By Daniel Archibald | CFA
The aim of portfolio management is to construct portfolios that best suit the risk and return objectives of the underlying investor. There are 3 main ways in which this is generally carried out:
- Minimising risk (maximising return) according to an investor's return requirement (risk tolerance) [Markowitz's optimal portfolio]
- Minimising probability of not achieving an investors' goals [bucket approach]'
- Minimising the difference (in risk, cashflow) between an investor's liabilities and their investments [asset-liability management]
While all of these methodologies are trying to achieve the same thing, their focuses are different and are often used by distinct types of investors. The first approach is the investment industry benchmark and is utilised by investment managers, advisers and sophisticated investors in building well-diversified and 'efficient' portfolios. The second is generally utilised by advisers and clients in constructing portfolios with greater links to personal and lifestyle goals. The third approach is widely used by investors that need to fund forecastable liabilities such as banks, life insurance companies and pension/annuity providers.
Even though the third approach of asset-liability management (ALM) approach is not widely used by individual investors, its principles can still be of use to them in constructing portfolios. The starting point for such a strategy is to understand the liability-side of an individuals wealth. This will include contracted debt such as home loans and lease payments. Aside from these set obligations, other 'non-negotiables' for an individual or family could include basic living expenses, education costs or known healthcare expenses. Negotiable (or discretionary) expenses are those that could be amended should portfolio performance be below expectations and could include any other expected living expense such as holiday costs, bequests and luxuries.
Not only should the size of these future expenses be estimated, but their characteristics should also be understood. For example, variable rate debt will cost more as interest rates go up (and vice versa) whereas fixed rate debt will not be affected by interest rate changes. Living expenses and other costs will likely rise by expected inflation, which is generally related to overall economic/business conditions. Some costs will rise at a faster pace than inflation (e.g. healthcare costs), whilst some might actually fall. Once the size and characteristics of an individual investor's liabilities are known, the ALM approach can be used to match the right investment assets with these liabilities.
This can be done by matching individual liabilities with individual assets (or basket of assets). For example, an individual might match 'non-negotiable' living expenses (which are likely to increase with inflation) with an investment in an inflation-linked Government bond. Such a bond will provide a 'risk-free' cash flow to match the living expense, while at the same time providing extra returns should inflation be higher than expected. Investing in healthcare related equities, could be a good match for long-term healthcare expenses, but not so much for short-term healthcare costs. Property is an obvious investment for housing-related expenses and stocks have proven to be a good long-term match for protecting against inflation (as well as gold and other commodities). Matching assets and liabilities can also be done more efficiently on a portfolio-wide basis, though this requires work upfront to model liabilities and the way in which their characteristics might correlate with each other.
Matching the cashflow and risks of liabilities with investment assets can be a common-sense way in which to ensure savings will properly fund future expenses. Though an ALM approach might very well lead an investor to the exact same portfolio that they would have built under a risk/return or goals-based approach, the added clarity of the purpose of each asset can be of benefit to investors and their advisers.