Written on 05 June 2018

Lionel MARTELLINI

Director, EDHEC-Risk Institute

John MULVEY

Professor, ORFE Department, Princeton University


Goal-based investing may (and should!) radically change the wealth-management industry. Catch up with Professor Martellini, EDHEC-Risk Institute Director and Professor Mulvey from Princeton University. 

 

How would you define goal-based investing, and what exactly makes it a new approach?

Professor Martellini - Goal-based investing (GBI) is a novel approach to wealth management because it is based on the principle that any investment process must start with a thorough understanding of the investor’s problems and needs. The idea is that individual investors do not need investment products with alleged superior outperformance with respect to market indices; they need investment solutions to help them solve their problems. Those problems can be broadly summarised as a combination of various wealth and/or consumption goals. For example, achieving a minimum or target replacement income in retirement. In this context, the key challenge in wealth management is to implement dedicated investment solutions aimed at generating the highest possible probability to achieve investors’ goals, and a reasonably low expected shortfall in case adverse market conditions should make it unfeasible to achieve those goals. An asset allocation solution must be designed to factor inparticular risks to which investors are exposed or to which they need to be exposed to fulfil certain goals. Modern portfolio theory and standard portfolio optimization techniques, which tend to focus on the risks impacting the market as a whole, are inadequate by comparison.

Professor Mulvey - The efficient management of all risk buckets, as opposed to market risk alone, is a central component of the goal-based investing framework introduced in 2005 by Ashvin Chhabra, now chief investment officer of Merrill Lynch Wealth Management. Michael Dempster from Cambridge University has produced a significant body of work on asset-liability management for individuals, and my work has also been in this area, but to date the practical implications of our findings have not been fully exploited. Most private wealth managers still maintain a sole focus on market risks taken in isolation, with investors’ preferences crudely summarised in terms of a simple riskaversion parameter. To this end, for example, risks for individuals should be measured in terms of Goals-at-Risk, as compared with the traditional Value-at-Risk measures. We can expect the next generation of private managers to focus on building a modern approach to wealth management. This approach will depart from a product-centric search for asset-only performance to focus on the satisfaction of investors’ needs through a dedicated, investor centric, goal-based investment solution.

“The emergence of internet-based wealth management platforms —‘Roboadvisors’— are providing wealth managers with another incentive for improving the performance of their services.” Lionel Martellini, Director, EDHEC-Risk Institute

 

If wealth managers haven’t been “investing with a goal”, what have they been doing up until now?

Professor Martellini - That’s actually a pretty good question. The fact that goal-based investing has not yet been implemented on a large scale seems to suggest that what we have we been doing so far is investing with no purpose, which does sound pretty bad! It is fair to say that wealth and asset managers have always had some reasonable goals in mind when managing their clients’ portfolios, such as outperforming a given commercial index, or maximizing a risk-return ratio, but it’s also true that these goals have had very little to do with solving their clients’ problems.

Professor Mulvey - It is critically important to understand that measuring performance with respect to asset class benchmarks is ostly irrelevant in the context of meeting important goals for an institution or an individual. As a matter of fact, the main benefit of goal-based investing, beyond providing a useful financial engineering framework for making meaningful investment decisions, is perhaps that it is a tool that can be used for facilitating the dialogue with the end investors, by providing them with updated estimates of the probability of reaching their goals and associated expected shortfall.

 

Are you optimistic that the goal-based investing revolution is at last about to happen?

Professor Martellini - While one should never underestimate the power of the forces and inertia and reluctance to change in any environment, I must say that I am fairly optimistic regarding the adoption of goal-based investing in the years ahead. The climate has changed dramatically for wealth management firms, in particular those located in tax havens like Switzerland. On a different note, the emergence of Internet-based wealth management platforms, which are also called “robo-advisors”, are providing wealth managers with yet another incentive for improving the performance of their services. Financial intermediation has to improve if it does not want to be overthrown by the kind of Web-based disintermediation that has taken place in other sectors.

