Advisors have been serving as investment managers ever since providing investment advice became a business. Think about how the advice business has evolved over time: Advisors originated as brokers who would help clients identify and purchase securities. Now, many advisors have shifted to providing full-service financial planning – and few rely on individual securities as the primary component to help clients build client wealth and achieve goals.
While advisors are less likely to be selecting individual stocks for clients in today’s landscape, many still take it upon themselves to act as an investment manager on their clients’ behalf. I am not going to discuss the DOL fiduciary rule here, but the fiduciary movement is here to stay and advisors should be thinking about how they set up an investment services structure that will hold up in discussions with regulators and attorneys.
Let’s take a look at what it takes to build out and manage infrastructure.
- Develop a process. How do you determine a client’s risk tolerance? How do you determine the risk tolerance of the strategy or strategies you’re recommending to that client?
- Document the process and revisit suitability annually. Prepare a paper trail that documents decisions being made with the client and the rationale for investment recommendations. Many times, firms choose to develop an Investment Policy Statement to help formalize the decision-making process. Revisit suitability on an annual basis to ensure the client’s risk tolerance and strategy risk tolerance still align and make adjustments if that is not the case.
Investment Component Selection
- Build a qualified team. Who is making the investment decisions? Are they qualified to make those decisions? Do they have the time to complete the analysis necessary to make informed decisions?
- Develop a process that includes identifying quantitative screens. Can you defend changes? Is the criteria alpha, risk, sharpe ratio (risk adjusted returns), or upside/downside capture? Annualized or calendar year results? How can you determine if the results are repeatable or driven by an isolated event?
- Document the process
- Create a thesis – This document memorializes the criteria, review and decision points associated with the choosing of any investment component, as well as expectations for that component and reasons why the component may need to be removed in the future.
- Calendar of review – Establish a timeline for monitoring and reviewing investment component decisions. Set up a set schedule for contacting the manager to discuss investment decisions, deviations from process, trade decisions, underperformance, etc.
- Build a qualified team. Who is making the asset allocation decisions? Are they qualified to make those decisions? Do they have the time to complete the analysis necessary to make educated decisions?
- Develop a process. How is an optimal asset allocation determined?
- Capital market assumptions – This is the process of creating risk and return expectations for each asset class that could be utilized in a diversified portfolio.
- Stress and scenario testing – The process by which asset optimizations are tested through thousands of simulations to help understand the viability of the diversified portfolio meeting a stated objective.
- Efficient frontier – Developing a set of strategies that line up across multiple risk and return objectives to satisfy investor needs.
- Document the process and establish a periodic review. How do expectations change as the market changes and what will you do about it? Assumptions should be reviewed regularly on a set timeframe, as well as on an ad hoc basis, in light of unusual occurrences in the market.
Review your process
We’ve worked with advisors for nearly 30 years. In our experience, many advisors underestimate the complexity of acting as an investment manager to their clients. The requirements include substantiating investment decisions and documenting them to provide clear rationale for initial decisions, as well as changes to those decisions over time. The process outlined above ties together in multiple places to provide validation of how portfolios are created, how the components of the portfolio are chosen, and why the strategy recommended aligns with the clients’ objectives.
An inability to fully complete the process in any one of these areas can cause the recommendation to be less sound and raise concern around the efficacy of the process. If you are acting in an investment management capacity to your clients today, review your process with the concepts above in mind to see how your process might be improved. John Anderson will be reviewing the costs associated with developing an end-to-end investment management process in a blog post this Thursday.
In case you missed it:
I recently spoke to ThinkAdvisor about one of the biggest misconceptions advisors have about the DOL Rule – the idea that you have to invest in the lowest-cost investments in order to comply. I also discussed a possible link between that (and other) misconceptions and passive investing’s “near-bubble level.” I hope you have a chance to read Being a Fiduciary is More than Offering the Lowest Cost Solution.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.