Contingencies Online - September/October 2009

markets will continue to price all such securities using the latest available information so that, when we make our purchases, our expected return (as measured by the market) from the more-correlated investments is no lower than that of the less-correlated ones. In other words, we can choose the more-correlated investments without sacrificing any expected return.

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Some have argued that investors can achieve much better correlation through investments like TIPS or bonds with returns linked to national GDP. The GDP linkage is particularly attractive as it represents standard of living, rather than cost of living, so that the retiree is participating in the growing (and also possibly declining) well-being of the population.

However, I question that such a major shift in portfolios is either necessary or desirable from a macroeconomic perspective. In the long term, the value of the total equity market must reflect its underlying economic performance. GDP measures are an attempt to capture underlying economic reality, whereas corporations are, in large part, that economic reality. There’s questionable benefit in introducing a statistical middleman, subject to the arbitrary decisions about what counts as economic activity in a changing world. (For example, when new mothers start work again and employ others for day care, how much new economic activity is created?)

Another suggested advantage of GDP bonds is the stability of economic growth versus equity-market highs and lows. However, it’s exactly the nature of equity investment that allows businesses to absorb economic highs and lows. Debt that’s related to GDP remains much closer to traditional debt with all its leveraging implications for corporate health.

So the challenge in educating for retirement is to convince investors of the link between a limited holding in certain equities and the costs of future goods and services. Until recently, the generally rising stock market and ever-present inflation have damped any general interest in their relationship. The current discussion about deflation and economic depression, whether or not it’s borne out by the future, creates a rare opportunity to re-engineer investment education. But, to be effective, investment education needs to be frank about retail investors’ opportunities to “beat the market.”

I mentioned earlier the competitive nature of the very short-term market response, which ensures that good corporate performance is rewarded and poor performance punished. Beyond that, active fund managers haven’t demonstrated added value over index funds. Small investors’ tendency to place funds where past returns have been exceptional is ultimately an exercise in frustration. Instead, investors should benefit from the lower fees of index funds.

Is this undercutting the mutual-fund industry? Not if, like all other industries, it accepts that competition and efficiencies

over time lead to keener margins. Equity investment should be at the forefront of free-market price competition, not lag behind it.

Moreover, there remains enormous scope for fund managers to build economic models that link current value to future purchasing power. Convincing investors will always remain a challenge because we can never test the truth of the model until it’s too late to go back and start over. Yet even short-term measures can be persuasive. For example, an investor holding 50 percent cash and 50 percent residential real estate investment trust (REIT) index could tolerably track the cost of housing. Some percentage in a basket of commodity companies could arguably track the cost of food, automobiles and even clothing. Health care should be even easier. Though these are short-term demonstrations that leave open the long-term effectiveness of such strategies, they’re surely a move in the right direction.

MARK O’REILLY is an actuary and principal at Deloitte Consulting LLP.

This article is solely the opinion of its author. It does not express any policy of the American Academy of Actuaries; nor does it reflect any investment advice or opinions of the Academy or its officers, members or employees.