Tailor­ing prod­ucts for in­di­vid­u­als

Tech­nol­ogy can play an im­por­tant role in the de­vel­op­ment of mass-cus­tomised prod­ucts for in­vestors.

Finweek English Edition - - COLLECTIVE INSIGHT - By Lionel Martellini Lionel Martellini is pro­fes­sor of fi­nance, EDHEC Busi­ness School, di­rec­tor at the EDHEC Risk In­sti­tute and se­nior sci­en­tific ad­viser at ERI Sci­en­tific Beta.

with the shift from de­fined ben­e­fit to de­fined con­tri­bu­tion pen­sion sys­tems and the need to sup­ple­ment re­tire­ment sav­ings via vol­un­tary con­tri­bu­tions, in­di­vid­u­als are in­creas­ingly re­spon­si­ble for their own sav­ing and in­vest­ment de­ci­sions. This global trend poses a sub­stan­tial chal­lenge as in­di­vid­ual in­vestors suf­fer from be­havioural lim­i­ta­tions and typ­i­cally lack the ex­per­tise needed to make ed­u­cated in­vest­ment de­ci­sions.

Ad­dress­ing this chal­lenge re­quires a whole new in­vest­ment par­a­digm, re­ly­ing upon li­a­bil­i­ty­in­formed in­vest­ment de­ci­sions rather than in­vest­ment de­ci­sions based on con­ven­tional as­set-only in­vest­ment re­turn or cap­i­tal-based mea­sures of per­for­mance. Meet­ing the re­tire­ment in­vest­ing chal­lenge em­pha­sises the im­por­tance of in­di­vid­u­alised, or at least mass­cus­tomised, in­vest­ment so­lu­tions, tai­lored to meet the need of spe­cific in­di­vid­u­als or suf­fi­ciently ho­moge­nous groups of in­di­vid­u­als.

While such ob­jec­tives might have seemed out of reach a few years ago, re­cent ad­vances in risk man­age­ment tech­nolo­gies and dis­tri­bu­tion through robo-ad­vice chan­nels have made them pos­si­ble as part of a ma­jor par­a­digm shift im­pact­ing how the in­dus­try will func­tion and the value it will add.

To­wards im­proved re­tire­ment in­vest­ment so­lu­tions

Cur­rently avail­able in­vest­ment op­tions hardly pro­vide a sat­is­fy­ing an­swer to the re­tire­ment in­vest­ment chal­lenge. Most in­di­vid­u­als are left with strate­gies not en­gi­neered to gen­er­ate the kind of tar­get re­place­ment in­come they need in re­tire­ment, while se­cur­ing min­i­mum lev­els of re­place­ment in­come.

A new in­vest­ment frame­work has emerged, la­belled goal-based in­vest­ing (GBI) in in­di­vid­ual money man­age­ment (see Deguest et al, 2015), where in­vestors’ prob­lems can be fully char­ac­terised in terms of their life­time mean­ing­ful goals, just as li­a­bil­ity-driven in­vest­ing (LDI) has be­come the rel­e­vant par­a­digm in in­sti­tu­tional money man­age­ment, where in­vestors’ prob­lems are broadly sum­marised in terms of their li­a­bil­i­ties.

The ben­e­fits of switch­ing to a dy­namic goal-based in­vest­ing process are ex­tremely sub­stan­tial when mea­sured in terms of im­prove­ment in prob­a­bil­ity to achieve mean­ing­ful goals. For ex­am­ple, the prob­a­bil­ity to reach tar­get lev­els of re­place­ment in­come can be in­creased for rea­son­able pa­ram­e­ter val­ues by a fac­tor up to 100%, e.g., tak­ing them from 35% to 70%. (See Martellini and Mil­hau, 2015).

From a prin­ci­ple stand­point, the frame­work is well-grounded in as­set-pric­ing the­ory and builds upon a com­pre­hen­sive and holis­tic in­te­gra­tion of the three forms of risk man­age­ment: hedg­ing for ef­fi­ciently pro­tect­ing min­i­mum lev­els of re­place­ment in­come; di­ver­si­fi­ca­tion for ef­fi­ciently har­vest­ing risk pre­mia as re­quired to reach tar­get lev­els of re­place­ment in­come; and in­sur­ance for ef­fi­ciently com­bin­ing the dual re­quire­ments of down­side pro­tec­tion and up­side po­ten­tial.

This stands in con­trast with ex­ist­ing prod­ucts or ap­proaches used in in­sti­tu­tional or in­di­vid­ual money man­age­ment, which are only based on se­lected risk man­age­ment prin­ci­ples. cus­tomised. Be­sides, the al­lo­ca­tion to the safe ver­sus risky build­ing blocks should also be en­gi­neered to se­cure each in­vestor’s es­sen­tial goals (e.g. min­i­mum lev­els of re­place­ment in­come) while gen­er­at­ing a rel­a­tively high prob­a­bil­ity to achieve their as­pi­ra­tional goals (e.g. tar­get lev­els of re­place­ment in­come).

That mass cus­tomi­sa­tion is the key chal­lenge has been recog­nised long ago, but only re­cently have we de­vel­oped the ac­tual ca­pac­ity to pro­vide such ded­i­cated in­vest­ment so­lu­tions to in­di­vid­u­als. There are two dis­tinct di­men­sions of scal­a­bil­ity; scal­a­bil­ity with re­spect to the cross-sec­tional di­men­sion (de­sign­ing a dy­namic strat­egy that can ap­prox­i­mately ac­com­mo­date the needs of dif­fer­ent in­vestors en­ter­ing at the same point in time); and scal­a­bil­ity with re­spect to the time-se­ries di­men­sion (de­sign­ing a dy­namic strat­egy that can ap­prox­i­mately ac­com­mo­date the needs of dif­fer­ent in­vestors en­ter­ing at dif­fer­ent points in time). Good news is that fi­nan­cial en­gi­neer­ing can be used to meet th­ese chal­lenges.

Ad­dress­ing the mass cus­tomi­sa­tion chal­lenge will be fa­cil­i­tated by the con­ver­gence of pow­er­ful forces. On the one hand pro­duc­tion costs are strongly re­duced, due to the emer­gence of pas­sive al­ter­na­tives to active man­agers for ef­fi­cient risk pre­mia har­vest­ing. On the other hand, dis­tri­bu­tion costs are bound to go down as the trend to­wards dis­in­ter­me­di­a­tion is ac­cel­er­at­ing through the de­vel­op­ment of robo-ad­vice ini­tia­tives.

Risk man­age­ment, de­fined as the abil­ity for in­vestors, or as­set and wealth man­agers act­ing on their be­half, to ef­fi­ciently spend their dol­lar and risk bud­gets to en­hance the prob­a­bil­ity to reach their mean­ing­ful goals, will play a cen­tral role in an industrial rev­o­lu­tion that will even­tu­ally lead to scal­able, cost-ef­fi­cient, in­vestor-cen­tric, wel­fare-im­prov­ing re­tire­ment in­vest­ment so­lu­tions. ■

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.