Asset/Liability matching for retail investors

“The world’s most sophisticated institutions invest using asset/liability matching strategies to help them properly navigate their liquidity needs over time. Banks, pensions and other large institutions don’t rely on vague “risk profiling” processes or Modern Portfolio Theory and instead use practical asset/liability matching strategies. Retail investors, on the other hand, are sold a narrative about earning high returns in “risk optimized” portfolios in exchange for the guarantee of high fees. We’re here to change that by giving retail investors and advisors an accessible way to implement asset/liability matching strategies and invest like the biggest and most sophisticated asset managers in the world.“

This introduction is taken from here. I know (not personally) the person behind it, Cullen Roche, because his website Pragmatic Capitalism explained to me why QE was not inflationary…among other things. He is a smart chap.

Asset/Liability matching, or asset/liability management (“ALM” from now on), is a mouthful definition for something simple: we save money (our assets) to fund future spending (our liabilities). As Cullen says, banks and pension funds do not invest ONLY based on their risk profile (they typically have a risk appetite statement as a foundational basis of their investing decisions) but they try to match with their assets the characteristics of their liabilities: assets are picked not only based on their ability to grow through time but also based on how much they move in synch with the liabilities.

Let’s say you want a buy a house in 5 years. The best possible investment (the asset) to meet that target (the liability) is something that will generate high returns and the peak of those returns in exactly 5 years. The second best is an investment that would go up in value if the price of the specific house you want to buy would go up and down if the house price would dive. You do not care if the investment would lose value as long as also the house would be cheaper because your goal is to have enough money to buy the house.

This is where financial planners go nuts on Modern Portfolio Theory: “Stop focusing on the highest return for any given level of risk”! they would shout at you, because what you should really care about is your REAL RISK, to not meet your financial goals, not volatility or downside volatility or….

I guess reality is more nuanced than this.

There are institutions, large and small, that are all-in on portfolio construction and management: endowments, family offices, sovereign funds and so on. They have an ALM problem as well but decided to tackle it from a different point of view: construct a portfolio that can generate a stable amount of income, to cover expenses…forever (ideally).

This framework can be applied to individual investors too. Especially now that we live in a world where an asset-light approach, “renting” everything, is feasible. Yes, maybe not the best financial option in some circumstances, but definitely feasible. And this approach does not prevent the individual from planning for “big expenses”, it just needs some twists.

The (ice) Bucket Challenge

The saving “bucket” strategy has always been an asset allocation strategy: X% emergency fund/liquidity (cash), Y% safety and/or planned expenses (bonds), Z% growth (stocks). See Cullen’s strategy as well, where he defines the buckets as stability, growth and insurance. The main difference with a plain-vanilla asset allocation strategy is that in this configuration each bucket weight in the portfolio is not fixed but varies depending on the saver’s needs. For example, throughout the accumulation phase of the “standard saver”, the emergency bucket will go from 100% to 5% or less.

This is the main reason why the strategy does not work in practice.

The most important feature of this technique is that it minimises the career risk of the person proposing it to you, typically a financial advisor. This is because instead of framing it as a 80/20, with all the pros and cons, the advisor can simply point you to the 80 when things are fine and to the 20 when stocks are in a crash.

It is a sleight of hand. Look here. No, now look there.

The 80 and the 20 are always there. Your financial objectives and liabilities, the overall portfolio returns are always there. The financial advisor turned illusionist is there to remind you of the yin of a bucket, when you need to, and forget about the yang.

The Emergency Fund heist

Let’s look at the emergency fund first.

This concept was imported into Europe from the US, without thinking that the raison d’être does not apply around here…while we have different and more relevant issues. In the US you can be fired anytime and you have no social net: no unemployment benefit, no free health care, nothing. Outside NYC, there’s probably nowhere you can survive without a car (I remember once I tried to take a bus in Miami and the driver asked me for the exact PAPER dollar amount to get in. The tech is there but they simply do not give a shite about those services).

I have a friend here in Zurich who was telling me about the importance of the emergency fund. The guy is single, no kids, no car, no mortgage and if he gets fired can get 70% of his salary for two years from the State (that he can use to cover his health insurance): can you tell me the need for an emergency fund? He couldn’t. This thing became a bloody religion here in Europe.

On the other side, those funds parked in a bank account are gnarled by inflation instead of compounding. All the emergency fund acolytes will arrive at retirement with their e-fund untouched and…not enough to retire comfortably. Europeans’ biggest risk is represented by the paltry salaries paid this side of the pond. We need every bit of compounding.

[Everything I wrote does not apply to entrepreneurs/solopreneurs; their salary is at risk so they should hold a substantial emergency fund. Compared to an employee, their barbell is ‘reversed’: they hold a lot of risk in their job therefore they have to be really conservative with their savings. I simply do not think that the entrepreneurship/solopreneurship culture is that spread here in Europe, therefore this specification is in brackets. I do not want to go from everyone needs an emergency fund to no one needs it 😉 Please consider your own circumstances before hedging risks that might not apply to you]

“Planned” expenses

In theory, we all have planned, chunky expenses and pairing them with an asset that can generate a return while providing (almost) zero volatility at term makes a lot of sense. So I thought, what are these short to medium-term liabilities in my family case?

And…I couldn’t find any?!? The more I ponder on it, the more I realise it is more of a design-your-lifestyle type of issue.

