It’s difficult to answer the question, “Is my investment advisor doing a good job?” Predictably, all investment advisors report that they are “doing great” and are “above average.” They all provide compelling charts, graphs and benchmarks to confirm their conclusions. The reason that this question is so hard to answer is that the capital owners (the “employers”) have failed to clearly define and measure the job for which the investment advisor (the “employee”) has been hired. Too often, defining the investment objectives and key performance indicators is left to the investment advisor with predictable results. It is for the capital owner (employer) to define the job that the investment advisor (employee) has been hired to accomplish. Absent clear instructions from the employer, it is impossible to evaluate the employee’s investment acumen.
A prudent capital owner will: (1) identify the financial objectives they are seeking to accomplish; (2) define investment policies that inform the investment advisor’s activities; and (3) establish procedures to test that the policies are being complied with. This three-step process is the framework for effective investment governance for both large and small portfolios. The capital owner’s question “Is my investment adviser doing a good job?” cannot be answered unless these investment policies and procedures have been established in writing.
The Job Description
The investment advisor’s job is to: (1) design a portfolio that is expected to accomplish the client’s financial objectives with low relative risk; (2) select the products, securities, or sub-managers that they feel will best optimize the portfolio they have designed; and (3) make tactical shifts with either the asset allocation or security holdings based on their assessment of prevailing risks or price deviations from intrinsic value. That is the job for which the investment advisor is being hired.
The Employee Review
Once the job has been defined by the employer (capital owner), the outcome that the employee (investment advisor) is being hired to manage toward must be defined. Following is an example of key objectives and expectations that are the foundation of the investment advisor’s employment. (The capital owner’s particular investment objectives, expectations, policies and procedures will likely differ from the sample answers provided in this illustration.)
- Long-Term Targeted Return: Inflation + 3%, which can be alternatively stated as 6%, in a normalized inflation environment.
- Investment Time Horizon: The remaining life expectancy for the capital owner is projected to be 32 years per the IRS actuarial tables.
- Projected Distribution: $200,000 per year (4% of the $5,000,000 portfolio value).
- Risk Expectations: 10% Standard Deviation with a normal range of annual returns between 16% on the high side and <4%> on the low side.
- Bear Market Expectations: Temporary downside deviation of <20%> or $1,000,000 of the current $5,000,000 portfolio value.
Investment Policies & Procedures
Not only will the employer (capital owner) define the performance objectives as noted above, but they will also define the parameters that the employee (investment advisor) is to adopt while doing their job. Following is an example of the key Investment Policies and Procedures that a capital owner should define. (Again, the capital owner’s particular investment objectives, expectations, policies and procedures will likely differ from the examples provided in this illustration.)
Performance Reporting: Performance reporting shall be provided at least quarterly and will be calculated according to the CFA Institute’s performance standards (time weighted rate of return net of fees).
Benchmarking: The portfolio will be compared against a series of blended benchmarks that reasonably approximate the risk and return characteristics of the portfolio. These benchmarks will include, at a minimum: (1) an advisor-suggested benchmark; (2) a strategic benchmark*; and (3) a peer group benchmark.
Liquidity Requirements: At least 90% of the portfolio shall be invested in securities that can be liquidated within 2 business days of the capital owner’s instructions (SEC T+2 settlement). The balance of the portfolio (10%) may be invested in investment products or strategies that do not provide 2-day liquidity.
Alternative Investments: So called “Alternative” investments may be used in the portfolio so long as: (1) the liquidity requirement above is met; and (2) appropriate disclosures about these assets are made by the investment advisor. In those instances when the advisor recommends that an “Alternative” investment be included in the portfolio, the advisor shall provide the following disclosures in writing:
- A description of the investment;
- The expected term of the investment;
- The level of capital committed to the investment (both in $ and %);
- A summary of the fees associated with the investment;
- A disclosure of any potential conflicts of interest that may exist;
- The anticipated risk (standard deviation) of the investment as a ratio to that of the S&P 500;
- The anticipated return of the investment as a ratio to that of the S&P 500; and
- The expected correlation to the S&P 500.
Diversification: On an annual basis the investment advisor will provide a report that identifies the largest five: (1) non-pooled holdings; (2) industry sectors; and (3) asset classes held in the portfolio (both by $ and %). If there is concentration greater than what a prudent investor would accept, a memo will be written memorializing the rationale for the concentration.
