A long-term investment strategy requires alternation only when the underlying factors of the client’s goals and objectives change. These changes tend to be infrequent, if not rare, and reviews directed toward constantly reassessing existing policy tend to be counterproductive. You should be particularly cautious of making changes during periods of market extremes.
Despite the infrequent need for policy modifications, periodic reviews can serve a very productive purpose. When aimed at educating the client, reviews can reinforce the logic for current policy and therefore reduce the chances of unnecessary alterations. In addition, whenever significant events occur that warrant a review, you should ensure that the strategy is examined in an orderly fashion.
The preparation and maintenance of the client’s investment strategy is the most critical function you perform as a fiduciary. The second most critical function is monitoring. This is the Step and the Dimension where you will likely make the most mistakes and, even when executed properly, will be the costliest component of your practice—in terms of your time, the staff required, and the technology to be employed.
When done properly, monitoring triggers a number of periodic reviews:
Monthly: At least monthly, you should analyze custodial statements.
Quarterly: (1) Compare the performance of each investment option used in a client’s portfolio to an appropriate index and peer group. (2) Determine whether a client’s portfolio should be rebalanced back to the asset allocation determined in Step 3. The discipline of rebalancing, in essence, controls risk and forces the client’s portfolio to move along a predetermined path.
Annually: Review the client’s strategy to determine whether goals and objectives have changed, and whether the investment strategy still holds the highest probability of meeting the client’s goals and objectives.
Central to the monitoring function is performance attribution analysis, which consists of two overlapping and sequential procedures: (1) performance measurement, the science; and (2) performance evaluation, the art.
Performance measurement consists of calculating portfolio characteristics, statistics (standard deviation, Alpha, Sharpe, and Sortino Ratios), and rates of return. Although performance measurement is referred to as the “science,” it is far from being exact.
The source and handling of the data used in performance measurement may have an impact on calculations. For this reason, you should request performance information from different sources to try to catch potential errors. For example—the rate of return calculated by the client’s custodian may differ from the rate of return reported by the money manager; and both of these returns may yet be different from the rate of return you calculate using your own performance measurement software. Like navigating a ship at sea, the prudent sailor takes as many bearings as possible to try to triangulate an exact fix.
Performance evaluation is where your skills as a fiduciary come into play: the client will be looking to you to identify the appropriate call to action. It is this phase of the analysis where you compare the results of the performance measurement to the client’s investment strategy and, if needed, suggest appropriate action to bring the investment strategy back into alignment.
- What is the current asset allocation of the overall portfolio?
- Does it need to be rebalanced? If so, what are the client’s cash flows for the coming six months; and can these cash flows (contributions or disbursements) be used to rebalance the portfolio?
- How has each investment option performed relative to their indexes and peer groups? Is there evidence that a money manager may be deviating from their strategy?
- Are there managers that should be placed on a watchlist, or even terminated?
The decision to terminate an investment option should not be taken lightly, since there are a number of costs associated with changing managers. When poor performance becomes an issue, it is important that you approach the evaluation process with the same rigor you applied when you conducted your due diligence process on the manager. In fact, we suggest it is prudent to apply the same criteria that you used in the due diligence phase:
- Has there been a change to the portfolio team?
- Has the firm encountered legal or regulatory problems?
- Has there been a change in the manager’s strategy?
- Has there been a change in the asset allocation structure of the manager’s portfolio (for example, is the manager beginning to hold more cash)?
- Has there been a marked increase in portfolio turnover?
- Has the manager consistently performed below the returns of an appropriate index, or below the manager’s peer group?
- Has risk-adjusted performance (Alpha, Sharpe, Sortino Ratio) dropped below the performance of an appropriate index, or below the manager’s peer group?
Over the years, we have seen a lot of fiduciaries try to come up with a quantifiable way to determine when an investment option should be terminated—for example, so many quarters below a certain benchmark. We think a disciplined methodology is essential, however, the best approach is remarkably simple: Fire the investment option when you have lost confidence in the money manager’s ability to do the job.
