What do members really want from an investment strategy, and what makes for a good strategy?

By Marcus Rautenbach, Principal Investment Consultant

Many retirement funds, including commercial umbrella funds, maintain a life-cycle investment strategy. Trustees carefully consider the investment strategy, with input from experts in the field. These experts design sophisticated investment strategies, often with complex portfolio construction and robust feedback processes. However, the extent of this complexity is not appreciated or understood by most retirement fund members.

Even though industry experts will find many valid technical reasons to argue against member perceptions, these are a reality that trustees and fund managers should heed when they evaluate and monitor the performance of their investment strategies.

The following elements are typically taken into account in the evaluation of a life-cycle investment strategy:

• the growth portfolio used in the life-cycle strategy;
• the pre-retirement portfolio used in the life-cycle strategy;
• the de-risking glide path used to switch individual members’ exposure from the growth portfolio to the pre-retirement portfolio when approaching normal retirement age; and

Retirement fund members mostly evaluate the nature and quality of the growth portfolio used in a life-cycle strategy, as most members are invested in growth rather than de-risking portfolios.

This raises the question: What do members really want from an investment strategy, and what makes for a good strategy in the minds of members?

Having listened to the questions and concerns of thousands of members over nearly 40 years, in my experience, four simple factors are important for members in life-cycle strategies:

1. Reasonable investment returns

Members understand that investment returns are often cyclical, consisting of phases of pleasing and disappointing returns. Members maintain reasonable expectations of the portfolios in which they invest. They are not so much concerned about whether portfolios meet or beat the benchmarks set by the fund managers. Sometimes fund managers set themselves sophisticated yet modest benchmarks which they continue to outperform despite delivering uncompetitive performance when compared with an appropriate peer universe. Members are careful to draw positive conclusions about the performance of a growth portfolio based on the outperformance of an “inhouse” benchmark only. They are more concerned about whether they receive a fair return compared with alternatives available in the market. In this regard, fund managers believe an appropriate peer group to consist of portfolios that are directly comparable with their own (in terms of philosophy, style, construction method, etc.) while members include in the peer group all solutions with the same investment objective. This often frustrates fund managers and members alike.

Most members focus on recent investment returns but are prepared to consider longer-term performance provided that recent investment returns are broadly in line with their expectations. The pain of short-term underperformance is a prominent feature in members’ minds.

A reasonable investment return expectation among members is top or second quartile performance over the periods used to measure and evaluate investment returns. In this regard, one-, three-, five- and ten-year returns are more important. It is crucial that fund managers achieve investment returns that are above the peer group median.

2. Consistency of investment returns

Members prefer consistent investment returns. Given the choice between two portfolios where the first produces top investment returns at greater volatility and the second slightly lower returns (say lower first quartile or upper second quartile performance) but at lower volatility, members prefer the second portfolio. They are often prepared, within reason, to sacrifice higher short-term returns for the sake of greater stability in their retirement savings.

There are several ways to measure the consistency of investment returns, ranging from the standard deviation of returns as a measure of total investment risk, to depth of drawdown and time required to recover to a highwater mark previously achieved. Members prefer less technical measures of consistency. Risk measures such as tracking error, Sharpe ratio (or Sortino ratio) and the information ratio seldom feature in members’ lexicon.

Consistency of investment returns should be considered alongside the measurement of investment returns. A consistent sub-optimal investment return is not acceptable. Likewise, a high but an inconsistent investment return is equally unacceptable.

3. Investment managers must do their jobs well

Fund managers and trustees set investment objectives for the portfolios offered to members, who understand that these objectives are not a promise made by fund managers but a target return they aim to achieve over time.

When it comes to measuring longer-term investment returns, members appreciate that the investment returns on their retirement savings are comparable with the investment objectives set by fund managers.

Investment objectives often target real investment returns, e.g. 6% p.a. above inflation for growth funds, 5% p.a. above inflation for moderate and absolute return funds, and 3% p.a. above inflation for conservative funds.

Members tend to use the same investment objective to evaluate all portfolios in the same category – for example, all growth funds will be measured to the same fund objective, etc.

Portfolio investment objectives are easy to understand and equally easy for members to calculate. In doing so, members are pleased to support fund managers with a better track record of consistently reaching the fund objectives.

4. Don’t lose my money

Members have an aversion to losses in their retirement savings. They accept that a growth portfolio may experience periods of negative investment returns, but they become concerned when fund managers post negative 12-month returns. Growth portfolio fund managers often follow an approach of looking through market cycles and are more tolerant of negative investment returns on their portfolios. This is when members find it challenging to form expectations by looking through the market cycle. Members want negative investment returns to be restricted to short periods and lose confidence in fund managers who do not respond to difficult market conditions.

The ultimate question

Who is right when it comes to constructing an investment strategy? Is it the fund managers, who have sophisticated tools and expert insight to construct portfolios, that are measured against complex benchmarks, or is it the retirement fund members whose savings are invested in these portfolios alongside with their emotions?

The obvious answer is the fund managers, who are knowledgeable and should construct investment strategies aimed at optimising growth on members’ retirement savings, but in doing so, fund managers should remember to aim for above-average and consistent investment returns that meet their investment objectives, not losing members’ money.

Disclaimer

First published in Pensions World Quarter 2 of 2024