The traditional model of investment management has remained largely unchanged for decades. Typically, fund managers work to generate returns by focusing on market benchmarks or comparisons with peer groups as a way to validate the effectiveness of their performance.
However, the economic and political upheaval we’ve experienced in the last year has made the markets far more volatile, creating a bumpy, nervy ride for investors.
Conventional investment strategies don’t seem to be soothing these nerves, and are also failing to prioritise the needs and goals of investors.
With this is in mind, we should arguably be moving towards strategies which manage volatility and soothe nerves by taking a longer-term approach with less undue risk.
These investment approaches should also focus primarily on achieving specific outcomes which align with people’s life goals.
With the age of generous final salary pensions now at an end and the sustained period of rock-bottom savings rates we’re currently in, it’s more important than ever that people are given investment options with clearly-defined outcomes to help them prepare for the future.
One of the biggest issues faced by people trying to invest for later life is a lack of understanding when it comes to how much money they need to achieve a certain standard of living - and how they are going to get there. This problem is exacerbated by the use of arbitrary, and often short-term performance measures.
The investment manager of a fund may be very skilled and do a good job against a certain benchmark, but the problem for investors is that the benchmark’s returns do not speak to their needs. To address this, investment strategies must be built on targets that people understand and can relate to their own life.
To give this some context, if someone decides to invest £20,000 today in the hope that the return on their investment will pay for a run-around first car for their son in five years’ time, they won’t be thinking about generating realised volatility below 5 per cent annualised or achieving a Sharpe ratio of 0.8.
Performance of £20,000 invested in three indices over 3yrs
Source: FE Analytics
Most investors take a more practical view and think in terms of risk, return and time and this is what should be guiding their decision-making process. They know, for example, that if the value of their investment grows by 5 per cent above inflation over a set period, then their £20,000 investment will be more valuable in tomorrow’s money than it is now – well on the way for that second-hand car.
However, the way that most funds work is by targeting a risk level, or a tracking error level, or a certain level of outperformance versus a particular index.
These approaches will inevitably lead to ‘accidental returns’, which though they may sound positive, fail to reference an investor’s individual targets. Outcomes-based investing takes a longer-term view, and while specific returns are not guaranteed, the fund manager’s deliberate targeting of a specified goal is very far removed from the traditional investment strategy and its random performance measurements.
Arguably, what most investors seek is something that lies neatly between traditional market investing and the guaranteed returns experience provided by something like a pension annuity.
Outcomes-based investing bears some of the hallmarks of both approaches. For example, the performance outcome targeted is a return in excess of inflation through the cycle.
Additionally, it focuses on making the journey to the outcome as palatable as possible. This provides a number of benefits such as reducing sequencing risk (the impact of poor performance on wealth, especially when the assets are at their largest) and perhaps more pertinently, the smoother the journey to the outcome, the greater confidence felt by investors - which helps then to stay the distance to achieve their necessary investment goal.
Outcomes-based investing also tends to exist in a risk-rated environment and this helps investors to understand both at the outset and on a continuous basis the ‘riskiness’ of their fund and compare that to their risk appetite.
An investor’s needs must always come first and although they loosely fall into one of three categories - the essential need to survive, the lifestyle wants and the future legacy aspirations - they always differ enormously from person to person.
The outcome-based journey enables planning which is tailored to each and every investor, detailing everything from the time it will take to achieve their goal to the milestones they will meet along the way.
It is not just investors who are seeking more meaning from their financial solutions. The FCA has recently issued a note cautioning investors about the dangers of schemes focusing on critical yield or other comparisons using generic assumptions for hypothetical returns.
Independent of the various issues associated with the critical yield approach, the simplicity of an outcome-based solution is that it distils the investment objective back to what is meaningful to the customer.
This is the premise of Momentum’s Factor Series. Each fund provides a mix of risk and reward to meet a customer’s varying objectives, targeting inflation plus returns over the medium to long term to help them grow and protect the real value of money. For example, our Factor 5 Fund aims to deliver 5 per cent returns, above fees and inflation, over a rolling six-year period. This is easy for investors comprehend and apply to their own future planning.
The current generation of workers have extremely challenging times ahead and the majority will need to make sound financial decisions to achieve the quality of life they’re hoping for in their later years. Central to this should be the adoption of outcomes-based jargon-free investment options and there’s also no reason why the same approach cannot be applied to all aspects of managing one’s finances.
Whether it’s mastering everyday spending or a creating a long-term investment strategy, all actions should follow the same route to achieving financial wellness and specific financial goals.
James Klempster is head of investment management at Momentum UK. All views are his own and should not be taken as investment advice.