Thoughts on the Future: Theory and Practice in Investment Management

Existing finance theory can be put into practice in ways that will greatly benefit clients—from individuals to pension funds to endowments. Existing finance theory can be put into investment management practice in ways that will greatly benefit clients—from individuals to endowments. Our profession has developed the tools, but too often, advisors rely on static one-period analyses when considering how best to handle the returns and risks of clients. These decisions are inextricably connected to horizons—the long run, the decision horizon, the planning horizon, and the planning subhorizons. These horizons vary for different client groups, as does the production of wealth and risk to wealth. Moreover, the trends, needs, and situations of client groups vary. My discussion focuses on households, then turns briefly to pension funds and to endowments.In the realm of households, one of the biggest trends of the past 20–25 years is that householders are being called upon to make complex and important financial decisions. The profession has developed models and made them available through advisory engines on the Internet and in books and pamphlets. But this disaggregated approach to saving and retirement planning simply hands out all the parts of the task to householders. They must make all the decisions and assemble the product parts.The time has come to extend the models by trying to capture the myriad of risk dimensions in a real-world lifetime financial plan. Analysis of risk must take into account human capital, the volatility and flexibility of human capital at various ages, and its correlation with other assets. In addition, our risk models for individuals and households should incorporate uncertainty about future reinvestment rates and uncertainty about the risk–reward opportunities captured by, for example, the Sharpe ratio. Different measures are needed for the risk to household wealth in the long run and in the short run. Instead of using dollars to measure the risk–reward frontier, an advisor would do well to use annuity units.Another element advisors should include as part of an integrated plan for households is the notion of targeted expenditures—such as college tuition. The financing of such expenditures can be taken off the table, and indeed, financial services firms can finance the amounts. A similar approach can be taken with core retirement funds (life annuities).In the future, I see investment services for households developing in the direction of services to deal with lifetime household risks, hedging and insurance for financial assets, and the offering of comparatively seamless products to implement those plans. Examples of services include integrated financial planning for retirement (such as wedding long-term care and life annuities), providing condo value insurance, and offering customized or special-purpose vehicles or derivatives that provide the payoff equivalent of a dynamic trading strategy without the household doing the actual trading.Those providing these services must consider a much wider set of asset classes and risks than are considered in today's analyses. To the traditional analysis of risk–return trade-offs for tangible wealth, we need to add explicit analyses of human capital, hedging of reinvestment rates, mortality and traditional insurance risk, and income and estate taxes.For the dwindling group of pension plans, if the pension fund sponsor chooses to keep the pension fund and its associated liabilities on its balance sheet, the sponsoring company absolutely must look at the risks chosen for the pension fund from the perspective of the whole company. Risk management should involve all parts of the company—operations, hedging of targeted risk exposures, and capital structure.Endowment funds, particularly those supporting universities, also need to consider all their asset and liability risks. Assets include both tangible ones, such as buildings, and intangible ones, such as future tuition receipts. On the liability side of universities, some aspects that are important for surplus management in pension plans apply to endowments. The endowment needs to consider the cost of operations and other liabilities of the university when considering what risks to take. For example, a substantial liability for many universities is salaries for tenured faculty.Investment managers and advisors have a much richer set of tools than they traditionally use. Thus, the issue in implementing my suggestions is more a question of engineering than new science. We know how to approach the problem in principle; the challenge is actually doing the modeling.