David Macchia: Let me begin with a question that’s a bit more personal in nature. Many people know you by reputation in our industry. You are, after all, one of our leading lights. But I think people would also like to know about your earlier life in terms of the personal aspects; where you grew up; where you were educated; and how you came to become the President and Chief Investment Officer of IbbotsonPeng Chen: Well, I grew up in China, a part of north China close to Siberia and North Korea, in city called Harbin. It’s famous for its ice sculptures. I grew up there, went to college there, graduated, and then came to the United States for my Ph.D. studies. I went to Ohio State. It was at Ohio State that my interest in investing really picked up, especially in terms of individual investing.
Upon finishing the Ph.D. program I started work here at Ibbotson. I was offered a job because I had used some of the Ibbotson data in my research. I also felt that it would be great to have a job at Ibbotson, should one be available. I applied for a position that seemed to fit, and I was hired.
That’s how I started at Ibbotson, in 1997. My first job was with the research group. Research was very important for the firm: Because of where Ibbotson came from, we have a strong academic root. I worked with Roger Ibbotson a lot, worked with Mike Hinkel quite a bit, as well as other research colleagues, such as Paul Kaplan.
Then things changed. I was promoted a few times, and in 2003 and 2004 we were starting to get more into advisory type of services where we increasingly acted as investment advisors for different asset allocation programs, including sub-advised asset allocation funds, or helping 401K investors to more effectively invest their 401K balances. There was a need to create an investment officer position and I was basically tapped in to run the investment decision group’s portfolio management. That was in 2004. Then in 2006 Morningstar acquired Ibbotson and our president, Mike Hinkel, stayed on for about six months following the acquisition. Mike decided to pursue other opportunities and I was asked to step in, including helping manage the overall business.
Tell me about your current responsibilities.Sure. First of all, lead the business; that includes things like managing the current products and services, and helping our client find new solutions. I still do quite a bit of research and also help with investment decisions. I have a few roles here, and that’s kind of the nature of our business; helping our clients by using our academic roots. We emphasize an investment process and methodology.
From your vantage point what is the biggest investment mistake that you see individuals making?Well, I think the biggest mistake individuals make is probably that they do not focus on both their long-term objectives and the long-term risk/return trade-offs. Often times they get sucked into the short term market and react to that. I think that’s probably the biggest mistake. If you look at investing, I think there are quite well-established principles in terms of what works over a long time, and what doesn’t work- both from an academic as well as from an industry practice perspective. I often see people making mistakes because of the short- term market; people reacting to what’s happening right now. And then they deviate from those principles. Often times that leads to results that are not as good as they could be.
What are some of the biggest mistakes that you see advisors making when they counsel their clients?What I see in terms of mistakes is- I’d rather say it’s an area of needed improvement- I think advisors help their clients understand investing principles, and, over the long-term, what actually does and does not make a difference. That’s one. And secondly, I think the fundamental reasons investors make some of these mistakes are behaviorally and emotionally related. Or, psychologically related rather than analytically related. I think they’re all smart people, so once you put numbers together they all understand them. But psychologically and behaviorally they still exhibit some bias. I think sometimes advisors don’t pay enough attention to those things, and I think that’s one area that could be improved.
You mentioned asset allocation earlier, and I’d like to ask you how it’s possible for an investor to know his or her true asset allocation?Right. How do the investors really know?
Yeah, how does someone really know?Well, I think that’s a very good question. I think what we try to do is establish two steps in the process. The first step is to try to determine from a pure asset class perspective in terms of, for example, US stocks, international stocks, bonds, cash, real estate, and from these pure asset class perspectives next determine what the appropriate asset allocation is.
Once you’ve decided that, then the second step is to put that asset allocation into work in the marketplace, really implementing that particular asset allocation policy. That’s where you have to be very practical in terms of what managers you feel comfortable with. And, often times, you have to give them leeway, because you don’t want to tie their hands if they are able to add value over time on top of the asset allocation policy.
But nonetheless I think you don’t want to undermine your asset allocation policy. So it’s a balance in terms of giving up some freedom in terms of achieving one hundred percent of asset allocation policy, but at the same time making sure the manager is effective over time. There’s a process that you can use to ensure that you give up the necessary freedom for a manager to do his or her job, but you’ll still be close enough to your long-term asset allocation policy so that you’re not jeopardizing that long-term perspective.
