You know your clients best; a fund manager does not. When you meet a client you will probably go through a number of steps to establish their attitude to risk, their risk capacity and their required risk to meet their stated objectives.
What is also important is to establish their own experiences of investing and knowledge of how markets work. This can often be gleaned generally during your discussions about their lives so far, including past investments and their working lives. You might even talk to them about any investment mistakes they think they might have made in the past – this can give you a good insight into their emotional attitude to investing.
You gather your data about your clients and then go about analysing it for them. During the analysis you will need to make a number of assumptions. These assumptions are often pre-loaded as defaults into software tools but it is essential to know what they are and to understand how they impact on the outputs that you will use as a basis of a report for your clients.
Attitude to allocation
One important aspect is your attitude towards asset allocation. You have probably read all about Brinson et al, and about how important the high level split between growth and defensive assets is in influencing the variation in portfolio returns. Even if not, you will understand that, in principle, as we do not know which parts of a market are going to rise or fall in value, we should probably have a bit of everything and then change the percentages of those asset classes to make them suitable for our clients’ individual circumstances.
To start you will need an over-arching asset allocation for the whole financial plan that reflects your client’s position with regard to these three risk measures and probably agree on a level of compromise between them with which they are comfortable.
Once you have that, you will need to analyse their existing assets to see how far they collectively meet that asset allocation and perhaps look at purchasing new investments to fill any gaps.
But who decides and controls the asset allocation? The overarching asset allocation for the client should be decided by the adviser, perhaps in conjunction with discussions with the client.
But the asset allocation of an individual fund will be the responsibility of the fund manager in conjunction with the management group/board of directors and determined by the fund’s investment objective.
You need to ensure that these two sit comfortably together and the interests are aligned.
Some funds set out their broad asset allocation and then strive to maintain it over time. You can get information from the fund factsheets and online about an individual fund’s investment objective and look up the most recent top holdings. Some sort of X-ray software tool will help you do this on a larger scale at a portfolio level.
Cash and fixed interest debate
Recently I have seen some discussion about whether more adventurous investors should be holding any cash and/or fixed interest investments. Some people have argued that, in the current economic climate, holding any cash would be counterproductive for that sort of investor. However, before you decide on whether any asset class should be excluded from a particular client’s portfolio let’s examine a few points worth remembering.
Even the most adventurous investors may have some objectives they wish to meet in the very short term, perhaps less than five years. If that is the case there is an element of certainty that can be achieved by placing the money to meet that objective in cash now because meeting the objective is probably more important to them than potentially gaining (or possibly losing) a little more investment growth on that proportion of the portfolio in the next couple of years.
Remember what Brinson, Hood, et al said about reducing the variance in a portfolio by holding a bit in all asset classes because we don’t know which are going to fall and which rise. Have a company philosophy on investment, explore the research out there and decide why you would recommend any client to hold (or not) fixed interest investments. Are they there to reduce the volatility in the portfolio or are they there to help contribute to improve overall returns? It will be important to consider both credit risk and maturity in this area.
Instead of the use of bonds or other fixed interest investments would you consider the use of defensive equities? When you analyse a client’s portfolio they may have a geographical spread along the lines of Chart 1. Depending on your discussions with them and notwithstanding the fact that their overall asset allocation between defensive and growth assets might be fine, there may still be a need to diversify some of the geographical risks here.
Invest in software
Good analytics software will carry out these sorts of breakdowns for you, but in all cases I would recommend that you decide first what your company policy is and how you are going to use data like this.
What happens if we do this and the clients’ objectives still cannot be met? A good starting point would be to discuss with the clients a combination of at least these three options: First, reducing expenditure; second, scaling back their objectives; and finally, taking more risk.
While prioritising these three, be aware that there may be others, such as increasing net income, for instance.
Perhaps one of these objectives could be met based on your assumptions and the analysis undertaken, but maybe not all of them. You would then have to discuss with the clients which they feel are the most important. It is more likely that they will follow through what actions are necessary to meet those objectives.
But hang on a minute. As advisers, there may be objectives that you think should be made a priority: protection of the client’s income stream in the event of illness or death of one partner, for example? This is an area often overlooked by clients.
Obviously you can point out that without an income stream at all, meeting any of their objectives is going to be tricky unless they win the lottery and that is never something on which you should rely.
Reference: Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986 and Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Determinants of Portfolio Performance II: An Update, The Financial Analysts Journal, 47, 3 (1991).
Criteria for researching funds
1. Structure of the product – what is its investment status? What is the investment style and who is the manager? What are the underlying fund details and gearing effects (if any)?
2. Management – what is their reputation like? Do they have any conflicts of interest?
3. Risks of operation – who is the custodian, the caretaker of the fund? How easily can you or your clients access information about that particular fund?
4. Performance risks – does the fund have a small cap or value tilt?
5. Costs – a number of studies show that since costs are certain and future performance is not, investing in lower cost funds tends to prove a worthwhile approach. Costs may be explicit (management and other charges listed in the annual report) or implicit (impact of portfolio turnover, for example).
