Recent surveys report more than half of Canadians feel they are behind on retirement savings and do not put enough money away. In many cases, retirement investors hold equity portfolios that trade broad market indices, either directly or through other investments such as target date funds.
Recent surveys report more than half of Canadians feel they are behind on retirement savings and do not put enough money away. In many cases, retirement investors hold equity portfolios that trade broad market indices, either directly or through other investments such as target date funds.
However, research from Dimensional Fund Advisorsshows that using what it calls a systemic active approach to investment can help investors enter retirement with an average of 15% to 20% more assets. For investors who start saving at 25 and retire at 65, this 20% bump was a consistent outcome.
The study’s findings are not limited to those who began saving early, however, as it also finds that even investors who use this approach when already in retirement are less likely to run out of money and are able to leave larger bequests behind to their loved ones ‒ all with little additional volatility or downside risk.
The big motivation for its study, says Mathieu Pellerin, a vice-president and senior researcher at Dimensional, is not so much about corporate investing, it's about the broader investment philosophy which is systematic active investing.
“In Canada, traditional active is still pretty dominant as opposed to passive. Traditional active still has the lion's share of the assets while in the US, passive actually overtook active funds at the end of 2022,” he says.
Most retirement savings plans ‒ whether defined contribution pension plan or registered retirement savings plan ‒ have large allocations to equities. With traditional active, “what you're trying to do is outguess market prices. You look for mispricing in securities and you try to guess that,” says Pellerin. What systematic active does is try to harness the information that's in market prices and exploit it.
The key difference between the two is that systematic active is really rooted in active evidence. It tries to do is take the best of investing ‒ the broad diversification, the low turnover, and the low cost and then use academic research to target segments of that in the market that are more likely to deliver higher returns in the long run.
“The idea was if you switch from a purely passive allocation, how much mileage can you get out of switching to a systematic active solution that has light and controlled deviation from the markets. You're not making a huge bet or doing something that's wildly different from the market. You're just starting from the market and tilting towards sources of higher expected returns which, in the paper, were value, size, and profitability.
“There’s a lot out there that people can try to do if they want to go beyond traditional stocks and bonds like bitcoin and private assets,” he says. However, just starting from equities and being a little bit smarter is one of the most powerful levers that can be pulled to improve outcomes.
The study focuses on core equity portfolios. “You start with the market prices for the entire US or Canadian stock market and overweight stocks that have good characteristics on value, size, and profitability which academic research identifies as the drivers of higher expected returns. “Stocks that have characteristics that are not as favourable are underweight, but the weights are controlled so the portfolio doesn't deviate too much from the market. It's a very convenient building block where basically you can substitute for a traditional active or a passive equity fund as part of your overall asset allocation,” says Pellerin.
While there's a number of ways systematic active can be implemented, Dimensional’s research shows that core equity investing typically is a little bit more efficient in terms of implementation.
Systematic active is not new. Dimensional has been doing it for decades. “Still the transition away from traditional active to passive is taking forever,” he says. “It's just that even when you have evidence that there is an investment solution out there that can help investors do better, the shift of the mindset and just getting used to that kind of new way of thinking is a big mental shift away from either passive or traditional active. These things tend to play out over a long time horizon.”
In terms of returns, historically over the last 100 years, it's about 100 basis points of out-performance. It comes from taking slightly higher volatility because the market is not being held perfectly. The intuition for all the findings in the study are essentially that “over the long run, the probability that you underperform becomes much smaller just because the law of averages kicks in and smooths out the results.”
And an interesting finding for those nearing retirement or in retirement is those who have a systematic active allocation, which has higher expected returns, get more mileage out of a smaller equity allocation. “So maybe instead of having 40% in an index, you have 35-ish percent in a systematic active allocation and you could get outcomes that are pretty similar,” says Pellerin.