Are we becoming more of a world economy in the sense that more and more equity asset classes are moving in the same direction?I think that the answer is yes. I think that with globalization the economies are much more tightly linked together. So if you look at the stock markets, at the end of the day they reflect the economic activities of that economy. However, given that economies are interlinked there’s definitely more correlation among them.
In terms of globalization, the second thing I think people often don’t talk much about, but I think it will have an equally important impact on this inter-correlation, is the development of financial markets. If you look at financial markets today they are so much more closely tied together than they were before, and not only with different companies treated in different stock exchanges, but also the trading activities themselves. The players or the investors that trade on these different exchanges are trading these instruments across the globe now. I think that has also helped, I shouldn’t say helped, but that it’s pushed the inter-linkage to be much tighter. And as a consequence, the equity markets have moved more in the same direction than probably at any time over the past twenty or thirty years.
It may be true that much of the return to U.S. investors in recent years has been due to the climb in the value of foreign currencies versus the US dollar. Does this enter your thinking in setting recommended allocation to international equities on a going forward basis?Sure, I think it’s fair to say a significant portion of investment returns on international assets over the past four or five years is due to the currency appreciation. And, that’s certainly something that we’ve factored it in. However, one of the things we also try to keep in mind is that, at the end of the day, the currency is just a nominal denomination of measuring the underlying value of a firm. The underlying value of the firm is determined by the product and services the company sells. And the value of those products and services, which tend to have more of a real economic meaning as opposed to the nominal currencies they’re denominating in over time.
I’m not trying to say currency doesn’t have an impact, but over the long-term you really have to look at what’s really driving the stock returns. And certainly currency creates a big impact, especially over the short-term and volatility side. But over the long-term, the number one determinant is what we call real economic activities. Meaning what the firms produce and supply, and the value they add to the customer or consumers at the end. So from that perspective, from a longer-term perspective, currency plays a lesser degree, but one that is certainly important.
In making changes to recommended allocations, does Ibbotson make a judgment as to an asset class’s current valuation being, say, relatively high or relatively low?Well, when you talk about these investment decisions there are different time frames. For example, most of our decisions are related to long-term investing, because if you look at the investment landscape the vast majority of the investors are long-term investors. It’s critical to find the appropriate long-term policy, asset allocation policies.
We definitely take valuation into consideration, and as a matter of fact, we published a paper in 2003 in the Financial Analysts Journal to talk specifically about the market valuations and their impact on stock market returns over a long while. So that’s the long-term decision. But on the other side there is a short-term decision. When you see there are market opportunities in the short-term to add value to the portfolio, basically add more returns to the portfolio by deviating from that long-term policy.
That’s when these valuations come into play as well, as when the market is – from a valuation perspective – somewhat at a point of equilibrium. Those are the area of opportunities you can take advantage of. The technology and real estate sectors in the past year or two, for example. For our clients that have requested us to make short-term decisions, we’ve underweighted real estate for the past year and a half primarily due to valuation measures. Valuation impact on our work goes to the long-term and the short term.
Looking ahead, how do you view Ibbotson’s long-term role in the spend down phase?Do you mean Ibbotson’s role in terms of the retirement industry overall? In terms of what role we can play?
Yes, how you see the role that you’ll play.Well, I felt that that there is a unique role Ibbotson can play. For years Ibbotson has been the leader in long-term asset allocation. As the shift into retirement and income generation unfolds, there are needs of individual investors, advisors and institutions in terms of how to allocate their assets to generate the retirement income. This is something that is a natural extension from what we have done in the past.
What we have done really is to extend our foot print into retirement both from a pure asset allocation perspective in terms of large cap, small cap bonds and so forth, to helping the individual investor generate income. But also we’ve begun to broaden the scope a little bit. We’ve done quite a bit of work looking at different- what I would call, outcome-guaranteed types of investment strategies in retirement.
What I mean is that these types of investment vehicles guarantee a particular outcome, whether it’s income or protection of principal in retirement. Those can help, in our opinion. And if you use them properly, can definitely help investors improve their risk return tradeoffs in retirement. So we have actively expanded the scope of asset allocation to include some of these investment vehicles, such as payout annuities or variable annuities with GMWB type benefit riders, and so on. That’s one of the things we wanted to do, is really to stay at the forefront to help advisors and help individual investors think about not just asset allocation in retirement, but also how these different outcome guarantee type of strategies fit into an overall portfolio. That’s the first area that we’re trying to spend a lot of time on.