Investment Cost: On an annual basis the fee charged by the investment advisor shall be compared to the results from an independent fee study comparing portfolios of comparable size, complexity and product mix. Additionally, this report shall include the weighted cost of the underlying pooled investment products or sub-advisors as compared to the average expense ratio of the no-load mutual fund universe for the same asset classes.
Without a job description an employee’s performance cannot be assessed. Without written investment governance policies and procedures an investment advisor’s efficacy cannot be evaluated.
For the most part, the investment industrial complex is at best unable, or at worst unwilling, to provide this level of documentation or accountability to their investment process. Their internal compliance departments simply will not allow them to do provide this level of detail. Further, they, like all employees, are not in the position to independently assess their own activities.
Anodos helps capital owners develop and manage an investment governance process. For many of our clients this oversight responsibility is not merely a subject of curiosity, but a duty they are obligated by statute to fulfill on behalf of the beneficiaries and organizations they serve. What makes Anodos unique is this is all we do. We don’t manage money, sell insurance, or accept referral fees. We don’t have a horse in the race.
*The Strategic Benchmark is made up of the Russell 3000, MSCI ACWI ex US and Barclays Aggregate Bond indexes in proportion to the portfolio’s beginning allocation.
At times it becomes necessary to end a relationship with one investment manager and begin a relationship with a new firm. When such a change has been decided upon, it is best practice to not rush to the next investment manager that promises good returns, low fees, and excellent client service. Instead, a thoughtful investor will take the time to solicit proposals from several investment managers who have a good reputation and standing within the investment community.
This “manager search” will include the following steps:
- Identify candidate managers.
- Contact candidate managers to determine if they are willing to participate in a formal Request for Proposal process.
- Deliver a data collection packet to the candidate managers (link to sample).
- Collect candidates’ investment responses/proposals.
- Evaluate similarities and differences between the candidates’ responses.
- Evaluate whether the candidates’ responses are in harmony with the client’s own investment objectives and principles. (In most cases clients have not taken the time to define these unique financial objectives and investment principles. It is really important that these be defined because they will serve as the foundation of the engagement with the new investment manager.)
- Deliver to the selected candidate(s) the client’s Investment Objectives, Principles and Procedures document, and coordinate relationship and asset transition.
Download Sample RFP Questions
At Anodos, we help our clients answer the question, “Is my investment advisor doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance, or accept referral fees. We don’t have a horse in the race.
Many investors ask, “Is it better to have a big bank (Goldman Sachs, for example) as my investment advisor or a Registered Investment Advisor (Bel Air, for example) to manage my money?” Following is a summary of the costs and benefits of each. The best investment platform should be determined by each investor’s unique preferences and principles. In short, reasonable minds can differ.
Bank Advantages Over RIA
- Too big to fail. Very rarely will a bank go out of business, but RIAs will with greater frequency have ownership transitions through acquisition, merger, or closure.
- A flexible platform. Each advisor has broad latitude to meet their client’s needs in a way that they believe is suitable. Few banks dictate an institutionalized solution that must be accepted. Depending on the bank, the platform varies from flexible to very flexible in how the advisor may decide to implement the client’s portfolio.
- “Deal flow” Banks have a distinct “investment banking” department that provides bank investment clients early access to interesting private equity deals and new issue public offerings.
- Greater autonomy and flexibility in fee negotiation. Each advisor is a business unit that can, within company guidelines, establish the client-level fee for the particular services or products being provided to that client. RIAs are much less flexible in their fee negotiations.
- Integrated banking functions with investment management solutions. Cash flow management, short-term credit facilities, long-term credit facilities (mortgages), personal banking, insurance, et cetera can be provided under one roof.
RIA Advantages Over Bank
- Fiduciary Standard applies to all accounts. An RIA is not allowed to receive income from any other source than the client. It is difficult, even impossible, for a bank to say that there are no potential conflicts of interest in their management implementation.
