Wealth management is a complex process

Should you invest in ETF?

Wealth management is a complex process of defining the client’s needs and designing a portfolio that is rightly exposed to meet the client’s requirements over a very long time. Most may confuse the definitive of wealth management and wrongly consider wealth management as stock selection. The latter has a scope too narrow and can be dangerous.

There is a huge ecosystem of professionals support the wealth management industry. Wealth managers are a critical person in the process. They determine the investment objectives and finalize the weighting targets for the individual portfolio’s targets. This process of finding the right instrument is carefully led by the pre-determined investor’s IPS — investment policy statement.

Determining the IPS is the first and most important step. A good IPS will mitigate the risk of the portfolio. Imagine the IPS as the parameter of your house. You draw clear parameters to ensure your family members do not cross over the line and be exposed to danger. A fund manager may have multiple interesting investment opportunities, some of them may possess unique risks that cannot be easily diversified in the context of your portfolio. A group of random collections, all promising high returns spell danger and volatility.

Investors have unique characteristics and different IPS. A retirement fund may have a time horizon of 20 years and prefer income to capital gains. A growth portfolio may have a longer time horizon of 50 years to fund the young executive’s savings. The growth portfolio will require a mix of high risk products. The same investment prospect cannot be equally considered for two different portfolios.
Given the complexity, the first goal of the investor is to select a highly skilled and persistent wealth manager. This is not a straight forward task. More than 80% of managers do not beat the market. An investor that prefers the cheapest investment strategy that outperforms most fund managers will be automatically attracted to the index fund investing. Index funds replicate the performance of benchmarks and do not make an attempt to outperform. Given the non-discretionary decision to replicate the market, professionals label this strategy as passive management. The benefits of passive are clear. Firstly, this strategy is simple and does not require complex selection of managers and determining of IPS. Secondly, the simplicity implies cheap fees since managers are not paid exorbitant incentives to outperform he market.

Investors need to make an informed choice between two options.

1. Adopt a more active process to select managers and to determine the investor policy statement and 

2. Invest in a non-discretionary equity index fund.

Annuities and Retirement Planning — Longevity Risk

A closer look at annuities and retirement planning in the context of Singapore

Annuities get very little respect because they are portrayed as expensive and loaded with sales fees. However, a rapidly aging demographic and declining real wages has jeopardised the current projections for government led pension plans. It is not easy to supplement retirement with private wealth management plans because the state cannot mandate how much citizens save beyond the scope of pension policy.

Life annuities are crucial because they hedge against longevity risks and medical expense risk. In fact, annuity payments should be inflation indexed. Life annuities have monthly payouts. The stream of cash flows can be replicated by a mix of bond payments. It does seem like bond yields may no longer be able to match up with the required annuity yield. To meet the annuity payouts over a longer time, annuity managers may need to introduce risky products like equity index funds into the portfolio. But it is unclear if citizens are open to endure the high risk.

In Singapore’s context, I am less sure if Singaporeans are preparing for longevity risks. Should they expect to systematically live longer, to say, 90 year old, the consumption save must reduce tremendously. Practically, a young professional who expects to live till 100 will need to start investing in equities as soon as he starts work.

It is incorrect to think that life annuities are expensive products if we assume Singapore is a competitive market for annuities. In a competitive market, we can assume that longevity risks and recent demographic trends are priced into these financial products.

There are ways to reduce premiums for annuities. The larger the insured pool, the lower the premiums. For one, the fixed costs will be reduced. The pooled risks approach a normal probability curve. This implies that Singapore government’s mandatory annuity policy is in the right direction from a policy point of view. But the policy makers should introduce the annuity programme with a softer approach. Perhaps annuities need not be made mandatory right at the start. In fact, the government can communicate the benefits of annuities and highlight the financial risks of not subscribing to an annuity.

Risks of the ETF in the near future

There are fears that ETFs will be the key contributor to the next financial crisis. ETFs now take up a huge percentage of retail and pension investments. Some suspect that the ETFs will lead the market instead of mirroring it. Lack of liquidity within ETFs may cause rapid selling of ETF units, destabilizing the general stock market.

Another concern is how over-levered some ETFs are. There are also complex ETFs that are leveraged, synthetic and inversed. It is not clear yet that the impact of these instruments on the overall markets when prices become unstable. For far too long, ETFs have been the cool kid on the street. Investors have ignored the voices of some who share the adverse side effects of ETFs. It is well known that the ETF structure is unique, requiring units of ETFs to be created and to be tracked according to the market. The creation and marking to market of the ETF is a constant arbitrage exercise. Not every ETF is liquid and simple. Some ETFs mirror complex markets like junk bonds, loans and less familiar municipal indexes.

Finally, ETFs when leading the market is a representation of herdish behaviour. Afterall, every ETF investor invests in the same market within the same ETF product. For some, they have preferred index funds over ETFs precisely for fear of the ETF structure.

Little known truths about the investing community

Net return received by investors is net of cost. There are many types of costs. Some are clear, some are hidden. Our financial system is complex. There are too many middlemen, the leftover returns for the common man can be too little to sustain savings. Investors (you) becomes the bottom of the priority list.

Investors commit money and get exposed to risk. If the market moves in your direction, the hedge fund manager takes a large chunk of your wins. If the market moves against your direction, the manager is insulated from losses. He still takes a fee from you.

Benjamin Graham said that anyone can design a strong portfolio with just stocks and bonds that are representative of the market.

A do nothing policy is always better than an active strategy. As long as you make a decision to move money, someone charges a fee. If I may summarize, always invest with the lowest cost instrument - index funds.