Sometimes the simplest plans are the hardest to achieve and maintain. As investment professionals, it is easy to overcomplicate the investment decision-making process. Advisors are influenced by market noise, trends and contrarian views. These factors can impact the substance of clients’ portfolios and, left unchecked, can have distorting and destructive long-term consequences.
Likewise, for fiduciary professionals, ensuring that assets and strategies stay aligned with a trust’s investment policy statement should be a straightforward process. However, a beneficial owner’s personal preferences, a good sales pitch from a product provider, or the search for yield can lead to decisions that shift the dynamics of a client portfolio away from the investment policy statement.
An increasingly important service that we, as asset allocation specialists, are providing for our investment and fiduciary partners is the provision of portfolio reviews, with the aim of realigning the portfolio asset allocation and, in some instances rebuilding the portfolio construction, to meet the investment objectives in accordance with the client’s risk profile.
Through this article, I want to introduce some of the key issues that we regularly see across portfolios and highlight the positive impact that conducting regular reviews can have from a compliance, performance and client relationship perspective.
Asset Allocation And Alignment to Risk Profile
The first step we take is to assess the current asset allocation. This process includes both quantitative and qualitative analysis of the existing holdings and an evaluation of the risk level of each asset held and of the overall portfolio. Once we have a clear understanding of the portfolio, we review the risk profile of the underlying client and compare the current portfolio with a risk-rated asset allocation that matches the client profile. This stage of the review is critical, as it highlights two key areas of divergence from the client mandate.
The first area that we see with regularity is a mismatch of assets from a risk perspective; a common example is finding a high-risk, illiquid fund in a low or moderate risk portfolio. Similarly, we often find that a particular asset has been misallocated: in a recent case, we found that an investment platform had categorised Structured Notes as Fixed Income assets (carrying a relatively low-risk rating), whereas they should more appropriately have been classed as Derivative Instruments (carrying a significantly higher risk rating).
The second area covers the weighting given to assets classes within the portfolio, often with a bias towards one particular asset class. For example, we frequently see portfolios with over 80% exposure to equities that are inappropriate for all but the most adventurous investor. This lack of diversification often leaves the portfolio susceptible to increased volatility in adverse market conditions.
Risk And Return
All investment professionals will, at some stage, have made poor investment decisions and errors in judgement. Even Warren Buffett makes mistakes on occasion! – “An attentive investor, I’m embarrassed to report, would have sold Tesco shares earlier. I made a big mistake with this investment by dawdling.” [Source: Berkshire Hathaway Inc. 50th Annual Letter to Shareholders.]
The aim of a portfolio review is not to emphasise past mistakes, but to identify the current asset allocation risks and issues so that informed decisions may be made in the best interests of the client.
The complex relationship between risk and return is at the forefront of the many challenges to participants in the investment management industry; not all risks are bad and it is generally accepted that higher levels of risk are associated with potentially higher returns. There is, however, a pertinent difference between increasing risk levels through adjusting asset class weightings, making strategic or tactical investment decisions, and holding very high-risk assets that promise to deliver high returns but have inherent flaws.
Unfortunately, the inclusion of higher risk assets can lead to capital loss, whether that’s through the suspension of a fund or a weak and incoherent investment strategy. Whilst conducting reviews, we have also noticed a recurring pattern: once one part of a portfolio fails, the natural inclination of an advisor or trustee is to try and recapture lost capital, invariably by taking riskier decisions that skew the asset allocation even further away from the risk profile of the client. It is also important to remember the fundamental fact that to recover a 20% loss you have to make a 25% gain!
Greg Easton’s most recent article featured in the July 2016 Money Marketing magazine.