Investment Methodology by Philip Wilson, AdvisoryWorld

By Philip S. Wilson, President, AdvisoryWorld

1. Are you establishing a Risk Profile for your clients including an overarching investment objective and a quantitative analysis of how much downside risk they are willing to accept?
2. Are you determining the risk and return characteristics of existing investment positions including return performance, volatility, downside risk and incremental risk per unit of additional potential return?
3. Are you documenting decisions regarding proposed investment portfolios that will, theoretically, achieve the highest possible return commensurate with the client’s Risk Profile?
4. If any answer to the above questions is negative, You may be in violation of SEC regulations, and FINRA’s Rule 2111 among others. Consequently, you may be subject to losing your license to practice as an investment or financial advisor and both you and your parent firm could be liable for financial restitution and penalties.

Being wrong when making investment decisions isn’t a crime, but not employing a comprehensive methodology for developing and implementing an investment strategy for clients could be.

After spending over 49 years advising institutional and independent investment managers it is truly amazing how the process of developing investment strategies spans the spectrum from applying a consistent methodology to blindly guessing which way the wind is blowing in making investment decisions and security selections. Back in 1987 I met with an advisor in Hawaii and asked him what he told clients about how he made investment decisions. He said “I tell them I read a lot and guess”. After I got up off the floor and stopped laughing, I commended him for his candor but suggested he might consider a more scientific and realistic approach to making investment decision.

I also recall how, in the late 1990’s, many advisors were simply investing their client’s capital in 80%+ stocks, 90% of which were technology oriented. There wasn’t any attempt to establish strategies that were consistent with a client’s risk/return profile. I don’t need to tell you how that strategy worked out.

One advisor in Colorado was found liable because, in an attempt to avoid fiduciary liability, he invested his client’s entire portfolio in Treasury Bills. The court found that he had failed to construct an investment strategy that attempted to achieve the highest possible rate of return commensurate with the client’s willingness to accept risk and to diversify the investments. Under ERISA regulations advisors are required to invest assets in a minimum of 3 asset classes in addition to balancing the client’s risk with an expected rate of return.

The FINRA rule on suitability of recommendations by advisors and their firms to customers and prospective customers which took effect in July, 2012, dealt with a number of issues of which firms and advisors alike will want to be aware of. One of those issues is the use in the regulatory notice of the wording “risk-based approach.” In one instance the notice mentioned a risk-based approach in documenting compliance with supervisory staff, and in another the phrase was used regarding the supervising of recommendations and investment strategies.

SCANalytics,

Virtually all pension sponsors and many money managers require an Investment Policy Statement which lays out the investor’s objectives and assumptions. Successful businesses always have a clear work flow and business plan in place and well executed. Should the advisor’s development and implementation of client investment strategies be any less rigorous? Should advisors be oblivious to the potential liability from failure to have a well-defined and repeatable method of determining where client capital should be invested? In the past 49 years I am not aware of any advisor that has ever been found liable when using investment tools such as SCANalytics, in the comprehensive and methodical development of investment strategies.

The following discussion assumes that advisors are interested in developing and implementing investment strategies based primarily on a method of investment analysis, portfolio design, and performance evaluation expressed, in large part, by quantitatively evaluating risk (client and investment) and its relationship to investment return. This method focuses attention on the overall composition of the portfolio rather than the traditional method of analyzing and evaluating the individual components. The investment manager is therefore able to examine and design portfolios predicated on explicit risk-reward parameters and on the identification and quantification of portfolio objectives.

Financial professionals need to consistently apply clearly defined, practical and repeatable methods of solving very sophisticated investment and retirement objectives. Applying these methods will help provide solutions (i) to better risk management, (ii) the design of investment portfolios with a high probability of achieving a client’s objectives, and (iii) the selection of appropriate investment vehicles and managers.

Such a methodology includes:

1. Establishing the investor’s risk profile as measured by the downside risk the investor is willing to accept in any 12 month period.
2. Establishing the investor’s financial objectives including retirement, major purchases, education, etc.
3. Analysis of current portfolio risk and return characteristics
4. Selection of a mix of asset classes that are suitable for the investor
5. The efficient allocation of capital to a selected mix of assets by matching performance characteristics to a specified and quantifiable tolerance for risk.
6. Establishing the probability that the recommended mix of investments will achieve the investor’s objectives.
7. Find investment vehicles that represent the asset classes chosen
8. Periodic review, analysis and rebalancing or modifications where necessary

The Foundation of This Methodology Rests Upon Four Basic Premises

1. Risk Aversion Investors are inherently risk-averse. Investors are not willing to accept risk except where the level of returns generated will fairly compensate for that risk. It is probably reasonable to assume that investors are more concerned with risk than they are with rewards. The problem in the past has been the quantification of risk and its relation to return. The SCANalytics application is extremely powerful in providing a detailed analysis of investment portfolios and relating those risk/return characteristics to a client’s risk profile.
2. Efficient Markets Most academic and industry research supports the concept that markets, at least in the broadest sense, are reasonably efficient. The nature of an efficient market is such that all participants have the same information regarding the markets in general, and specific issues in particular, at the same time, although they may come to opposite conclusions as to an appropriate price for individual securities. It is, perhaps, ironic that the sophistication of money managers and their virtually instantaneous access to information today creates greater unparalleled efficiency in the marketplace, thereby making above-average returns extremely difficult to achieve. With the advance in information technology and more sophisticated investors, the markets are likely to become even more efficient.
3. The Portfolio As The Determining Factor The third, and most important, premise is that the focus of attention should be shifted away from individual security analysis to the consideration of portfolios as a whole predicated on explicit risk-reward parameters and on the identification and quantification of portfolio objectives. Today it is more likely that the efficient allocation of capital to specific asset classes will be far more important than selecting the “right” components of any asset class.
4. Portfolios Can Be Quantitatively Optimized The fourth premise is the optimality of portfolio returns vis-à-vis portfolio risk. In other words, for any level of risk that one is willing to accept, there is, mathematically, a rate of return that should be achieved. Quantitative methods are used for measuring risk and diversification, making it possible to create efficient and theoretically optimal portfolios. Portfolio diversification is not so much a function of how many issues are involved, as it is of the relationships of each asset to each other asset and the proportionality of those assets in the portfolio. Investors should search for those assets which tend to have negative relationships to each other. In other words, the portfolio should include assets which go up in value as the value of other assets declines. There are essentially two methods of optimizing portfolios:
   1. Find optimal portfolios based on historical performance. This method will invariably find that mix of assets that did, in fact, provide the highest rate of return for any comparable level of risk.
   2. Find optimal portfolios using forecasted rates of return and standard deviations. In many cases theoretically optimal portfolios are not acceptable simply because the historical rates of return are not in line with what the advisor and client believe to be realistic. Therefore, it is incumbent upon the advisor to forecast rates of return for each asset. For example, in 1987 historical mean rates of return for EAFE companies were far greater than were reasonably expected for the near future. In many cases prices were at, or greater than, 90 times earnings. Remarkably similar to domestic security prices in 2000. Using those historical mean returns in modeling a portfolio would have led to portfolios that were extremely over-weighted in EAFE type securities and a poor performing portfolio. While correlation and covariance characteristics don’t tend to change over short periods of time, there is absolutely no reason to assume that historical returns are like to repeat themselves in the relatively near future.
   Both options may require some modifications by establishing holding constraints for individual assets. In effect, the entire process is as much art as it is science.

The extent to which knowledge of one asset return provides information regarding the behavior of another asset is measured by the correlation of returns. Are they moving in the same or opposite directions at the same time?