Objective Based Investing is relevant to everyday Australians seeking to achieve security in their retirement. But what is Objective Based Investing, and how does it differ from a traditional approach?

Objective Based Investing

You may have come across this approach in recent years, but this concept has been around for hundreds, arguably thousands, of years. Simply put, the term ‘objective based’ refers to investing with a specific absolute return, risk and/or income target. Some examples include:

  • I want my investments to achieve an annual return of inflation at +3%;
  • I want my equity investment to have a total risk [1] no greater than 12% p.a.;
  • My income portfolio objective is to achieve a gross yield of 5% p.a.

How this is different from a traditional approach?

Objective based investing does not explicitly refer to benchmarks; established market indexes are typically weighted by size (and determined by price). Figure 1 provides a high-level comparison of objective based and traditional approaches.

Source: Clime Group
The diagram above highlights the important differences between the two approaches. In this case, we’ll use an equity investment to illustrate. Starting with the right hand side of the diagram, this shows the primary objectives under a traditional approach.
Traditionally, the return, risk and efficiency are measured relative to a market index. This equity approach seeks to outperform the market index by 2-4% p.a., while assuming relative risk of not more than 5%.
Under a traditional approach
A successful manager will outperform the market index, without being too different.
The left hand side shows the same key objectives under an objective based approach. Return, risk and efficiency are all measured on an absolute basis. This objective based equity approach seeks to deliver a total return of 8% p.a. while assuming total risk of not more than 12% p.a.
Under an objective based approach
A successful manager will deliver strong risk-adjusted total returns.

Why does this matter to everyday Australians?

An objective based approach allows a manager’s investment objectives to be directly aligned with investor’s objectives. For the vast majority of everyday Australians, their primary investment objective is to achieve security in their retirement.
A traditional approach does not directly align the manager’s and investor’s objectives. At best, there is only a loose association between manager and investor objectives, which is highly dependent on the sequence market index returns are achieved in.
There are two key reasons for this:

  1. The market index is not the market; and
  2. Building portfolios based on the market index is non-sensical.

Reason 1: The market index is not the market
For a variety of reasons and driven by a number of powerful forces which I will speak about at another time, over the past quarter of a century investors seem to have forgotten that widely accepted indices are no more than a barometer of the broader market. Considering Australian equities, the widely accepted market indices are dominated by just a handful of companies [2].
When it comes to Australian equities, I believe there is more to life than the major banks, BHP and Telstra! Yet it is these handful of stocks that typically dominate Australian equity portfolios. There are a whole range of investment opportunities out there, so why not go and grab them? The good news is, by adopting an objective based approach you can.
Reason 2: Building nonsensical portfolios based on the market index
Under a traditional approach, investing differently to these index weights is viewed as risky. The largest ten stocks in the S&P/ASX 200 Index account for almost half of the total index’s weight. The big four banks represent more than 25% [3]. To us, this does not make sense that diversifying away from the significant concentration risk contained in the established Australian equity market index is risky?
An objective based approach applied to Australian equities, focusses on the most favourable investment opportunities, forgets traditional indexes and manages total risk. To me this makes a whole lot more sense.
In summary, objective based investing refers to an approach focussed on absolute return, risk and/or income targets. This investment approach directly aligns manager and investor objectives and is well suited to helping everyday Australian achieve security in their retirement.
Written by Anthony Golowenko, Head of Investments.

[1] In this context total risk is refers to the variability of total returns on an annualised basis.
[2] Index weighting is effectively determined by company size. The largest companies have the highest weight and vice versa.
[3] Source: S&P/ASX 200 Index weights as at 17 June 2016.