In this article, Tim Hale (pictured), managing director at Albion Strategic Consulting, argues the case that investing is simple, but not easy.
It is always tempting for clients to judge the value of their adviser on the short-term performance of their investment portfolio. That is unfair as no-one can control the returns that the market delivers. Anyone who thinks they can time when to be in or out of markets successfully, over time, is probably deluding themselves and their clients. Research on multi-asset managers in the US, UK and Canada reveal this to be the case.
While an adviser’s value – from an investment perspective – starts with the structuring of a robust portfolio that will weather varied and unknown future market storms, their true value, over time, lies in avoiding the dangerous combination of investor emotions and bad, yet often tempting, investment ideas. A good adviser can earn their ongoing fee several times over, simply by helping clients to have the patience, fortitude and discipline to stick with the programme.
In this article we will explore the different areas of value that a good adviser will bring to the client’s investment programme, which starts with, but goes well beyond, structuring a portfolio.
Value level 1: Building a robust portfolio for all seasons
The first step in the investment process is to decide how and what to invest in. There are an infinite number of ways to construct a portfolio and no absolute right or wrong answers to doing so. However, there are certainly better and worse ways of doing things.
In practice, astute advisers i.e. those willing to look at and be guided by the deep empirical evidence available, can build portfolios around an elegantly simple set of risk choices, using institutional quality, low cost, systematically managed funds that seek to deliver the return of each market risk selected as effectively as possible.
Most would agree that the primary portfolio construction decision is gauging how much to invest in growth assets, such as equities, and how much to invest in defensive assets, such as high quality bonds offering protection against large falls in the value of the growth assets the investor owns. The Sandler Review, commissioned by HM Government over 15 years ago, concluded:
‘For the individual investor, the asset allocation decision is by far the most important factor in determining returns.’
A good adviser will have a disciplined asset class screening process to ensure that each chosen investment is worthy of its place in the portfolio. As David Swensen – CIO of the Yale University Endowment – states:
‘By understanding and articulating the role played by each asset class, investors avoid making allocations based on the fashion of the day.’
Successful portfolio construction lies in understanding the long-term attributes of each portfolio building block and how it contributes positively to the overall robustness of the portfolio.
Owning a diversified portfolio inevitably means that some elements of the portfolio will do well and other elements less well, from time to time. Markets will do what they do and no investor can control them, or even second guess them with any degree of persistence. The sound advice provided by William Bernstein, who is a prolific author on investing and an adviser, is as follows:
‘Since the future cannot be predicted, it is impossible to specify in advance what the best asset allocation will be. Rather, our job is to find an allocation that will do reasonably well over a wide range of circumstances.’
These days, building a robust portfolio structure and populating it with high quality, low cost products that capture the rewards for the risks taken on, is perhaps the easiest part of the investment process, which is becoming increasingly commoditised. That is great for investors, but means that advisers need to help clients to understand the broader value they deliver.
Value level 2: Maintaining the efficacy of the portfolio and avoiding fads
Once a portfolio has been established, the next level of value that an adviser delivers is often hidden from sight. Given that a long-term portfolio structure has been put in place, and best-in-class funds have been selected to execute the strategy, it is quite usual that from one period to the next, nothing much changes on the portfolio. Some investors may even begin to feel that their adviser is not doing much for their money.
It is worth remembering the wise words of the renowned investment consultant and author Charlie Ellis: ‘In investing activity is almost always in surplus.’
Behind the scenes a good advisory firm will have an Investment Committee that meets regularly to: monitor how each fund is performing; look at any new funds that might compete for best-in-class status; review new asset classes and investment ideas using the same rigorous and disciplined process used to select the incumbent investments in the portfolio; and generally challenge the status quo.
High-level, client communications around the role of, and decisions taken in, the Investment Committee can be useful in demonstrating the work being undertaken behind the scenes.
It is the discipline of the Investment Committee that stops clients getting sucked into investment fads and flavour of the month investment ideas: these might range from more esoteric investments in, say, Ecuadorian rain forests to the pursuit of yield using sub-investment grade bonds. As Donald Trump is reputed to have stated – before he became quite so (in)famous – is actually very astute:
‘Sometimes your best investments are the ones you don’t make’
Value level 3: Providing support and guidance along the way
The harder part of investing is having the confidence and emotional fortitude to stick with the programme through thick and thin. A good adviser will take every client through a disciplined risk assessment process, which takes into account both the emotional and financial consequences of the trade-off between hoped-for returns and possible losses. They will also take time to explain the role that each of the assets plays in the portfolio.
Even so, when markets are either going up or down with great magnitude, as they inevitably do from time to time, a client’s emotions will kick in either in the form of greed or fear. As human beings, we simply can’t help it. Given that investors feel the pain of losses twice as much as the pleasure of gains, they are most vulnerable at times of market falls. A good adviser needs to act as an emotional counter-weight at these times and reinforce in the client’s mind (engaging the logical side of their brain) that the portfolio is structured as it is for a specific reason and knee-jerk reactions should be avoided at all costs. As the legendary, Jack Bogle – founder of Vanguard – once stated:
‘If I have learned anything from my 52 years in this marvellous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.’