Whether you are helping the client define their goals and objectives, developing the client’s investment policy, or implementing and monitoring the strategy; the success of the client’s investment program will be determined by the quality of your decision-making process. For that reason you also should develop effective assessment procedures to evaluate the strengths and weakness of your practice, and also to assess your effectiveness as the leader of that practice.
We are one of the last professions not to have defined standards and assessment procedures. Standard-setting and corresponding assessment procedures are the norm today, with more than 15,000 internationally recognized standards. Assessment procedures, in turn, all share certain attributes—the procedures help determine whether:
- There is conformance to a defined standard (to the Dimensions in this case);
- The entity (your practice) can comply with statutory, regulatory, and contractual requirements;
- The entity can meet its goals and objectives; and
- There are areas for potential improvement.
There are numerous benefits to having a defined assessment process:
- It demonstrates to clients, compliance officers, and regulators that you have a procedurally prudent investment process in place.
- The assessment process can double as a training curriculum—for educating your clients and staff.
- It may help you discover blind spots—shortfalls and omissions to your investment process.
- It can facilitate the sharing of best practices with other investment advisors.
- At some point in the future, P&C insurers providing liability insurance for investment advisors will likely start providing “good advisor” discounts to those advisors who can demonstrate conformance to a defined standard.
- It can help improve the investment services you provide to your clients—an objective worthy of all of our efforts.
The legal and practical scrutiny you undergo as a fiduciary is tremendous. It comes from multiple directions and for various reasons. Over the last few years, this scrutiny has increased liability.
The most common mistake made by fiduciaries is the omission of one or more prudent practices, as opposed to the commission of a prohibited transaction or being involved in a conflict-of-interest. However, instances of the latter are common enough that you should monitor your services for possible breaches. Any activity that is not in the best interests of the client will cause problems, and it is critical that you ensure that no party has been unduly enriched by a client’s portfolio.
The undivided loyalty you owe your clients means that you do not invest or manage assets in such a way that there arises even a hint of a personal conflict of interest. You have a duty to employ an objective, independent due diligence process at all times; and have defined policies and procedures to manage potential conflicts of interest.
The ability to build client trust and maintain client loyalty, are critical success factors for anyone who serves in the financial services industry. Trust has become the new currency on Wall Street. It doesn’t matter whether you’re a broker, agent, or advisor; or, whether you’re with a money management firm, custodian, or any other service vendor that provides valuable collateral support.
There are 7 essential traits – 7 C’s – that you need to demonstrate in order to build trust and loyalty.
You need to be:
2. Communicative: You need to be persuasive in the spoken and written word; know how to customize communications to your audience; and be affable, cordial, and demonstrate a sense of humor. Did you ever notice how difficult it is to trust someone who can’t smile, or take a joke?
3. Cognitive: To succeed over the long-term, you need to have a sustained passion for continuous improvement, and be a life-long learner. You need to demonstrate the ability to draw upon your training and experience so that you can deal effectively with abstract concepts, market volatility, and the introduction of new products and services.
4. Collaborative: A key to success is the ability to marshal resources. This statement is as true today as it was in the days of cave dwellers. Collaborate, or die. No single service provider has all the products or answers, and you will raise anxiety and generate distrust when you provide your clients with single-set solutions.
5. Committed: You must be able to demonstrate the distinctive patterns of our professional ethos – the behavior, core values, and unique decision-making process that is at the heart of our profession. You need to communicate a sense of purpose, and demonstrate passion for that purpose.
6. Conscientious: Trust and loyalty are values-based, and nothing erodes trust faster than evidence of character flaws. It’s why your reputation is so important, and why you need to be deliberate in whom you work for, associate with, and support.
7. Courageous: Our industry is often maligned because those who know better have often turned a blind eye. The most pressing problem with our industry is that legal opinions and compliance requirements have become the prosthesis for courageous and ethical decision-making.[/mk_custom_list]
To be a trusted advisor, clients must view you as a leader, steward, and prudent decision-maker. You must demonstrate that your work is meaningful, and that you are committed to serving others.