However, whilst an appropriate benchmark is an important step in assessing this market, the variety of funds and objectives that they attempt to manage highlights the difficulty in using them without appropriate advice.

Investors aren’t limited to one risk. Volatility, income, liquidity, capital loss and inflation are just some of the typical risks they face– each has a different emphasis depending on life stage and personal circumstances.

Portfolios need to be constructed to match these shifting risk-return trade-offs– and this is can only be achieved with objectives-based advice.

Objectives-based advice: More than a product

An objectives-based fund, by definition, is blind to the true needs of an investor. These products are ultimately just one of many building blocks in a rich tapestry of solutions that can help investors meet their actual goals.

This can only be discovered via a goals-based advice framework, which can help determine how to put the pieces together in an appropriate way, monitor progress and be adjusted as personal circumstances change.

This type of objectives-based advice looks at more than an investor’s risk tolerance– how much they can withstand when markets don’t perform. Objectives-based advice also looks at an investor’s risk capacity– what actions and risk need to be taken to reach personal goals.

This is a far more holistic approach which ties the investor’s outcome directly with investment and lifestyle decisions. Products– even objectives-based funds– are just one small component.

However, good objectives-based advice is also far more complex than the traditional risk tolerance-based approaches which have dominated the financial planning industry for many years.

It delves into far-reaching aspects of an investor’s life and so requires immense analytic firepower to run thousands of potential scenarios. It is only in recent years that new low-cost technology, combined with cloud computing, has made this possible.

Crucially, this technology enhances the ability of advisers to engage with investors, building a foundation for advisers to distil what their clients actually want. Sound modelling can often reveal an expectations gap, which can encourage investors to make changes.

This is why objectives-based advice needs to take prominence or the performance of objectives-based funds– and whether they ultimately deliver on their stated goals– will only be relevant to the industry rather than the investors they are designed to serve.

Milliman is a risk and actuarial firm with more than 55 offices around the world. Its powerful technology and analytics platform helps organisations analyse the needs of their customers and to deliver holistic solutions which build engagement, retention and trust.


This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, [and for other persons who are wholesale clients under section 761G of the Corporations Act].

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