Think about cars. Buying and maintaining a car is probably the most used example of a liability that falls into this bucket. Cars are freaking expensive, they tend to break down at the worst possible moment and the cost to repair them is exorbitant (at least that’s how it feels when you have to reach for your wallet). Still, you need a car…don’t you?

Maybe not.

Ok, I do not want to sound like one of those “go live in a forest and eat berries” types of bloggers. I just want to point out that if you have to go to such a length to plan for something that is not that necessary, you become the slave to that object. This is because 90% of the time, the financial discourse about a car is not about the object that will get you from point A to point B, it is about status. You might need a car, but you definitely do not need that car.

House repairs and maintenance follow the same logic. First, if you rent you have none of those issues. Second, when you buy you might already consider that you will have to maintain the mansion you are targeting; and it is going to be expensive.

The design solution has nothing to do with financial planning: grow. your. salary. And then live within your means.

There is nothing wrong with wanting a car, a house, a pool, a boat, you name it. But if in order to own it and maintain it you have to bend over three times…sure financial planning can help but it is like looking for an aspirin because you banged your head against the wall as a game. Let’s at least be honest about this. You should get to the point where your monthly salary can cover most of your planned expenses; the rest should be manageable within the year, so you need at best a high-yield cash account (if you want to bother) not a bond ladder.

The “bucket” solution introduces three main issues:

• the sleight of hand already mentioned
• some of these “planned” expenses can be moved around (you might wait another year to re-do the bath or buy a new car) but their amount might surprise you (inflation ;)). Or they might happen way sooner! What about unplanned ones? What if someone in the family needs an expensive medical treatment? There is a bit of hybris in our (or our financial planner) forecasting ability, which in the best of scenarios turns into being too conservative (see the emergency fund issue) and in the worst into selling stocks at the bottom. This solution is designed to mitigate the volatility of the growth bucket but it is not that effective at it (but sure enough gives you a lot of comfort when you design it in a calm environment).
• savers shortcut bonds -> ONLY for planned expenses. Or bonds do not lose value if bought at 100 and sold at 100 (remember…inflation?). Imagine running this strategy for 30 years and then, 10 years before retirement, someone tells you that you have to de-risk the growth bucket by adding bonds. Sure you will get it.

Instead, here is my solution:

• Invest in yourself and grow your human capital. Design your life so that your revenues grow way faster than your “burn”, your fixed and unavoidable expenses (this is also the most effective hedge against inflation).
• Use insurance to cover financial ruin risks. If you are young and single, buy disability insurance for a big amount. If you have a family, buy term life insurance and then scale it down while your savings grow.
• build an endowment-like portfolio (unfortunately, Risk Parity is a tainted term that needs a re-branding. But if you have opposable thumbs, that’s what I am referring to).

The Endowment Model

My blog is dedicated to explaining this model. I will just list the pros and the cons here, read the rest of the blog if you want to know more. It does not have anything to do with Markowitz, or “leveraging” past volatility and correlations, it is about diversification. And knowing that certain patterns will repeat: bond prices are inversely correlated to yields and yields go down (via Central Banks cuts) when the economy goes into recession; trend-following returns are convex; long-vol strategies spike when stocks crater. It is about holding a diversified group of risk premia and rebalancing them regularly.

I find it funny that the detractors of this model also base all their investment theory on the past, in particular on the existence and persistence of the Equity Risk Premium. I guess 99% of us grew up in monotheistic societies, why not…

Sometimes, their solution to stock crashes is their ability, due to their experience, to side-step the biggest downfalls, aka time the market. Another sleight of hand (see the insurance bucket in Cullen’s strategy. I mean, I trust HIM to run it in the most effective way but…would I have the same confidence in someone else? Would he accept me as a client? How can I assess Cullen’s ability going forward? TBH I would not trust Taleb to manage my money eheheheh).

The pros of the endowment model:

• it makes something non-ergodic a bit more ergodic. It lowers the sequence of returns risk, both in the accumulation and decumulation phases. You do not have to understand which premia are expensive and which are cheap, you just buy them all.
• by employing leverage, you can target your desired level of returns. Before you jump on your chair, ain’t talking about deterministic shit, ok? But risk premia are called this way because they offer a return higher than the risk-free rate, otherwise they won’t be premia. Getting cheap leverage is not easy but is not hard either. And none of the stories you read about leveraged disasters happened when leverage was set at max 2x. Save them for someone else.
• You can dial leverage up or down based on your path vs goals. This is way easier, even behaviourally, compared to switching strategy/portfolio. Especially when approaching retirement (let me know how that V-Glidepath strategy meeting goes the next time).
• “your investment strategy max drawdown is the one that has not happened yet”. This works for every strategy. Do you think this risk is higher or lower if you increase diversification?
• When you need funds along the path, you can sell an equivalent part of the portfolio without worrying which line is “overvalued” and which is “undervalued” (somehow, the bucket strategy is linked to this notion to always sell your bonds first, which obv doesn’t make sense).

The cons:

• a way way way steeper learning curve is required. But that’s literally your (financial planner) job, innit?
• some instruments might not be available everywhere. Portfolios in different jurisdictions will have different configurations but the founding principles should stick, no?
• after-tax returns would need a different optimisation (see above).

What I am reading now:

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