Some of the value advisers create stems from their investment services; therefore, the more control an adviser has over this process, the greater the value of the business.
There are many reasons for advisers to consider creating their own model portfolio service.
But it is easier said than done, writes Zen Wealth founder Patrick Murphy, who believes it is a route well-worth taking.
First steps
Establish an investment committee and create an investment policy statement to provide a comprehensive and unambiguous record of the firm’s investment philosophies, strategies and processes.
The benefits of this are:
- A clear understanding of the firm’s attitude to investment risk;
- Performance objectives and expectations are clarified; and,
- Misunderstandings are less likely.
The committee should meet regularly to ensure that information remains up to date and relevant.
Investment Policy Statement
This document should set out the investment philosophy and ought to explain what the firm will do with client money and why.
It should cover:
Core Beliefs
Active, passive or evidenced-based investing?
Investment styles are often categorised as active or passive. What are the firm’s views and beliefs in this area?
Asset Allocation
Is the firm planning to adopt a strategic asset allocation approach or a tactical asset allocation approach?
What are the main asset classes that will be used and why?
Risk Assessment, Asset Allocation and Portfolio Construction
Describe the portfolio construction process. This allows the firm to take some of the asset classes that it has identified and combine them into a number of portfolios.
Firms should build investment portfolios with various degrees of risk and expected returns and express these variables in simple terms that clients will understand.
Portfolio construction
Having established the factors of risk that can be combined to form a suitable portfolio – and a means for measuring that risk – firms should now consider the process of building a portfolio.
This diagram illustrates a framework for construction.
Fund Selection
There are various modelling techniques that can be used to project a range of possible outcomes for determining how assets will behave in relation to each other to determine an ‘optimal’ allocation.
One technique is based on Harry Markowitz’s Modern Portfolio Theory (MPT), which seeks to maximise return from a portfolio for a given level of risk.
Introduced in 1952, it is still widely used in the wealth management industry.
In all areas, funds should be compared against their peers and benchmarked in the following areas:
- Diversification
- TER/Ongoing Fund Charge
- Performance
- Volatility
- Fund Size
- Qualitative Screening
- Fund Manager Background
- Fund Philosophy
- Fund Management Processes
- Risk Controls
- Manager Resources
Quarterly Review Process
Once the portfolios have been created, the firm will need to ensure that they are regularly reviewed and monitored.
Asset allocation changes should be dictated by any alterations made in the portfolios following a review by the investment committee. This should filter through to the weightings given to the funds selected.
The committee should also consider the performance of the portfolios and should make fund changes to react to corporate actions (where funds are closed, given a new objective, given a new benchmark or charges increased) or where it is considered that there has been continued divergence from the market return.
As evidenced above, it is not easy to build and run portfolios and here are some of the pros and cons of doing so:
Great value demonstrators
- Sense of diversification;
- Sense of customisation;
- Plenty of touch points of perceived value add;
- CGT management.
But are hugely inefficient
- Suck up resource;
- Unable to respond quickly to changes in markets;
- Admin burden;
- Reliant on multiple third parties;
- Reliant on platform fund availability;
- Mifid II and regulatory concerns.
Tales from the coalface
While the last five years have delivered a great investment experience for clients, we at Zen Wealth have become increasingly worried/concerned about the future, as most of our clients are in (or approaching) drawdown where volatility and sequence risk will be major concerns to them.
These factors have caused us to reconsider our own strategy and assess the need to build a new range of portfolios, which will cope with the tough investment environment that we believe lie ahead.
The reasons for our concerns about the future economic / investment environment are:
- At some point in the next few years, we will have to see the end of quantitative easing and maybe move into a period of quantitative tightening (this was attempted in the last quarter of 2018 by both the Fed and the ECB, but the negative stock market reaction over those three months, has led both to backtrack, for the time being).
- In July 2019, this current economic cycle exceeded the 1990s as the longest expansion since the second world war.
- Most central banks around the world are raising interest rates.
- All positive equity returns are made when the average central bank is in rate cutting mode. Raising rates has equalled negative global equity returns average = -0.70% pa.
- We are starting to experience a global economic slowdown.
- The US stock market is now very expensive, both in comparison to the rest of the world and versus its own history.
- There are a series of on-going geopolitical risks that could derail markets (ie trade wars between US & China, Brexit, rising military tension in the Middle East, the Italian debt crisis).
- Sterling is now weak against both the dollar and the euro and so there must be a good chance that this trend will reverse, leading to a stronger pound.
We have a view that the strategic asset allocation approach that has worked so well since 2008, will not be as effective over the next five years or so.
As a result, we believe a more tactical approach, covering a broader asset range will provide the diversification and efficiency that will be required in the brave new world before us.
This article was written for International Adviser by Patrick Murphy, founder of Zen Wealth, which was recognised in International Adviser’s Best Practice Adviser Awards 2018 for Excellence in Investment Planning in the UK region.
The awards are run in partnership with Old Mutual International.