- Institutionalized investment process. Investment decisions are typically made by an investment committee that has a definable and defensible investment strategy and process that is institutionalized and does not vary from client to client. Few banks have this rigid, institutionalized investment process. Most banks have a collaborative “so what do you think about this strategy” approach which makes accountability and measurement of future results difficult to directly attribute to the advisor. This blurring of lines of responsibility is less likely to happen with an RIA. If you like what they do, you buy their strategy and get their solution.
- Fees tend to be easy to calculate. Fees charged on “assets under management” utilize an agreed upon fee schedule. Most banks have a variety of fee arrangements which differ between clients based on the various strategies that the investment advisor recommends.
- Service continuity. You deal with employees at an RIA who may come and go, but if they leave the firm, there is service and strategy continuity. There is little risk of advisors moving from firm to firm every few years and asking clients to follow them because the “new firm offers more flexibility.”
The investment industry is embroiled in a “great debate” concerning which investment philosophy is best: active vs. passive management. The debate concerns how the building blocks (asset classes) that make up the portfolio are constructed. The raging question is whether investment advisors should use passive index funds and ETFs as the building blocks or whether it is better to use more active sub-managers or products.
But this “great debate” is a head fake. It misses the elephant in the room. The main issue is NOT whether the investment advisor used active vs. passive building blocks. The issue is whether the investment advisor’s subsequent strategic and tactical allocation decisions with those building blocks, be they active building blocks or passive ones, were cumulatively beneficial or harmful to the investor’s risk and return experience. We have known for decades that the primary driver of the portfolio’s eventual performance is the relative weighting of the asset classes the investment advisor selects, not whether the allocation decisions are implemented using active vs. passive products or sub-managers. An investment advisor could build a “bad” portfolio using only passive products in the same way another advisor could build a “good” portfolio using actively managed products. (Good and bad in the prior sentence is defined by the risk and return characteristics of the portfolio over an extended holding period.)
If 90% of the results will flow from the investment advisor’s strategic and tactical allocation decisions, shouldn’t the effort be placed on measuring the effect of these decisions rather than whether the investment manager uses active or passive building blocks in their implementation? Shouldn’t 90% of investors’ time be spent developing governance processes to test whether their investment advisors’ strategic and tactical allocation decisions were beneficial or not, irrespective of whether active vs. passive products/managers were used to implement these decisions?
If the capital owner is a Business Manager or other fiduciary (individual trustee, ERISA trustee, endowment trustee, et cetera), this practice of establishing several key performance indicators to test the effectiveness of the investment manager’s strategic and tactical decisions is central to accomplishing the fiduciary’s oversight duties.
Following is a link to a white paper that explains these benchmarking best practices.
Link to Benchmarking White Paper
Josh Yager | Portfolio PI
At Anodos, we help our clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance, or accept referral fees. We don’t have a horse in the race.
The Problem: You are a business manager(1), and it is either explicitly or implicitly the case that you are responsible for monitoring the activities of the investment managers that have been entrusted with your clients’ capital. (If you are not a business manager or disagree with this statement, stop reading. This paper does not apply to you.) The problem is that most business managers don’t have the internal systems, licensure, training, staff support, or time to conduct the independent monitoring functions that their clients expect and the law requires(2).
The Way It Is: In response to this problem, many business managers rely on the current money managers to evaluate their own investment acumen. These self evaluations produce predictable results. The incumbent managers typically report, “We did great! We are above average!” Looking for a more objective analysis, business managers frequently ask a competing money manager to review the portfolio designed by the current money manager. Again this “peer review” has predictable results; the competing money manager reports that the incumbent manager is a knucklehead and that the Business Manager should fire the incumbent manager and higher the candidate manager because they are “above average.”
The Way It Should Be: It should be easy to answer the question, “Is my client’s investment manager doing a good job?” And it is easy if the business manager takes the time to define what the job is that the investment manager is being hired to do. Good investment governance begins with the business manager helping their client document the outcomes that the investment manager is being hired to accomplish. Not only should the job description include the financial objectives being pursued, but also the parameters or investment principles that the client holds. This job description will include, at a minimum, the client’s targeted rate of return, the anticipated contribution & distribution rate from the portfolio, the agreed upon fee to be paid to the investment manager, the maximum allocation to illiquid investments, a policy regarding the minimum amount to be allocated to a capital reserve (a “bond bunker” made up of short-term, investment-grade bonds), and how frequently and by which party independent monitoring and review will be conducted.
