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.
Josh Yager, Esq., CFP®, ChFC®
Anodos helps individual trustees save time, reduce their personal risk, and fulfill their fiduciary duties. We do this by helping trustees develop and maintain a series of governance documents which demonstrates they have fulfilled each of their duties of care. We also will act as an expert witness to defend our clients’ findings in court. What makes us unique is that trustee governance support is all we do. We do not manage money, sell insurance, or accept referral fees. We don't have a horse in the race.
We help trustees save time, reduce risk, and fulfill their fiduciary duties. What makes us unique is that trustee governance support is all we do.