Professor Mulvey - The massive shift from defined benefit to defined-contribution pension schemes around the world implies that individuals are becoming increasingly responsible for making investment decisions with respect to their need to finance their own retirement. Contributing to solving the retirement problem is definitely the key challenge the wealth management industry has to face, and some progress definitely has to be made with respect to existing investment practices with respect to this formidable challenge. It is critically important to understand that measuring performance with respect to asset class benchmarks is mostly irrelevant in the context of meeting important goals for an institution or an individual. As a matter of fact, the main benefit of goal-based investing, beyond providing a useful financial engineering framework for making meaningful investment decisions, is perhaps that it is a tool that can be used for facilitating the dialogue with the end investors, by providing them with updated estimates of the probability of reaching their goals and associated expected shortfall.

“Contributing to solving the retirement problem is definitely the key challenge the wealth management industry has to face.” John Mulvey, Professor of Operations Research and Financial Engineering, Princeton University

What are the initiatives that EDHEC-Risk Institute and Princeton’s ORFE department expect to develop in this area in the years ahead?

Professor Martellini - Probably inspired by the need to leave the comfortable ivory tower in which we live in academia so as to feel somewhat useful to society, I have personally decided to dedicate the remainder of my professional life to the promotion of meaningful investment solutions for individuals, especially in the context of retirement investment decisions. This ambition I have will translate not only into more research initiatives, but also into new educational initiatives, including dedicated executive education seminars, an “Investment Solutions” textbook, related MOOC [massive open online course] or SPOCs [small private online course] initiatives, etc. It will also involve partnerships with industry players so as to help them meet the implementation challenges involved in providing scalable goal-based investment solutions to their clients. I am glad to know that I am not alone in this search for a better investment world, and that I can count on the active participation of John Mulvey, whose expertise in the domain of asset-liability management, for both institutions and individuals, is unparalleled.

Professor Mulvey - The collaboration between EDHEC-Risk and Princeton has given rise to an ambitious research program me on asset liability management and goal-based investing for institutions and individuals. Lionel has spent the 2011-12 academic year as a visiting scholar at Princeton’s ORFE department, and one of my doctoral students from Princeton is planning to spend the next academic year at EDHEC-Risk Institute in France. Our key ambition in this partnership is to develop innovative academic research that could have a strong influence on the practice of investment management, at a time when the industry is facing a number of key paradigm changes.

In May 2018, the research efforts towards the design of more meaningful retirement solutions, with the support of Bank of America’s Merrill Lynch Wealth Management group, have led to the design of the EDHEC-Princeton Retirement Goal-Based Investing Index Series, available at risk.edhec.edu/indices-investment-solutions. Individuals need "flexicurity" in retirement solutions, and would benefit from the same risk management techniques used by institutional asset owners. Our hope and ambition is that this initiative will pave the way for new welfare-improving forms of investment solutions that are better suited to the needs of individuals preparing for retirement. 

CONTRIBUTORS: Lionel MARTELLINI, Director, EDHEC-Risk Institute and John MULVEY, Professor, ORFE Department, Princeton University

Lionel Martellini is a Professor of Finance at EDHEC Business School and Director of EDHEC-Risk Institute. Lionel holds Master’s Degrees in Business Administration, Economics, Statistics and Mathematics, as well as a PhD in Finance from the Haas School of Business, University of California at Berkeley. He is a former member of the faculty at the Marshall School of Business, University of Southern California, and has been a visiting fellow at the Operations Research and Financial Engineering department at Princeton University. Lionel is a member of the editorial board of The Journal of Portfolio Management, The Journal of Alternative Investments, and The Journal of Retirement. He conducts active research in a broad range of topics including long-term asset allocation decisions, equity and fixed-income portfolio construction, risk management and derivatives valuation.

John Mulvey is a Professor in the Operations Research and Financial Engineering Department and a founding member of the Bendheim Center for Finance at Princeton University. His specialty is financial optimization and advanced portfolio theory. For over thirty-five years, he has implemented asset-liability management systems for numerous organizations, including PIMCO, Towers Perrin/Tillinghast, AXA, Siemens, Munich Re-Insurance, and Renaissance Re-Insurance. His current research addresses regime identification and factor approaches for long-term investors, including family offices, and pension plans, with an emphasis on optimizing performance and protecting investor wealth (and surplus wealth). He has published over 150 articles and edited 5 books. He is currently editing a book “Machine Learning in Finance,” and is a senior consultant for the California Public Employees Retirement System.

This article was first published on Otherwise magazine (#3 issue). If you enjoyed reading it, subscribe here and receive the next issue for free ! 

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