In Part One of a two-part series, Andrew Fairweather asks whether there’s a smart way for financial planners to construct portfolios for clients.
The past 12 months have proven to be quite stressful for all participants in the financial services industry, with most pain being felt by those who receive advice: the clients.
The current market volatility is a result of the substantial deleveraging brought on by the sub-prime crisis in the US, and it has revealed that many market participants were “swimming naked” in the great bull market that is now a distant memory.
It has also highlighted that planners who have taken on the role of chief investment officer (CIO) for their clients without the necessary systems and oversight are most at risk of feeling the full brunt of their clients’ anger during the bear market we now find ourselves in.
It is in times of crisis that prevailing industry business models are questioned – and it is when things are strong that business models should be questioned, but this rarely happens – and we are now seeing one set of participants doing just that, as regulators and politicians come together globally in a co-ordinated manner which will result in more oversight and regulation.
Some of their actions will be politically smart but economically suspect. They have to be seen to be doing something, which is consistent with responses to market meltdowns throughout history.
But advisers and their dealer groups should also be asking what business they are in and what is the best model going forward, rather than waiting to be directed by legislation. Many forward-looking businesses have already done this and are on the way to future success.
IS THERE A BETTER WAY?
The first question to ask is why do advisers attempt to manage their clients’ wealth as part of their value proposition, when their education and training is generally not geared toward this competency?
There are probably a myriad of reasons, which could include:
• Justification of fees.
• Investment being something they enjoy.
• Dissatisfaction with investment managers
• Rebates from, and relationships with, investment managers.
The risks for advisers and dealer groups in adopting the planner-as-CIO business model are numerous and include:
• Taking on “blame” risk when things do not work out (like now).
• Fee leakage for those dealer groups that rely on rebates, due to the difficulty in measuring retail funds that are not listed on platforms.
• Difficulty removing poorly performing investment managers from portfolios across a disparate group of clients.
• The “normalised” business value of an adviser’s practice could be lower as clients potentially ascribe too much investment management expertise, and therefore value, to their adviser. For example, will the next adviser who buys this practice be as good (maybe better?).
• Less time for client-facing activities, due to having to manage multiple investment managers who have the newest and greatest investment idea.
• The gap between research and implementation is too long – much can change from when an external/internal researcher makes a recommendation to the time it is reflected in a client’s portfolio.
• The simple fact remains that most advisers do not have the skills, training, or time to manage multi-asset class portfolios in an increasingly complex investment environment – this is not a criticism but a recognition that this is not the foundation of most advisers’ training.
Some dealer groups have tried to deal with these issues by creating model portfolios, either in-house or in conjunction with external research houses. But these, too, have their problems as many advisers ignore them and/or supplement them with their own investment overlay, which is generally clunky and static in a dynamic asset price environment.
An example of this is that many researchers manage asset class research in a fairly rigid manner (this is appropriate, given their human resource constraints and the large number of managers in traditional asset classes) and may not visit some asset classes (such as alternative investments) every year.
In a dynamic market the shelf life of their reports is limited, whereas the gap between research and implementation at the adviser level can be long, such that in some cases the reports become irrelevant and using them can be dangerous. So, model portfolios are only a partial solution in managing compliance and portfolio risk, and often are as much about capturing fund rebates for dealer groups as they are about providing investment solutions for clients. This is why, in most cases, portfolios bear little resemblance to the clients’ objectives or needs.
Let’s start with the client in mind – a novel apÃ‚Âproach in the financial services industry (I say this tongue in cheek!). We are very much a product-led industry, rather than customer-centric, but that is a discussion for a later time.
It has been empirically proven by Daniel Kahneman (2002 Noble Prize winner in Economics) that investors prefer gains only half as much as they detest losses. This recent market period has shown that, irrespective of the gains investors have made in the last few years (many of which have now been wiped out), they do not like the downside risk which is associated with having their wealth managed in a manner resembling a traditional balanced fund – that is, one where risk is treated as the standard deviation of returns.
Large endowment funds, like those managed by Yale and Harvard or very wealthy family offices and high-net-worth individuals (HNWI), understand the destructive force of downside risk very well and adopt an absolute return methodology in managing their capital.
This is implemented by having true diversification, requiring a mix of traditional and alternative investments in the portfolio. They do this because they know how hard it is to create wealth, and would rather earn 65 per cent of the upside in a bull market and “miss out” on the rest of the gains, in return for suffering only 25 per cent of the downside in bear markets. This way, they avoid large capital drawdowns, which can take years to recover from, depending on the severity.
These absolute-return or endowment-style portfolios will and do suffer capital drawdowns but, if managed well, these last for only short periods when compared to the traditional balanced approach, which the financial advice industry generally adopts in Australia.
WHAT IS THE RIGHT INVESTMENT PHILOSOPHY?
Wealth is created by achieving steady rates of compound returns in the good times, and by preserving capital in the bad times. This is best achieved by adopting a truly diversified, multi-asset class, multi-manager, multi-jurisdiction and multi-vehicle portfolio approach to investment management. This approach must be dynamic and flexible, and include a mix of both traditional and alternative investments to address many of the problems associated with an over-reliance on growth assets to manage wealth, as is the case for the typical balanced growth fund.
In addition to true diversification, wealth can be created through flexible, dynamic asset allocation, rather than rigidly adhering to strategic benchmarks with limited flexibility. This enables capital to be deployed where there are opportunities of substantial value, and capital drawdowns to be avoided by staying clear of overpriced asset classes when they emerge – for example, listed property trusts (LPTs) trading at a premium to NTA.
These views should be reflected in the portfolio in real time – for example, there should be a minimal gap between research and implementation at the portfolio level.
How can an adviser possibly manage this process and do it well, given the number of moving parts in managing wealth and the administrative burden of doing so? The fact that many advisers had direct property investments for their clients – which are in some cases now closed to redemptions – when the liquid LPT market was sending a very loud signal about value, is another example of the issues which advisers face and which they are now left to explain.
This is understandable, however, as advisers are inherently time-poor, which highlights why they should re-think their current model.
Whether dealer groups and advisers accept this proposed method of managing wealth, they should at the very least have an overarching investment philosophy that guides the portfolio construction process for the client, and resources should be applied by the dealer group to help advisers and their clients understand it, how it will perform in given market conditions, and to provide regular updates on its performance relative to its objective.
It may not be absolute return in the way suggested above, but it should be defendable and backed by robust processes and human resources.
This portfolio construction and investment approach is an institutional mindset and, when followed through to implementation*, should result in enormous cost and compliance savings in an adviser’s business, in addition to increased client satisfaction, because the approach is defendable and robust and likely to lead to improved investment performance over time.
* Part Two of this article – how to implement a different business model – will appear in the next edition of Professional Planner.
Andrew Fairweather is head of corporate development for Select Asset Management