Investments in Real Assets Surge Among U.S. Institutions
In an effort to diversify their portfolios, institutions are making sizable investments in real assets and are planning to increase their level of activity next year, according to a Greenwich Associates report.
Data from Real Assets: An Increasingly Central Role in Institutional Portfolios reveals that a majority of institutions active in real assets have target allocations in the realm of 10% of total portfolio assets. Approximately one in five institutions will increase their target allocations from current levels as a part of changes in their investment strategy, while a similar number will begin using new categories of real assets for the first time.
When investing in these private and listed real assets, including real estate, infrastructure, farmland, timber and precious metals, institutions value the expertise of their asset managers. Their reliance on expertise reflects institutions’ unfamiliarity with real assets and the complexity associated with the investments.
“The experiences of institutions with significant investments in real assets strongly suggest that institutional investors will be more satisfied with their results if they invest with managers with high levels of demonstrated expertise,” says Andrew McCollum, Greenwich Associates consultant. “In many cases, these will be specialist managers with long track records in specific real-asset categories.”
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Measuring risk tolerance is critical, say experts in the field of risk tolerance and decisionmaking, but few retirement plan sponsors and advisers in the U.S. do it correctly.
Most retirement plan advisers and
plan sponsors are not getting at the investor’s real risk profile because they do not ask the right questions,
contends Tyler Nunnally, a U.S. strategist for the Australian
financial services company FinaMetrica. “It’s a matter of the questions that
are being asked,” he tells PLANADVISER. Most risk assessment tools in use don’t measure true risk tolerance because they’re combining the issue of the
time horizon—the amount of time a younger investor has to correct mistakes and
market ups and downs—with risk tolerance itself.
John Grable, professor of financial
planning at the University of Georgia in Athens, says the typical five- or 10-question
scale used for 401(k) plan risk assessments scare him to death as a researcher. He is only half
joking. “Typically, what you see is they’re asking different questions,” he
tells PLANADVISER. Time horizons are very important to think about when you’re allocating
assets, but these have nothing to do with your willingness to take risk,” he
says. “Whether you are young or old has nothing to do with your willingness to
take risk.”
“Risk capacity and risk tolerance
are two separate things,” Nunnally points out. In the U.K., where he spent a
substantial part of his career, regulators have scrutinized investor risk
tolerance assessments, and some common measures were found “not suitable for
purpose.” Some of the questions were found to be “not answerable” or “not
understandable.” Nunnally explains that many of the questions were too wordy or
required an overly advanced understanding of investments.
U.S. regulators have not subjected
risk tolerance assessments to the same scrubbing, but Nunnally points out that in
the wake of the financial crisis, FINRA in fact added “risk tolerance” as an
explicit factor for advisers to assess before making an investment
recommendation. However, there has been
little accompanying guidance on best practices and methodologies to do risk
tolerance assessments, he says. There has been some discussion about how
to address risk tolerance for those nearing retirement.
No Context
According to Nunnally, the typical risk tolerance profile in the U.S. measures an investor’s responses to isolated questions removed
from context. “They administer the test and then say, ‘This is your profile.’ We
call those portfolio pickers,” he says. The questionnaires do not address the
investor’s risk capacity and other components of a risk profile.
Standard risk questionnaires
do not go far enough, Grable feels. “One reason they make us nervous is that
you’re getting an answer, but you don’t know what it’s measuring,” he says. “They’re
designed to help investors choose portfolios and investment vehicles.”
A common question asks the investor
to imagine that the stock market tumbles 20%. Would the investor buy more? Keep
or sell his holdings? “They will give you a few options,” Grable says.
However, answers are heavily
influenced by the market environment. “If I asked someone that question during
a bull market, they would answer entirely differently than they would during a period
of heavy volatility. People do not answer accurately,” Grable says. The reason
is an optimism bias. “Most people, particularly men, overestimate their willingness
to hang in,” he says.
A more holistic approach is called
for, Nunnally feels. One aspect is delving into how much downside discomfort an
investor thinks he can withstand emotionally. “This is a matter of conversation
with the adviser,” he says. Questions would run along the lines of how the
investor adapted to financial disappointment in the past, and what the
emotional impact was, and could the investor stomach a 20% fall in the market?
“The questions are a starting
point, not the endpoint,” Nunnally says. Plan sponsors and advisers need to see
what kind of emotional impact distressing financial events might have on a
participant. If the impact was significant, the appropriate thing is to try to
avoid a situation where there could be a repeat of that distress.
Goals to Reach For
The investor’s end goal is also
critical. “What do they want to achieve, and where do they want to be at
retirement?” Nunnally asks. Now the adviser can begin to examine the amount of
risk an investor might need to take on to reach those goals.
Grable outlines four areas that can
form a more complete picture of someone’s risk profile. First is the investor’s
preference for particular types of risk. Some people want to avoid risk, while
others like to gamble, he says. Next, what is the investor’s perception of
risk? One person might evaluate risk based on loss of money versus choosing
safe options that carry the least amount of risk. Others might be able to
accept some percentage of risk.
Third, a person’s actual capacity
to take risk should be assessed. Someone might prefer to avoid risk because he prefers to avoid losses, Grable notes. But the investor with enough insurance, a solid
emergency fund and other supports that make it possible to take a potential
loss without feeling too much shock has a different outlook than someone lacking
these buffers. “We think people who faced loss and didn’t have ability to
withstand tended to be the ones who panicked and made the most dramatic asset-allocation
shifts,” he says, “and quite often these are the least optimal decisions.”
Composure is the fourth component
of a risk profile. What has someone done historically? Even with a rock-solid
foundation that can withstand loss, people can make inconsistent choices. These
traits may not lineup in linear fashion necessarily, but they form a more
complete profile, Grable explains.
The reason to strive for a more
accurate risk tolerance profile, Grable says, is that it can make investment
choice and retirement planning more effective. “The whole point of a risk
profile or measuring risk tolerance is to help the plan participant create a portfolio
that does two things,” he says. “Reach retirement objectives, and also make
sure that allocation or fund selection is appropriate, and not too excessive so
that if markets fall, they panic. You’re trying to be somewhat predictive of
their behavior, particularly in a down market or stressful financial situation.”
The problem is, Nunnally contends, is
that most tests simply give a score without any basis for comparison. “The only way to know what a score means is in comparison to someone
else,” Nunnally says.
“People lie to themselves, but not
maliciously,” Grable says. Everyone assumes that the questions commonly used work,
but very few have been empirically tested. Research has not yet really entered
the industry’s consciousness, he feels, but this could be changing as people become
more aware of the nuances that plan sponsors and advisers need to use to help
participants make investing decisions.