Active management has come under steady attack from a whole host of critics who demand better investment outcomes and lower costs. But we see the “active versus passive” debate as a false dichotomy. There are compelling arguments to be made that both strategies can play complementary and constructive roles as components of a well-diversified portfolio. Passive can allow for low cost exposure to commoditized sectors and asset classes, while active can potentially generate outperformance within less efficient and “under-covered” areas both within and across markets.
But more importantly, we view the debate as a distraction from what is most important: meeting investors' actual objectives. Both active and passive strategies are measured against some index or market “benchmark.” In this context, success or failure is determined by how closely they track their respective indices, whether or not they provide incremental returns, and their overall costs to investors.
But these “measures of success” do not tell us much about whether or not the underlying investment approach is actually on track to achieve life and investment goals. Instead, they measure performance against a static index which may or may not be aligned with an investor’s self-identified set of goals. To help bridge this gap, we need an investment framework that provides a focused approach to meeting an investor's specific objectives.
This brings us to goals-based investing, which analyzes and models for a set of expected outlays, and then identifies the investment portfolio that best aligns to those needs. This concept has been easier for institutional investors to adopt because insurance companies and pension funds have more clearly identified outlays (e.g. defined benefit plans), and the large number of participants allowed for an “averaging effect” that reduced the range of potential outcomes.
But improvements in technology, and our deeper understanding of the needs of households, have dramatically enhanced our ability to leverage this process with individual investors. We have therefore developed our own “goals-based” investing framework that assigns client objectives to three general categories, which we call the “3Ls”: liquidity (to fund short term essential expenditures); longevity (to provide for growth in assets to meet life and lifestyle needs); and legacy (to provide for multi-generational aspirations). This framework is flexible enough to adapt to each individual client’s needs, yet structured in a way that it provides a disciplined approach toward meeting objectives.
As we continue to evolve toward a goals-based framework, success will no longer be defined simply by beating an index, but instead by how well that underlying investment serves the purposes and needs of the individual.
For more, read the UBS House View Weekly , published on August 14