Whilst most investors probably acknowledge these feelings, evidence reveals that we are, collectively, truly hopeless at stopping ourselves from engaging in wealth destroying investment decisions that result in buying at the top of markets and selling out at the bottom.
It is possible to quantify this by looking at the difference between the returns that funds deliver (where the impact of investor flow, into and out of the funds, are ignored) and the returns that investors in funds actually achieve (which take into account the timing of when they get in or out). The former returns are known as time-weighted returns and the latter as money weighted – or investor – returns.
Research by Morningstar/Russel Kinnel in 2014 entitled Mind the Gap, reveals that across a number of different categories of funds in the 10 years to December 2013 the average difference on an annual basis between the returns of a fund and those that the average investor receives is -2.5% per annum to the detriment of investors, on account of their poor entry and exit timing.
Given that most advisers charge 1% as an ongoing fee, which should also include comprehensive financial planning and regular goal tracking, it is easy to see the value of employing a steady hand to guide an investor through choppy waters.
Value level 4: Instilling the fortitude and discipline to rebalance
At the outset of a portfolio, the appropriate level of portfolio risk is established for each client. Over time, and accentuated by rapid market rises or falls, the balance between riskier growth assets and defensive assets can drift away from the desired balance. The Credit Crisis, that began in late 2007 and reached its nadir in early 2009, provides a good example of this drift. A portfolio with 60% in UK equities and 40% in short-dated UK gilts would have ended up with around 44% in equities and 56% in bonds at the end of February 2009.
Given the emotional pressures at the time, some would have been tempted to sell even more equities to avoid further pain. Rebalancing the portfolio structure back to the original asset allocation would have been the sensible thing to do, restoring the right level of risk to the portfolio. David Swensen describes the value and challenges of rebalancing as follows:
‘The fundamental purpose of rebalancing lies in controlling risk, not enhancing return. Rebalancing trades keep portfolios at long-term policy targets by reversing deviations resulting from asset class performance differentials. Disciplined rebalancing activity requires a strong stomach and serious staying power.’
Rebalancing forces investors to sell assets that have done well and to buy assets that have done less well. That is surely better than a buy-high, sell-low strategy driven by emotion. As the legendary investor Warren Buffett says about his investment strategy at Berkshire Hathaway:
‘We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful’.
Those who rebalance their portfolios are in good company. Good advisers will have the discipline, process and stomach to make sure that their clients rebalance just at a time when they think that this is the last thing they want to do. Optional rebalancing leaves advisers exposed to the same emotions that their clients face. A systematic, disciplined approach takes out the emotion.
Value level 5: Doing the boring stuff
The final level of value that an adviser delivers is undertaking some of the menial, yet highly valuable, administrative functions such as ensuring that ISA allocations are made use of and that capital gains are taken in a controlled manner, avoiding as little time out of the market as possible. We all hate paperwork, so letting someone else take care of it makes good sense. It is worth reminding clients of this, from time to time.
Whilst the structuring of a robust ‘portfolio for all seasons’ is the primary step in the investment process, the true value of the adviser, goes way beyond this. It is highly likely that if a client took the portfolio that the adviser set up and decided to manage it themselves, they would end up with a less favourable outcome in the long run; new, better funds might be available that would be missed, the portfolio might need to be refined over time, all sorts of new investment fads and ideas might tempt them without the proper due diligence to understand what the risks and rewards are likely to be, and when markets crash, it is unlikely that they will have the fortitude to rebalance and may bail out altogether.
Making use of ISA allowances and managing capital gains is also an important administrative function that matters, which take knowledge and discipline to execute. Failing to do so would be costly. Investing is never easy, but a good adviser will make it easier and the chances of success are higher than going it alone. That must be good value.
Tim and his team at Albion are passionate about good investing. They work with high quality, financial planning boutiques around the UK to build robust, systematic, risk-focused investment strategies – and ongoing governance structures – to use with their wealthy family clients.
Tim loves investing and working with clients. He is passionate about the social utility that good investing delivers. His key aims are to simplify investing and build belief. He can’t think of anything much better than a good piece of investment research!
He wrote Smarter Investing – now in its third edition – after seeing the mistakes made by investors, both institutions and private clients, when working for what is now JP Morgan Asset Management.
He lives in Devon and loves his girls, the Exeter Chiefs and beer (obviously in that order).
 Clare, Andrew and O’Sullivan, Niall and Sherman, Meadhbh and Thomas, Steve, Multi-Asset Class Mutual Funds: Can They Time the Market? Evidence from the US, UK and Canada (April 2, 2015). Available at SSRN: http://ssrn.com/abstract=2589043