Your Job v. Their Job: Once the “Job Description” has been approved by the client and delivered to the investment manager it is important that the business manager’s role be constrained to monitoring the actual results versus the documented objectives. Too many business managers are willing to accept responsibility for strategic and tactical portfolio decisions which are beyond their contractual responsibility, legal authority, or licensure. It is reasonable for the business manager to have an opinion that their client relies upon, but if the business manager does not have the legal authority to do so, their personal views should not dictate policy. The allocation, strategy, and tactics are the investment manager’s responsibility, though they must remain consistent with the “Job Description” that has been given to them. The business manager’s job is to be the arbiter of whether the investment manager’s recommendations stay within these defined bounds. If the business manager confuses their job (monitoring and reporting) with the investment manager’s job (investment allocation and tactics), the business manager opens the door for a charge by the investment manager that “the business manager told me to do it this way. It’s not my fault that things went badly.” The investment managers have and will continue to make this claim under oath because in most cases it is true.
The Portfolio Audit: A truly objective portfolio audit is designed to compare the actual outcome produced by the investment manager’s decisions against a series of predefined objectives and key performance indicators. To preserve the independence and objectivity of the review process, the auditor must be disqualified from ever managing the portfolio that is being audited. The auditor should also have a depth of experience and training to conduct such an audit. Knowing how to manage money and knowing how to conduct a portfolio audit are close disciplines, but they are not the same. There are five central questions that any portfolio audit should answer:
- Is this portfolio likely to accomplish the desired objective?
- Is the return that was realized appropriate given the risk taken?
- Is the portfolio reasonably diversified?
- Is the advisory fee fair given the portfolio size and objectives being pursued?
- Are there any operational risks with the investment manager or their company?
The Admonition: That’s how to watch the hen house. Go and do likewise.
Anodos helps clients answer the question, “Is my investment manager doing a good job?” Many of our clients are individual trustees, business managers, ERISA trustees and endowment board members who are obligated to independently monitor the activities of the agents to whom investment duties have been delegated. What makes us unique is this is all we do. We don’t manage money, sell insurance or accept referral fees. We don’t have a horse in the race.
(1) Typically a hybrid accounting practice providing a variety of related service (accounting, audit, bookkeeping, investment oversight, royalty audit, financial project management, et cetera) for high net worth clients typically in the entertainment, sport, or other creative performing arts industries.
(2) CalProbate Codes 16052(a)(i,ii,iii) re prudent selection, delegation and monitoring of investment advisory functions.
Do “big investors” have better investment results than “small investors”? Many business managers expect that their wealthy clients with large portfolios ($25m+) should have better returns because the clients have access to the best and brightest members of the investment industrial complex. Many business managers believe that size does matter.
Based on our experience of doing investment manager audits since 2005 for portfolios as small as a few hundred thousand dollars to mega pension plans exceeding $20b, the size of the portfolio is not a contributing factor in the portfolio’s risk and return outcome. To be sure, larger investors do have access to esoteric, non-correlated, alternative investment products. But these more exotic investment options that are only available to “qualified” investors add complexity, cost, and opacity to the investment process which smaller investors are not burdened by. Given a similar asset allocation, we have not observed that the risk and return outcomes of large portfolios are better than the retail investment options available to investors of more modest size. In short, size does NOT appear to matter.
If you disbelieve our observation, simply test the performance of your largest client’s portfolio against the return produced by the Vanguard Lifestrategy Moderate Growth mutual fund (VSMGX) which has a globally diversified 60% equity and 40% bond allocation and requires a minimum investment of only $3,000. If the best and brightest minds in the investment industry can’t outperform this retail mutual fund that is designed for investors who are just starting out, it puts into question the assumption that size matters. (If your largest client’s portfolio is more conservative than a 60% equity and 40% bond allocation, you can instead use the Vanguard Lifestrategy Conservative Growth fund (VSCGX) which has a 40/60 allocation.)
I am not arguing that business managers rush off and recommend that their clients fire their investment managers and move all their money to Vanguard funds or a model portfolio from Betterment. I merely suggest that a prudent business manager will test the thesis that the investment industrial complex purports–that the big guys do better than the little guys. Trust, but verify.