The second is where we are one of the industry leaders of providing individualized advice to plan participants. Currently we advise almost twelve and a half billion dollars in our 401(k) managed account platform. What we’re doing is basically helping individual investors in analyzing their asset allocation, their savings decision, their spending decision, and giving them some systematic and customized investment advice that they can follow in terms of picking mutual funds, in terms of how much to save, in terms of how much to spend. That’s one of the areas that I think is also in the great demand. To summarize, we feel that we’re in the unique position to stimulate solid leadership in retirement income in terms of issues related to what the retirement income portfolio ought to look like for individual investors. Not just from a pure asset allocation perspective, but also including some of these different investing strategies including using guarantees.
The third role we play is by acting as a reputable third party independent advice provider, providing individual investor advice. That might be through the retirement managed account services we offer, or through some target maturity funds, target date funds, or target risk type of funds which have our investment expertise embedded in them.
Right. Let me mention that I had a fascinating conversation with your friend, Moshe Milevsky. I know that you and Moshe worked together on an intellectual property design that was awarded a patent. I’m interested to know how that work is being implemented at Ibbotson.Well, I think that falls into the first category I discussed. We’re actively expanding the scope of investment process and investment strategies we can utilize to help investor better manage their retirement portfolios. That particular piece that we did with Moshe was to try to figure out to what extent payout annuities make sense in the retirement portfolio, and if so, how can we develop a framework, a mechanism, to help the individual investor decide how much they need to annuitize. I think your question is how do we intend to implement this strategy?
Yes.We have actually implemented it with a few of our clients already. Mostly as a guidance and advice type of mechanism, to help individual investors and specifically 401K participants understand the benefits and costs of these annuity products. This provides some guidance, depending on their circumstances; over how much and when they should think about buying some of these annuities.
I really applaud your efforts in this area. At the same time I’d like to make an observation and gauge your reaction. The industry is putting a lot of effort into the development of software tools, like optimization, designed to help advisors become more effective in putting assets into a distribution mode. At the same time, I’ve been speaking about and writing about another dynamic, one which I feel is underappreciated and potentially quite costly to retirement income businesses. Let me explain what I mean.
In more than 30 years of working with advisors over the curse of the accumulation phase, I consistently witnessed one phenomenon that repeated itself over and over again. That is, people invested in products and strategies that they truly did not understand. What they did understand was that they had confidence in their financial advisors.
As we enter the spend down phase I believe that the role of confidence begins to change in a dramatic fashion. Specifically, because of the financial liability potential for all parties associated with even one individual investor making a “mistake” in income distribution strategy – to the investor who may suffer portfolio ruin, to the retirement product provider that created a product which turned out to be sub-par, to the distributor that sold the product, to the financial advisor that recommended the product- the resulting financial liability could be extreme. Therefore, because the stakes are so high, I believe investors are going to demand confidence in the retirement product itself, not just the advisor. If I’m right about this it implies a massive communications and educational challenge. And at least for now, there is too little emphasis being placed on that vital confidence-building. I’m wondering if you agree with me on this assertion?I do agree. I think you’re spot on. I think it’s critical to educate and communicate the tradeoffs as well as the benefits of costs of all these different products and services. I think there is a transition into definitely more solution oriented discussions. To help build the confidence from individual investors in terms of how they are understanding the product, as opposed to how it used to be positioned: here is a great manager or here is a great product, or here is a great service. We’ve seen firms taking active steps to try to elevate the discussion on, not necessarily to a total solution, but on a solution perspective. They are basically saying “Okay, here’s your retirement landscape, here’s your social security benefit, here’s some DB pension you have, and here’s some 401(k). Let’s look at all these together and help you put it together. By the way, this may not be easy. You have to make some choices, not only in terms of risk return with the investment, but also in terms of in retirement. I think the most important thing is how much you want to spend and how fast you want to spend all your money. So we are actively developing those strategies, although currently I think you would agree that a small percentage of advisors are well versed in these types of discussions, and in terms of communicating them to individual investors there is much work to be done.